The SEC is shining the spotlight on conflicts of interest, with the agency’s Enforcement Division’s Asset Management Unit (AMU) prioritising the issue, setting out particular priorities, and pursuing enforcement actions that generally entail financial penalties – including fines and disgorgement of profits – but sometimes go further and censure, or strike off, individuals or even firms. “Many enforcement actions can ultimately be tied back to conflicts of interest,” explains Cordium Managing Director and Partner, Patrick Shea, who heads up Cordium’s compliance consulting division and runs the firm’s Boston office.
Having been a compliance lawyer in the investment industry for years, Shea has seen thinking on conflicts evolve. The aspiration to eliminate all conflicts in the 1960s has given way to a more pragmatic approach today. “Regulators have recognised that some conflicts of interest are inherent to the investment management industry. Though some conflicts can be eliminated, many of them need to be identified, mitigated, managed and disclosed,” he points out.
Chief Compliance Officers (CCO) have responsibility (and increasingly individual liability) for this, and a debate continues over the pros and cons of outsourcing the CCO function. All of Cordium’s asset manager clients, including many hedge fund managers, have their own CCO, and Cordium does not provide outsourced CCO services. Cordium does however provide consulting support and training on conflicts of interest, and recently held a webinar on the topic with law firm Sidley Austin and private equity firm TA Associates.
Cordium, which received The Hedge Fund Journal’s 2016 award for ‘The Leading Regulatory Compliance Firm’, follows a risk-based approach to identifying conflicts, which includes interaction with a broad range of employees, including senior management and non-compliance professionals. Shea gave us a few big picture examples of widely observed conflicts and popular ways of addressing them.
Allocation of investment opportunities (such as co-investments), or trades, amongst clients is one situation that gives rise to potential conflicts. Says Shea “the basic approach would be to allocate opportunities or trades pro rata in efforts to treat clients fairly over time.”
Some of Cordium’s clients run both long only and hedge fund mandates, and in this instance Shea finds “creation of informational barriers between the divisions as one approach.” He adds: “Very strict policies and processes are needed, particularly where it is difficult to demonstrate strict informational barriers.”
Fees and expenses
Allocation of fees and expenses amongst clients is another hot topic where the private equity industry has been in focus, due to the wide array and complexity of fees, including broken deal fees. But Shea flags that fee issues are potentially relevant to all kinds of asset managers. First and foremost funds must disclose fees and expenses, and they should also “ensure their expense practices are within the expense provisions of the fund.” Any fees paid directly or indirectly (for instance via recommendations of affiliated products) to firms, related parties or affiliates are particularly sensitive.
Fees and investment performance are typically impacted by valuation, which results in another possible conflict, particularly around hard to value assets (often classified as ‘level 3’ under FAS 157) “where there may be differing opinions about how to value an asset” Shea says.
This is one example where oversight from independent boards, committees, or service providers can be one conflict-mitigant. Yet even when valuations are done by one or more independent administrators, auditors and valuation agents (as they are for many hedge funds today), potential conflicts arise if policies are not adhered to. An example could be a manager seeking to override a third party valuation, contrary to the manager’s valuation policy. Assets marked to counterparty quotes (often classified as ‘level 2’ under FAS 157) are also a source of potential conflicts, with the SEC concerned about “the use of friendly broker marks.”
Friendly relationships with brokers can also give rise to best execution issues, which have many facets, including “oversight, approved broker lists, payment for research, payment for order flow and commissions,” enumerates Shea.
In the European Union, MIFID 2 proposes to substantially unbundle research and commission from 2018 (some firms have already unbundled in 2016 while others never bundled), whereas in the US commission can be used to pay for research – within certain constraints: “From a US perspective, managers need to pay close attention to available guidance on eligible research and eligible brokerage to ensure, if applicable, that they are within the 28(e) safe harbour,” warns Shea.
But political donations can extend beyond what some individuals might consider to be their freedom of conscience. “Under the Advisers Act, ‘pay to play’ cases have involved political contributions to officials who might influence or control the decision to hire an asset manager,” observes Shea.
Any contributions above a de minimis amount of $350 to candidates for whom the donor is entitled to vote could attract scrutiny. “State and municipal officials are most relevant, though Federal officials could also be covered if they concurrently hold state or municipal offices,” highlights Shea.
A landmark enforcement action relating to the Mayor of Philadelphia and Governor of Pennsylvania, was seen in 2014. This marked a significant milestone because previous ‘pay to play’ scandals at CalPERS and New York State Common involved explicit payments directly related to raising assets (and some improper payments). Now the implicit assumption is that political contributions that bear no contractual or formulaic link to assets raised might indirectly compromise officials’ judgment. A focus on conflicts around familial or ‘other’ relationships further broadens the definition of conflicts, and could intrude into individuals’ privacy.
When marketing outside the US, business development professionals must also be alert to the risk that any gift or payment to foreign officials could be covered by the Foreign Corrupt Practices Act (FCPA). “Cordium has helped clients institute policies around anti-bribery to ensure that anyone meeting foreign officials realises that there is very little room for interpretation as any type of payment or exchange can be considered improper,” says Shea, whose client base is treating this with respect.
Where and how to disclose?
Compliance manuals can be mainly or entirely for internal firm use, but other disclosures to investors, potential investors and to the public are also recommended and should be thorough enough for readers to understand the conflict. “As applicable, we would first make sure that timely disclosures are made in Form ADV,” says Shea, but for the sake of consistency Cordium would move onto offering documents, DDQ (Due Diligence Questionnaire) responses, RFP (Request for Proposal) answers, and other marketing materials such as monthly or quarterly newsletters.
“But not every conflict gets disclosed in every place,” says Shea, who has so far noticed enforcement actions based on non-disclosure per se, rather than not disclosing conflicts in enough places. Potential conflicts need to be disclosed whether or not the manager thinks they could result, or have resulted, in any adverse effect on clients.
Cordium recommends regular training to keep pace with the changing profile of hedge funds (often highly innovative businesses); the relentless onslaught of new regulations, and precedents set by enforcement actions.