Published on Mar 3rd, 2023 |

Repeat Violations by Advisors’ Parents | Fred Teufel Reacts

Vigilant Insights

Vigilant’s Director and Industry Veteran, Fred Teufel, was quoted in BoardIQ on repeat violations by Advisors’ Parents, which is causing concern at the Fund Director Level.

Fred covered the following areas below in his quotes throughout the article:

  1. The importance of understanding the relationship between the Parent Company and the Investment Adviser
  2. Assessing whether the parent company’s apparent culture of noncompliance permeates the Adviser subsidiary
  3. Fund Boards review of regulatory or legal actions involving the Adviser and/or any of its affiliates at Board Meetings
  4. Actions that Fund Board’s may take to mitigate the impact of parent company compliance failures (i.e., ask service providers direct questions regarding their management of the compliance and reputation risk)

As it relates to Registered Investment Company’s (“RICs”) Compliance Programs for requirements, responsibilities, maintenance, and oversight, Fred has provided a beneficial synopsis below.

  • RICs are required to (1) maintain a Compliance Program and adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws, (2) review those policies and procedures annually for their adequacy and the effectiveness of their implementation.
    • RIC Boards are required to oversee that program.
  • The Compliance Program of RICs should be designed to identify, evaluate and maintain written policies and procedures that (1) address the inherent conflict of interest between the Adviser (and its Parent Company), and the shareholders of the RIC and (2) the added risk of non-compliance associated with the Parent Company’s history of violations of federal rules and regulations.
  • In addition to the maintenance and oversight of a rigorous Compliance Program, engagement of a competent and experienced CCO and Outside Counsel, Boards may want to consider the following:
    • Asking the RIC’s Outside Counsel, Adviser Management and CCO to review and report on the RIC’s policies and procedures designed to mitigate the risk associated with the relationship of the Parent Company – Compliance Risk and Reputational Risk.
    • Gain an understanding of the breadth and depth of the financial institution/parent activities that gave rise to the penalties and whether those activities implicate the Investment Adviser.
    • Consider as part of the Board’s annual self-assessment process whether the Independent Directors are sufficiently challenging the Adviser and Board Chair on matters that might be influenced by the Parent Company relationship.
    • Review affiliated transactions and/or service contracts with affiliates to make sure that they approximate arm’s length/market prices for those transactions/services.
    • Require that the Fund and Investment Adviser maintain and test an incident (including an un-flattering press release) response plan that addresses how the Fund and Adviser will respond to parent company incidents.
      • The Fund could perform tabletop exercises simulating activation of the plan and responding to the incident on a periodic basis.
Fred Teufel's Frame of Reference and In-Depth Analysis

Fred Teufel’s Frame of Reference and In-Depth Analysis

  • Brief Overview on RICs and Board of Directors
    • The Investment Company Act of 1940 defines the term “investment company” and establishes criteria that would require an investment company to register with SEC (registered investment company or RIC).
    • A RIC is typically externally managed; it is not an operating company, and it has no employees in the traditional sense. Instead, a RIC relies on third parties or service providers that are either affiliate organizations or independent contractors (the investment adviser, distributor, custodian, transfer agent, and others) to invest  assets and carry out other business activities.
    • All RICs are required by law to have a Board of Directors (sometimes referred to as a Board of Trustees).
  • Role of the RIC Directors and Board
    • Like the Directors of a Corporate Board, RIC Directors oversee the management and operations of the RIC and have a fiduciary duty to represent the interests of shareholders. The focus of RIC Directors, however, is slightly different because of the RIC structure.
    • Among other things, they oversee the performance of the Fund, approve the fees paid to the Investment Adviser for its services, and oversee the Fund’s Compliance Program.
    • Because a RIC has no employees and relies on the Adviser and other Service Providers to run its day-to-day operations, the Board focuses on the performance of these entities under their respective contracts and monitors potential conflicts of interest.
    • Notably, the RIC Board is not the Board of the Investment Adviser nor the other Service Providers. In fact, in some cases, the Service Providers, and most notably the RICs Investment Adviser may itself be a Public Company with its own Board of Directors and shareholders. Thus, while the Fund Board oversees the services the Service Providers provide to the RIC, it does not own the Service Providers, nor does it oversee the management and operations of the Service Providers.
  • Role of the Investment Advisers
    • The Investment Adviser is the most influential and prominent of the RICs Service Providers. In a sense, the RIC serves as a distribution channel for the Investment Adviser’s services.
    • Investment Advisers to RICs earn revenue from managing the assets of the RIC in accordance with the RIC’s investment strategy and subject to various restrictions that are disclosed to RIC investors. Accordingly, although the Investment Adviser is a fiduciary, that profit motivation may present an inherent conflict of interest between the shareholders of the RIC and the RIC’s Investment Adviser.
    • The ownership structure of Investment Advisers is varied. Investment Advisory Firms can be sole proprietors, partnerships, or subsidiaries of other companies. A large number of Investment Advisers are owned by some of the world’s largest financial institutions that offer a plethora of financial products and services subject to a myriad of rules and regulations across multiple regulatory regimes.
  • SEC Penalties, Rules, and Regulations on RICs and Independent Directors
    • According to a recent report on penalties imposed by SEC since 2000, financial institutions were identified as the top 10 companies in terms of penalties and infractions. Although the majority of penalties were not imposed on the activities of the Investment Adviser subsidiary, each of those financial institutions was a parent company of a an Investment Adviser. Of course, it is important to put the size of the penalties in context as although the absolute amounts are large, they represent a very small percentage of the financial institutions revenue, expenses and net worth. Further, some might argue that SEC makes an example of the larger firms to send a message to the rest of the industry on certain compliance matters that they believe may be pervasive around the industry or that they want to re-emphasize.
    • RIC Rules and Regulations require that a certain percentage of the Board be comprised of Independent Directors.
    • Federal Regulations impose specific responsibilities on Independent Directors and Regulators look to them to monitor potential conflicts of interest between the fund and its adviser. In fact, according to the Supreme Court, the Independent Directors have “the primary responsibility” for looking after the interests of the Fund’s shareholders and serve as “independent watchdogs” who “furnish an independent check” upon the management of the Fund. The 1940 Act requires a certain percentage of each Fund’s Directors to be independent.

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