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News April 27, 2015 Issue

BlackRock Conflict of Interest Case Includes First Rule 38a-1 Board Disclosure Charge

The SEC appears intent on using as many of the arrows in its quiver as it possibly can.

Those "arrows" include the rules that the SEC recently for the first time charged firms or funds with violating, such as the Pay-to-Play Rule (ACA Insight, 6/30/14) or the rule prohibiting retaliating against a whistleblower (ACA Insight, 6/23/14).

On April 20, the SEC let fly a new arrow, this time charging an advisory firm and its chief compliance officer with causing the violation of an Investment Company Act Rule 38a-1 requirement to report material compliance matters to fund boards. It hit a major bullseye – the firm was BlackRock Advisors, which paid a $12 million penalty to settle the case.

The settlement is also another example of the Division of Enforcement’s focus on conflicts of interest. In this case, the alleged conflict involved a BlackRock managing director/co-portfolio manager in its energy sector starting up and managing his own oil and natural gas production company.

"This case fits squarely within the SEC’s long history of alleging violations against investment advisers who fail to disclose conflicts of interest," said Zaccaro Morgan partner Nicolas Morgan.

The conflict of interest charge

The managing director, Daniel Rice III, who joined BlackRock in 2005, founded the family-owned-and-operated company, Rice Energy, in 2007. He personally invested approximately $50 million, according to the administrative order instituting the settlement, and his three sons took top positions at the firm, specifically as chief executive officer, chief financial officer, and vice president of geology.

In February 2010, Rice Energy formed a joint venture with a publicly traded coal company held in the BlackRock funds and accounts that Rice himself managed, the SEC said. By the end of June 2001, the coal company’s stock was the largest holding – almost 10 percent – in the $1.7 billion BlackRock Energy & Resources Portfolio that Rice managed, according to the administrative order.

BlackRock and its CCO, Bartholomew Battista, knew of Rice’s plan to start Rice Energy and the conflict of interest it presented, but did not inform the board of directors, the SEC said. Battista agreed to pay a $60,000 civil money penalty to settle the charges against him.

"BlackRock violated its fiduciary obligation to eliminate the conflict of interest created by Rice’s outside business activity or otherwise disclose it to BlackRock’s fund boards and advisory clients," said SEC Division of Enforcement director Andrew Ceresney. "By failing to make such a disclosure, BlackRock deprived its clients of their right to exercise their independent judgment to determine whether the conflict might impact portfolio management decisions."

As for violating Rule 38a-1, also known as the Compliance Program Rule for investment companies, SEC Division of Enforcement Asset Management Unit co-chief Julie Riewe noted that "this is the first SEC case to charge violations of Rule 38a-1 for failing to report a material compliance matter such as violations of the adviser’s policies and procedures to a fund board." Both BlackRock and Battista were charged with having caused the BlackRock funds’ violation of the Rule, which requires a fund to adopt a compliance program, retain a CCO, and report material compliance matters to the board.

The SEC, in the settlement, made much of BlackRock’s alleged approval of Rice’s outside business activity, which gave rise to the alleged conflict of interest, even though the business activity may have violated the firm’s private investment policies, Morgan said. "Advisers should expect that the SEC will give heightened scrutiny to any activities that violate internal policies."

Further, the SEC criticized BlackRock’s alleged failure to monitor Rice’s business activity in the approximately three years that followed, during which time the activity increased in scope, Morgan said. "This highlights the need for investment advisers to reassess compliance issues even after an initial determination is made to ensure ongoing compliance in the face of changing circumstances."

BlackRock was also charged with willfully violating Advisers Act Rule 206(4)-7, the counterpart to Investment Company Act Rule 38a-1. In addition, the firm was charged with willfully violating Sections 206(2) and 206(4) of the Advisers Act. Attorneys representing BlackRock and Battista did not respond with comments to voice mails and emails.

Adviser and fund responsibilities

The Blackrock settlement really shows how interlinked the various securities laws have become.

"What you have is a feedback loop of sorts," said Stern Tannenbaum partner Aegis Frumento. That’s because under the Advisers Act, investment advisers may not engage in conflicts of interest, must have policies and procedures to prevent such conflicts, and must disclose such conflicts to its registered funds. Those funds, governed by the Investment Company Act, have an obligation to ensure that their investment advisers are compliant with all their legal requirements, and the funds’ CCOs must report to the fund board any lapses by the investment adviser.

"Since the investment adviser in this case allegedly did not disclose its issues to the funds, the funds did not know there were any issues to report to their boards," he said. "So, the investment adviser ends up directly violating the Advisers Act, and indirectly causing the funds to violate the Investment Company Act."

"The next shoe to drop in this scenario," Frumento said, "may be to hold investment companies responsible for making sure that their investment advisers have adequate policies and procedures in place to prevent things like this from happening. Funds registered under the Investment Company Act may well find themselves being deputized to review and pass muster on the adequacy of the policies and procedures of the investment advisers they work with. I can easily see investment company CCOs being liable if the SEC thinks they’ve turned a blind eye to compliance policy or procedure lapses by their investment advisers."

Compliance and the CCO

BlackRock did not have written policies and procedures regarding the outside activities of employees, only a requirement for pre-approval for an employee to serve on a board of directors, the SEC said. The firm had only a "general" conflicts of interest provision in its Code of Business Conduct and Ethics "that addressed conflicts or potential conflicts that could arise from the personal activities or interests of BlackRock employees."

Specifically, the agency claimed that BlackRock failed to adopt and implement policies and procedures that:

  • Addressed how the outside activities of BlackRock employees would be assessed for conflicts of interest, as well as who would be responsible for determining whether such activities would be permitted, and
  • Would monitor employees engaging in firm- approved outside activities.

"As BlackRock’s CCO, Battista was responsible for the design and implementation of BlackRock’s written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules," the SEC said. "Battista knew and approved of numerous outside activities engaged in by BlackRock employees (including Rice), but did not recommend written policies and procedures to assess and monitor those outside activities and to disclose conflicts of interest to the funds’ boards and to advisory clients."

BlackRock adopted new written policies and procedures addressing the outside activities of employees in January 2013.

What BlackRock knew and when it knew it

If what the SEC charged in its administrative order is true, BlackRock learned that Rice had formed and funded the Rice Energy Irrevocable Trust to hold interests in Rice Energy, "in violation of BlackRock’s private investment policy," by January 2007.

"By at least that time, certain BlackRock senior executives, including Battista, were told that Rice intended to form and fund Rice Energy," the SEC said. "BlackRock’s legal and compliance department, including Battista, reviewed and discussed the matter and allowed Rice to form Rice Energy. BlackRock concluded that it did not see any conflict of interest with regard to Rice Energy. By no later than January 2010, BlackRock learned that Rice had made additional loans of approximately $14 million to a Rice Energy subsidiary in violation of BlackRock’s private investment policy.

But did BlackRock report its knowledge to the boards of directors of the Rice-managed funds or to its advisory clients? Not according to the SEC, which said the firm "did not report the formation or the funding" of Rice Energy or the trust to the boards. "BlackRock also did not advise the funds’ boards of Rice’s violations of BlackRock’s private investment policy. BlackRock did not monitor or reassess Rice’s outside business activity and the conflicts associated therewith between January 2007 and January 2010."

Memory and follow-up

In January 2010, things began to get interesting. Rice told BlackRock that he wanted to serve on the joint venture’s board, at which point "BlackRock’s legal and compliance department did not recall its review of Rice Energy in early 2007" and "incorrectly" believed that Rice’s new request "was the first time it was learning about Rice Energy," the SEC said.

The next month, according to the agency, the Blackrock legal and compliance department sent Rice a memo expressing concerns about potential conflicts of interest. "There are potential conflicts of interest in entering joint ventures with companies that you hold in your BlackRock client portfolios and funds," said a memo excerpt, provided by the SEC in the administrative order.

Despite this stated concern, however, the firm allowed Rice to continue his involvement with Rice Energy while serving as a firm portfolio manager, the SEC charged. The firm did put some conditions on Rice’s involvement, however, stating that he could not participate in any decisions involving the joint venture, could not become a joint venture board member, could not receive material information about the joint venture that could restrict his ability to trade in the coal company’s stock, and would have to pre-clear any future Rice Energy-related board seats that he wanted.

The firm did not disclose any of this, including the memo, to the fund boards or to advisory clients, the agency said.

Nor, the SEC said, did BlackRock initiate any follow-up thereafter with Rice about Rice Energy. "Instead, BlackRock expected Rice to report back to BlackRock." The firm also did not verify whether steps specified in the memo, such as removing references to BlackRock from the Rice Energy web site, were taken, the agency said. "Ultimately, those references were not removed until after … June 2012 press articles about Rice’s involvement with Rice Energy raised questions about related conflicts of interest."

Drilling down on the conflict allegation

Not everyone can afford to invest $50 million into a family investment. But Rice, according to the SEC, "was one of BlackRock’s most highly compensated portfolio managers." As an incentive to Rice in the firm’s recruitment of him in late 2004, BlackRock agreed to pay him a portion of the annual investment advisory fees Rice earned on the funds and separate accounts he managed, the agency said.

After forming Rice Energy, Rice also set up a number of subsidiaries, the result of which was to give him the ability to "exercise broad power and authority over Rice Energy," the agency said. Between 2007 and mid-2010, according to the SEC, Rice funded or loaned to Rice Energy approximately $50 million.

The three sons in key executive positions at Rice Energy "routinely shared information regarding Rice Energy operational issues with Rice, and sought and received direction and advice from Rice," the agency charged, adding that Rice himself was a manager at two Rice Energy drilling subsidiaries. "Rice and his sons exercised their power and authority to manage the business and affairs of the companies and made decisions on their behalf."

The conflict of interest even extended to communications, if the SEC’s allegations are correct. "Rice used his BlackRock email address for Rice Energy related communications during which Rice discussed the
company," the agency claimed.

The joint venture and the portfolio

At the end of the first quarter of 2010, and after the joint venture was formed between Rice and the coal company, the Rice-managed funds and separate accounts held more than two million shares of coal company stock, according to the administrative order. The largest fund, the BlackRock Energy & Resources Portfolio, with $1.2 million in AUM at the time, held a 3.5 percent position in the coal company, "making it one of the fund’s top 10 largest holdings," the SEC said.

By the end of the second quarter of 2011, and following the coal company’s acquisition of still another energy company – shares of which were already held in the Rice-managed funds and separate accounts – the number of shares held in the coal company’s stock "increased to over eight million," the SEC said. The BlackRock Energy & Resources Portfolio, now valued at $1.7 billion, had increased its position in the coal company to 9.4 percent, "making it the fund’s largest holding," according to the agency.