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Category: fiduciary duty

Adviser Pays $8.9 Million for Allowing Bankers to Influence Manager Selection

 

A large investment adviser affiliated with a global bank agreed to pay $8.9 Million in disgorgement, fines and interest for allowing affiliated investment banking relationships to influence the selection of a portfolio manager recommended to retail clients.  The adviser’s due diligence team had recommended the termination of a third party money manager because of personnel changes.  According to the SEC, senior executives, seeking an investment banking mandate with the third party, lobbied and influenced the due diligence group to delay the termination until after the awarding of the mandate.  The SEC faults the respondent for allowing this conflict of interest to influence its fiduciary obligations to recommend investment products in the best interest of its retail clients.

OUR TAKE: Compli-pros face an enormous challenges in large, global institutions to ferret out multi-lateral business relationships and ensure that the firm adequately observes its fiduciary obligations.

Private Equity Exec Barred from Industry for Personal Transaction with Portfolio Company

 A private equity firm’s managing partner, who also served as its Chief Compliance Officer, was barred from the industry and fined for failing to disclose his personal interest in a portfolio company.  The SEC alleges that the respondent caused the fund to make a loan to the portfolio company on the condition that the company used a portion of the proceeds to redeem his investment.  The SEC faults the executive for failing to disclose the transaction or to obtain consent to it from the limited partnership committee.  Neither the fund nor the investors lost money because the portfolio company ultimately sold the notes to an unaffiliated third party.

OUR TAKE: Without proper disclosure and consent, a transaction that benefits the fund sponsor or its principals will violate the Advisers Act’s fiduciary duty whether or not the investors suffered any harm.  This case also highlights the perils of the CCO dual-hat model whereby a senior executive with a pecuniary interest also serves as the Chief Compliance Officer, thereby avoiding independent scrutiny.

 

PE Firm Pays $6.5 Million to Settle Conflict Allegations over Portfolio Consulting Fees

 

A private equity firm agreed to pay over $6.5 Million in disgorgement, interest and fines for failing to adequately disclose, before commitment of capital, that it would receive accelerated portfolio consulting fees upon IPO or sale of the applicable portfolio company.  The PE firm did disclose in the Limited Partnership Agreement that it received portfolio consulting services and disclosed in its Form ADV that it received accelerated fees.  Fees were also described in the funds’ annual reports and in a side letter for one of the funds.  Also, the PE firm credited a large percentage of the accelerated fees against future management fees.  However, the SEC faults the firm for neglecting to inform all limited partners before committing capital that it would accelerate portfolio consulting/advisory fees upon IPO or sale for based on the present value of contract fees that could extend up to 10 years.  The SEC asserts that only the limited partnership committee could approve these potentially conflicted transactions.

OUR TAKE: The SEC has brought several cases charging PE firms with taking various forms of ancillary fees (e.g. portfolio monitoring, broken deal expenses, overhead expenses).  PE firms should reconsider these ancillary fees in favor of a more inclusive management fee.

The Friday List: 10 Things You Need to Know About Regulation Best Interest

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

A few weeks ago, the SEC proposed Regulation Best Interest, which requires a broker to act in the best interest of each retail customer at the time the recommendation is made, notwithstanding the broker’s own financial interests.  The SEC has been pondering a broker fiduciary rule for many years but lost the regulatory race to the Department of Labor, which promulgated its own rule.  Now that the 5th Circuit has vacated the DoL Rule and the SEC has proposed its own rule, the current state of the law is unclear.  Regardless, we have read the release and offer our list of the 10 things you need to know about proposed Regulation Best Interest.

10 Things You Need to Know About Regulation Best Interest

  1. Reasonable basis.  A broker must have a reasonable basis that the recommendation is in the best interest of the client.
  2. Applies to retail customers.  A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.
  3. “Recommendation” remains the same.  The proposal does not seek to change the definition of “recommendation,” preferring to defer to the current FINRA interpretations.
  4. No definition of “best interest”.  In 400+ pages, the SEC never defines the term “best interest” when proposing Regulation Best Interest.
  5. More than suitability, less than fiduciary.  Regulation Best Interest combines elements of the current suitability standard (e.g. suitable at time of transaction) with a few fiduciary-like elements (e.g. disclosure).
  6. Fails to harmonize RIA and BD standards.  Advocates of a uniform fiduciary standard want a single standard so that consumers are not confused by the differing standards of care applicable to advisers vs. brokers.  This proposal fails to ensure a “uniform” standard.
  7. Disclosure of conflicts of interest.  The most significant new requirement is that brokers must disclose (or mitigate) conflicts of interest.
  8. Must consider series of transactions.  Expanding traditional suitability, a broker must also consider the series of recommended transactions.
  9. Product neutrality not required.  Brokers can make more money on recommended products, including proprietary products, so long as the conflict is properly disclosed and mitigated.
  10. Regulation Best Interest is not law.  Comments are due on this controversial proposal by August 7, 2018.  Thereafter, we expect much debate and re-drafting before any final rule is adopted.

SEC Proposes Broker Best Interest Standard

The SEC has voted to propose a best interest standard for broker-dealers giving advice to retail customers.  The proposed “Regulation Best Interest” requires a broker to act in the best interest of the retail customer at the time the recommendation is made, notwithstanding its own financial interests.  The broker must disclose its conflicts of interest and have a reasonable basis to believe the recommendation and the series of transactions are in the client’s best interest.  The proposal also requires that brokers and advisers deliver a new disclosure form describing the relationship and conflicts of interest.  A retail customer is defined as a person who uses the recommendation primarily for personal, family, or household purposes.  The Rule defers to existing broker-dealer regulation to define the term “recommendation.” The SEC also proposed a companion rule seeking to clarify an investment adviser’s fiduciary duty including the obligation to provide advice in the best interest of the client, a duty of best execution, a commitment to provide ongoing monitoring, and a duty of loyalty.  The SEC has provided a 90-day comment period.

OUR TAKE: Don’t change anything yet based on this proposal.  Expect much debate during the comment period and thereafter, as even one of the SEC Commissioners dissented.  Our view is that brokers should be subject to the same fiduciary standard as investment advisers.  We don’t understand why the SEC would take this half-measure and enhance the broker standard without making it the same as the adviser standard.  This confusion is bad for customers and for brokers.

 

Large BD/IA Pays $2.2 Million for Recommending Wrong Mutual Fund Share Class

A large BD/IA agreed to pay $2.2 Million in remediation, interest and penalties for failing to recommend the lowest mutual fund share class available to retirement plan customers. Instead of recommending load-waived “A” shares, the respondent recommended other higher-cost share classes that resulted in compensation paid to the BD/IA.  The SEC faults the firm for failing to have adequate systems and controls in place to ensure that retirement clients benefitted from available discounts.   The SEC also asserts that the BD/IA omitted necessary disclosures about revenue sharing and the impact on overall investment returns.  An SEC Enforcement official warned that “these types of actions remains a priority for the Division” as evidenced by its recently-announced Share Class Selection Disclosure Initiative.

OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled.  Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.

 

Adviser Failed to Stop Principals from Looting Client Accounts

The SEC censured an investment adviser and ordered it to pay $1.7 Million in fines, disgorgement, and interest for failing to implement a compliance program that would detect and prevent the looting of client accounts.  Two firm principals ultimate went to prison for using their positions as fiduciaries over trust accounts to steal funds.  The SEC faults the firm for (i) failing to adopt legitimate policies and procedures, (ii) neglecting to obtain the required surprise examinations, and (iii) preparing misleading Form ADVs.  In addition to charging violations of the Advisers Act fiduciary, custody and compliance rules, the SEC also cites violations of Section 10(b) and Rule 10b-5, which prohibit fraudulent conduct in the offer or sale of securities, presumably for misleading statements made in Form ADV.

OUR TAKE: Just because the principal wrongdoers went to jail doesn’t mean the firm is off the hook.  The SEC holds the adviser accountable for allowing the conduct to continue.  It is also significant that the SEC uses 10b-5 as a charge, which opens the door to more significant civil and criminal penalties.

https://www.sec.gov/litigation/admin/2017/34-82399.pdf

Adviser Charged with Defrauding Professional Athlete

The SEC has commenced enforcement proceedings against an adviser that it alleges lied to his professional athlete client about management fees.  The SEC asserts that the adviser told representatives of the client that the client paid between .15% and .20% of assets in management fees when the client actually paid 1.00%, resulting in significant payments to the adviser who received 60% of the revenue earned by his firm.  According to the SEC, the adviser misled the client and his representatives by using false account statements, forged documents, an impostor acting as a Schwab representative, and multiple misrepresentations in emails and meetings.    The client’s representatives ultimately contacted Schwab, who then informed his employer.  The adviser tried to convince the client to lie on his behalf to protect his job, although the client refused.

OUR TAKE: This type of case shows the problem with assuming that wealthy people are financially sophisticated.  Many wealthy people earn their income in fields (e.g. sports, medicine, technology) that would not necessarily make them qualified to make investment decisions.  Instead, these successful professionals rely on advisers who are supposed to act as fiduciaries and protect their clients’ interests.

 

Longstanding Church Fund Violated Fiduciary Duty

The sponsor of a church fund agreed to pay over $2.25 Million in returned profits, disgorgement, interest and penalties for failing to properly disclose a reserve fund created to smooth returns.  According to the SEC, the Board of the fund, which was launched in 1973, created the reserve fund in 1993 as a vehicle to retain excess profits and ensure liquidity so that the fund could distribute consistent returns between 5% and 6.7%.  The SEC faults the fund sponsor for failing to fully disclose that it would charge fees on the reserve fund and that redeeming investors would not receive their pro rata amounts held in the reserve fund.  OCIE identified the fiduciary violations during a 2014 exam, which followed the sponsor’s registration in 2012.

OUR TAKE: The SEC appears to be most disturbed that the fund sponsor did not return client assets and double-dipped advisory fees by moving assets into the reserve fund.  Private fund firms that registered after 2012 as a result of Dodd-Frank, should audit their operations to determine whether longstanding business practices run afoul of their fiduciary duties.