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Adviser Benefited When Clients Invested in Its Lender

An investment adviser and its principal agreed to pay over $1.3 Million in disgorgement, interest and penalties for misleading clients about the adviser’s relationship with a lender. Following the action, the adviser was sold to another adviser, and the principal was barred from the industry. According to the SEC, the adviser, through the principal, advised clients to invest in the lender’s promissory notes without telling them that the loan’s repayment terms depended on the amount invested. The adviser characterized its relationship with the lender as a “strategic affiliation.” The SEC also maintains that the principal misled a client into investing in the adviser for the purpose of acquiring other advisers but the client’s investment was instead used to pay the principal’s personal expenses. The scheme was uncovered following the SEC’s action against the lender for fraudulent securities sales.

Don’t engage in direct transactions with your clients. We do not believe any amount of disclosure could adequately mitigate such a significant conflict of interest and resulting breach of fiduciary duty.

Fund Manager Rigged Auction Process in Client Cross-Trades

A private fund and CDO manager agreed to pay over $400,000 to settle charges that it facilitated an illegal cross-trade that benefitted one client over another.  The SEC alleges that the firm sold securities held by its CDO client to its private fund at an artificially low price because the respondent failed to obtain required third-party bids.  Instead, the SEC asserts, based on a record of a phone conversation, that the firm asked friendly firms to provide false bids with assurances that they would not have to purchase the securities.  The private fund ultimately sold the securities at a significant profit.  The SEC also charged the firm’s Chief Operating Officer (who was fined and barred from the industry) for arranging the transactions and personally benefitting through his investment in the private fund.

Firms should avoid client cross-trades.  One side will always benefit, which gives rise to conflict of interest and favoritism allegations.  A fiduciary on both sides of a transaction may not be able to cure the conflict with any amount of disclosure. 

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.


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 Exonerates IRA Custodian

The full SEC dismissed an enforcement case against a self-directed IRA custodian because it had no fiduciary or other obligation to investigate the merits of underlying investments.  The custodian held assets that ultimately turned out to be Ponzi schemes, but the SEC opined that the custodian, which was not registered as an investment adviser or broker-dealer, had no implied duty to conduct due diligence in the absence of actual knowledge of red flags suggesting misconduct.   The SEC cited the custodian’s low per account fees and its client agreements which specifically disclaimed any fiduciary obligation.  The SEC determined that the firm acted as a reasonably prudent passive self-directed IRA custodian, as determined by governing state law.  The SEC dismissed the appeal of the Enforcement Division from a similar finding by the Administrative Law Judge.

OUR TAKE:  The full SEC came to the right decision on the law given the Enforcement Division’s dubious legal theory that could encompass almost any third party actor in any way connected to a fraudulent transaction.  (See https://cipperman.com/2015/06/17/sec-takes-action-against-ira-custodian/.)  Unfortunately, it took the respondent more than 2 years to clear its name.  Third party service providers would be better off conducting due diligence and avoiding any SEC entanglements altogether.


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.


Unregistered Fund Manager Still Liable for Breach of Fiduciary Duty


The SEC fined and barred the principal of an unregistered private fund manager for breaching his fiduciary duty by failing to disclose that affiliate intermediaries profited from fund transactions.  The SEC alleges that the respondent used affiliate companies as intermediaries for the buying and selling oil and gas royalty interests and that the affiliates collected significant profits.  The SEC charges the firm with failing to disclose these transactions, instead telling investors that the fund would receive the best price possible and that any affiliate transaction would be conducted at arm’s length.  Even though the fund manager was not registered, the SEC accused him of violating the Advisers Act because he engaged in advisory activities and breached his fiduciary duty of full disclosure.

OUR TAKE: Private fund managers maintain accountability for alleged breaches of fiduciary duty even if not registered.  This includes conduct that pre-dates Dodd-Frank’s registration requirements.  Also, it is unclear how much disclosure is enough to allow affiliate transactions.


The Friday List: 10 Private Equity Practices that Cause Regulatory Problems

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The Friday List: 10 Private Equity Practices that Cause Regulatory Problems

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.

The private equity industry has seen increased SEC scrutiny and several significant enforcement actions since the adviser registration requirement went into effect in 2012.  In today’s list, we offer 10 PE practices that have caused regulatory problems for registered PE firms.


10 Private Equity Practices that Cause Regulatory Problems

  1. Direct transactions with portfolio companies. The SEC will highly scrutinize affiliate loans to portfolio companies, consulting arrangements with affiliates, and insiders serving as officers.
  2. Varying seniority rights for LPs. Giving preferential treatment to certain LPs (especially insider co-investors) will violate a fiduciary’s obligation to treat all clients equally.
  3. Mis-allocating co-investor expenses. Insider co-investors must bear the same expense allocations as outside LPs.
  4. Accelerating portfolio monitoring fees.  The SEC has brought at least 2 significant cases for failing to fully disclose how LPs will absorb accelerated portfolio monitoring fees incurred after a liquidation event.
  5. Charging broken deal expenses. The SEC views this practice as another way for a fiduciary to illegally line its own pockets at the expense of LPs.
  6. Legal fee discounts. Getting lower rates from your law firm (and other service providers) because they work on the funds violates your fiduciary duty.
  7. Overcharging overhead expenses. Several firms have been cited for taking overhead expenses out of the funds without adequate disclosure.
  8. Cross-portfolio transactions. Transactions between funds including interfund lending or cross-trading will violate the Advisers Act.
  9. Not registering as broker-dealer.  Investment banking activities for portfolio companies require broker-dealer registration.
  10. Weak compliance program.  Several PE firms failed to hire a competent and dedicated CCO to implement a specific Advisers Act compliance program.

Adviser Barred in Connection with Receiving Asset-Based Fees and Commissions


The SEC fined and barred the principal of an investment adviser for lying to clients about why he made investment recommendations and changed custodians.  According to the SEC, the respondent recommended that clients move assets to a proprietary fund from a third-party fund because he could no longer receive trail commissions from the third party fund.  The SEC also faults the respondent for failing to explain to clients that he had to change custodians because the incumbent custodian terminated its relationship due to a prior regulatory action.   The adviser failed to “disclose important facts to his clients so they could make their own informed decisions.”

OUR TAKE: An adviser walks a very treacherous regulatory path when it charges a client both asset-based fees and commissions.  It is possible that no amount of disclosure could cure this inherent conflict of interest that compromises an adviser’s fiduciary responsibility.