Identifying and Mitigating Advisory Conflicts of Interest

Conflicts exist in every business.  However, investment advisers have a fiduciary duty to always put the interests of their clients ahead of their own.  There are several areas of an adviser’s business that have potential conflicts of interest and even certain activities that carry inherent conflicts.  An example of the latter is when an investment adviser recommends to a prospective client that they should hire the firm to manage the client’s money.  There is an inherent conflict since the adviser has a financial incentive behind the recommendation. 

Identifying and Mitigating Advisory Conflicts of Interest

Conflicts come in many shapes and sizes and are not always easy to spot. To address this issue this month’s Risk Management Update (“RMU”) highlights common conflicts of interest found within investment advisers’ business models and provides best practice guidelines for handling them. 

Identification of Conflicts of Interest

To help identify conflicts of interest, a good rule of thumb is to “follow the money.”  In other words, many conflicts of interest are a result of a direct or indirect financial incentive tied to an advisory activity that would benefit the firm and/or any of the firm’s associated persons.   

For example, consider the following conflicts related to common advisory activities:

Portfolio Management

  1. Allocation of investment opportunities – allocating favorable investments in proprietary accounts and/or accounts that pay performance fees.
  2. Discretionary management – selecting investments and/or investment strategies that provide additional or higher compensation to the firm or its employees.
  3. Proxy voting – voting a proxy for a company in which the firm or a representative has a business arrangement and the proxy outcome could affect the arrangement.
  4. Side by side management – favoring higher fee-paying clients, such as hedge funds over other types of clients.

Brokerage and Trading

  1. Use of soft dollars – excessive trading in clients’ accounts to generate a larger amount of soft dollars credits.
  2. Trading with affiliated broker-dealers – placing client trades with an affiliated brokerage firm that charges a higher commission rate.
  3. Directed brokerage arrangements – placing trades with brokers in exchange for client referrals.
  4. Employee personal trading – trading in personal accounts based on knowledge of client trading.
  5. Insider trading – trading in client and/or personal accounts based on non-public material information.

Valuation and Fee Billing

  1. Valuation of non-publicly traded securities – valuing a private investment at cost without performing due diligence to substantiate the value.
  2. Favoring certain clients over others – giving incentives, additional services, fee discounts or waivers only to a particular client segment (such as those with higher assets under management).
  3. Expense reimbursements – receiving payments from third-parties to assist with costs of providing advisory services.

Solicitation Arrangements

  1. Client referrals – providing benefits, such as lower fees, to clients that refer potential clients to the firm.
  2. Receiving compensation from third-parties – recommending clients to third party service providers that provide compensation to the firm and/or its employees.

Employee Activities

  1. Political and charitable contributions – making contributions in exchange for potential advisory business.
  2. Gifts and entertainment – favoring certain clients or service providers by providing excessive gifts and/or entertainment.
  3. Outside business activities – allowing associated persons to conduct other business activities during business hours, which takes time away from servicing advisory clients or the advisory firm.  

Best Practices for Addressing Conflicts of Interest

Advisers must either mitigate or eliminate conflicts of interest that they have identified; however, there are different ways this can be done.  First, any conflict that could result in actual client harm needs to be eliminated. In addition, there are certain conflict areas that are specifically addressed through regulation. For example, Rule 206(4)-5 under the Investment Advisers Act of 1940 (the “Advisers Act”) governs political contributions by certain employees and outlines steps firms must take at a minimum to mitigate the associated conflicts.  Another example is Rule 204A-1 under the Advisers Act, which requires firms to have a written Code of Ethics that covers, among other things, employee personal trading.

Most conflicts can be mitigated and managed through disclosures, procedures and strong internal controls.  For instance, the SEC requires advisers to describe potential and actual conflicts in their Form ADV Part 2A, along with material information on how such conflicts are addressed. The staff also has an expectation that advisers adopt policies and procedures to address those conflicts identified. The types of internal controls a firm considers will vary depending on the materiality of the conflict.  The following list is provided as to illustrate how an adviser may address certain conflicts, dependent upon certain facts and circumstances.[1] 

  1. Allocation of investment opportunities
    1. Ensure written allocation policies and procedures specifically cover the types of investments made by the firm (e.g., initial public offerings, fixed income, private funds).
    2. Perform and document periodic reviews of trade activity to confirm procedures are being followed.

 

  1. Trading with affiliated broker-dealers
    1. Perform and document an analysis of trading costs vs. other brokers.
    2. Assign dedicated traders that have ultimate trade placement authority.
    3. Review execution prices vs. a benchmark, such as National Best Bid Offer (NBBO) or Volume Weighted Average Price (VWAP).

 

  1. Valuation of non-publicly traded securities
    1. Obtain relevant information from issuer, such as current financials and tax filings.
    2. Create a Valuation Committee with oversight and review of security values responsibility.
    3. Task portfolio managers with providing Committee with estimated values and documentation to substantiate the values.

 

  1. Outside business activities
    1. Require employees to report all outside business activity and obtain pre-approval for certain types of activity, such as serving as a board member or working for a broker-dealer or other investment advisers.
    2. Implement employee annual conflict of interest questionnaires that seeks information related to family member financial affiliations.

 

Conclusion

Firms should perform a conflicts inventory/review at least annually and any time there is a change to business practices. This is particularly important prior to the annual amendment of Form ADV, as investment advisers must disclose conflicts that are material to their business. It is essential for investment advisers to review disclosures within the firm’s Form ADV Part 2A to assess whether they provide enough transparency and information about the circumstances surrounding conflicts of interest and how they are handled.  Consider utilizing technology to assist with monitoring and review internal controls for identifying and mitigating conflicts often. Moreover, spend time training employees on how to identify conflicts and what steps should be taken if and when identified (such as reporting conflicts to the Chief Compliance Officer).

 

Core Compliance consultants assist firms in conducting conflict inventories and offer consultation on how investment advisers can eliminate and mitigate conflicts.  For more information, including Form ADV and internal control assistance, please contact us at info@corecls.com, at (619) 278- 0020 or visit us at www.corecls.com for more information.

 contact core compliance

Author: Tina Mitchell, Lead Sr. Compliance Consultant; Editor: Michelle Jacko, CEO, Core Compliance & Legal Services (“Core Compliance”).  Core Compliance works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.

This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer and/or tax professional.

 

[1] This list is not meant to be all-inclusive, but rather, a representative example of best practice protocols for firms to consider based on their unique business model.

Author: Adam Stutz, Compliance Consultant; Editor: Tina Mitchell, Lead Sr. Compliance Consultant Core Compliance & Legal Services (“CCLS”).  CCLS works extensively with investment advisers, broker-dealers, investment companies, hedge funds, private equity firms and banks on regulatory compliance issues.