PORTFOLIO MANAGEMENT
"...the Investment Advisers Act of 1940 reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser - consciously or unconsciously - to render advice which was not disinterested."
-See SEC vs. Capital Gains Research Bureau, Inc.
Certiorari to the United States Court of Appeals for the Second Circuit.
INVESTMENT OBJECTIVES AND STRATEGY
Investment advisers, by contract or otherwise, explicitly agree to manage a client's account within specific investment guidelines and regulatory limitations. An adviser that manages one or more registered investment companies must manage each fund within its stated investment objective and investment strategy to meet that objective, risks, and limitations set forth in the fund's prospectus and statement of additional information filed under Form N-1A. Any material changes to these disclosures will likely require board approval and an amendment to the fund's registration statement. With respect to private fund clients, a registered adviser or adviser required to be registered with the SEC has an obligation to adhere to the client's investment policies, restrictions, guidelines and/or legal requirements set forth in such client's organizational documents. Certain investment restrictions may be specific limitations, whereas others may be general statements of investment intent. For example, a private fund client may restrict investments in certain types of securities that may be permitted by another private fund client managed by the same adviser. A fund's private placement memorandum may target a percentage investment in a particular asset class, but have broad latitude to invest outside the stated investment guidelines in order to meet the fund's investment objectives. An adviser that provides investment advice to multiple private funds, alternative investment vehicles, and separately managed accounts should adopt procedures to govern co-investments and allocation of investment opportunities among clients in keeping with clients' governing documents. Compliance oversight will necessitate periodic reviews of investments against client governing documents to safeguard against a violation of client investment guidelines and other limited partner governance protocols.
TRADING
The SEC expects an investment adviser's policies and procedures to address, among other things, the firm's trading practices. In executing trades for clients, a firm is required to uphold its fiduciary obligation to act in a client's best interests with respect to transaction price and execution. Firms may aggregate or "bundle " trades for two or more clients for the purposes of achieving best execution and no client is disadvantaged resulting from the bundling. If trades are bundled, the adviser must adopt trade allocation procedures to ensure that securities are distributed fairly to all clients. Advisers are permitted to use "soft-dollars" (i.e., an arrangement whereby the adviser uses client commissions to pay for brokerage and investment research that qualify under the "safe harbor" provision of Section 28(e) of the Securities Exchange Act of 1934), provided that the amount of the commission is reasonable in light of the overall value of the services obtained and that such arrangements are fully disclosed and monitored closely. For example, a review of commissions paid to brokers should be aggregated by broker and type of security, and reviewed quarterly against brokerage commissions charged by other brokers for similar securities across all client accounts or funds. If using soft dollars, the commissions should be reviewed in light of execution quality and other factors under the safe harbor. This type of transactional testing will document the firm's broker selection process, the amount of commissions paid, and any potential conflicts of interest arising from corporate or personal financial relationships between the executing broker and members of the firm and its affiliates. In addition, a firm should be explicit in its disclosures to clients regarding its trade aggregation and allocation procedures. Disclosures should coexist with operational controls that safeguard against an allocation of trades that favor one type of client account or group of clients over another. The size of the firm and the complexity of the trading environment will dictate whether an automated tracking solution is appropriate.
AFFILIATED TRANSACTIONS
Principal transactions are trades in which an adviser, an affiliate of the adviser or an affiliate of controlling person of the adviser acting for its own account, purchases a security from or sells a security to a client. Section 206(3) (see page 27) of the Investment Advisers Act of 1940 prohibits principal transactions unless the adviser first discloses the transaction, the capacity in which the adviser or its affiliate is acting, including any conflicts of interest and how they are addressed, and obtains written consent from the client. This conditional permission applies to each and every principal transaction. An adviser found to be operating under a blanket client consent will be in violation of Section 206(3), and more importantly, Sections 206(1) and (2), the anti-fraud provisions of the Act. The disclosure and consent requirements are intended to prevent an adviser from self-dealing and dumping unwanted securities into client accounts without the client's knowledge. Agency cross transactions are trades in which the adviser, an affiliate of the adviser or affiliate under common control with the adviser, acts as a broker for the adviser and the client on the other side of the transaction. Agency cross transactions are permitted under Rule 206(3)-2, provided that full disclosure of all material facts related to the transaction and conflicts of interest are provided to the client, and the adviser has obtained prior written consent for the transaction from the client. A client may provide to the adviser a prospective consent for agency cross transactions, provided that the adviser has supplied the required disclosure beforehand. Other communication provisions apply. The disclosure and consent are intended to prevent an adviser from favoring one client over another client based on the potential of earning additional fees and commissions. An adviser engaging in principal transactions or agency transactions must also uphold its fiduciary obligation to act in a client's best interests with respect to transaction price and execution. Private fund advisers should review their affiliated relationships for any fees charged to fund clients in connection with the acquisition of assets or services rendered that may benefit related persons of the adviser or its affiliates. Transactions among related parties give rise to conflicts of interest that, if not governed by a fund client's organizational documents, require that the adviser formulate additional procedures to comply with Section 206(3) and the anti-fraud provisions of the Act.
VALUATION
The SEC will seek to understand the adviser's methodology for valuing client assets and assessing fees based on those valuations. An adviser firm should be prepared to provide supporting documentation of any pricing and pricing adjustments to market pricing. The firm's compliance program should include periodic transactional testing of pricing against significant market events, particularly with respect to thinly traded securities, such as emerging market securities and securities for which market prices are not available, to identify any deviations from pricing procedures and ensure that such deviations are properly documented and reported as appropriate under any client governing documents.
PROXY VOTING
Registered investment advisers who have the authority to vote proxies, have a fiduciary duty to vote proxies in the best interests of their clients; generally in a manner that maximizes the value of client's assets. Rule 206(4)-6 requires advisers to adopt and implement policies and procedures designed to ensure that the adviser will vote in the best interest of its clients, including the manner in which it addresses and resolves material conflicts of interest. Material conflicts of interest can arise from an economic relationship between the adviser, its affiliates and related persons and the issuer through investment or through services provided by the issuer to the adviser or its affiliates. Under these circumstances, the adviser may be inclined to vote in favor of the issuer's management to the detriment of the adviser's clients. The adviser's disclosure to clients must be specific regarding the nature of the conflict and request the client's consent to vote the shares. An adviser could insulate against conflicts of interest by designating an independent third party to vote proxies or suggest that the client designate another party to determine how a proxy should be voted. The rule also requires advisers to provide clients with the means with which to obtain a record of votes cast. Finally, an adviser must disclose in summary fashion, its proxy voting policy in its Form ADV and provide a copy of the adviser's policy and procedures upon request. The rule imposes record keeping requirements on an adviser with respect to its policies and procedures, proxies received, votes cast, client requests for copies of proxy voting data, and any documentation related to conflicts of interest.