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Dual-Hat Principal/CCO Caused Multiple Compliance Violations

The SEC charged an investment adviser’s principal, who also served as the firm’s Chief Compliance Officer, with multiple compliance violations. The SEC charges the respondent with (i) overcharging his client, (ii) overstating his assets under management, (iii) failing to disclose two client lawsuits, (iv) misrepresenting the reason he switched custodians, and (v) neglecting to maintain required books and records. The SEC also alleges that the principal aided and abetted violations of the compliance rule (206(4)-7) by purchasing a template compliance manual, omitting required policies and procedures, and failing to implement required procedures. The firm ultimately ceased operations, and the respondent agreed to pay over $500,000 in fines, disgorgement and interest.

The dual hat CCO model (i.e. a senior executive also serving as the Chief Compliance Officer) doesn’t work. The dual-hat CCO usually does not have the time, expertise, or interest to do the job properly. Also, a CCO must have enough independence from the business to properly enforce the applicable regulatory and compliance obligations.

Federal Court Says that Outside Advice is Not a “Get-Out-of-Jail-Free Card”

The United States Court of Appeals for the D.C. Circuit upheld the SEC’s decision that an investment adviser failed to fully disclose mutual fund revenue sharing even if it sought and relied on the advice of outside compliance consultants. The Court found that the adviser acted negligently by failing to fully disclose the conflict of interest inherent by receiving shareholder servicing payments for investing in certain funds offered by its broker/custodian. Although the record was unclear about whether the adviser sought or relied on an outside compliance consultant’s advice, the Court decided that it didn’t matter because “any reliance on such advice was objectively unreasonable because [the adviser] knew of their fiduciary duty to fully and fairly disclose the potential conflict of interest.” The Court did, however, throw out the SEC’s claim that the adviser intentionally filed a misleading Form ADV, because the SEC failed to show that the adviser acted with the requisite intent to deceive.

As we have previously reported, this case argues in favor of seeking outside advice because it will help defend against the claim that you acted with intent, which would draw more punitive penalties. However, the Court here makes clear that relying on outside advice, even though you (should) know otherwise, will not exonerate you from claims that you acted negligently.

Adviser Didn’t Fully Disclose Financial Incentive to Recommend Affiliated Wrap Program

 A bank-affiliated adviser agreed to reimburse clients over $600,000 and pay an additional $100,000 fine for failing to disclose that it had an incentive to recommend an affiliated wrap program.  The affiliated wrap program paid a 2% up-front incentive to the adviser if its investment counselor recommended the program.  If the client withdrew from the program within two years, the client would pay a termination fee.  Approximately 78% of client assets were directed to the affiliate program even though two other third-party wrap programs were available.  The SEC faults the firm’s disclosures for failing to fully describe the financial incentive to recommend the affiliate program and that the investment counsellor would retain the up-front incentive fee even if the client terminated.  Although the adviser was state (not SEC) registered, the SEC maintains that the respondent violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction that operates as a fraud on any client or potential client.

OUR TAKE: Recommending proprietary products over third party products requires enhanced due diligence and disclosure because of the inherent conflicts of interest.  When the adviser recommends proprietary products that benefit the adviser to the direct detriment of the client, the arrangement will draw heightened scrutiny and will often result in an enforcement action.

 

Private Equity Manager Lowballed Purchase Offer to LPs

 The SEC censured and fined a private equity manager for lowballing the price offered to liquidate limited partnership interests.  The SEC asserts that the private equity manager, through its principal, offered to purchase remaining limited partnership interests at the December 2014 valuation.  The SEC faults the firm for failing to revise the price or fully disclose that it had received financial information indicating that the NAV had increased during the first quarter of 2015.  The SEC opines that the offer letter, termed “as an accommodation,” made it appear that the limited partners would receive full value for their interests.  The SEC charges violations of Rule 206(4)-8, the Advisers Act’s antifraud rule.

OUR TAKE: We generally advise against principal transactions with clients/investors/LPs.  Purchasing private interests directly from a client is so rife with conflicts that no amount of disclosure may be sufficient.

 

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.

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.

Private Equity GP Received a Percentage of Group Purchasing Arrangement

A private equity sponsor agreed to pay over $770,000 in fines, disgorgement, and interest for failing to obtain prior approval of a group purchasing arrangement that benefited the sponsor.  The respondent entered into a group purchasing agreement with a third party organization that negotiated group discounts on business expenses such as rental cars and office supplies.  The third party agreed to pay the respondent 25% of net revenue received from the underlying vendors.  The SEC asserts that the respondent did not disclose or seek independent limited partner approval for the arrangement, which created an incentive for the sponsor to recommend the services.

OUR TAKE: Any transaction that benefits the GP that is not specifically disclosed up-front must be approved by all, or a committee of, independent limited partners.

 

Fund Manager to Pay $3.6 Million for Failing to Fully Disclose Securities Lending Benefits

 

A large mutual fund manager agreed to pay $3.6 Million in disgorgement, interest, and penalties for failing to disclose that affiliates would receive tax deductions that would deprive fund investors of securities lending income.  The fund manager told investors and the Board that it would engage in discretionary securities lending and told the Board that affiliates could benefit from certain tax deductions.  The SEC faults the respondent for failing to tell either investors or the Board that it might recall securities before the dividend record date, which allowed affiliates to take a dividend received deduction and deprived the fund and its shareholders of additional securities lending revenue.  The SEC cites violations of the Advisers Act’s antifraud rules, acknowledging that proof of intent is not required and that such charges “may rest on a finding of simple negligence.”

OUR TAKE: This type of fraud charge based on simple negligence looks a lot like the type of “broken windows” enforcement cases that former SEC Chairman Mary Jo White championed.  The SEC does not allege that fund investors would have made a different investment decision if it included the SEC’s enhanced disclosure.  The conflict of interest makes the disclosure insufficient notwithstanding any effect on investors.

https://www.sec.gov/litigation/admin/2018/34-82837.pdf

Adviser’s Insider Loans Not Permissible Despite Lawyer’s Advice

A private fund manager was censured, fined, and ordered to hire an Independent Consultant in connection with undisclosed and unapproved loans he took from the fund.  The adviser arranged loans with the fund, rather than purchase securities, as a way to receive distributions.  Although his lawyer advised that the loans were permissible, the SEC faults the adviser for not obtaining investor consent and for disclosing the loans after they were made.  Additionally, the SEC faults the adviser for failing to explain the inherent conflicts of interest that the loans created.

OUR TAKE: A lawyer’s opinion is not a “get out of jail free” card.  If you violate your fiduciary obligations under the Advisers Act, the SEC will hold you accountable.  That is why it is important to implement a legitimate compliance program that avoids the regulatory gray areas.

 

Adviser Tried to Conceal Loans to Parent Company

A mortgage loan adviser and its two principals agreed to pay over $9 Million in disgorgement, interest, and fines for using funds it managed to make loans to the parent of its affiliated advisers and then using straw man transactions in an attempt to conceal the loans.  The SEC maintains that the respondent funneled money to the parent company through undocumented, undisclosed, and unlawful loans made by two private funds and a registered closed-end fund.  The respondent then tried to repay the loans by laundering mortgage assets through a straw man that bought mortgage loans from one fund and then transferred them to another fund.  The misconduct was uncovered when discrepancies arose between the registered fund’s collection account and its custody account.  The SEC asserts that the respondent misled the Board and investors, thereby violating the anti fraud rules as well as the compliance rule.

OUR TAKE: Making the unauthorized loans was bad enough and would have resulted in breach of fiduciary duty charges.  Trying to conceal the loans through straw man transactions led to the fraud charges, which also could have carried criminal penalties if the U.S. Attorney decided to prosecute.