The SEC sanctioned a registered investment adviser for breaching its fiduciary duty by failing to disclose to its clients a conflict of interest created by a portfolio manager’s outside business activity and personal investments. The SEC found that the firm violated, among other things, Rule 206(4)-7 under the Advisers Act, which requires registered investment advisers to adopt written compliance policies reasonably designed to ensure that the adviser does not violate the federal securities laws.

The SEC also found that:

  • The firm caused certain affiliated mutual funds to violate Rule 38a-1 under the 1940 Act, which imposes similar requirements to adopt written compliance policies on registered funds; and
  • The firm’s CCO caused the firm and its affiliated funds to violate the compliance rules.

According to the SEC, the portfolio manager managed funds and accounts that invested in the energy sector and, while employed by the firm, the portfolio manager established a family-owned business that operated in the energy sector. Over time, that business formed a joint venture that became the largest holding in the funds and accounts managed by the portfolio manager.  Importantly, the portfolio manager’s compensation included a portion of the investment management fees earned on the funds and separate accounts that he managed.

Although the firm had a policy related to private investments by firm personnel, and the formation of the family-owned business was not consistent with that policy, the SEC found that the firm did not take any action to address that compliance breach when it was discovered. Moreover, the firm failed to disclose to the boards of affiliated funds and other clients that there had been a material compliance violation. The SEC said that this violated the firm’s fiduciary obligation to eliminate the conflict of interest created by an outside business activity or to disclose it to the boards of affiliated funds and other advisory clients. By failing to do so, the SEC said, the firm “deprived its clients of their right to exercise their independent judgment to determine whether the conflict might impact portfolio management decisions.”

The SEC also found that, by failing to report a material compliance matter to the board of certain affiliated funds, the firm caused such funds to violate Rule 38a-1. The firm and the CCO were found to have “denied the funds’ boards critical compliance information alerting them to [the] outside business interests.”

The firm was fined $12 million, and the CCO was fined $60,000. In addition, the firm was required to retain an independent compliance consultant.

Our Take

In light of this action, firms should evaluate whether their compliance policies are, in fact, “reasonably designed” to ensure compliance with the federal securities laws. In particular, firms should ensure that they have adopted policies related to outside business activities by key employees and that such policies reflect how the firm will assess, mitigate and monitor any conflicts of interest presented by outside business activities.

CCOs should also be cognizant that the SEC believes the obligation to design procedures for monitoring and assessing, on an ongoing basis, any identified conflicts of interest lies squarely on the shoulders of the CCO.  Failure to do so may result in a CCO causing a firm to violate its obligations under the compliance rules. Once again, it appears the SEC is signaling that the role of the CCO as gatekeeper is not one to be undertaken lightly.