Guidance Update Requires Funds to Address Adviser Gifts and Entertainment
Donít be done in by a gift to the adviser managing your fund.
A new guidance update (February 2015, No. 2015-01) from the Division of Investment Management reminds mutual funds that they must address gifts and entertainment to fund advisers in their policies and procedures, as required by Section 38a-1 of the Investment Company Act. Funds that fail to do so may violate not only a fundís code of ethics, but Section 17(e)(1) of the Investment Company Act.
"The staff is highlighting the conflict of interest that arises when the personnel of a fundís investment adviser are presented with gifts, favors or other forms of consideration Ö from persons doing business, or hoping to do business, with the fund," the guidance update states.
Why did the SEC staff issue this reminder now? "Thereís got to be something behind the curtain," said Eaton & Van Winkle partner Paul Lieberman. "When the SEC staff issues a reminder, it could be a predicate for action against those advisers and funds that have taken no remedial action after the reminder was issued."
"Itís possible that, during examinations, the staff is seeing that funds have neglected to address this in their policies and procedures," said Mayer Brown attorney Adam Kanter in speculating as to why the staff chose to re-emphasize this requirement in a guidance update.
Another reason for the guidance, Kanter said, may be that it "makes a little bit more explicit that the staff will look for an indirect link between a gift or entertainment and a transaction, even if there is no direct connection."
Section 17(e)(1) states that "[i]t shall be unlawful for any affiliated person of a registered investment company, or any affiliated person of such person Ö acting as agent, to accept from any source any compensation (other than a regular salary or wages from such registered company) for the purchase or sale of any property to or for such registered company or any controlled company thereof, except in the course of such personís business as an underwriter or broker." Other sections of the Investment Company Act identify a fundís investment adviser as an affiliated person, and the adviserís officers, directors and employees, among others, as affiliated persons of the adviser and second-tier affiliates of the fund, the guidance states.
An example of a conflict of interest that would violate Section 17(e)(1) offered by the SEC staff is when a fundís portfolio manager accepts gifts or entertainment from a broker-dealer in regard to the purchase or sales of the fundís portfolio securities.
"The prohibition reflects one of Congressí fundamental policy concerns when it enacted the 1940 Act [Investment Company Act] ... Ė the potential for funds to be managed, or their portfolio securities selected, in the interest of their investment advisers and their affiliates or other persons, rather than in the interest of the fundís shareholders," the SEC staff said.
Policies and procedures
The staff is typically non-prescriptive in suggesting just how funds should address the receipt of gifts or entertainment by fund advisory personnel under Section 38a-1, although it does offer some suggestions. "The particular policies and procedures concerning the receipt of gifts or entertainment that might be appropriate would depend on the nature of the adviserís business, among other considerations," the guidance says. Possibilities might include:
A blanket prohibition on the receipt of gifts or entertainment by fund advisory personnel; or a
A pre-clearance mechanism for the acceptance of gifts or entertainment to assess "whether they would be for the purchase or sale of any property to or for the fund and therefore prohibited under Section 17(e)(1)," the guidance said.
While the update, since it was written primarily for investment companies, emphasizes Rule 38a-1 under the Investment Company Act, it also reminds funds and their advisers that, pursuant to Advisers Act Rule 206(4)-7, the Compliance Program Rule, registered advisers are required to adopt and implement written policies and procedures reasonably designed to prevent violations of the Adviser Act by the advisers and any of their supervised persons.
The Fidelity Management settlement
Funds have generally been aware of the requirement that fund advisers may not accept gifts or entertainment since the 2008
Fidelity Management & Research Company settlement, said Kanter. In that case, two senior executives and 10 equity traders of Fidelity Management & Research, a registered adviser with approximately $1.25 trillion in assets under management that managed 350 registered investment companies, were accused of collectively accepting approximately $1.6 million in travel, entertainment and gifts from brokerage firms that sought and obtained orders to buy or sell securities on behalf of Fidelity Management & Research investment clients.
The SEC staff, in the guidance update, noted that the improper conduct on the part of Fidelity Management & Research resulted in violations not only of Section 17(e)(1) under the Investment Company Act, but also several sections under the Advisers Act. Specifically, under the settlement, the SEC alleged that the firm and its employees, who did not admit or deny guilt, violated Advisers Act Section 206(2) for failing to seek best execution by allowing its traders to accept gifts, as well as failing to disclose those gifts to investors; and Sections 204, 206(2) and 207 for making false statements in its Form ADV to the Commission. Fidelity Management & Research was ordered to retain an independent compliance consultant and pay a civil money penalty of $8 million.
Given the issuance of the guidance, what should smart compliance officers at advisers and funds do?
Consider the following:
Re-visit codes of ethics, written supervisory procedures, and other policies and procedures. "See whether a change is needed," Lieberman said. "If you have a pre-approval process, how well is it working? See how itís being used. Do you want to continue it?"
Issue periodic reminders about gifts and entertainment policies to staff. Kanter suggested that the holiday season would be a particularly good time to do so.
Dig into books and records, both operational and financial. Make sure you know who keeps copies of records, who supervises their upkeep, and whether the books and records are being utilized. "Trace the money," said Lieberman. "Were exceptions to any practices granted?" he asked, and, if so, "Was there an appropriate review process?"
Certification. "Specific certifications regarding acceptance of gifts and entertainment can be included in other quarterly or annual certifications that an adviser or fund might have in place," Kanter said.
Refocus on conflict of interest disclosures in Form ADV and in fund prospectuses. "If the disclosures donít match whatís conducted in the business office, there is a serious issue," Lieberman said.
Utilize the training program. Send out a compliance bulletin including the guidance update, reemphasizing the SEC staffís concerns. Urge employees to review policies and procedures, as well as current conflict disclosures, Lieberman said.