United States: For Investment Management Clients And To Other Interested Parties Conflicts Unavoidable For Investment Advisers

The subject of "conflicts of interest" is an area of particular interest among regulators but often times misunderstood by investment advisers.

It is well documented that an investment adviser has a fiduciary duty to its clients. The concept comes from common law where the U.S. Supreme Court in SEC v Capital Gains Research Bureau (375 US 180 1963) held that the Congressional intent of the Investment Advisers Act of 1940 was in part, to eliminate, or at least expose, all conflicts of interest which might lead investment advisers to provide a client advice which was not disinterested. The Court stated that investment advisers are fiduciaries with an affirmative duty of utmost good faith, to provide full and fair disclosure of all material facts and to avoid misleading clients. Among the adviser’s fiduciary duties to its clients is the duty to expose all conflicts of interest.

Investment advisers should confront this issue by first accepting the fact that all investment advisers have some conflicts of interest. Some conflicts are unavoidable. If you believe that your firm has no conflicts of interest, you have not conducted a careful review to root out and identify your conflicts of interest. Investment advisers are required to identify those conflicts on a periodic basis. Upon identification, it is necessary to disclose those conflicts which cannot be eliminated.

Disclosure of the conflicts in Part II of Form ADV or comparable written disclosure document, should avoid "boiler plate" language. The content of the written disclosure by one firm about its conflicts of interest is not necessarily the description that another firm should implement. Conflicts of interest vary from firm to firm and disclosure of such conflicts of interest should be customized for each investment advisory firm.

In addition, if the conflict clearly exists, then the investment adviser should avoid stating that a conflict "may" exist. Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations in a recent speech emphasized that it is important not to mislead clients and the best way to do that is to provide full and fair disclosure of all conflicts of interest, both actual and potential.

Both the subtle and not-so-subtle conflicts of interest must be described by clear disclosure. Whenever a conflict exists where the investment adviser might not act in the client’s best interest, full and complete disclosure provides the client the opportunity to determine whether the investment adviser is likely to act in the client’s best interests, and whether the client should engage the investment adviser for services.

Advisers are required to establish a set of written policies and procedures designed to, among other things, address conflicts of interest and prevent violations of the Advisers Act.

During an examination, regulators will review whether the firm has fairly and completely identified its conflicts and potential conflicts of interest and whether the firm’s disclosure to its clients of the conflicts is full, fair and clear.

Recently, the Securities Exchange Commission ("SEC") published an interpretive release in which it provided guidance with respect to the safe harbor of Section 28(e) of the Securities Exchange Act of 1934 ("Section 28(e)"). ¹ This safe harbor allows money managers to use client commissions to purchase "brokerage and research services" for their managed accounts under certain circumstances without breaching their fiduciary duties to their clients. This practice is commonly referred to as paying with "soft dollars." The guidance provided in the July 18, 2006 Release became effective on July 24, 2006 and updates previous guidance.²

The 2006 Release provides specific guidance with regard to:

• The definition of services that constitute "research services" and "brokerage services";

• The eligibility of research and brokerage services as "lawful and appropriate assistance";

• Mixed-use items and reasonable allocation between eligible and ineligible uses; and

• The principles that a money manager must apply to avail itself of the safe harbor.

The SEC reiterates in the 2006 Release the statutory requirement that a money manager must make a good faith determination that commissions paid for "research or brokerage" services are reasonable in relation to the value of the products and services provided. The SEC clarifies that any brokerage or research services provided in reliance on Section 28(e) must satisfy the "lawful and appropriate assistance" standard that the SEC articulated in the 1986 Release. In that release, the SEC construed the Section 28(e) safe harbor to be available to research services that satisfied the statute’s definition of "brokerage and research services" and provided "lawful and appropriate assistance to the money manager in the performance of his investment decision-making responsibilities." The SEC also reaffirmed its view that third-party research and brokerage can be provided pursuant to the Section 28(e) safe harbor.

In the 2006 Release, the SEC articulated a three step process for determining whether a service satisfies the "lawful and appropriate assistance" standard:

• A money manager must determine whether the product or service for which it wishes to pay client commission dollars is "research" covered by Section 28(e)(3)(A) or (B) or is "brokerage" under Section 28(e)(3)(C);

• A money manager must determine whether the research or brokerage actually provides lawful and appropriate assistance in the performance of investment decision-making responsibilities (and if only a part of the service or product does so, must allocate the costs of the product or service according to its use); and

• A money manager must make a good-faith determination that the amount of client commissions paid is reasonable in light of the value of the product or service provided by the broker-dealer.

With regard to "research" the SEC in the 2006 Release established as a baseline that a product must constitute "advice", "analyses" or a "report". Further, such a product must reflect the "expression of reasoning or knowledge."³ The SEC articulated a "temporal standard" to distinguish brokerage services from other products and services. The temporal standard assumes that brokerage services begin with a communication between a money manager and a broker-dealer for the purpose of transmitting an order for execution and end when funds or securities are delivered or credited to the advised account of the account holder’s agent.⁴

Money managers must carefully consider both the attributes of any product for which they are contemplating paying with client commission dollars, unless the product clearly is research under Section 28(e)(3)(A) or (B), or brokerage, under Section 28(e)(3)(C), as well as the manner in which the money manager intends to use the product.

When a money manager wishes to pay for products or services only part of which lawfully and appropriately assist the money manager in making investment decisions or in effecting a securities transaction, the money manager must allocate costs so that client commission dollars are used only to pay for the portion of those products and services that are eligible for the Section 28(e) safe harbor. The SEC repeated its guidance from the 1986 release, that a "money manager must keep adequate books and records concerning allocations so as to be able to make the required good faith showing" of the basis of how it allocated the cost of products and/or services between client commission dollars and its own "hard dollars".

To the extent that client commission dollars are used for products or services originating with third party producers, the broker-dealer providing the products and services must be legally obligated to pay the cost of the products or services and must pay for them. Furthermore, the broker-dealer must be involved in effecting transactions in securities to receive client commission dollars for which it provides brokerage or research. The SEC considers a broker-dealer involved in "effecting" brokerage transactions if the broker-dealer is executing, clearing or settling trades, or (i) taking financial responsibility for customer trades; (ii) maintaining records relating to customer trades; (iii) monitoring and responding to customer comments concerning the trading process; or (iv) monitoring trades and settlement, with all other functions allocated to another broker-dealer.

In addition, the broker-dealer must review products and services provided to money managers for red flags that may indicate that a product or service is not eligible for the Section 28(e) safe harbor; and the broker-dealer must develop and maintain procedures to ensure that brokerage and research are paid for promptly and that payments to third parties are promptly paid and well documented to ensure availability of the Section 28(e) safe harbor for the money manager. Money managers must make a "good faith determination" that the commissions paid are reasonable in relation to the value of the brokerage and research services provided.

Although the SEC confirmed the availability of the Section 28(e) safe harbor to obtain bundled services and third party products and services, some money managers may nevertheless move in the direction of paying for such services with hard dollars or may demand an unbundling of the costs of products or services. The decision by Fidelity last year to move to an unbundled, hard dollar model for obtaining research from Lehman Brothers, and the requirement reiterated in the 2006 that a money manager must satisfy the "good faith" standard described above, both suggest trends in this direction.

In conclusion, the Section 28(e) safe harbor for appropriate and lawful use of client commission dollars to pay for certain research and brokerage services remains fully intact and available to money managers, provided that the standards discussed above are satisfied. Practices in this area will continue to evolve, as the market place changes. Both money managers and broker-dealers will have to apply strict standards to ensure that their practices in this area satisfy these standards.

When the Securities and Exchange Commission adopted new rules this summer to make it easier for mutual funds to invest in shares of other registered funds and private funds, it also adopted changes to the disclosure requirements for the fee table in the prospectus that apply to mutual funds that one would not typically consider to be "funds of funds." The new rules require any mutual fund that invests in other funds (sometimes referred to as acquiring funds) to disclose the fees and expenses that it incurred indirectly by investing in other funds (sometimes referred to as acquired funds), subject to a de minimis exception. The new disclosure requirements may apply to mutual funds that invest in even a single fund.

The new disclosure requirements apply to updates to a mutual fund’s Form N-1A registration statement filed on or after January 2, 2007.

Under the new disclosure requirements, a mutual fund that invests in any registered fund, which includes exchange traded funds registered as investment companies, or any private fund excepted from registration by Section 3(c)(1) or 3(c)(7) of the Investment Company Act, which includes many hedge funds, to disclose as a separate line item in the fee table the fees and expenses incurred indirectly by the fund by investing in acquired funds. An acquiring fund does not have to include this new line item if the aggregate fees and expenses attributable to the acquired funds do not exceed one basis point of the acquiring fund’s average net assets. Instead, if this de minimis exception applies, the fees and expenses incurred indirectly by the acquiring fund by investing in acquired funds are included in the current line item "Other Expenses."

The new line item will set forth the acquiring fund's pro rata portion of the cumulative fees and expenses charged by the acquired funds. (The item will appear directly above the current line item titled "Total Annual Fund Operating Expenses.") These fees and expenses will be included in the acquiring fund's total annual fund operating expenses, and will be reflected in the "Example" portion of the fee and expense disclosure.

To assist an acquiring fund in determining the amount of the acquired fund's fees and expenses that must be reflected in its fee table, the SEC adopted instructions that provide for a standardized calculation. Under this standardized calculation, the acquiring fund must aggregate (1) the amount of total annual fund operating expenses of the acquired funds and (2) the transaction fees paid by the acquiring fund in connection with acquiring or disposing of shares of the acquired funds, and then express the aggregate amount as a percentage of its average net assets. To calculate the pro rata share of total annual fund operating expenses for each acquired fund, an acquiring fund will divide the acquired fund's expense ratio as disclosed in the acquired fund’s most recent shareholder report by the number of days in the relevant calendar year, and multiply the result by the average invested balance and the number of days invested in the acquired fund.

The SEC noted that this standardized calculation may yield total annual fund operating expenses in the fee table that are higher than those reflected in the expense ratio in the financial highlights table (namely, the ratio of expenses to average net assets) because the financial highlights table reflects only the operating expenses of the acquiring fund and does not include acquired fund fees and expenses. As this potential discrepancy may be confusing to investors, the SEC has provided that acquiring funds may address this discrepancy in a clarifying footnote to the fee table.

Those investment advisers who experienced an SEC examination during the last couple of years probably received a request by the staff for a copy of all e-mails of the firm for a significant period of time. That type of request frequently caused great consternation among advisers and their counsel due to the sheer volume of correspondence that was requested and whether such correspondence included any client-attorney privileged correspondence.

There is some anecdotal evidence suggesting that the SEC has reacted to the complaints of investment advisers subject to such requests and taken a more practical approach in its document production requests. Examination requests now are targeted to those areas the examiner believes are potential problem areas. Requests for copies of such communication are directed to a particular person or a group of persons at the firm or to a particular activity and during a limited period of time.

Investment advisers who receive requests from the SEC for a copy of e-mail correspondence may also try asking the staff to modify the request. The staff has stated that if there is another way to address the information request, they are ready to listen.

Protection of attorney-client privileged correspondence is an important issue. Generally, once a request for information is received, the investment adviser should ask its outside counsel to review copies of information proposed to be delivered to the SEC to determine if any of the information is protected by the attorney-client privilege. Not all of that information has to be provided to the SEC and counsel should be brought into help make that determination. A way to help to narrow the amount of the correspondence that may have to be forwarded to the SEC is to train the investment adviser’s personnel to identify and label e-mail correspondence that should be treated as privileged information.

Investment advisory firms should have a system in place to sample e-mail correspondence to determine if certain persons of the firm are more likely than others to be involved in illegal or questionable activity. The mere fact that all personnel of the firm understand that the compliance department monitors e-mail traffic, in and itself, has a positive compliance effect. The SEC has repeatedly promised to provide more guidance on e-mail retention for investment advisers. That guidance has not been provided and the SEC has given investment advisors no reason to expect that the guidance will be provided any time soon.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.