Navigating Interactions Between Investment Advisers and Their Portfolio Companies: Risks and Best Practices
Insider trading and the potential misuse of material nonpublic information (MNPI) have long been areas of intense focus of the U.S. Securities and Exchange Commission’s (the SEC) examination and enforcement programs. Recent SEC actions reflect a trend toward increased scrutiny of the potential for investment advisers to receive — and possibly to misuse — MNPI as a result of frequent interactions with the issuers in their investment portfolios, even where there is no evidence of misuse. Even in instances where the SEC does not allege that insider trading actually occurred, these actions reflect that investment advisers may face challenging regulatory examinations, enforcement actions and civil money penalties if the SEC alleges that an investment adviser’s policies and procedures were not adequately and effectively designed, implemented and enforced to address the potential for such misconduct. Accordingly, we suggest best practices with respect to the design and implementation of policies and procedures relating to the treatment of MNPI.
Recent MNPI actions involving investment advisers. The SEC has recently brought a number of MNPI-related enforcement actions, including these:
- an order alleging that an investment adviser’s policies and procedures did not adequately address the risks posed by its business model, which involved, among other things, entering into nondisclosure agreements with multiple issuers and engaging in confidentially offered transactions (e.g., secondary offerings and private investment in public equity (PIPE) transactions) with such issuers, notwithstanding that the SEC did not allege that the investment adviser or its employees had engaged in insider trading 1
- an order alleging that an investment adviser to a private equity fund failed to implement and enforce policies and procedures reasonably designed to prevent the misuse of MNPI in view of the fact that the firm had representation on the board of one of its portfolio companies. 2 Just based on purported policies and procedures violations, and without any finding that insider trading occurred, the adviser was censured and paid a significant civil money penalty. This action reflects the SEC’s attention to the heightened risk that an investment adviser may receive or misuse MNPI where its employee occupies a board seat in one of its sponsored fund’s portfolio companies or otherwise receives confidential information about an issuer.
These actions underscore the SEC staff’s focus on the specific risks posed by frequent interactions between investment advisers and the companies in which they invest even in the absence of evidence that any misuse of MNPI or insider trading actually occurred. Rather, the focus of these actions was access to potential MNPI and alleged failures to implement and enforce policies and procedures to sufficiently prevent and detect the misuse of MNPI.
Moreover, we note that for every enforcement proceeding the SEC staff publicizes, there are dozens of investment adviser examinations focusing on these issues that may not result in enforcement action but nevertheless can be distracting, burdensome and expensive if an adviser is not adequately prepared.
The broader MNPI enforcement landscape. The SEC has long warned of the risks of receiving MNPI from companies in which an individual or entity invests in other contexts. Notable MNPI-related actions in the past several years have included, for example, charges brought against an entrepreneur who was invited to participate in a confidential PIPE transaction (and who traded in shares of the company involved in the transaction on that basis) 3 and an action brought against defendants including various employees of public companies who provided MNPI to an expert consulting firm, which then relayed the information to hedge fund clients who traded on it. 4
While many of these actions focused on individual investors and hedge funds, the SEC has for years also alerted broker-dealers to the risks inherent in interacting with public companies. In September 2012, the staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) published a report summarizing trends and areas of concern identified in its examination of various broker-dealers. 5 Specifically, the OCIE staff’s report focused on its review of broker-dealer compliance with regulatory requirements surrounding MNPI pursuant to Section 15(g) of the Securities Exchange Act of 1934 (Exchange Act), which requires that broker-dealers “establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such broker’s or dealer’s business, to prevent the misuse . of material, nonpublic information[.]” 6 Among the risks highlighted by the OCIE staff was the potential for individuals and entities operating in the private equity space to receive MNPI through their interactions with portfolio companies:
With respect to Asset Management, Private Equity tends to have more frequent contacts with their portfolio companies as well as with corporations seeking potential investments.
As a holder of a substantial interest in a corporation, Investment Groups may receive confidential information, which at times may be MNPI, directly from the corporation. For example, the Investment Group may have an employee serving on the board of directors of the company or a shareholder committee. If a company has financial difficulty, a representative from the Investment Group may be invited to participate in bankruptcy or creditor committees of distressed companies (or even pre-bankruptcy committees).
Investment Groups may also obtain MNPI as part of the investment process. The information may be obtained by discussions between the employee and an insider of the company. For example, Investment Groups may be approached about investing in an offering that has not yet been publicly disclosed (e.g., a PIPE). 7
As described, recent enforcement actions reflect that the SEC is increasingly focused on the potential misuse of MNPI by investment advisers in light of the close relationships such firms often maintain with the companies in which they invest. Indeed, annual reports published by the SEC’s Division of Enforcement reflect that for each of the last three years, cases involving (i) investment advisers/investment companies and (ii) insider trading have ranked among the top five types of enforcement actions the SEC has brought. 8 The data also suggests that this trend will continue; for example, in fiscal year 2019, investment adviser and investment company issues accounted for 36 percent of all enforcement actions the SEC brought, an increase from 22 percent in fiscal year 2018. 9
Best practices and key takeaways. The SEC’s approach with respect to policies and procedures and the potential misuse of MNPI — and the alleged deficiencies on which they focus — provide a roadmap for best practices for investment advisers that may have access to confidential information about their portfolio companies:
- DO implement and enforce a set of policies and procedures narrowly tailored to address the risks specific to your business. Simply maintaining written policies and procedures is not sufficient. Section 204A of the Advisers Act requires advisers to
- reasonably design MNPI policies and procedures, taking into consideration the nature of the adviser’s business in light of the totality of the facts and circumstances
- implement, monitor and enforce such policies and procedures
- periodically review and, as appropriate, modify those policies and procedures to prevent even the potential misuse of MNPI
DO exercise great caution in relying on conclusions about the materiality of any potential MNPI. The determination of whether information is “material” will always be subject to second guessing, and advisers should expect that the SEC staff will assess such determination with the benefit of hindsight. In that regard, an adviser should maintain policies and procedures that require employees who suspect they may have obtained MNPI to consult internal and/or external legal counsel and/or the chief compliance officer to avoid making subjective determinations about the materiality of information they either do receive or may receive.
DO NOT rely on information barriers if they are difficult or impossible to enforce consistently in light of the nature and structure of your business. Many advisers choose to implement policies and procedures providing for the establishment of “ethical walls” or other information barriers; however, as a practical matter, such barriers may be difficult or impossible to enforce depending on the size and structure of the business. In establishing procedures, an adviser should consider the feasibility of implementing and enforcing such measures.
DO NOT rely exclusively on assurances from an issuer that the firm is not in possession of MNPI. An adviser should not rely on assurances from portfolio companies that such companies are not in possession of MNPI without undertaking its own independent review.
1 In the Matter of Cannell Capital, LLC, Inv. Adv. Act Rel. No. 5441 (Feb. 4, 2020), https://www.sec.gov/litigation/admin/2020/ia-5441.pdf.
5 U.S. Sec. and Exch. Comm., Staff Summary Report on Examinations of Information Barriers: Broker-Dealer Practices Under Section 15(g) of the Securities Exchange Act of 1934 (Sept. 27, 2012), https://www.sec.gov/about/offices/ocie/informationbarriers.pdf.
6 The Investment Advisers Act of 1940 (Advisers Act) contains a substantially identical provision under Section 204A subjecting investment advisers to the same standard. See 15 U.S.C. § 80b-4a.
7 U.S. Sec. and Exch. Comm., Staff Summary Report on Examinations of Information Barriers: Broker-Dealer Practices Under Section 15(g) of the Securities Exchange Act of 1934 (Sept. 27, 2012), https://www.sec.gov/about/offices/ocie/informationbarriers.pdf.
8 U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 6, 2019), https://www.sec.gov/files/enforcement-annual-report-2019.pdf; U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 2, 2018), https://www.sec.gov/files/enforcement-annual-report-2018.pdf; U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 15, 2017), https://www.sec.gov/files/enforcement-annual-report-2017.pdf.
9 U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 6, 2019), https://www.sec.gov/files/enforcement-annual-report-2019.pdf; U.S. Sec. and Exch. Comm., Division of Enforcement Annual Report (Nov. 2, 2018), https://www.sec.gov/files/enforcement-annual-report-2018.pdf.
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Compliance Considerations of Portfolio Management and Trading
In its 2019 Examinations Priorities Letter, the Securities and Exchange Commission (“SEC”), Office of Compliance Inspections and Examinations, listed Portfolio Management and Trading as SEC Examinations priorities. [1] Many Firms are unaware of their Compliance requirements, putting those firms at risk for regulatory sanction.
The SEC intends to examine to ensure investment or trading strategies of advisers are: (1) suitable for and in the best interests of investors based on their investment objectives and risk tolerance; (2) contrary to, or have drifted from, disclosures to investors; (3) venturing into new, risky investments or products without adequate risk disclosure; and (4) appropriately monitored for attendant risks.
Registered Investment Advisers (“RIA” or the “Firm”) should take steps to review the current rules and their Policies and Procedures to ensure they are meeting their compliance requirements regarding Portfolio Management and Trading.
What are your Requirements?
The SEC’s article “Information for Newly-Registered Investment Advisers” [2] describes how RIAs are fiduciaries and have the fundamental obligation to act in the best interests of the RIAs clients. The letter states:
“As an investment adviser, you are a “fiduciary” to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients. Generally, facts are “material” if a reasonable investor would consider them to be important. You must eliminate, or at least disclose, all conflicts of interest that might incline you — consciously or unconsciously — to render advice that is not disinterested. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict. You cannot use your clients’ assets for your own benefit or the benefit of other clients, at least without client consent. Departure from this fiduciary standard may constitute “fraud” upon your clients (under Section 206 of the Advisers Act).”
As described above, these fiduciary requirements extend themselves to Portfolio Management and Trading. As an RIA, are your Portfolio Management decisions and trading practices designed with the best interests of the client as the primary goal? Are you disclosing to your clients any conflicts of interest that may put the interests of your Firm in conflict with the interests of the client? Have you taken steps to mitigate or eliminate those conflicts?
The SEC has taken enforcement action against Firms that did not meet their compliance and/or their fiduciary responsibilities when addressing Portfolio Management and Trading. For example:
- In the matter of Saxony Capital Management, LLC, September 30, 2019 [3] , among other actions, was required to pay disgorgement of $212,324.53 and prejudgment interest of $17,896.3 for inadequate disclosure of Mutual Fund Investments.
- In the Matter of Lefavi Wealth Management, Inc., September 3, 2019 [4] , the Firm was required to pay disgorgement of $994,296.10 and prejudgment interest of $144,439.12, and a civil monetary penalty in the amount of $150,000 for among other violations, failure to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act, and the rules thereunder, in connection with its duty to seek best execution related to Alternative Investments.
- In the matter of Putnam Investment Management, LLC and Zachary Harrison, September 27, 2018 [5] , among other actions, the Firm was required to pay a civil money penalty in the amount of $1,000,000 and respondent Harrison was required to pay a civil penalty of $50,000 for violating Section 206(2) of the Advisers Act, which prohibits any investment adviser from engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client. Specifically, in its dealer interposed cross transactions, Putnam favored certain of its clients and did not seek to obtain best price and execution for certain of its clients in these cross-trades.
These are only a small sample of many enforcement actions brought by the SEC that involve Portfolio Management and Trading. In addition, the fact that Portfolio Management and Trading remain on the SEC’s Examinations Priorities Letter highlights the importance of this topic.
What should you do to Ensure Compliance?
What should Advisers do to maintain regulatory compliance regarding Portfolio Management and Trading? A good place to start is a review of your duties to your clients as a Registered Investment Adviser.
- RIAs must perform a best efforts inquiry to obtain information regarding the client’s objectives, risk tolerance, time horizons, liquidity needs, and any special considerations. This information should be documented in some manner, with many firms relying on the use of an Investor Profile Form” which, when utilized, is typically completed with client input as part of the initial client intake process. Firms should verify that they have a methodology for gathering, documenting, and utilizing this information.
- RIAs are required to provide clients with accurate disclosures of all material facts relating to the Investment Adviser-client relationship. These disclosures are typically provided through the use of Form ADV which must be provided to the client. In particular, Form ADV among other things, should accurately describe any conflicts of interest that may exist which may put the needs of the Firm in conflict with those of the client. Firms should perform a conflict of interest inventory and verify that these conflicts are adequately disclosed and that steps are taken (and described in Form ADV) to mitigate or eliminate these conflicts.
- When creating the client’s investment portfolio, RIAs must provide advice that is in the client’s best interest. This includes performing adequate due diligence of the investments and ensuring the suitability of the investment itself. For example, a particular investment may be highly rated and fit into a particular asset allocation, but it may not be suitable for a particular client due to the investment’s volatility. RIAs should perform due diligence of particular investments, and client portfolios should be reviewed by supervisory personnel when available, to verify the suitability and use of individual investments when deployed.
- RIAs are also required to seek and obtain “Best Execution”. This means the RIA is required to monitor the trade execution performance of the broker-dealers/custodians it uses to execute client trades. This is normally done by obtaining the “Best Execution Scorecard” for the broker-dealer/custodian used, and comparing it with the scorecards of other and similar broker-dealer/custodians to see if the execution quality of the chosen firm is performing in the best interests of the client. In evaluating Best Execution, the cost of trades is not the only factor taken into consideration. Factors such as quality and availability of client services, the range of other services offered by the Broker-Dealer/Custodian should also be considered. This analysis should be performed on a periodic basis and memorialized in a “Best Execution Report”.
- Once an investment portfolio has been created for a client, the RIA must monitor the portfolio on an ongoing basis and meet with clients at least annually to discuss the portfolio and any possible changes to the client’s status that may necessitate a change in their portfolio.
RIAs should perform a review of their Policies and Procedures Manual to ensure the above requirements are adequately and accurately addressed. If not, the Manual should be revised to include these steps and requirements.
Once, the Firm’s Policies and Procedures adequately address these requirements, Firms should include the testing of their Policies and Procedures designed to meet these requirements and document these tests as part of the Firm’s Annual Review.
In closing, Firms have a fiduciary duty to act in the best interests of their clients. This requirement extends to Portfolio Management and Trading. The SEC and other regulators take this duty seriously and have stated these are areas that will be considered during examinations. Firms should take steps now to review their Portfolio Management and Trading procedures for adequacy.
Author: 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] 2019 EXAMINATION PRIORITIES Office of Compliance Inspections and Examinations https://www.sec.gov/files/OCIE%202019%20Priorities.pdf
[2] Information for Newly-Registered Investment Advisers, November 23, 2010 https://www.sec.gov/divisions/investment/advoverview.htm
[3] INVESTMENT ADVISERS ACT OF 1940 Release No. 5385 / September 30, 2019 ADMINISTRATIVE PROCEEDING File No. 3-19552 https://www.sec.gov/litigation/admin/2019/ia-5385.pdf
[4] INVESTMENT ADVISERS ACT OF 1940 Release No. 5336 / September 3, 2019 ADMINISTRATIVE PROCEEDING
File No. 3-19411 https://www.sec.gov/litigation/admin/2019/ia-5336.pdf
[5] INVESTMENT ADVISERS ACT OF 1940 Release No. 5050 / September 27, 2018 INVESTMENT COMPANY ACT OF 1940 Release No. 33257 / September 27, 2018 ADMINISTRATIVE PROCEEDING File No. 3-18844
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