operational due diligence breakfast briefing final.pdf · breakfast briefing december 13, 2018...
TRANSCRIPT
OPERATIONAL DUE DILIGENCE
Breakfast Briefing
December 13, 2018
Moderated by:
Greg Florio
Jim Leahy
2
Table of Contents
About Orical………………………………………………………………………………….……3
About Orical’s Operation Due Diligence Breakfast Briefings………………………..…..........….4
Topic 1: SEC Examinations…………………………..……………………...……………………5
Summary of the SEC’s 2018 Examination Priorities…………………………...…………5
SEC Risk Alerts……………………………………………………………………………5
ODD Questions to Ask…………………………………………………………………….8
Topic 2: SEC Enforcement Actions…………………………………………………………….…9
Summary of SEC Annual Report, Division of Enforcement………………….…………..9
Topic 3: Fiduciary Duty and Conflicts of Interest…………………………………………...……11
Summary of the SEC’s Proposed Commission Interpretation Regarding Standard of
Conduct for Investment Advisers.…………………………………………………..……11
Orical Article, Undisclosed Conflicts, by James Leahy………………………Attachment 1
Enforcement Actions Related to Conflicts of Interest………………………….…………12
ODD Questions to Ask………………………………………………………...…………16
Attachment 1: Orical Article, Undisclosed Conflicts, by James Leahy...….....……………..……17
Attachment 2: Orical Service Descriptions and Partner Bios.………………....……….…………21
3
About Orical
The Orical family of companies provides investment advisory legal and compliance
services, as well as leading investment management compliance technology, in one unified
offering1. Orical LLC is an investment management compliance consulting firm founded in 2010.
With clients in the U.S. and abroad, Orical services some of the financial industry’s most well-
respected firms, including investment managers, broker/dealers, family offices and banks. The
premier law firm and extensive in-house industry experience of our professionals enables Orical
to provide timely, practical advice and hands-on assistance that reflects a comprehensive
understanding of the real-world issues facing today’s industry participants. Our business model is
to provide extremely responsive and cost-effective expert compliance services. Orical, together
with its affiliates, Florio Leahy LLP, an investment management law firm, and Real World
Compliance LLC, a compliance software firm, provides a full suite of investment management
services, including the following:
• Registration Services with low Start-Up Costs (RIA, CPO/CTA, B/D);
• Development and Administration of Customized Compliance Programs that Represent
the Industry’s Best Practices;
• Compliance Software;
• Forensic Trading Reviews (Anti-Insider Trading and Market Manipulation Surveillance);
• Assistance with Investor Due Diligence;
• Assistance through Regulatory Examination;
• Mock Examinations (SEC/FINRA/CFTC);
• CCO Training Programs, Guidance and Education;
• Periodic Regulatory Updates;
• Compliance Training;
• Compliance Initiatives, Including in the Areas of Marketing and Performance Reporting,
Investment Allocation, Expense Allocation, Conflicts of Interest, Disclosure, SEC
Readiness, Custody, Cybersecurity, Disaster Recovery and Books and Records
Compliance; and
• Expanding the Bandwidth of our Client’s Internal Personnel.
1 Legal services are provided by Florio Leahy LLP and compliance technology is provided by Real World
Compliance LLC, both of which are under common ownership and control with Orical LLC.
4
About the Operational Due Diligence Breakfast Briefings
Orical’s Operational Due Diligence Breakfast Briefings are a series of informative conferences
designed to cover the topics of most significance to the alternative asset operational due diligence
community and investors. Briefings are open to all alternative asset ODD professionals, as well as the
principals and operational staff of Orical’s clients, which include hundreds of alternative assets managers.
Topics are chosen with input from the ODD professionals, Orical’s clients and Orical’s broader network,
with 2-3 topics to be covered in each Briefing.
Orical’s goal in conducting the Briefings is to foster an exchange of information in an open and
“off-the-record” format, to help those who participate obtain a better understanding of how the industry’s
best practices apply in different settings, and, ultimately, to increase the likelihood of success for alternative
asset ODD professionals, investment managers and investors alike.
5
Topic 1: SEC Examinations
• Summary of the SEC’s 2018 Examination Prioritieshttps://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2018.pdf
In February 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”)
announced its 2018 Examination Priorities. Its interests this year will be tailored to matters
involving critical market infrastructure, duties to retail investors, and developments in
cryptocurrency, initial coin offerings and secondary market trading. OCIE broke down its
priorities into five categories: (1) compliance and risks in critical market infrastructure; (2)
matters of importance to retail investors, including seniors and those saving for retirement; (3)
FINRA and MSRB; (4) cybersecurity; and (5) anti-money laundering programs. In regard to
protecting retail investors, OCIE will focus examinations on the disclosure and calculation of
fees, expenses, and other charges investors pay, the supervision of representatives selling
products and services to investors, and the execution of customer orders in fixed income
securities. When examining cybersecurity, OCIE will put an emphasis on governance and risk
assessment, access rights and controls, data loss prevention, vendor management, training, and
incident response. Examiners will review for compliance with applicable anti-money
laundering requirements, including whether firms are appropriately adapting their AML
programs to address their regulatory obligations.
• SEC Risk Alerts
✓ Advertising, https://www.sec.gov/ocie/Article/risk-alert-advertising.pdf
On September 14, 2017, OCIE provided a list of the most frequently cited compliance
issues related to Rule 206(4)-1, which prohibits any advertisement that contains any untrue
statement of material fact or that is otherwise false or misleading. The most frequently
cited compliance issues included the use of: (1) misleading performance results (e.g.
providing gross performance without also including net, lack of disclosures when
comparing performance to a benchmark, use of hypothetical or back-tested performance
results without disclosure of how such results were generated, etc.); (2) misleading one-
on-one presentations where fees and expenses were not deducted from displayed results;
(3) misleading claim of compliance with voluntary performance standards; (4) cherry-
picked profitable stock selections; (5) misleading selection of recommendations (e.g.,
displaying only certain specific recommendations and not all in order to illustrate a specific
strategy, and providing the best performing holdings without providing an equal amount
of worst performers); (6) lacking, or failing to adhere to, policies and procedures
reasonably designed to prevent deficiencies; (7) misleading use of third party rankings or
6
awards; (8) misleading use of professional designations; and (9) published testimonials of
clients attesting to services provided.
✓ Advisory Fee and Expense Compliance Issues, https://www.sec.gov/files/ocie-risk-alert-
advisory-fee-expense-compliance.pdf
On April 12, 2018, OCIE issued a Risk Alert outlining the most frequent issues identified
during examinations. The list included: fee-billing based on incorrect account valuations
due to the use of a different metric or valuation process than what was specified in a client’s
advisory agreement; billing fees in advance or with improper frequency; applying incorrect
fee rate; omitting rebates and applying discounts incorrectly; disclosure issues involving
advisory fees; and adviser expense misallocations. OCIE put an emphasis on advisers
adopting and implementing written policies and procedures that are reasonably designed
to prevent any violation of the Advisers Act due to a failure to adhere to terms of an
advisory agreement related to a client’s advisory fees and expenses, as well as language set
in Form ADV and other materials provided to clients.
✓ Best Execution, https://www.sec.gov/files/OCIE%20Risk%20Alert%20-
%20IA%20Best%20Execution.pdf
In July 2018, OCIE issued a Risk Alert to inform investment advisers of the most common
deficiencies cited by examiners in relation to best execution obligations. As a fiduciary,
advisers have an obligation to obtain “best execution” of client trades and must execute
securities transactions in a manner that is most favorable in terms of client’s total costs or
proceeds for each transaction. An adviser should consider, among other things, the value
of research provided as well as execution capability, commission rate, financial
responsibility, and responsiveness to the adviser. Examples of common deficiencies
included: (1) not periodically and systematically performing best execution reviews; (2)
not considering materially relevant factors during best execution reviews such as,
evaluating qualitative factors like execution capability, financial responsibility, or
responsiveness to the adviser, as well as advisers not reviewing input from traders and
portfolio managers; (3) not seeking comparisons from other broker-dealers initially and/or
on an ongoing basis; (4) not fully disclosing best execution practices; (5) not providing a
full and fair disclosure of soft dollar arrangements; (6) not properly administering mixed
use allocations; and (7) advisers having inadequate policies and procedures relating to best
execution or not following their best execution policies and procedures.
✓ Cash Solicitation, https://www.sec.gov/files/OCIE%20Risk%20Alert%20-
%20Cash%20Solicitation.pdf
In October 2018, OCIE issued a Risk Alert to advise investment advisers of the most
common deficiencies observed by OCIE staff relating to Rule 206(4)-3, or the Cash
7
Solicitation Rule. Registered investment advisers are generally prohibited from directly or
indirectly paying a cash fee for soliciting clients for the adviser, unless certain conditions
are met. When using a third-party solicitor, the Cash Solicitation rule requires the
following: (1) the solicitation agreement contains certain provisions such as compensation
to be received; (2) the agreement requires that a copy of the adviser’s brochure and a
separate, written disclosure document are provided to the client at the time of any
solicitation activities; (3) the adviser must receive acknowledgement of aforementioned
items; and (4) the adviser must make a bona fide effort to ascertain the solicitor has
complied with the agreement. The most common deficiencies of the Rule include: (1)
advisers whose third-party solicitors provided solicitor disclosure documents without all of
the required info to prospective clients, or none at all; (2) acknowledgements of adviser
brochure and disclosure documents were not received timely or were incomplete; (3)
advisers paid cash fees to solicitors without an agreement or pursuant to an agreement not
containing specific provisions; and (4) no efforts by advisers to confirm compliance with
agreements.
✓ RIC Initiative, https://www.sec.gov/files/OCIE%20Risk%20Alert%20-
%20RIC%20Initiatives_0.pdf
In November 2018, OCIE published a Risk Alert on conducting examination initiatives
focused on mutual funds and exchange-traded funds (“Funds”). The following topics will
be generally covered in the initiatives: (1) policies and procedures of Funds and/or advisers
to ensure they address risks and conflicts; (2) Fund disclosures to investors and shareholder
communications, and by advisers to Funds’ boards regarding risks and conflicts; and (3)
processes by Funds, advisers, and boards to assess practices and controls pertaining to risks
and conflicts. More specific focus areas of the initiatives include: (1) Index Funds that track
custom-built indexes and the unique risks and challenges of advisers and index providers
relating to the selection and weighting of these indexes; (2) compliance risks, conflicts, and
practices related to smaller and/or thinly traded ETFs; (3) factors of a mutual funds’
aberrational underperformance relative to their peer groups; (4) the policies, practices,
governance, and disclosures to investors of mutual funds with higher allocations to certain
securitized assets and/or their advisers; (5) Allocation practices, disclosures, policies and
procedures, etc., for addressing conflicts of interest and other risks associated with side-
by-side management of mutual funds and private funds; and (6) Funds managed by advisers
that are relatively new to managing registered investment companies.
8
ODD Questions to Ask
Preparation: What have you done to prepare for the inevitable SEC exam?
✓ Conduct SEC readiness exercises
✓ Identify the SEC response team, including your administrator
✓ Conduct mock exams with interviews
✓ Make sure conflicts are disclosed, follow the money, find the conflict
✓ Respond to testing recommendations
Presentation: How will your firm handle an actual exam?
✓ Be Present
✓ Create a First Day Presentation and subject matter slides
✓ Who will be the quarterback
✓ Prepare your witnesses
✓ Review every submission
✓ Be timely
✓ Communicate
✓ Never back date
✓ Provide all responsive documents
✓ No cover-ups, don’t be evasive
✓ Seek assistance from experienced professionals
9
Topic 2: SEC Enforcement Actions
Summary of SEC Annual Report, Division of Enforcement
The SEC recently published its Agency Financial Report for Fiscal Year 20182 (“SEC Report”) as well as
the Annual Report of the Division of Enforcement 20183 (“Enforcement Report”). In the SEC Report,
Chairman Clayton reiterated the SEC’s three-part mission which is to (i) protect investors, (ii) maintain
fair, orderly and efficient markets, and (iii) facilitate capital formation. The Chairman also indicated that
the SEC has three strategic goals for the next four years (2018-2022): the first goal is to focus on the
interests of Main Street investors. The second goal is to be innovative and responsive to the changing
nature of markets, particularly as a result of technological advancements. And finally, the third goal is to
increase the SEC’s performance by using technology, data analytics and human capital.
As of September 30, 2018, the SEC employed as staff of approximately 4,500 people. Of that number,
approximately 1300 were assigned to the Division of Enforcement (“Enforcement”) and 1100 were
assigned to the Office of Compliance Inspections and Examinations (“OCIE”). The Enforcement Report
indicates that personnel resources are down in Enforcement by approximately 10% since late 2016 as a
result of an SEC-wide hiring freeze.
As of September 2018, there were approximately 13,200 investment advisers registered with the SEC.
These advisers reported regulatory assets under management of nearly $80 trillion. The number of
registered advisers (“RIAs”) increased by approximately 5% during the year. Despite that increase, the
SEC was able to examine 17% of the RIA population during fiscal 2018. To put that number in
perspective, the SEC examined only 8% of RIAs in FY 2012. The number of SEC exams that get referred
to Enforcement continues to hover around 10%.
The Enforcement Report cites Main Street investors as a principal focus. Enforcement was able to return
$794 million to harmed investors. The Retail Strategy Task Force was formed and the Share Class
Selection Disclosure (“SCSD”) was announced. The SCSD program is designed encourage RIAs to self-
report undisclosed conflicts of interest related to marketing fees and expenses associated with the
selection of mutual fund share classes. Scores of RIAs participated.
The Enforcement Division’s Cyber Unit became fully operational and began to prosecute cases related to
digital assets and initial coin offerings. Enforcement is also leveraging enhanced data analytics to pursue
insider trading and allocation of investment opportunity (cherry picking) cases.
2 See https://www.sec.gov/reports-and-publications/annual-reports/sec-2018-agency-financial-report.
3 See https://www.sec.gov/files/enforcement-annual-report-2018.pdf.
10
During FY 2018 Enforcement brought 821 actions (490 of which were stand-alone) and obtained
judgements and orders totaling more than $3.9 billion in disgorgement of ill-gotten gains and penalties. It
also returned $794 million to harmed investors, suspended trading in nearly 300 companies and obtained
approximately 550 bars and suspensions.
A breakdown of the 490 stand-alone actions in FY 2018 is as follows:
Actions Percent
Securities Offerings 121 25%
RIA/Inv. Company 108 22%
Reporting & Disclosure 79 16%
Broker Dealer 63 13%
Insider Trading 51 10%
Market Manipulation 32 7%
Public Finance Abuse 15 3%
FCPA 13 3%
Misc. 3 1%
NRSRO 2 0%
Transfer Agent 2 0%
SRO or Exchange 1 0%
Total 490 100%
11
Topic 3: Fiduciary Duty and Conflicts of Interest
Summary of the SEC’s Proposed Commission Interpretation Regarding Standard of
Conduct for Investment Advisers https://www.sec.gov/rules/proposed/2018/ia-4889.pdf
On April 18, 2018, the SEC issued a release (the “Proposal”), entitled, “Proposed Commission
Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on
Enhancing Investment Adviser Regulations”. All investment advisers that are subject to the
Advisers Act should take note of the Proposal because it is proposing to:
1. Define, consolidate and codify the attributes of the federal fiduciary standard
applicable to investment advisers; and
2. Greatly enhance the regulatory requirements applicable to investment advisers.
I. Summary of the Standard of Conduct
The proposals stated objective is “to reaffirm—and in some cases clarify—certain aspects of
the fiduciary duty that an investment adviser owes to its clients under section 206 of the
Advisers Act.” It reaffirms that the Advisers Act fiduciary duty derives from common law
principles. It draws heavily from SEC v. Capital Gains Research Bureau, Inc., the 1963
Supreme Court opinion commonly cited for having held that the Advisers Act imposes a
fiduciary standard on registered investment advisers. The Adviser Conduct Proposal
describes a two-pronged fiduciary standard that includes (1) a duty of care and (2) a duty of
loyalty.
Duty of Care
Duty to provide advice that is in the best interest of the client, including duty to:
• Provide personalized investment advice that is suitable for and in the best interest of the
client based on the client’s investment profile, and to update such profile from time to
time;
• Seek best execution of a client’s transactions, and
• the duty to provide ongoing advice and monitoring.
Duty of Loyalty
• An investment adviser must put its clients’ interests ahead of its own;
• Must not unfairly favor one client over another;
• Must make full and fair disclosure of all material facts relating to the advisory
relationship.
• Must seek to avoid conflicts, and, at a minimum, make full and fair disclosure of all
material conflicts of interest that could affect the advisory relationship;
12
• May not favor proprietary accounts over client accounts (for example, in connection with
allocations of investment opportunities) and may not favor certain client accounts that
pay higher fee rates over other client accounts.
• Disclosure to be clear and understood by clients in order to satisfy Section 206 and the
duty of loyalty, such that
▪ The client is able to understand the adviser’s conflicts of interest and business
practices well enough to make an informed decision
▪ The SEC states that disclosure that a conflict “may” exist is not sufficient if the
conflict actually exists.
• A client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit, although an adviser cannot infer consent if the facts and circumstances indicate that the client did not understand the nature and importance
of the conflict.
• The SEC also noted that there may be circumstances with some complex or extensive
conflicts where it may be difficult to provide disclosure that is sufficiently specific, but
also understandable to clients.
II. Request for Comment on Enhanced Investment Adviser Regulation
• Federal Licensing and Continuing Education
• Provision of Account Statements
• Financial Responsibility (Net Capital Requirements)
Orical Article, Undisclosed Conflicts, by James Leahy
✓ See Attachment 1
Enforcement Actions Related to Conflicts of Interest
✓ In the Matter of Kohlberg Kravis Roberts & Co. L.P., Advisers Act Release No. 4131 (Jun. 29,
2015) https://www.sec.gov/litigation/admin/2015/ia-4131.pdf
• KKR misallocated $17.4m in broken dealer expenses to private equity fund instead of co-
investment vehicle and did not disclose this allocation to its co-investors.
• Violation of Section 206(2) of the Advisers Act, prohibiting an investment adviser,
directly or indirectly, from engaging “in any transaction, practice, or course of business
which operates as a fraud or deceit upon any client or prospective client.”
• Paid over $18m in disgorgement and other penalties.
✓ In the Matter of THL Managers V, LLC and THL Managers VI, LLC, Advisers Act Release No.
4952 (Jun. 29, 2018) https://www.sec.gov/litigation/admin/2018/ia-4952.pdf
• THL provided inadequate pre-commitment disclosure of certain accelerated fees received
from portfolio companies and failed to obtain fund advisory committee consent as a
result of the potential conflict of interest posed by negotiating and receiving accelerated
fees.
13
• Inadequate disclosure of fees was in violation of Section 206(4) and Rule 206(4)-8 of the
Advisers Act, and failure to obtain consent and approval from Funds’ LPAC was a
violation of Section 206(2) and a negligent breach of fiduciary duty.
• Paid over $5m in disgorgement and other penalties.
✓ In the Matter of VOYA INVESTMENTS, LLC and DIRECTED SERVICES LLC, Advisers Act
Release No. 4868 (Mar. 8, 2018) https://www.sec.gov/litigation/admin/2018/34-82837.pdf
• Voya Holdings Inc. failed to disclose conflicts of interest and made misleading
disclosures in connection with their practice of recalling securities on loan so their
affiliates could receive tax benefits. This resulted in the loss of securities lending income
of the Funds and individuals invested in those Funds when securities were recalled.
• This was in violated Sections 206(2) and 206(4) of the Advisers Act, and Rule 206(4)-8.
• Paid over $3m in disgorgement and other penalties.
✓ SEC v. Strong Investment Management, et al., Civil Action No. 8:18-cv-00293 (C.D. Cal. filed
Feb. 20, 2018) https://www.sec.gov/litigation/complaints/2018/comp24054.pdf
• SEC filed complaint against Strong Investment Management and its president, Joseph
Bronson, for operating a “cherry picking” scheme, in which Bronson was allocating
profitable trades to himself and unprofitable trades to Strong's clients for over 4 years.
CCO, John Engebretson discharged his duties as CCO, by not conducting the required
reviews of trades and ignoring red flags.
• Bronson and Strong are charged with violation of Section 10(b) of the Securities
Exchange Act and Rule 10b-5 thereunder, for cherry picking and misleading clients and
compliance consultants. Also charged with violation of Sections 17(a)(1) and 17(a)(2) of
the Securities Act, for fraud, and Sections 206(1), 206(2), and 207 of the Advisers Act for
false and misleading statements in the ADV and to clients. SEC also charged Bronson
and Engebretson for aiding and abetting those violations.
✓ In the Matter of NORMAN M.K. LOUIE and MOUNT KELLETT CAPITAL MANAGEMENT LP,
Advisers Act Release No. 4968 (Jul. 16, 2018) https://www.sec.gov/litigation/admin/2018/34-
83637.pdf
• Portfolio manager, Norman Louie (“PM”) made an undisclosed, undocumented personal
$3m loan to the chairman of the BOD of Energy XXI Ltd. (“EXXI”), that Mount Kellett
had made a substantial fund investment in. The PM then began a successful email
campaign to become an independent member of EXXI’s board (aided by a vote from the
loan beneficiary) and made operational and personnel changes at EXXI to improve its
financial performance and stock price.
• As a result of the PM’s failure to disclose the loan to Mount Kellett and EXXI, EXXI
filed an inaccurate and misleading Form 8-K announcing the PM’s appointment to the
EXXI board as an “independent” director. The PM also caused a failure by Mount Kellett
to disclose the conflict of interest created by the loan to its clients.
14
• Mount Kellett failed in its beneficial ownership reporting obligations under Section 13(d)
of the Exchange Act requiring any person or group, who directly or indirectly acquires
beneficial ownership of more than 5% of a class of certain equity securities to file a
Schedule 13D (within 10 days), disclosing the purpose of the acquisition of securities,
and any plans to affect the issuer’s BOD.
• Louis paid $100,000 civil money penalty and Mount Kellett $160,000.
✓ In the Matter of LENDINGCLUB ASSET MANAGEMENT, LLC, f/k/a LC ADVISORS, LLC,
RENAUD LAPLANCHE, and CARRIE DOLAN, Advisers Act Release No. 5054 (Sept. 28, 2018) https://www.sec.gov/litigation/admin/2018/ia-5054.pdf
• LendingClub Asset Management LLC (“LCA”), and its president, Renaud Laplanche,
caused a private fund that LCA managed to purchase interests in loans that were at risk of
going unfunded in order to benefit the parent company instead of the fund, in breach of
LCA’s fiduciary duty.
• For improper valuation of LCA funds and disclosures regarding the private fund’s assets
and its valuation, Section 206(1) and 206(2) of the Advisers Act were violated, as well as
Section 207 and Section 204(a) of the Advisers Act and Rule 204-1(a) thereunder.
Section 206(4) of the Advisers Act and Rules 206(4)-7 and Rule 206(4)-8, thereunder
were also violated.
• Paid over $4.2m in penalties in total, as well as $1m to reimburse investors.
✓ In the Matter of Blackstone Management Partners L.L.C., Blackstone Management Partners III
L.L.C., and Blackstone Management Partners IV L.L.C., Advisers Act Release No. 4219 (Oct. 7,
2015) https://www.sec.gov/litigation/admin/2015/ia-4219.pdf
• Three private equity advisers within The Blackstone Group were charged with breaches
of fiduciary duty. According to the SEC Order, Blackstone terminated certain portfolio
company monitoring agreements between Blackstone and its funds’ portfolio companies,
and accelerated the payment of future monitoring fees.
• Although Blackstone disclosed in its offering documents that it might receive monitoring
fees from portfolio companies, it failed to disclose to its funds, and the limited partners
prior to their commitment of capital, that it might accelerate future monitoring fees upon
termination of the monitoring agreements.
• Blackstone breached its fiduciary duty to the funds, violating Section 206(2) and Section
206(4) of the Advisers Act and Rule 206(4)-8 thereunder. Section 206(4) and Rule
206(4)-7 thereunder were also violated.
• Paid over $28.9m in disgorgement and other penalties.
✓ In the Matter of Apollo Management V, L.P., Apollo Management VI, L.P., Apollo Management
VII, L.P. and Apollo Commodities Management, L.P., Advisers Act Release No. 4493 (Aug. 23,
2016) https://www.sec.gov/litigation/admin/2016/ia-4493.pdf
• In 2016, an SEC Order was issued against Apollo Management for similarly terminating
certain portfolio company monitoring agreements and accelerating the payment of future
monitoring fees provided for in the agreements but failing to adequately disclose to its
15
funds, and to the funds’ limited partners prior to their commitment of capital, that such
acceleration of fees may occur.
• Apollo’s actions resulted in violation of Section 206(2) and Section 206(4) of the
Advisers Act and Rule 206(4)-8 thereunder, as well as Section 206(4) of the Advisers Act
and Rule 206(4)-7 thereunder.
• Paid over $40m in disgorgement and other penalties, as well as $12.5m in civil money
penalties.
✓ In the Matter of TPG Capital Advisors, LLC, Advisers Act Release No. 4830 (Dec. 21, 2017)
https://www.sec.gov/litigation/admin/2017/ia-4830.pdf
• In 2017, again at issue in the SEC Order against TPG Capital Advisors was a failure to
adequately disclose or obtain consent prior to receipt of accelerated monitoring fees.
While TPG’s receipt of the accelerated monitoring fees was disclosed in its Form ADV
filings, as well as in reports to funds’ limited partner advisory committees, these
disclosures were provided only after limited partners had made capital commitments to
the funds.
• TPG’s inadequate disclosure resulted in a breach of its fiduciary duty to the funds,
violating Section 206(2) and Section 206(4) of the Advisers Act, and Rule 206(4)-8
thereunder.
• Paid over $9 in disgorgement and other penalties, as well as $3m in civil money
penalties.
✓ In the Matter of Fenway Partners, LLC, Peter Lamm, William Gregory Smart, Timothy Mayhew,
Jr., and Walter Wiacek, CPA, Advisers Act Release No. 4253 (Nov. 3, 2015)
https://www.sec.gov/litigation/admin/2015/ia-4253.pdf
• In 2015, the Commission charged Fenway Partners and four executives with failing to
disclose several conflicts of interest to a private equity fund they advised. Fenway
Partners had initially entered into monitoring agreements with its portfolio companies,
and the resulting fees paid to Fenway Partners were offset against Fenway Partners’
management fee paid by the fund.
• According to the SEC Order, Fenway Partners and four executives caused certain
portfolio companies to terminate their payment obligations to Fenway Partners and enter
into consulting agreements with an affiliated entity named Fenway Consulting Partners
LLC. Fenway Consulting Partners provided similar services to the portfolio companies,
often through the same employees, but the fees paid to Fenway Consulting Partners were
not offset against the management fee that the fund paid to Fenway Partners. This altered
arrangement was not disclosed to the limited partner advisory committee or investors.
• Paid over $1.5 in disgorgement and other penalties.
16
ODD Questions to Ask
✓ How does the adviser monitor for conflicts of interest?
✓ Is there any process in place to evaluate the accuracy and completeness of disclosures
related to conflicts of interest?
✓ What are the adviser’s and its supervised persons sources of revenue?
✓ What fee sharing arrangement does the adviser maintain?
✓ What are outside business activities of the adviser’s supervised persons?
✓ What private interests do the adviser’s supervised persons hold?
✓ How does the advisor monitor for fair and equitable investment allocations?
✓ Do some clients have a higher incentive allocation than others?
✓ How does the advisor monitor expense allocations and reimbursements?
✓ Have any clients negotiated a cap on certain expenses?
✓ Ask for numeric examples of complicated fee structures and offsets.
Orical LLC Commitment, Responsibility, Expertise, Service, Trust
370 Lexington Avenue
Suite 511
New York, NY
10017
(212) 257-5790
www.orical.org
17
ATTACHMENT 1
Undisclosed Conflicts
Jim Leahy
December 10, 2018
For registered investment advisers (“RIAs”), recognizing, mitigating and disclosing potential, apparent
and actual conflicts of interest is a vital component of a viable compliance program and an essential
component of running a successful advisory business. Conflicts may arise from a variety of sources that
must be continuously monitored. By way of example, RIAs have built in conflicts merely by virtue of
having more than one client, particularly if multiple clients have similar investment objectives. In this
context, the adviser’s first conflict and challenge is how to allocate his time. Advisers need to be fair to
all clients and not spend a disproportionate amount of time on one client to the detriment of other
clients. The adviser also needs to consider how much time he will dedicate to all of his clients in the
aggregate versus the time he will spend on outside business interests. As a fiduciary1, the RIA’s first
obligation is to his clients. As a result of having multiple clients, other potential conflicts arise in making
investment and expense allocation decisions. Trades between clients are also a concern.
Each year, many advisers either (i) fail to adequately disclose conflicts or (ii) fail to follow their policies
and procedures with respect to resolution or mitigation of conflicts that have been disclosed.
Conflicts often arise in situations where a supervised person or firm has an incentive to serve one
interest at the expense of another interest. This incentive is frequently financial but could also be the
result of a personal, family or business relationship. The conflict might be an incentive to serve the
interest of the firm over that of a client; alternatively, it could be an incentive to serve the interest of
one client over that of another client. A conflict could also arise when a particular supervised person
places his own interest above those of the firm or its clients.
Conflicts are like viruses. They come in a vast array of constantly mutating forms; if they are not
eliminated, mitigated or disinfected by exposing them to sunlight (disclosed), even the simplest virus
1 For a general discussion of registered investment advisers as fiduciaries, see Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Advisers Act Release No. 4889 (Apr. 18, 2018).
Orical LLC Commitment, Responsibility, Expertise, Service, Trust
370 Lexington Avenue
Suite 511
New York, NY
10017
(212) 257-5790
www.orical.org
18
poses a mortal threat to the health and wellbeing of the RIA.2 Nearly all bad behavior and violations of
the securities laws by registered investment advisers can be explained in terms of conflicts of interest.
As a practical matter, an RIA must periodically assess the risks of running his business and then update
disclosures in relevant offering documents and in the RIA’s public registration statement on Form ADV.3
Significant regulatory problems develop when important conflicts of interest are not disclosed and the
RIA’s investors are not aware of them. Undisclosed conflicts are the basis for dozens of SEC enforcement
actions every year. Full disclosure requires not only that the adviser identify the conflicts it has or is
likely to have but also how such conflicts are mitigated or handled. This generally involves disclosure of a
specific policy or procedure, trade allocation, for example. It is absolutely essential that an adviser’s (i)
policies and procedures, (ii) disclosures in client governing documents and (iii) disclosures in Form ADV
(particularly in Part 2A) are consistent and that they are followed.
A recent SEC case4 stated that: “A ‘fundamental purpose of [the Advisers Act is] to substitute a
philosophy of full disclosure for the philosophy of caveat emptor [or buyer beware] and thus to achieve
a high standard of business ethics in the securities industry.’5 Accordingly, Section 206 [of the Advisers
Act] imposes ‘federal fiduciary standards’ on investment advisers,6 which means they have ‘an
affirmative duty of “‘utmost good faith, and full and fair disclosure of all material facts.’”7 Because
Section 206 was designed ‘to eliminate, or at least expose, all conflicts of interest which might incline an
investment adviser—consciously or unconsciously—to render advice which was not disinterested,’8 the
“[f]ailure by an investment adviser to disclose potential conflicts of interest to its clients constitutes
fraud within the meaning of Sections 206(1) and (2).’”9
General Instruction 3 of Form ADV Part 2A is instructive: “Under federal and state law, you are a
fiduciary and must make full disclosure to your clients of all material facts relating the advisory
relationship. As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a
minimum, make full disclosure of all material conflicts of interest between you and your clients that
2 See October 22, 2012 speech by Carlo V. di Florio on Conflict of Interest and Risk Governance to the National Society of Compliance Professionals https://www.sec.gov/news/speech/2012-spch103112cvdhtm. 3 The Compliance Rule (Advisers Act Rule 206(4)-7) requires RIAs to implement written policies and procedures reasonably designed (based on the risks of their particular business) to prevent violations of the Advisers Act. Those policies and procedures must be reviewed at least annually. Form ADV must be updated within 120 days of the end of the RIA’s most recent fiscal year. Part 2A of Form ADV (the “Brochure”) places a significant emphasis on identifying conflicts as well as how those conflicts are handled or mitigated by the RIA. General Instruction No. 2 of Part 2A cautions advisers against saying that they “may” have a conflict when in fact such conflict exists. For a case discussing the inappropriate use of “may” see In the Matter of Jan Gleisner and Keith D. Pagan, Advisers Act Release No. 4537 (Sept. 28, 2016). 4 In the Matter of The Robare Group, Ltd., Advisers Act Rel. No. 4566 November 7, 2016. 5 SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963). 6 Transamerica Mortg. Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979). 7 Capital Gains, 375 U.S. at 194; see also Montford & Co., Inc., Advisers Act Release No. 3829 (May 2, 2014) (“Section 206 prohibits ‘failures to disclose material information, not just affirmative frauds.’”) 8 Capital Gains, 375 U.S. at 191-92. 9 Fundamental Portfolio Advisors, Inc., Exchange Act Release No. 48177 (July 15, 2003).
Orical LLC Commitment, Responsibility, Expertise, Service, Trust
370 Lexington Avenue
Suite 511
New York, NY
10017
(212) 257-5790
www.orical.org
19
could affect the advisory relationship. This obligation requires that you provide the client with
sufficiently specific facts so that the client is able to understand the conflicts of interest you have and
the business practices in which you engage, and can give informed consent to such conflicts or practices
or reject them….”
In addition to identifying and describing applicable conflicts, many specific items of Form ADV Part 2A
also require RIAs to explain how those conflicts are addressed, handled or mitigated. In other words, it is
not enough to simply identify that a conflict exists.
Consequently, every decision that a supervised person makes needs to be scrutinized to see if this
critical question can be answered affirmatively: “Am I acting in the best interest of my firm’s clients?” If
a supervised person is about to embark on a course of action that relates to or affects the RIA’s clients
but is based on any factor other than the best interest of that client—perhaps because it will also
benefit a friend, business partner or business interest or a family member—then the supervised person
should pause and bring this matter to the attention of the firm’s Chief Compliance Officer and senior
management. This pause for review could result in concluding that the specific conflict that arises from a
particular course of action is already disclosed to the RIA’s investors through an offering document or in
Form ADV. The result might be that the firm either amends its conflict disclosures or perhaps makes a
different decision. Proper disclosure of conflicts can both powerfully protect an RIA and permit its
investors to make an informed decision about whether or not to invest.
What follows is a suggested list of areas to review. Each RIA should conduct its own enterprise risk
assessment and periodically monitor any conflicts of interest that are identified. RIAs cannot be
complacent about known conflicts because changes in the business such as new supervised persons,
funds, managed accounts, products, markets, sources of investment ideas, counterparties, affiliates, to
name just a few, could sufficiently alter the conflict landscape to warrant alteration of an existing
disclosure or policy or even necessitate new disclosures and policies.
In subsequent articles, we shall endeavor to highlight relevant SEC enforcement actions where an RIA
failed to meet its obligations concerning conflict disclosure particularly with respect to the following
areas:
Allocation of investment opportunities and expenses
Valuation
Conflicted Transactions: Principal Trades, Cross Trades, Agency Cross Transactions
Affiliations with and compensation from broker dealers, portfolio companies and other third parties
Incentives to benefit certain affiliates or invest in certain types of investments
Compliance program, including policies and procedures tailored to identified and monitored risks
Identification of specific authorization for all fees and expenses (including acceleration of fees) charged
Orical LLC Commitment, Responsibility, Expertise, Service, Trust
370 Lexington Avenue
Suite 511
New York, NY
10017
(212) 257-5790
www.orical.org
20
Outside business interests such as the making of personal loans or serving on boards of directors of
portfolio companies
Proxy Voting
In conclusion, RIAs need to be ever vigilant when it comes to conflicts. Existing conflicts evolve as the
RIA’s business changes. New conflicts come to the fore with the addition of new clients, new products,
new markets and new counterparties. Hopefully supervised persons will be sufficiently trained to detect
and report any potential conflicts as they go about trying to serve their firm’s clients and investors in the
best possible way. The solution for almost all conflicts that cannot be eliminated is to put policies and
procedures in place to mitigate them and to thoroughly disclose the conflict. As Supreme Court Justice
Louis D. Brandies once said: “Sunlight is the best disinfectant.”
If you have any questions about this article please contact:
Jim Leahy Greg Florio 212-257-5783 212-257-5781 [email protected] [email protected]
Orical provides this information as a service to clients and other friends for educational
purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client
relationship.
Extensive Legal & Operational Experience P A R T N E R - L E V E L R E S P O N S I V E N E S S O N E V E R Y M A T T E R
I N V E S T M E N T M A N A G E M E N T L E G A L S E R V I C E S
COMMITMENT RESPONSIBILITY EXPERTISE SERVICE TRUST
370 LEXINGTON AVENUE, 5 FLOOR, NEW YORK, NY 10017TH
CONTACT US
212 257 5790
https://www.�orioleahy.com/
ATTORNEY ADVERTISING
Registration services for investment advisers, CPOs/CTAs and broker-dealers
Assistance through SEC and CFTC examinations
Customized compliance programs that are streamlined to appropriately address each client’s risk profile
On-going compliance monitoring services through our affliate, Orical LLC
We are the firm of choice for fund offering document review and operational due diligence services related to private fund and other alternative investments.
Our partners have a unique combination of large law �rm and buy-side expertise, which makes us particularly well-suited for providing legal document review, compliance and operational due diligence services.
Partners with practical buy-side expertise and top investment management law firm experience
Extensive experience with regulatory examinations and compliance testing initiatives
Practical advice based on real-world experience to ensure that our clients maintain best-in-class compliance controls and SEC readiness
Decades of industry experience and current knowledge of prevailing industry terms
Formation and counsel to U.S. and offshore hedge funds, fund of funds, private equity funds, commodity pools and separately managed accounts
Regulatory Filings: Form ADV, Form PF, Form D, etc.
Cost-e�ective legal services, with little to no start-up cost
Registration ServicesPrivate Fund & Managed Account Services
Investor Due DiligenceCompliance Testing, Mock Audit & Risk Assessment
Attachment 2
21
Best-In-Class ComplianceSupport & Registration Services
I N V E S T M E N T M A N A G E M E N T C O M P L I A N C E S E R V I C E S
COMMITMENT RESPONSIBILITY EXPERTISE SERVICE TRUST
370 LEXINGTON AVENUE, 5 FLOOR, NEW YORK, NY 10017TH
CONTACT US
212 257 5790
https://www.orical.org/
We provide investment adviser, commodity pool operator, commodity trading adviser, and broker-dealer registration services.
We develop and administer compliance programs that represent the industry’s best practices at a fraction of the cost of bringing commensurate expertise in-house.
We provide dedicated compliance professionals and hands-on assistance to expand the bandwidth and expertise of our client's internal personnel.
Full Service, Hands-On Registration and Compliance Program Administration
Code of Ethics administration
White-glove implementation
Easier electronic feed set up for automatic transaction and holdings reports
Consultation regarding conflicts, allocation, valuation, best execution, insider trading, code of ethics and marketing practicesCompliance training and assistance with bespoke compliance initiativesWe serve as independent committee members
Our compliance professionals and lawyers have extensive operational experience serving in senior officer positions at institutional investment managers
Owner-level responsiveness on every matterQuarterly onsite reviews and compliance committee mmeetings
Trade surveillance Pre-trade clearance automation Customizable trade review rules and forensic reports Trade investigation capabilities
Gift, conflict and political contribution reporting Customizable electronic formsCompliance calendars
Leading-Edge Compliance Software - Real World Compliance LLC ("REAL")
Other Services Experienced & Responsive
22
CONTACT US370 LEXINGTON AVENUE TH, 5 FLOOR, NEW YORK, NY 10017 212 257 5790
I n t e g r a t e d I n v e s t i g a t o r y T o o l s
E a s y S e t - u p a n d A d m i n i s t r a t i o n
F u l l y A u t o m a t e d C o m p l i a n c e P r o g r a m D e t e c t s a n d P r e v e n t s I n s i d e r T r a d i n g / M a r k e t M a n i p u l a t i o n
• REAL has the ability to pull in emails and otherdocuments for review without leaving the application
• Investigate suspicious trading activity without leaving the REALapplication
• Document the review and resolution of elevated matters withinREAL
• All compliance related documentation held in one system
• User-friendly interface• Easy integration with internal and external data systems• Establish electronic broker feeds more efficiently• Offered by Orical LLC, which provides expert compliance advice
upon request• White-glove administration available
• Forensic Trading Reviews of Employee and Firm Tradingo Automatically elevate suspicious trading activity for reviewo Multi-factor elevation rules, to eliminate false positiveso Fully customizable to match a firm’s internal policieso Review trading activity in view of reported conflicts of interest
Investment Management Compliance Technology
REAL is a leading-edge investment management compliance platform designed by expert regulatory attorneys and chief compliance officers. It is customizable and can be easily programmed to match a firm’s existing policies and integrate with internal and external systems. REAL's intelligent forensic engines effectively reduce the time and money typically required to maintain an effective supervisory program.
I t ' s T i m e t o G e t R E A LWhat is REAL?
OFFERED BY ORICAL LLC
• REAL reviews trading activity in real-time• Designed by regulatory attorneys and chief compliance
officers to match the SEC's and CFTC's books and recordsrules
• All-in-One Applicationo Captures, elevates and investigates trades all within
one applicationo Central repository for all compliance related reporting,
approvals and documentationo Automated compliance calendaro Personal and firm trading reviewso Restricted and watch list integrationo Automated pre-trade clearanceo Conflicts reporting and surveillance
Outside business activities, gifts, political andcharitable contributions
o Anti-insider trading Information barriers Document review and archiving Research consultant supervision
o Marketing material reviewo Contract managemento Service provider supervision
T h e R E A L A d v a n t a g e
• Smarter - Eliminate false positives • More efficient - Supervise better in less time• Designed by regulatory experts • Leading-edge technology
• Easy to use and administer
23
Owner Biographies
Gregory L. Florio, Founder, Co-Managing Partner/Member
Gregory L. Florio is the founder of Florio Leahy LLP and Orical LLC. With over 20 years
of legal and regulatory experience, Mr. Florio is an expert in all aspects of investment
management law and regulation, including the Investment Advisers Act of 1940, the
Investment Company Act of 1940 and all other laws, rules and regulations that govern the
securities industry. His practice focuses on the private fund industry, including formation,
structuring, offering terms, private funds, separately managed accounts, compliance
programs, regulatory examinations, investigations, enforcement actions and compliance technology. He
routinely advises and represents investment mangers, broker/dealers, family offices and other financial
institutions in connection with their legal and compliance needs. Mr. Florio also directs the Firm’s technical
solutions effort, Real World Compliance LLC (“REAL”), a product he designed and developed. Before
founding the Firms in 2010, Mr. Florio was a Senior Counsel and the Chief Compliance Officer of a multi-
billion-dollar global fund manager, Marathon Asset Management, LP (“Marathon”). Before joining
Marathon, Mr. Florio was an associate and regulatory specialist in Seward & Kissel (“S&K”) LLP’s
Investment Management Division and, before S&K, was an attorney for the Investment Funds Group at
Sidley Austin LLP. After graduating from Fordham University School of Law in 1995 with honors, Mr.
Florio began his career serving as an assistant district attorney in New York City. Mr. Florio holds a
Bachelor’s degree in Consumer Economics from Cornell University and is a member of the New York State
Bar Association.
Experience Highlights
• Successfully assisted hundreds of firms through the SEC/CFTC registration and examination
process;
• Assisted Marathon through the financial crisis commonly referred to as the “Great Recession”,
during which time the firm not only gained assets, but was also selected to manage assets for the
U.S. Treasury as part of the U.S. Government’s Legacy Securities Public-Private Investment
Program, after an application process that included well over 100 institutional asset manager
applicants;
• Qualified as an expert witness in high profile criminal cases related to SEC enforcement actions;
• Commonly referenced as an expert in investment adviser regulatory compliance, and anti-insider
trading and market manipulation surveillance;
• Since 2002, has been a leader in designing technical solutions to address operational difficulties in
the investment adviser and broker/dealer compliance arenas, including designing and developing
Orical’s compliance software, REAL.
24
25
James M. Leahy, Co-Managing Partner/Member
James M. Leahy is Co-Managing Partner of Florio Leahy LLP and Co-Managing Member
of Orical LLC with 29 years of capital markets, securities, operations, and legal experience.
Mr. Leahy prepares his clients for and assists them with regulatory examinations. He has
extensive experience assisting firms to identify enterprise and compliance risks and
conflicts; he also assists with the development, implementation and testing of firm-specific
policies, procedures and disclosures tailored to mitigate those risks and conflicts. Mr.
Leahy is a frequent author and speaker concerning regulatory developments impacting the fund industry.
He conducts due diligence for several active fund investors, drafts fund offering documentation and
negotiates a variety of contracts on behalf of funds and fund service providers.
Prior to joining Orical in 2013, Mr. Leahy served as Chief Financial Officer of Marathon Asset
Management, LP where he managed teams of professionals responsible for tax, accounting, operations and
internal audit. Mr. Leahy’s responsibilities included monitoring cash, profit and loss as well as financing
lines and relations with external service providers such as prime brokerage, ISDA counterparty, audit,
valuation and fund administration. Mr. Leahy met regularly with investor due diligence teams. He also
spent significant time on governance, conflicts, allocation, valuation, best execution, cross trade, side
pocket and liquidating fund issues, particularly during the last financial crisis. Prior to Marathon, Mr.
Leahy was a Vice President, Senior Credit Officer and Team Leader at Moody's Investors Service and was
also a member of the CDO team. He helped found the Hedge Fund Operations Quality business where his
group was responsible for assigning Operational Quality Ratings to hedge funds. Prior to Moody’s, Mr.
Leahy was a lawyer at Skadden, Arps, Slate, Meagher & Flom LLP and Milbank, Tweed, Hadley & McCloy
LLP in New York City. His legal practice involved corporate, securities and financing transactions. He
has comprehensive knowledge regarding public and private placements of securities and has negotiated
many lending facilities, debt instruments and structured finance transactions. Prior to practicing law, Mr.
Leahy was a Surface Warfare Officer in the United States Navy. He served aboard three warships, designed
curriculum and taught at the Navy’s Gas Turbine Engineering School in Newport, Rhode Island. Mr. Leahy
holds an honors law degree from Boston College Law School and an undergraduate degree in English from
Dartmouth College. Mr. Leahy is a member of the Bar in New York and Massachusetts.