Source: https://www.sec.gov/news/speech/conflicts-everywhere-full-360-view.html
Timestamp: 2019-04-18 10:31:52+00:00

Document:
Good morning everyone, and thank you, Carl, for that kind introduction and for inviting me to speak here today. Before I begin, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any other colleague on the staff of the Commission.
I am excited to be here to deliver the keynote address at this important conference on compliance and other issues affecting investment advisers. I am joined today by several of my colleagues from around the Commission — including from the Commission’s Office of Compliance Inspections and Examinations (OCIE) Director Drew Bowden, Deputy Director Marc Wyatt, National Associate Directors Jane Jarcho (Investment Adviser/Investment Company) and Kevin Goodman (Broker-Dealer), and Assistant Director Mavis Kelly, and from the Division of Investment Management Associate Director Diane Blizzard and Assistant Director Dan Kahl — all of whom will be speaking at the conference. It is an honor to be here alongside some of the Commission’s most experienced and talented staff.
Today I will discuss the AMU’s evolution over the past five years, our coordination and collaboration with our colleagues in OCIE and in the Division of Investment Management, the AMU’s 2015 priorities, and then spend a few minutes touching on the AMU’s overarching concern — conflicts of interest.
The Asset Management Unit just turned five years old, and, as with any milestone birthday, this is a natural time to reflect on where the Unit has been and what we see on the horizon. The AMU today consists of approximately 75 professionals, now in all 12 SEC offices. Our focus is investigating potential misconduct involving registered investment companies, private funds (both hedge funds and private equity funds), and separately managed accounts and retail accounts. Working side-by-side with our attorneys are seven former industry professionals who have enhanced the manner and speed at which we are able to target risk areas and investigate potential misconduct. Among these experts are former mutual fund professionals with extensive experience in the marketing, distribution, and servicing of mutual funds, including 12b-1 fees and board governance issues (such as the 15(c) process) and former hedge fund and private equity professionals with portfolio management and due diligence experience. One is a former FBI agent. As a group, they have done and seen it all, from go-anywhere equities trading to algorithmic trading systems, derivatives trading, credit analysis, and bond and options trading. They assist on our cases by sharpening document requests, questioning sophisticated witnesses in testimony, and devising investigative theses and building analytics around those theses. They also conduct trainings and assist the Commission’s rulemaking divisions when a potential rule or staff guidance touches their areas of expertise. We simply could not run the AMU program without them.
The Unit’s staff is tremendously talented and highly experienced after five years of asset management specialization. Five years ago, we underwent rigorous training at inception (and renewed that training in the past year); now others around the Commission seek us out to provide training, consult on rulemaking, play leading roles on initiatives such as the Distribution in Guise sweep, and to speak at such conferences such as this one. As a result of the training and expertise, we have brought many terrific cases over the last five years: F-Squared Investments, Inc. (false performance advertising), Paradigm Capital Management, Inc. (Commission’s first case charging a firm with retaliating against a Dodd-Frank whistleblower), J. Kenneth Alderman (violations by eight former directors of Morgan Keegan mutual funds for failing to satisfy their responsibilities to determine fair value in good faith), Northern Lights Compliance Services, LLC (violations by five trustees, CCO, and administrator in investment advisory contract approval process), Oppenheimer Asset Management Inc. (adviser mislead private equity fund about valuation and performance), Harbinger Capital Partners (Commission’s first case settled with admissions), AMMB Consultant Sendirian Berhad (first Investment Company Act of 1940 Section 36(b) case in more than 30 years), and AXA Rosenberg (quantitative model error), just to name a few.
Critical to the AMU’s success over the past five years has been its constant collaboration and coordination with the Commission’s other two main stakeholders for investment adviser and investment company issues: OCIE and the Division of Investment Management.
First, the Asset Management Unit has, not surprisingly, a special relationship with the OCIE staff around the country who examine investment advisers and investment companies. We coordinate very closely with those examiners, including regularly conferring with them on emerging risks and problematic conduct they are seeing in the field and on our respective priorities year to year. The Unit also frequently collaborates with OCIE on initiatives and sweeps where our shared expertise can be most effectively leveraged. For example, most recently, AMU experts have been centrally involved in developing and conducting the Distribution in Guise and Alternative Mutual Fund sweeps.
This close coordination with OCIE is not cause for alarm. Our collaboration with exam staff is nothing new, and the Division of Enforcement has always worked many cases referred by exam staff and now, with AMU fully established, we have a group of Unit staff who understand the exam work being done in the investment adviser/investment company space and who understand the importance of regulatory violations such as compliance and custody rule violations. That said, we firmly believe that not every exam deficiency warrants an enforcement response. In fact, just the opposite: in the vast majority of cases, non-compliance will be addressed through engagement with the registrant, deficiency letters, and other approaches, short of an enforcement action. It is of course the case that a small percentage of exams result in an enforcement referral, but it is very important that exam staff have the ability to refer matters when in their judgment the conduct warrants enforcement action.
Second, the AMU is similarly closely aligned with the Commission’s Division of Investment Management. We are “repeat customers” with IM staff, who assist the AMU’s enforcement program in various ways, including helping us to evaluate complex legal issues that crop up in our investigations and reviewing our enforcement recommendations to ensure that they are consistent with Commission practice. IM staff also direct us to practices they view as problematic for possible investigation, and they consult with us and our experts when they are writing rules or contemplating issuing guidance that impacts the asset management industry. We likewise keep IM staff apprised of what we see in terms of how regulation impacts the industry and when additional guidance might be beneficial.
This three-legged stool of collaboration — AMU, OCIE, and the Division of Investment Management — has yielded tremendous results in the past five years. For example, the AMU’s successful Ambassador Capital Management enforcement case originated from an OCIE examination that in turn was generated by ongoing analysis of money market fund data by IM staff that involved a review of the gross yield of funds as a marker of risk. In addition, the Unit’s Fund Fee Initiative, which I will discuss more in a moment, is a coordinated effort by AMU, the Division of Investment Management, and OCIE to examine fee arrangements involving registered funds, their advisers, and boards of directors.
And, if I were going to stretch the metaphor, I would change the furniture from a stool to a chair, and add a leg for the Division of Economic and Risk Analysis (DERA) because the Unit works very closely with DERA in devising and conducting risk-analytic initiatives, including the Aberrational Performance Inquiry, in which we use proprietary risk analytics to identify hedge funds with suspicious returns, and our Cherry-Picking Initiative, in which we are using big data to identify unlawful preferential trade allocations.
I want to touch on the AMU’s 2015 priorities, and then spend time talking more expansively about one overarching, perennial priority — conflicts of interest — that should be of concern to everyone in this room. The Unit roughly divides the vast asset management industry it polices into three primary categories by investment vehicle: registered investment companies, private funds (both hedge funds and private equity funds), and other accounts (e.g., separately managed accounts/retail accounts). Each vehicle presents unique risks, and naturally our enforcement priorities differ somewhat as to each.
For registered investment companies, the Unit’s 2015 priorities include valuation and performance and the advertising of that performance; funds deviating from their investment guidelines or pursuing undisclosed strategies; fund governance, which includes boards’ and advisers’ discharging of their obligations under Section 15(c) of the Investment Company Act of 1940 (“Investment Company Act”) when they evaluate advisory and other types of fee arrangements; and fund distribution, including whether advisers are causing funds to violate Rule 12b-1 by using fund assets to make distribution payments to intermediaries outside of the funds’ Rule 12b-1 plan, whether funds’ boards are aware of such payments, and how such payments are disclosed to shareholders. Fund distribution is of particular concern given the conflicts of interest it presents for the adviser — i.e., whether to use its own assets or fund assets to distribute shares. We brought a number of cases in these areas in 2014. For example, in the fund governance area, building on the Unit’s prior 15(c) cases, we brought a fourth case as part of our Fund Fee Initiative, in which we examine whether advisers made misrepresentations to boards about services provided and fees received. In that fourth case, Chariot Advisors, LLC, we charged an adviser with Section 15(c) violations for misrepresenting to the fund’s board of trustees the adviser’s ability to engage in algorithmic currency trading. And, in December 2014 we brought the F-Squared case, in which we charged an adviser to managed ETF portfolios with approximately $29 billion in AUM with advertising a materially inflated, and hypothetical and back-tested, performance track record. To settle the case, the firm paid $35 million and made admissions; the firm’s co-founder and former CEO Howard Present is litigating. I include this case under the registered investment company category because the Commission’s order found that F-Squared, among other things, caused violations of Section 34(b) of the Investment Company Act because various mutual funds for which it serves as a sub-adviser included F-Squared’s false historical performance numbers in their own Commission filings. In 2015, we anticipate additional performance advertising and 15(c) cases, along with cases in all of these priority areas.
For private funds — meaning hedge funds and private equity funds — the AMU’s 2015 priorities include conflicts of interest, valuation, and compliance and controls. On the horizon, on the hedge fund side, we anticipate cases involving undisclosed fees; all types of undisclosed conflicts, including related-party transactions; and valuation issues, including use of friendly broker marks. We also continue to refine the analytics for the AMU’s signature risk initiative, the Aberrational Performance Inquiry, or API, which uses proprietary risk analytics to identify hedge funds with suspicious returns. In 2014, the Enforcement Division brought its eighth case generated by API. On the private equity side, the AMU continues to work very closely with the exam staff and we expect to see more undisclosed and misallocated fee and expense cases like the Clean Energy Capital and Lincolnshire Management, Inc. cases we brought in 2014.
For other client accounts (e.g., separately managed accounts and/or retail accounts) — and recognizing that the following is doing rough justice to very different types of accounts — the Unit’s 2015 priorities include conflicts of interest, fee arrangements, and compliance. Leaving aside conflicts for a moment, the Unit brought a number of fee arrangements cases in 2014, including Transamerica Financial Advisors, Inc., in which we charged a firm with failing to aggregate accounts for purposes of applying breakpoint discounts. The case also highlighted a compliance theme — recidivism — because the firm had been told by OCIE after a branch exam that it might have a firm-wide aggregation issue, but Transamerica never undertook a global review. On the compliance front, the AMU brought a number of additional cases as part of our Compliance Program Initiative, a joint effort with OCIE to identify advisory firms that lack effective compliance programs for possible enforcement action. The goal is to drive firms to address repeated or systemic compliance failures that may lead to bigger problems, so the Initiative targets firms that have been previously warned by SEC examiners about compliance deficiencies but failed to effectively act upon those warnings, or firms that have wide-ranging compliance failures. To date, we have brought eleven cases, including most recently against Barclays Capital, Inc., where we found systemic compliance failures after the firm acquired an advisory business for the first time from Lehman in 2008. In addition, we are still focused on Custody Rule violations, as is exam staff.
Now a few words about one of the Asset Management Unit’s overarching concerns across all of the investment vehicles: conflicts of interest. In reality, conflicts of interest is the risk area into which nearly all of the more granular priorities I just mentioned fall. In nearly every ongoing matter in the Asset Management Unit, we are examining, at least in part, whether the adviser in question has discharged its fiduciary obligation to identify its conflicts of interest and either (1) eliminate them, or (2) mitigate them and disclose their existence to boards or investors. Over and over again we see advisers failing properly to identify and then address their conflicts.
The Court in Capital Gains stated that the types of conflicts of interest encompassed by the Advisers Act include instances where there is a facial incompatibility of interests, as well as any situation where an adviser’s interests might potentially incline the adviser to act in a way that places its interests above clients’ interests, intentionally or otherwise. There is, therefore, no exception to disclosure: no “well-meaning or good-faith adviser” exception for an adviser that legitimately believes it is putting its clients’ interests first notwithstanding any conflicts; no “mitigation” exception for an adviser that believes it has taken adequate internal measures to account for potentially incompatible interests; and no “potential conflict” exception for an adviser that did not act upon the conflict to enrich itself at the expense of its clients.
An adviser’s failure to disclose conflicts of interest to clients subjects it to possible enforcement action. Because disinterested investment advice — or, alternatively, clients’ knowledge of any conflicts that might render their adviser’s advice not disinterested — is at the heart of advisers’ fiduciary relationship with clients, the Asset Management Unit has aggressively pursued enforcement cases where appropriate. We brought a number of significant conflicts cases this year, and more are in the pipeline.
On the registered fund side, we are intensely focused on conflicts of interest. We brought several cases in fiscal year 2014 in which we alleged that advisers to registered investment companies failed to seek to obtain best execution for their fund clients. In the Manarin Investment Counsel case, we charged an adviser to three funds-of-funds with breaching its fiduciary duty by failing to seek best execution when it caused those funds to buy Class A shares of underlying mutual funds when the funds were eligible to own lower cost “institutional” shares of the mutual funds. As a result, private fund of fund clients paid more than $600,000 in avoidable Rule 12b-1 fees on their mutual fund holdings, which were passed through to the adviser’s affiliated broker-dealer.
Likewise in the private equity fund arena, we continue to focus on the inherent conflicts in various fee and expense arrangements. In 2014, we brought our first two cases in this area. In the Clean Energy Capital case, we alleged that the adviser misallocated its expenses to funds it managed — including a majority of the principal’s compensation. The money taken from the funds for the adviser’s expenses was in addition to millions of dollars in management fees the fund was already paying. In the Lincolnshire Management Inc. case, we alleged that a private equity adviser misallocated expenses between two portfolio companies owned by separate funds it managed.
Conflicts of interest are similarly rife in the RIA space, including improper principal transactions (like those in the Paradigm case), best execution involving affiliated broker-dealers, and undisclosed compensation arrangements. To address certain of these conflicts, the Unit, in collaboration with exam staff, developed its Undisclosed Adviser Revenue risk-analytic initiative, which targets undisclosed compensation arrangements between investment advisers and brokers that result in potentially tainted investment advice. In the most recent case, from January 2015, we alleged in Shelton Financial Group Inc. that an investment adviser failed to properly disclose compensation it received from a broker-dealer for investing client assets in certain no transaction fee mutual funds, thus creating incentives for the adviser to recommend certain funds to its clients.
On the horizon, we expect to recommend a number of conflicts cases for enforcement action, including matters involving best execution failures in the share class context, undisclosed outside business activities, related-party transactions, fee and expense misallocation issues in the private fund context, and undisclosed bias toward proprietary products and investments. We also anticipate enforcement action from the Distribution in Guise Initiative, where we are examining, among other things, conflicts presented by registered fund advisers using the fund’s assets to grow the fund and, consequently, the adviser’s own fee.
To fulfill their obligations as fiduciaries, and to avoid enforcement action, advisers must identify, and then address — through elimination or disclosure — those conflicts. There are many ways to do that, but among others, and at a very high level: Take a step back and rigorously and objectively evaluate your firm, its personnel, its business, its various fee structures, and its affiliates. Is the firm a dually registered investment adviser and broker-dealer, or does the adviser have an affiliated broker-dealer? If so, the firm will have inherent conflicts risks if it engages in principal transactions or trades through its brokerage arm or an affiliated broker-dealer. Does the firm manage clients side-by-side? If so, and if the firm’s clients are funds, do they engage in inter-fund lending or investing? Does the firm receive compensation from any third parties for recommending investments or using certain service providers? Does it engage in proprietary trading or investing? If so, has the firm disclosed its potential biases and that its investment advice could be tainted by compensation received from any third parties or from proprietary investing?
For each conflict identified, as a threshold matter, can the conflict be eliminated? If not, why not? If the adviser cannot, or chooses not to, eliminate the conflict, has the firm mitigated the conflict and disclosed it? Is there someone — a person, a few individuals, a committee — at the firm responsible for evaluating and deciding how to address conflicts? Is that person or individuals or committee sufficiently objective? Is the process used to evaluate and address conflicts designed to be objective and consistent? Does the firm have policies and procedures in place to identify new conflicts and monitor and continually re-evaluate ongoing conflicts? As to mitigation, are the firm’s policies and procedures reasonably designed to address the conflicts the firm has identified, and are they properly implemented?
As to written disclosure, has the firm reviewed all of the relevant disclosure documents — among others, Forms ADV, private placement memoranda, limited partnership agreements, client agreements, prospectuses — to ensure that all conflicts are disclosed, and disclosed in a manner that allows clients or investors to understand the conflict, its magnitude, and the particular risk it presents? Does the firm review those documents regularly to ensure that new or emerging conflicts are disclosed in a timely way? Further to disclosure, is the adviser keeping the chief compliance officer and boards of directors (if any) informed about conflicts of interests, particularly the adviser’s analysis and decisions on whether to eliminate or mitigate a conflict?
Only through complete and timely disclosure can advisers, as fiduciaries, discharge their obligation to put their clients’ and investors’ interests ahead of their own.
In conclusion, I appreciate the opportunity to share my thoughts on these critically important conflicts issues and on the work of the Asset Management Unit within the Division of Enforcement. Thank you very much and enjoy the rest of the conference.
 The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.
 In re F-Squared Investments, Inc. (Dec. 22, 2014).
 In re Paradigm Capital Management, Inc. et al. (June 16, 2014).
 In re J. Kenneth Alderman, CPA et al. (June 13, 2013).
 In re Northern Lights Compliance Services, LLC et al. (May 2, 2013).
 Oppenheimer Asset Management Inc. (Mar. 11, 2013); see also In re Brian Williamson (Aug. 20, 2013).
 SEC v. AMMB Consultant Serdirian Berhad (D.D.C. filed June 26, 2012).
 In re AXA Rosenberg Group LLC et al. (Feb. 3, 2011).
 In re Further Lane Asset Management, LLC et al. (Oct. 28, 2013); In re GW & Wade, LLC (Oct. 28, 2013); In re Knelman Asset Management Group, LLC et al. (Oct. 28, 2013).
 In re Ambassador Capital Management, LLC et al. (Initial Decision Sept. 19, 2014).
 In re Northern Lights Compliance Services, LLC et al. (May 2, 2013); SEC v. AMMB Consultant Serdirian Berhad (D.D.C. filed June 26, 2012); In re Morgan Stanley Investment Management Inc. (Nov. 16, 2011).
 In re Chariot Advisors, LLC et al. (July 3, 2014).
 In re GLG Partners, Inc. et al. (Dec. 12, 2013). The other seven cases brought to date are: SEC v. Yorkville Advisors, LLC et al. (S.D.N.Y. filed Oct. 17, 2012); SEC v. Balboa et al. (S.D.N.Y. filed Dec. 1, 2011); SEC v. Rooney et al. (N.D. Ill. filed Nov. 18, 2011); In re LeadDog Capital Markets, LLC et al. (Nov. 18, 2011) (Initial Decision Sept. 14, 2012; SEC v. Kapur et al. (S.D.N.Y. filed Nov. 18, 2011); SEC v. Reid et al. (S.D. Ga. filed Feb. 1, 2011); SEC v. Neufeld et al. (N.D. Ill. filed Apr. 19, 2010).
 In re Transamerica Financial Advisors, Inc. (Apr. 3, 2014).
 In re Barclays Capital Inc. (Sept. 23, 2014).
 SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963) (“Capital Gains”).
 Id. at 191-92 (emphasis added) (footnote omitted). This formulation has been followed consistently by the courts. See, e.g., SEC v. DiBella, 587 F.3d 553, 567 (2d Cir. 2009); Monetta Financial Services, Inc. v. SEC, 390 F.3d 952, 955-56 (7th Cir. 2004); SEC v. Wall St. Transcript Corp., 422 F.2d 1371, 1376 (2d Cir. 1970); SEC v. K.W. Brown and Co., 555 F. Supp. 2d 1275, 1305 (S.D. Fla. 2007).
 Capital Gains, 375 U.S. at 196 (citing United States v. Mississippi Valley Generating Co., 364 U.S. 520 (1961)); id. at 196 n.50 (“‘The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them.’” (citation omitted)); Vernazza v. SEC, 327 F.3d 851, 859 (9th Cir. 2003) (“It is indisputable that potential conflicts of interest are ‘material’ facts with respect to clients and the Commission.”); see also K.W. Brown and Co., 555 F. Supp. 2d at 1305 (“The existence of a conflict of interest is a material fact which an investment adviser must disclose to its clients….”).
 The Supreme Court in Capital Gains rejected the argument that advisers are not liable under Section 206 for failing to disclose conflicts of interest where their advice to their clients “was ‘honest’ in the sense that they believed it was sound and did not offer it for the purpose of furthering personal pecuniary objectives.” 375 U.S. at 200.
 In re Feeley & Willcox Asset Management Corp. et al., Admin. Proceeding File No. 3-9571, 2003 WL 22680907, at *13 (July 10, 2003) (Commission opinion) (“It is the client, not the adviser, who is entitled to make the determination whether to waive the adviser’s conflict. Of course, if the adviser does not disclose the conflict, the client has no opportunity to evaluate, much less waive, the conflict.”).
 Vernazza, 327 F.3d at 858-59. The Supreme Court in Capital Gains held that “[i]t is the practice itself … with its potential for abuse, which ‘operates as a fraud or deceit’ within the meaning of the Act when relevant information is suppressed. The Investment Advisers Act of 1940 was ‘directed not only at dishonor, but also at conduct that tempts dishonor.’” 375 U.S. at 200 (citing Mississippi Valley Generating Co., 364 U.S. at 549). The courts have consistently held that the failure to disclose the existence of incentives that could predispose an advisor to act contrary to the clients’ interests is itself a violation. See, e.g., Monetta Financial Services, Inc., 390 F.3d at 955-56 (affirming in relevant part Commission order that adviser violated Section 206(2) and noting fact that it “did not, in fact, favor [certain directors of its mutual fund clients in allocating IPO shares] over the funds is of no consequence because the potential for abuse nonetheless existed”) (citing Capital Gains, 375 U.S. at 191-92); Steadman v. SEC, 603 F.2d 1126, 1130 (5th Cir. 1979) (rejecting defendant’s argument that “actual” conflict of interest was required to meet the materiality requirement enunciated in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), and holding that a “potential” conflict of interest was sufficient).
had a duty to disclose any potential conflicts of interest accurately and completely, and to recognize that [what amount to a referral fee agreement] created such a potential conflict. . . . In this case  the Commission was entitled to conclude that any competent investment adviser would have recognized that the [agreement] created such a potential conflict, and that the [advisers’] failure to identify the conflict was either knowingly or recklessly in disregard of their duties.”).
 In re Manarin Investment Counsel, Ltd. et al. (Oct. 2, 2013).
 The Commission brought a number of cases in FY2014 in which it charged advisers with violations of Section 206(3) for engaging in improper principal transactions. See, e.g., In re Strategic Capital Group, LLC et al. (Sept. 18, 2014); In re Clean Energy Capital, LLC et al. (Oct. 17, 2014); In re Paradigm Capital Management, Inc. et al. (June 16, 2014); In re Parallax Investments, LLC et al. (Nov. 26, 2013); In re Tri-Star Advisors, Inc. et al. (Nov. 26, 2013); In re Further Lane Asset Management, LLC et al. (Oct. 28, 2013).
 In re Clean Energy Capital, LLC et al. (Oct. 17, 2014).
 In re Lincolnshire Management, Inc. (Sept. 22, 2014).
 In re Shelton Financial Group, Inc. (Jan. 13, 2015); see also In re The Robare Group, Ltd. et al. (Sept. 2, 2014); In re Focus Point Solutions, Inc. (Sept. 6, 2012).
 Form ADV was amended in 2010 and these amendments require most Commission-registered advisers to file and to start using client disclosure brochures that meet the requirements of new Part 2A as of 2011. See Advisers Act Rel. No. 3060 (July 28, 2010). Item 14A of the new Form ADV Part 2A requires disclosure of an adviser’s receipt of economic benefits from non-clients for providing investment advice or other advisory services to clients as well as the resulting conflicts and how the firm addresses them.

References: v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 v.