Third-Party Agreements: Ensure Clients Don’t Get Burned by Conflicts of Interest
Advisers may see agreements with other advisory firms as a way to enhance revenue. While such third-party agreements may on their face bring in additional dollars, advisers should also take precautions that they don’t create conflicts of interest with clients. When that happens, the agreements may bring in more than additional revenue – they may bring in SEC examiners and investigators.
Advisory firms considering such arrangements may want to review the agency’s recent settlement with Lyxor Asset Management, a New York City-based advisory firm with approximately $11 billion in assets under management. Lyxor, which primarily services institutional clients, is a subsidiary of the French asset management firm, Lyxor Asset Management S.A.S.
Lyxor’s conflict arose from an agreement, described by the SEC as a "side letter," the advisory firm made with two third-party advisers. Under the agreement, the third-party advisers would make payments to Lyxor based on the total amount of Lyxor client assets placed or maintained in certain funds advised by the third-party advisers.
Not only did Lyxor receive approximately $648,000 in fees from the third-party advisers between July 2012 and September 2014, according to the administrative order instituting the settlement, but – perhaps more importantly – the firm did not disclose the arrangements to its clients. That failure to disclose was not only in itself a possible conflict of interest, but, according to the SEC, it was also a violation of investment management agreements that Lyxor had made with two of its own clients.
The SEC, in the settlement, found that Lyxor, which produced the side letter to agency examiners, not only was engaged in an arrangement that presented conflicts of interest with its duty to clients, it failed to account in its books and records for the amounts owed and paid under the arrangement, and lacked necessary policies and procedures reasonably designed to detect and prevent such conflicts.
"This case is particularly interesting because, on the one hand, you have a sophisticated adviser to institutional clients investing in hedge funds," said Pasquarello Fink Haddad partner William Haddad. "On the other hand, the alleged misconduct is brazen and basic."
"Where were the chief compliance officer and the legal team?" asked Scarinci Hollenbeck partner Paul Lieberman. "Not involved in the paperwork?"
It should first be understood that Lyxor, in two of its investment management agreements with clients, placed disclosure requirements and limits on financial benefits Lyxor might receive, the agency said. In an August 2010 agreement signed with Client A, under which Lyxor stated that it would, at its discretion, invest that client’s assets with different outside investment managers, the agreement stated that Lyxor would "’account to [Client A] for all advantages and benefits received from third parties resulting from managing [Client A’s assets], including fees, commissions or other benefits received . . . from sponsors, managers, advisers, operators or distributors of underlying funds,’" according to the settlement order. It also quoted the Client A agreement as saying that "’there should be no commission payable to [Lyxor] by the underlying fund. Any rebates on fees that [Lyxor] can obtain should be disclosed to [Client A] and credited back to [Client A].’"
When Lyxor entered into a separate investment management agreement with another client, Client B, the wording may not have been the same, but the SEC made clear that the point in the agreement language was similar: "’[Lyxor] shall not directly or indirectly receive any benefit from recommendations made to [Client B] and shall disclose to [Client B] any personal investment.’"
By placing these agreement requirements near the top of its settlement order, the agency made clear the contractual constraints under which Lyxor could act in making separate agreements with third party advisers.
The third-party adviser agreements
In July 2012, Lyxor and the two third-party advisers executed the "side letter," the SEC said. On the same date,the agency said, Lyxor S.A.S., the parent company, and the same third-party advisers executed a separate agreement, which the SEC dubbed the "Paris side letter." The Paris side letter did not concern Lyxor’s clients, however.
"Significantly, the (non-Paris) side letter provided Lyxor with the right to quarterly payments from the third-party advisers based on a percentage of client assets that Lyxor placed or maintained in the two funds," the SEC said. The agency acknowledges that Lyxor "initially sought to negotiate an economic benefit for its clients in early drafts of the side letter," but said that "the third-party advisers would not agree, and Lyxor agreed to a final version of the side letter that called for payments to be made directly to Lyxor."
"The settlement order alleges that the advisory firm accepted payments from third-party asset managers in violation of the firm’s duty to avoid or disclose conflicts to its clients and did so after attempting to avoid such conflicted payments by negotiating that the monies instead be credited to clients," said Haddad. "Having failed to persuade the asset managers to do so, the respondent firm appears to have backed off, opting to take the money and not tell clients."
"When do third-party advisers set the ground rules for an RIA?" asked Lieberman, noting that this allegation from the SEC, if true, also meant that the adviser was "ignoring its financial arrangements with the two clients entirely." In addition, he said, payment requirements should be checked with the accounting/finance department.
Disclosure and recordkeeping
According to the settlement order, Lyxor did not seek pre-approval from Client A or Client B, nor did it disclose to either client the execution of the side letter that provided Lyxor with a fee based on the total amount of client assets placed or maintained by Lyxor in the funds.
In addition, the SEC said, once the side letter was executed, Lyxor failed to create a receivable on its books and records for amounts due under the side letter and failed to accrue the receivable going forward.
"In October 2013, the third-party advisers notified Lyxor by email that they intended to pay Lyxor $647,739 (approximately) in fees owed to it pursuant to the side letter," the agency said. "In the same email, the third-party advisers also notified Lyxor that they intended to pay $111,037 (approximately) pursuant to the Paris side letter. Staff at Lyxor engaged in several email exchanges with personnel at Lyxor S.A.S. and the third-party advisers about these payments without identifying that one of the two payments was made pursuant to the side letter, the receipt of which was in contravention of its clients’ investment management agreements."
Lyxor then "directed the third-party advisers to make both payments to Lyxor S.A.S.," the SEC said. "Accordingly, Lyxor did not account for the receipt of $647,739 (approximately) it was owed from the third-party advisers or the payment of that money to Lyxor S.A.S. on its books and records."
Nor, the agency said, did Lyxor disclose the side letter or the payment made by the third-party advisers to Clients A and B at that time.
That changed, however, after the SEC’s Office of Compliance Inspections and Examinations began an exam of Lyxor in December 2014.
"During the course of the examination and in response to documentation requests, Lyxor produced the side letter, following which OCIE staff requested information from Lyxor concerning any payments it may have received pursuant to the letter," the SEC said. "At that time, Lyxor informed OCIE staff that the third-party advisers had made no payments pursuant to the side letter."
After further discussions with the examiners, however, "Lyxor undertook a review of the matter, found the October 2013 payment advice, and informed OCIE staff that Lyxor had directed the third-party advisers to pay Lyxor S.A.S.," the agency said. The advisory firm then notified its clients and rebated the monies related to the side letter, plus interest, according to the settlement order.
The advisory firm also began a review of its agreements with other outside managers to ensure that there were no similar problems there, and took steps to improve its policies and procedures.
Violations and punishment
As part of the settlement, Lyxor was found to have willfully violated Section 206(2) of the Advisers Act, which prohibits fraud; Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to implement written policies and procedures reasonably designed to prevent violations; and Section 204(a) and its Rule 204-2(a)(2), for failing to maintain and preserve books and records.
Lyxor was censured and ordered to pay a civil money penalty of $500,000. The attorney representing the advisory firm did not respond to a voice mail or email seeking comment.