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Conflicts of Interest Brian S. Hamburger, JD, AIFA®, CRCP Managing Director August 4, 2009 NASAA Investment Adviser Training Workshop Conflicts of Interest 2 “Having a conflict of interest is not like being a thief or holding a grudge. One can have a conflict of interest without being in the wrong. To have a conflict of interest is merely to have a moral problem. What will be morally right or wrong, or at least morally good or bad, is how one responds to the problem.” - NCSP Currents March/April 2004, quoting “Report on Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services” (1939). Conflicts of Interest Conflicts of interests have always been the centerpiece of investment adviser regulation. One of the most challenging issues in IA compliance. Detection relies upon a learned analysis; not memorization. There are a lot of new entrants that are not used to such stringent treatment of conflicts. History of IA Conflicts 4 Testimony of first hearing on IAs (1939): IA could not completely perform its basic functions of furnishing competent and unbiased advice to clients, unless all conflicts between the adviser and the client were removed. The most fundamental problem IAs faced was the unethical fringe that falsely represented itself as investment counsel. A professional adviser is “utterly unbiased.” IAs are professionals known for the nature of their advice – like physicians and lawyers. The RAND Report (2008) Found that retail investors had difficulty distinguishing between investment advisers and broker-dealers and understanding the varying affiliations and other relationships among the different firms. Defining a Conflict of Interest 5 Working definition: Some activity or relationship involving an investment adviser or its employees that has or has the potential of favoring the interests of the investment adviser, or its employees or affiliates, over the interests of the investment adviser’s clients or some other person to whom the investment adviser owes a fiduciary duty. Only concerned with those conflicts that are “material.” Something is material “. . . if there is a substantial likelihood that a reasonable investor would consider the information to be important in making an investment decision.” Basic, Inc. v. Levinson 485 U.S. 224 (1988). SEC vs. Capital Gains Research Bureau 6 SEC alleged: IA argued: IA was engaged in scalping its clients. An IA may be motivated to recommend securities because of their potential for short-run price increases, which would benefit the adviser, rather than because of their potential for long-term benefit to the client. Its advice was sound and not offered for the purpose of furthering his own pecuniary objectives. Court held: Conduct violated § 206(2) of the Advisers Act because the IA failed to disclose the material conflict of interest caused by this activity. Detecting Conflicts of Interest 7 You should search for those business practices that have the potential to sacrifice the interests on one set of customers in favor of the interest of another. You should also identify any situations in which the firm could place its or its employees’ interest ahead of the firm’s customers. Remarks of Stephen M. Cutler Former Director of Enforcement U.S. Securities and Exchange Commission Detecting Conflicts of Interest 8 Think in very realistic terms. Consider the types of abusive conduct that regulators have already identified in enforcement actions – but be more expansive in your analysis. Think about service providers and how their conduct – or misconduct – might harm the adviser’s clients. Consider establishing committees and enlisting outside assistance. Remarks of Lori Richards Director of OCIE U.S. Securities and Exchange Commission Detecting Conflicts of Interest 9 See Proposed Amendments to Form ADV (Part 2) for some guidance (Release No. IA-1862). Most common sources: Financial interests Family connections Detecting Conflicts of Interest 10 Documents alone usually point to conflicts: Form ADV or disclosure document Client contracts Client complaints Contracts with outside parties Outside business activities Financial records Check registers Receipts and disbursements Policies and procedures Correspondence Marketing materials Resolving Conflicts of Interest 11 Avoidance Disclosure Management Resolving Conflicts of Interest 12 Avoidance Subject of the conflict is simply removed from the conflicted matter. Most effective resolution. Beware of breaching an adviser’s “duty of care.” Disclosure Management Resolving Conflicts of Interest 13 Avoidance Disclosure An IA fulfills its fiduciary obligation if it properly discloses the conflict to the affected clients and obtains the clients’ consents before engaging in the conflicted activity. Most widely adopted by IAs. Does not cure the conflict. Must be deemed “effective” to, well, be a resolution. Beware of “boilerplate” disclosure! Management Zion Capital Management, LLC et. al. 14 IA traded in an omnibus account and allocated the trades once he could determine their profitability. Profitable trades were generally directed to an account where the IA took a performance allocation; and away from a hedge fund the IA managed. Fund’s offering circular stated: The IA “is or may in the future sponsor, manage or participate in other securities investment activities and programs unrelated to the [fund’s] business” and “the other activities of the [IA] may create conflicts of interest with the [fund].” Disclosure included only potential conflicts of interest when, the IA had an actual conflict of interest. Alliance Capital Management, L.P. 15 IA entered into arrangements with market timers in which the IA provided “timing capacity” in certain of its mutual funds in exchange for negotiated levels of “sticky money” in other funds. Because of these arrangements, funds had highly volatile fund flows. Prospectuses for the funds actually stated that the IA sought to restrict timing. Resolving Conflicts of Interest 16 Has the client been notified of the conflict? Nature of the conflict must be clearly and fully disclosed Has the client consented to a transaction despite the disclosure? Was the client in a position to evaluate the effect of the conflict on their account? Did the client know the full fiscal impact of the conflict? Did the client have any alternative to the conflict? In the law, we call that “informed consent” Resolving Conflicts of Interest 17 Avoidance Disclosure Management Should be utilized along with other options to increase effectiveness. Least desirable option on its own. It neither removes the impediments to the decision-maker’s judgment nor eliminates the danger of deceit and breach of trust. Often used as a last resort when exigent circumstances make avoidance and disclosure impossible. Common Conflicts of Interest 18 Conflicts exist everywhere. They are inherent in the advisory relationship. Advisory Fees Performance-based Wrap fee Commissions (securities / insurance / mortgage) % of AUM Hourly Fixed Fee debits Advance vs. arrears Basis for fee calculation Conditions for fee adjustment Common Conflicts of Interest 19 Contractual Arrangements Hedge Clauses Adviser is not liable for any loses resulting from Adviser’s actions unless Adviser has acted with “gross negligence” or “willful misconduct.” Adviser shall not be liable for losses from actions taken in “good faith.” Arbitration Provisions SEC has taken provision that these are hedge clauses and violate the Advisers Act. U.S. Supreme Court has held that pre-dispute agreements to arbitrate are enforceable under both the Securities Exchange Act of 1934 and Securities Act of 1933. Common Conflicts of Interest 20 Financial Interests Financial Interest with an Issuer Mutual fund where IA is the fund’s adviser Partnership where IA is the general partner or adviser IPO where affiliate is involved with underwriting Public offering where IA has a direct financial interest in the company Inflating the values of customer assets to encourage more investing and hence, higher fees Personal Trading Abuses Front-running Side-by-side investing in the same or related securities Common Conflicts of Interest 21 Brokerage Practices Soft dollars Brokerage for client referrals Negotiating or managing trading costs Directed brokerage Permit Regular practice Common Conflicts of Interest 22 Brokerage Practices Commission recapture Commissions earned by IA or affiliates Including trailing commissions (such as 12b-1 fees) Common control with a broker-dealer Self-custody of assets Common Conflicts of Interest 23 Proxy Voting Commission recapture Commissions earned by IA or affiliates Including trailing commissions (such as 12b-1 fees) Common control with a broker-dealer Self-custody of assets Common Conflicts of Interest 24 Referral Arrangements Financial Industry Activities and Affiliations Referrals quid pro quo Broker-dealers Other IAs Accountants Attorneys Solicitors When using non-affiliated solicitors, IA must enter agreement with the solicitor and disclose that referral fees were paid, and whether it increased the client’s fee. Common Conflicts of Interest 25 Wrap Fee Programs A wrap program is: “a program under which any client is charged a specified fee or fees; not based directly upon transactions in a client's account; for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers); and execution of client transactions.” Conflicts: The adviser has an incentive to trade less because it will mean less expenses that the adviser is responsible for. The adviser has a greater incentive to go with the cheapest execution for a client regardless of whether it is “best execution.” Common Conflicts of Interest 26 Controls over Valuation Currently one of the SEC’s “hot topics”. Emphasis should be placed on controls when pricing structured products, illiquid securities, and other difficult to price securities. Adviser has the ability to overstate the value of securities, thereby increasing its own compensation. Brian S. Hamburger, JD, CRCP, AIFA® 27 Brian Hamburger is the Founder and Managing Member of the Hamburger Law Firm. Brian is also the Founder and Managing Director of MarketCounsel, affiliated business, regulatory, and compliance consulting firm for entrepreneurial investment advisory firms nationwide. MarketCounsel and the Hamburger Law Firm are the result of an incessant entrepreneurial spirit and genuine desire to provide an unexpected level of value and service. Together, the consulting and law firms represent an unparalleled combination of preeminent counsel and uncompromising service to the retail securities industry. an Previously, Mr. Hamburger was an attorney with the securities practice group of a large New Jersey law firm. While there, he practiced in the area of securities law, concentrating in investment adviser and broker-dealer registration and compliance matters as well as broker transition and practice management issues. Prior to that post, Brian served as a law clerk in the Enforcement Division of the U.S. Securities & Exchange Commission. He was also a judicial intern at the U.S. District Court for the Southern District of Florida and then, the State of Florida Third District Court of Appeal. Earlier, Brian was the chief compliance officer of an SEC-registered investment adviser. In addition to his father's lifelong influence, Brian’s involvement in the securities industry started before he could even drive a car. Since then, he has been involved in a myriad of areas within the industry, posting a rich diversity of experiences with investment adviser and financial planning firms. Mr. Hamburger is admitted to the bars of New Jersey, New York, Pennsylvania, Massachusetts, the District of Columbia, as well as the U.S. Supreme Court. He is a member of the American Bar Association (Business Law Section) and other bar associations; the Securities Industry and Financial Markets Association, Compliance & Legal Division; National Society of Compliance Professionals; Financial Planning Association; and Society of Financial Service Professionals. Brian has been appointed to the American Bar Association’s Committees on Federal Regulation of Securities; State Regulation of Securities; and Professional Conduct; and is a Platinum and Gold Key Member of the New York Chapter of the Investment Management Consultants Association and New Jersey Financial Planning Association, respectively. He has also heeded the call of the Certified Financial Planner Board of Standards to sit on various task forces to shape industry-wide initiatives. Brian is a frequent lecturer to regional and national groups in the securities industry including members of the wealth management, investment management, financial planning, accounting, and insurance professions. His forums have ranged from delivering the keynote address to the country's state securities regulators to addressing school-age children on career and entrepreneurial issues. For the past several years, he has been engaged by the North American Securities Administrators Association (NASAA) to train state securities examiners on the intricacies of Form ADV and investment adviser client contracts. Mr. Hamburger proudly sits on several boards of directors and advisory boards. He maintains his FINRA securities licenses (Series 7, 63 and 65), is a member of the FINRA Dispute Resolution Board of Arbitrators and served as an arbitrator for the New York Stock Exchange. A graduate of Quinnipiac College, Mr. Hamburger received his B.S. with the school's first dual major in Economics and Financial Management. He went on to earn his Juris Doctor from the University of Miami School of Law where he was the recipient of a Dean’s Service Scholarship and the President's Pinnacle Award for his role as Editor-in-Chief of the Res Ipsa Loquitur, the Bi-Weekly Journal of the University of Miami School of Law. Brian was among the first to earn the designation of Certified Regulatory and Compliance Professional (CRCP) by the Wharton School and the FINRA Institute after completing his residency at the Wharton School of the University of Pennsylvania. He was recently awarded the Accredited Investment Fiduciary Analyst™ (AIFA®) designation by the Center for Fiduciary Studies. AIFA designees have the knowledge necessary to understand and implement a prudent investment process for investment advisers, investment managers, and investment stewards and can perform a fiduciary assessment to verify or certify an entity's conformity to a "global fiduciary standard of excellence.“Brian is an active member of the US Coast Guard Auxiliary. He lives with his wife, Kari, their daughter, Ella, and sons, Jacob and Sidney, in New Jersey. © 2009 MarketCounsel, LLC. All rights reserved. No portion of this presentation may be reproduced without the express written consent of the author. MarketCounsel is a consulting firm, is not affiliated with any government entity, and does not render legal or investment advice. MarketCounsel is affiliated with the Hamburger Law Firm, LLC. 201.705.1200 www.marketcounsel.com Speaker Contributors Brian S. Hamburger, JD, AIFA®, CRCP Alyssa M. Kolber, JD