The SEC staff issued a February 2015 IM Guidance Update (the “Guidance Update”), reminding investment advisers to funds and other fund industry participants that the receipt of gifts or entertainment may violate the Investment Company Act of 1940 (the “1940 Act”) and, in the staff’s view, should be addressed by a fund’s 1940 Act Rule 38a-1 compliance policies and procedures.
In an oft-cited opinion, the court wrote that “[t]he objective of § 17(e)(1) is to prevent [a fund’s] affiliated persons from having their judgment and fidelity impaired by conflicts of interest.”United States v. Deutsch, 451 F.2d 98, 109 (2d Cir. 1971). Specifically, Section 17(e)(1) prohibits an affiliated person of a fund, or an affiliated person of such person, acting as agent, from accepting from any source any compensation (other than regular salary or wages from the fund) for the purchase or sale of any property to or for the fund. The SEC has found that gifts or entertainment meets the broad definition of “compensation” in the context of section 17(e)(1).
In the Guidance Update, the staff opined that the conflicts arising from the receipt of gifts and entertainment by fund advisory personnel should be addressed in a fund’s compliance policies and procedures required by Rule 38a-1 under the 1940 Act. The staff did not mandate specific parameters for such a policy and instead suggested that the written policy might range from an outright ban on the receipt of gifts and entertainment by a fund’s advisory personnel, to some type of pre-clearance system that would determine whether the proposed gift or entertainment would be for the purchase or sale of any property to or for the fund and, therefore, prohibited by Section 17(e)(1).
In a footnote, the Guidance Update stated that the prohibition in Section 17(e)(1) is broader than the provisions in FINRA’s rules concerning gifts and gratuities and non-cash compensation for broker-dealers (e.g., FINRA Rule 3220 prohibits broker-dealers and their associated persons from giving “anything of value, including gratuities, in excess of one hundred dollars per individual per year to any person . . . where such payment or gratuity is in relation to the business of the employer of the recipient”). Therefore, investment advisers cannot simply adopt modified versions of the FINRA rules. In another footnote, the Guidance Update stated that, because Section 17(e)(1) “prohibits the receipt of compensation in exchange ‘for’ the purchase or sale of property to or for a fund, courts have found some nexus must be established between the compensation received and the property bought or sold.” Due the difficulty of proving the existence of this “for” nexus, the Guidance Update, quoting a leading 17(e)(1) case, stated that “once a conflict of interest is proven, the burden shifts to the party in conflict to prove that he has been faithful to his trust.”
Although it covers familiar territory, the Guidance Update underscores the need for firms to have written policies and procedures, which are followed, to ensure that the concerns underlying Section 17(e)(1), and the burden-shifting that can occur under Section 17(e)(1) if a conflict of interest is proven, are adequately addressed. Advisers may want to review their policies and procedures accordingly.