Conflicts of Interest Targeted by SEC’s Asset Management Unit
Most fraud comes down to conflicts of interest – and the Asset Management Unit, one of the more assertive teams within the SEC’s Division of Enforcement, is cracking down on them full bore.
Conflicts of interest are an "overarching concern" at the five-year-old unit, and a risk area into which many smaller risk areas, such as disclosure, fit, said Asset Management Unit co-chief Julie Riewe in a speech at a recent industry conference in Washington, DC.
"In nearly every ongoing matter in the Asset Management Unit, we are examining, at least in part, whether the adviser in question has discharged its fiduciary obligation to identify its conflicts of interest and either 1) eliminate them, or 2) mitigate them and disclose their existence to boards or investors," she said. "Over and over again we see advisers failing properly to identify and then address their conflicts."
"Riewe made clear that conflicts of interest, in their many forms, will remain a major enforcement priority for the SEC, as they have been for the past several years," said Foley Hoag partner Daniel Marx. "If advisers have not recently taken a very careful look at their potential conflicts, there is no time like the present."
Conflicts and disclosure
Riewe described conflicts of interest as "material facts that investment advisers, as fiduciaries, must disclose to their clients." The U.S. Supreme Court, she said, quoting from the 1963 case SEC. v. Capital Gains Research Bureau
, stated that one of the reasons Congress enacted the Advisers Act was "’to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously [emphasis Riewe] – to render advice which was not disinterested,’" and that investors must "’be permitted to evaluate … overlapping motivations, through appropriate disclosure, in deciding whether an adviser is serving ‘two masters’ or only one, especially … if one of the masters happens to be economic self-interest.’"
"There is … no exception to disclosure: no ‘well-meaning or good-faith adviser’ exception for an adviser that legitimately believes it is putting its clients’ interests first notwithstanding any conflicts; no ‘mitigation’ exception for an adviser that believes it has taken adequate internal measures to account for potentially incompatible interests; and no ‘potential conflict’ exception for an adviser that did not act upon the conflict to enrich itself at the expense of its clients," Riewe said.
Riewe’s reference to the 1963 Capital Gains case in her speech may be significant, said Marx. "She may have been signaling that the enforcement efforts concerning conflicts will be even more aggressive going forward. She suggested that Capital Gains stands for the proposition that problematic conflicts broadly include any circumstances that may consciously, or unconsciously, influence advisers to give anything other than disinterested advice to their investors. She also asserted that the law provides no shelter for conflicted advisers that act in good faith, that mitigate but do not disclose conflicts, and that do not act on conflicts but fail to eliminate them. Given these views, advisers should not be surprised if forthcoming enforcement actions push the boundaries on conflicts."
While Riewe stated what most advisers already know, that it is critical to identify all potential conflicts and then either eliminate them or mitigate and disclose them to investors, Marx said, "she went further in noting that addressing conflicts is not a one-time effort but an ongoing, iterative process. Advisers must repeatedly re-evaluate both conflicts and disclosures, particularly as their business models evolve and additional guidance becomes available from the SEC."
Her speech can be read in several ways, suggested
Wilmer Hale partner and former SEC Division of Investment Management associate director Matthew Chambers.
"She says there is no ‘mitigation’ exception for an adviser that believes it has taken adequate internal measures to account for potentially incompatible interests, and no ‘potential conflict’ exception for an adviser that did not act upon the conflict to enrich itself at the expense of its clients," he said. "At the same time, however, she says that the Division of Enforcement will consider if ‘the firm mitigated the conflict and disclosed it’ and whether ‘the firm [has] policies and procedures in place to identify new conflicts and monitor and continually re-evaluate ongoing conflicts.’"
"Given the myriad of relationships and responsibilities in the financial services industry, it’s possible that there are relationships that the SEC would see as presenting a conflict where others might disagree," Chambers said.
With that in mind, he said, "the SEC should take into account whether a firm has made a careful, good faith effort to identify and address conflicts before the agency determines whether to institute an enforcement action, or even began an investigation."
The Asset Management Unit anticipates taking enforcement actions from the results of an ongoing examination sweep called the Distribution in Guise initiative, which focuses on "examining, among other things, conflicts presented by registered fund advisers using the fund’s assets to grow the fund and, consequently, the adviser’s own fees," Riewe said.
Beyond the sweep, she said that the unit expects to scrutinize the following types of conflict:
Best execution failures in the share class context,
Undisclosed outside business activities,
Fee and expense misallocation issues in the private fund context, and
Undisclosed bias toward proprietary products and investments.
Riewe also listed a number of enforcement actions that the Asset Management Unit has already taken to combat conflicts of interest. These include actions against registered funds, hedge funds, private equity funds, and advisers themselves. Among the cases she listed were:
Manarin Investment Counsel
(ACA Insight, 10/14/13). In this 2013 case, the SEC charged an adviser to three funds of funds with breaching its fiduciary duty by failing to seek best execution when it allegedly caused those funds to purchase Class A shares of underlying mutual funds when the funds were eligible to own lower cost institutional shares.
Paradigm Capital Management (ACA Insight, 6/23/14). This 2014 hedge fund case "involved a conflict we see frequently: principal transactions without the required written disclosure and consent," Riewe said. The adviser in the case went so far as to set up a conflicts committee, "but the committee itself was conflicted," as it consisted of the adviser’s chief financial officer and chief compliance officer, each of whom reported to the adviser’s owner, she said.
Lincolnshire Management (ACA Insight, 10/20/14). The SEC alleged in this 2014 case that a private equity adviser misallocated expenses between two portfolio companies owned by separate funds it managed.
Shelton Financial Group.In this January 2015 case, the agency charged an adviser with failing to properly disclose compensation it received from a broker-dealer for investing client assets in certain no-transaction-fee mutual funds, "thus creating incentives for the adviser to recommend certain funds to its clients," Riewe said.
Adviser conflict of interest questions
"Take a step back and rigorously and objectively evaluate your firm, its personnel, its business, its various fee structures and its affiliates," Riewe suggested to advisers. By identifying and then addressing conflicts of interest, either through elimination or disclosure, she said, advisers will be able to both meet their fiduciary duties and avoid enforcement action.
She provided the questions listed under each of the topic areas below for advisers to ask themselves:Dual registration. Is the firm a dually registered investment adviser and broker-dealer, or does the adviser have an affiliated broker-dealer? "If so, the firm will have inherent conflicts risks if it engages in principal transactions or trades through its brokerage arm or an affiliated broker dealer," she said.
Side-by-side client management. Does the firm manage clients side by side? If so, and if the firm’s clients are funds, do they engage in inter-fund lending or investing?
Third-party compensation. Does the firm receive compensation from any third parties for recommending investments or using certain service providers?
Proprietary transactions. Does the firm engage in proprietary trading or investing? If so, has the firm disclosed its potential biases and that its investment advice could be tainted by compensation received from any third parties or from proprietary trading?
Conflict elimination and disclosure. For each conflict identified, as a threshold matter, can the conflict be eliminated? If not, why not? If the adviser cannot, or chooses not to, eliminate the conflict, has the firm mitigated the conflict and disclosed it?
Responsible party. Is there someone – a person, a few individuals, a committee – at the firm responsible for evaluating and deciding how to address conflicts? Is that person or individuals or committee sufficiently objective?
Process. Is the process used to evaluate and address conflicts designed to be objective and consistent?
Policies and procedures. Does the firm have policies and procedures in place to identify new conflicts and monitor and continually re-evaluate ongoing conflicts?
Mitigation. Are the firm’s policies and procedures reasonably designed to address the conflicts the firm has identified, and are they properly implemented?
Written disclosure. Has the firm reviewed all of the relevant disclosure documents – among others, Form ADV, private placement memoranda, limited partnership agreements, client agreements, prospectuses – to ensure that all conflicts are disclosed, and disclosed in a manner that allows clients or investors to understand the conflict, its magnitude, and the particular risk it presents? Does the firm review those documents regularly to ensure that new or emerging conflicts are disclosed in a timely way?
Internal disclosure. Is the adviser keeping the chief compliance officer and board of directors, if any, informed about conflicts of interests, particularly the adviser’s analysis and decisions on whether to eliminate or mitigate a conflict?
"Only through complete and timely disclosure can advisers, as fiduciaries, discharge their obligation to put their clients’ and investors’ interests ahead of their own," Riewe said.
Other 2015 priorities
Aside from its "perennial priority" of cracking down on conflicts of interest, Riewe said that the Asset Management Unit in 2015 divides the vast asset management industry it polices into three primary categories by investment vehicle:Registered investment companies. 2015 priorities include valuation and performance, as well as the advertising of that performance; funds deviating from their investment guidelines or pursuing undisclosed strategies; fund governance, including boards’ and advisers’ discharging of their obligations under Section15(c) of the Investment Company Act when they evaluate advisory and other types of fee arrangements; and fund distribution, including whether advisers are causing funds to violate Rule 12b-1 by using fund assets to make distribution payments to intermediaries outside of the funds’ Rule 12b-1 plan, whether boards are aware of such payments, and how such payments are disclosed to shareholders.
Private funds. 2015 priorities for both hedge funds and private equity funds include conflicts of interest, valuation, and compliance and controls, Riewe said. For hedge funds alone, "we anticipate cases involving undisclosed fees; all types of undisclosed conflicts, including related-party transactions; and valuation issues, including use of friendly broker marks," she said. For private equity funds, expect more undisclosed and misallocated fee and expense cases, which it works on with the agency’s Office of Compliance Inspections and Examinations, she said.
Other client accounts. 2015 is seeing the Asset Management Unit focus on conflicts of interest, fee arrangements and compliance, Riewe said.