WA-9: Managing Conflicts of Interest in an Institutional ...

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SIFMA COMPLIANCE AND LEGAL SOCIETY 2020 ANNUAL SEMINAR

MANAGING CONFLICTS OF INTEREST IN AN INSTITUTIONAL

BUSINESS

Scott Flood (Moderator) Citigroup Global Markets, Inc.

Managing Director & Senior Deputy General Counsel

Mark Steffensen HSBC Bank

Senior Executive Vice President & General Counsel

Stephen Shine Prudential Financial

Chief Regulatory Counsel

Tanya Weisleder Credit Suisse

Global Head, Conduct Risk

Jeremiah Williams Ropes & Gray LLP

Partner


I. MANAGING M&A FINANCIAL ADVISOR CONFLICTS a. Delaware courts increasingly have scrutinized the alleged conflicts of financial

advisors in M&A transactions. Since the Delaware Chancery Court’s decision In re Rural/Metro Corp. S’holders Litig., 88 A.3d 54 (Del. Ch. 2014), the Chancery Court has continued to sustain claims for aiding and abetting liability against financial advisors at the motion to dismiss stage or beyond under a variety of circumstances. The Delaware Supreme Court’s ruling on appeal in the Rural/Metro matter is the first time Delaware’s highest court has held a financial advisor liable to shareholders for aiding and abetting a corporate board’s breach of the duty of care. The Delaware Supreme Court’s decision disavowed the Chancery Court’s suggestion that financial advisors were “gatekeepers” with an obligation to affirmatively prevent fiduciaries from breaching their duties of care to constituents.

i. Rural/Metro: Del. Supreme Court decision is RBC Capital Markets, LLC v. Jervis, , 129 A.3d 816, 2015 WL 7721882 (Del. Nov. 30, 2015)

1. Following trial in 2014, Vice Chancellor Laster issued an opinion finding that the board of Rural/Metro Corp. had breached its duty of care by failing to take reasonable steps to maximize Rural’s sale price at auction before approving its sale to Warburg Pincus LLC, and that its financial advisor had aided and abetted this breach by deliberately structuring Rural’s sale process to advance the advisor’s undisclosed interests in securing sell-side financing roles.

2. The court also noted in dicta that “[d]irectors are not expected to have the expertise to determine a corporation’s value for themselves, or have the time or ability to design and carry out a sale process. Financial advisors provide these expert services. In doing so, they function as gatekeepers.” Rural I, at 88.

3. Delaware Supreme Court affirmed, but it rejected the suggestion of

broad “gatekeeper” liability for financial advisors and limited their liability for aiding and abetting to cases where they can be shown to have acted with scienter.

a. Emphasizing that the financial advisor had been found by the lower court to have acted deliberately, the Delaware Supreme Court affirmed the Chancery Court’s “narrow” holding that a non-fiduciary third-party can be held liable for aiding and abetting if it “knows that the board is breaching its duty of care and participates in the breach by misleading the board or creating the informational vacuum” that caused the predicate breach. Id. at *32.1

1 The Court further held that the retention of an additional financial advisor failed to cleanse the alleged defects in the sale process because, the Court found, its advice was treated as secondary and its compensation was mostly contingent upon consummation of a transaction. Id. at *35.


b. The Court stated that this standard is “among the most difficult to prove,” and that its holding “should not be read expansively to suggest that any failure on the part of a financial advisor to prevent directors from breaching their duty of care gives rise to a claim for aiding and abetting.” Id. at *35 & n.191.

c. The Court also affirmed the Chancery Court’s holding that any directors who qualified (or would have qualified, had they not settled prior to trial) for exculpation from financial liability under the company’s § 102(b)(7) provision could not be deemed joint tortfeasors for contribution purposes. Because Rural’s advisor had presented a “unified front” defense at trial, it was left with limited evidence to establish that its settling co-defendants would not have qualified for exculpation. Id. at *37-44.

ii. Other Chancery court decisions:

1. In re Stillwater Mining Co., 2019 WL 3943851 (Aug. 21, 2019) a. This case was brought to determine the fair value of the

common stock of Stillwater Mining Company (“Stillwater”) at the time when Sibanye Gold Limited (“Sibanye”) completed its acquisition of Stillwater through a reverse-triangular merger.

b. Stillwater’s CEO Michael McMullen forwent the opportunity to work with an investment bank when searching for an acquirer for Stillwater. Instead, after initial talks with Sibayne, McMullen met with financial advisor Bank of America Merrill Lynch (“BAML”) to discuss a possible merger of equals.

c. Petitioners claimed that after this meeting, BAML did not have time to run an organized and meaningful process because (i) BAML “hastily called a list of potential interested parties, who then were given only days after signing an NDA to prepare an expression of interest.” Id. at *34.

d. The Court of Chancery held that although petitioners showed that “BAML’s pre-signing process was suboptimal, they have not shown that it was worthless, nor that it was harmful. To the contrary … the pre-signing efforts, while rushed, were a positive factor for the sale process.” Id. at *35.


2. Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., 210 A.3d 128 (Del. 2019)

a. Verition concerned a statutory appraisal proceeding arising out of the Hewlett-Packard Company’s (“HP”) May 2015 acquisition of Aruba Networks, Inc. (“Aruba”) for $24.67 per share. The Court held that Aruba’s 30-day unaffected stock price of $17.13 per share, 30.6% less than the deal price, was the most reliable indication of fair value despite Aruba’s status as a widely held, publicly traded company that was sold in an arm’s-length transaction, and despite clear evidence of a conflict of interest for Aruba’s financial advisors.

b. In evaluating whether the stock price was fair, the Chancery Court also considered arguments regarding deficiencies in the performance of Aruba’s financial advisors. Aruba had hired Qatalyst Partners to manage negotiations with HP. During negotiations it came to light that Qatalyst’s principal, Frank Quattrone, had a strained relationship with HP’s CEO Meg Whitman due to a failed deal wherein Qatalyst had represented UK software firm Autonomy in its 2011 sale to HP, which ultimately led to a near $9 billion write-down for HP.

c. The Chancery Court summarized: “In this case, the

petitioners proved that the Aruba’s bankers catered to HP. Once Whitman refused to work opposite Qatalyst, Quattrone and Boutros perceived HP’s stance as an existential threat to their technology-centered franchise. They wanted and needed to get back on HP’s good side. Their primary goal from that point on was to rehabilitate their relationship with HP.”

d. While acknowledging that “the petitioners proved that

Aruba’s bankers catered to HP,” including evidence that Aruba’s financial advisors sought to leverage the transaction to gain future business from HP, the Chancery Court held “that is not enough to call into question the deal price for purposes of appraisal.” According to the Court, “[i]n a scenario where the underlying market price is reliable, competition and negotiation become secondary.” Quoting Dell, Vice Chancellor Laster further explained that “[t]he issue in an appraisal is not whether a negotiator has extracted the highest possible bid. Rather, the key inquiry is whether the dissenters got fair value and were not exploited.”


e. The Delaware Supreme Court reversed and remanded the Chancery Court’s decision but only on the grounds that the Court abused its discretion in using the unaffected market price to determine fair value.

3. Mesirov v. Enbridge Energy Company, Inc., 2018 WL 4182204 (Aug. 29, 2018)

a. The case arises from a transaction where a master limited partnership, Enbridge Energy Partners, L.P. (“EEP”), repurchased 66.7% interest in the United States segment of the company for $1B from its general partner, Enbridge Energy Company (“EEP GP”). Plaintiff, a stockholder, sued Enbridge entities and its financial advisor, Simmons & Company International (“Simmons”).

b. Plaintiff alleges that Simmons knew EEP was overpaying for its interest in EEP GP and breached its fiduciary duty. First, Plaintiff points out that several years prior, EEP GP purchased the same interest from EEP for $800M with a right to expand the company’s pipeline work. Also, the discounted cash-flow equity value of interest was $478M at the time of this sale, which would have meant EEP overpaid by 45% for the interest. Other metrics similarly indicated that EEP was paying far above market value for the interest. Finally, Plaintiff alleged that the transaction was unfair because the Class E shares given to directors were considerably more valuable because of Special Tax Allocations tied into the directors’ class of shares.

c. In contrast to Stillwater, the Court of Chancery found that Plaintiff had stated a claim that Simmons aided and abetted a breach of fiduciary duties by (i) using “a manipulated valuation to support a fairness opinion;” (ii) creating “an ‘informational vacuum’ with regard to Class E unit value that made assessing value difficult if not impossible; (iii) basing its fairness opinions on ‘fully baked,’ ‘last-minute manipulations of 2015 projected EBITDA;’” and (iv) because Simmons “was willing to perform its perfunctory valuation, as it had in the past, in order to preserve its longstanding relationship with Enbridge, knowing well that EEP GP and Enbridge would invoke the fairness opinion as a means to escape liability for breach of fiduciary duty following the closing of the Transaction.” Id. at *15.

4. In re PLX Technology Inc. Stockholders Litigation, 2018 WL 5018535 (Oct. 16, 2018).

a. PLX Technology concerned a merger between PLX


Technology, Inc. (“PLX”) and Avago Technologies Wireless (U.S.A.) Manufacturing Inc. (“Avago”). PLX was initially pressured to sell by defendant Potomac Capital Partners II, L.P. (“Potomac”) and its co-managing member Eric Singer. During meetings between PLX management and its board of directors (“Board”), Potomac nominated five candidates to the Board. After seating three of these members on the Board, Singer was tasked with exploring strategic alternatives for PLX.

b. Avago noticed the Board change at PLX and contacted PLX’s financial advisor, Deutsche Bank, saying that they would like to acquire PLX once their deal with a competitor had closed. Avago said they would like the deal to be around $6.50 per share, a price that PLX had previously rejected as too low.

c. Deutsche Bank did not share the information with PLX, but did share it with Singer. The $6.50 offer was found to be much lower than projections, so new projections were generated that could back up the number. Without seeing these projections, the Board signed off on the deal. Avago correctly labeled the projections as “downside case,” while Deutsche Bank had labeled them “base case.”

d. In 2014, the merger between PLX and Avago was announced at $6.50 per share. No disclosures were made about Avago’s contact with Deutsche Bank. Plaintiffs subsequently sued the directors for a breach of fiduciary duties, and sued Potomac, Deutsche Bank, and Avago for aiding and abetting this breach.

e. The Court of Chancery found that the directors were liable for a breach of fiduciary duty because they engaged in a sale process without knowing critical information about Avago’s communications with Deutsche Bank.

f. The Court also found that Potomac, through Singer, knowingly participated in this breach because Singer knew about the tip from Avago and failed to disclose it. The Court noted that “[w]hen the aiding and abetting claim targets an unrelated third party, a court's analysis of whether a secondary actor “knowingly participated” is necessarily fact intensive, but that “[w[hen the fiduciary and primary wrongdoer is also a representative of the secondary actor who either controls the actor or who occupies a sufficiently high position that his knowledge is


imputed to the secondary actor, then the test is easier to satisfy.

5. Blueblade Capital Opportunities LLC v. Norcraft Cos., Inc., 2018 WL 3602940 (July 27, 2018)

a. In contrast to Verition, the court in Blueblade declined to rely on the deal price as evidence of fair value, citing, among other things, its view that the sell-side advisor acted improperly by affirmatively dissuading potential buyers from coming forward to make a bid during a post-signing go-shop period.

b. The case arose from a May 12, 2015 merger whereby Fortune Brands Home & Security, Inc. (“Fortune”) acquired Norcraft for $25.50 cash per share. In the transaction, Norcraft, a cabinetry manufacturing business, merged with an indirect, wholly-owned subsidiary of Fortune, Tahiti Acquisition Corp. (“Tahiti”), with Norcraft surviving as a wholly-owned subsidiary of Fortune.

c. Mindful of the Delaware Supreme Court’s recent weighting

of deal price in DFC and Dell as a “strong indicator” of fair value for a public company that engages in a robust sales process, the Court nonetheless found that the merger price did not reflect the fair value of the Company due to a flawed sales process.

d. The Court found that, prior to signing the merger

agreement, Norcraft and its advisors chose not to look past Fortune as a potential merger partner. Although the Court conceded that a single-bidder focus, if made as a strategic choice, would not necessarily undermine the deal process, the Court found no evidence suggesting the decision to focus solely on Fortune was strategic. Rather, Fortune’s financial advisors attempted to contact and dissuade potential bidders from topping Fortune’s bid.

6. In re Good Technology Corp. Stockholder Litigation, C.A. No.

11580-VCL (consol.) (May 12, 2017). a. The Company hired J.P. Morgan in February 2015, and J.P.

Morgan began to prepare to launch the IPO during the week of March 16.

b. Shortly before the scheduled launch, J.P. Morgan concluded that the IPO should be delayed until the Company received its first quarter results.


c. J.P. Morgan did not immediately advise the Board to delay

the IPO, instead telling the Board that the IPO could proceed as scheduled. Court found there was evidence the Board did not pursue an offer by a strategic buyer in reliance on J.P. Morgan's advice that the IPO could proceed.

d. Court also found that J.P. Morgan was motivated to delay

the IPO because a merger would be more lucrative for J.P. Morgan. Could found that “J.P. Morgan sought to construct a pretext for delaying the IPO by blaming the Company's former CEO, Brian Bogosian, for refusing to sign a lock¬up. This excuse disappeared when, on March 18, Bogosian signed the lockup.”

e. This conceivably left time to launch the IPO and the

Company prepared to go forward with the IPO on that day. On the afternoon of March 19, J.P. Morgan told the Company that it would not launch the IPO the next day. Court found that J.P. Morgan could have launched the IPO as scheduled, but refused for self-interested reasons.

f. Finally, court concluded that J.P. Morgan favored

Blackberry when the Company began negotiating with potential buyers in June and July 2015. According to the Court, J.P. Morgan wanted Blackberry to buy the Company because J.P. Morgan wanted to cultivate Blackberry as a future client. J.P. Morgan provided Blackberry with a lower asking price than it gave other bidders. Court found there was evidence that J.P. Morgan lied to the Board about providing Blackberry with price guidance.

g. In July 2015, J.P. Morgan did not attempt to develop a

proposal with a competing private equity buyer and successfully encouraged the Company's CEO to enter into an exclusivity agreement with Blackberry.

h. V.C. Laster found that these actions may have caused the

Company to receive an unfair price in the Merger.

i. JP Morgan moved for a continuance shortly ahead of trial, in part potentially to seek enforcement of an engagement letter provision that it said permitted it to withhold consent to a settlement “participate[d] in" or "facilitate[d]” by its former client. In the end, JP Morgan settled for $35 million.


7. IRA Tr. FBO Bobbie Ahmed on Behalf of Class A Stockholders of

NRG Yield, Inc. v. Crane, 2017 WL 6335912 (Del. Ch. Dec. 11, 2017).

a. Plaintiff alleged the failure to disclose the size and nature of Moelis’s advisory fee did not constitute a disclosure violation.

b. Court observed that the “[b]est practice certainly would be to disclose the size and nature of a financial advisor's compensation.157 Best practice, however, does not necessarily equate to materiality.”

c. “Contingent fee arrangements obviously can be

problematic because they may incentivize advisors to prioritize the closing of the transaction over getting the best deal possible for stockholders.”

d. Court concluded that this concern was not present because

Moelis’s compensation was non-contingent. The company’s Conflicts Committee hired Moelis to be its “financial and capital markets advisor.” Thus, whatever amount the Conflicts Committee “decided to pay its outside adviser on a non-contingent basis falls squarely within the Conflicts Committee's business judgment.”

e. “In short, the failure to disclose the specifics of Moelis’s

compensation does not constitute a material omission under the circumstances of this case because there was no potential for a conflict of interest, and directors do not have an obligation to disclose information about the non-existence of misaligned incentives.”

8. In re Dole Food Co., Inc. Stockholder Litig., and In re Appraisal of

Dole Food Co., Inc., Consol. C.A. Nos. 8703-VCL, 9079-VCL, 2015 WL 5052214 (Del. Ch. Aug. 27, 2015).

a. Plaintiff claimed that Dole’s chairman/controlling shareholder and its general counsel had breached their fiduciary duties by colluding in connection with a going-private transaction by the controlling shareholder, and that Dole’s financial advisor had aided and abetted their breaches in acting as financial advisor to the corporation while simultaneously providing advice to the chairman/controlling shareholder.

b. Following trial, Vice Chancellor Laster found that the


controlling shareholder and general counsel had breached their fiduciary duties by taking steps to artificially depress Dole’s stock price prior to the chairman’s initial bid, and to inflate the attractiveness of the chairman’s bid by providing Dole’s special committee with “lowball” management projections. 2015 WL 5052215, at *2.

c. The Court also criticized Dole’s financial advisor for

allegedly “secretly helping” the chairman prepare his going-private proposal while advising Dole on other matters, id. at *8, and for treating the chairman as its “real client” even prior to the merger. Id. at *2. Ultimately, however, the court found that the advisor did not “knowingly participate” in the chairman’s “critical breaches,” and was therefore not liable on the aiding-and-abetting theory. Id. at *42.

9. In re TIBCO Software Inc. Stockholders Litig., C.A. No. 10319-CD, 2015 WL 6155894 (Del. Ch. Oct. 20, 2015)

a. Plaintiff alleged that TIBCO’s board breached its duty of care by failing to adequately inform itself of details of a share-count error that impacted the total value of agreed-upon merger consideration by $100 million, and that TIBCO’s financial advisor—which accidentally provided the incorrect double-counting—aided and abetted the board’s breach by not disclosing to the board that the acquirer had relied on the incorrect share count in determining its per-share offer.

b. The Court (Chancellor Bouchard) dismissed the breach of fiduciary duty against TIBCO’s board pursuant to the exculpatory provision in TIBCO’s charter. Id. at *2.

c. Also dismissed the professional malpractice claim against

financial advisor.

d. However, the Court declined to dismiss the aiding and abetting claim against TIBCO’s financial advisor in light of what it found to be well pleaded allegations that the advisor had knowingly created an “informational vacuum” by allegedly failing to inform the board regarding the underlying acquirer’s reliance on the initial misinformation regarding the company’s share-count. Id.

10. In re Zale Corp. Stockholders Litig., C.A. No. 9388-VCP, 2015


WL 6551418 (Del. Ch. Oct. 29, 2015) – decision at motion to dismiss stage after motion for reconsideration

a. Financial advisor to Zale in its acquisition by Signet, had, prior to its engagement, met with Signet and discussed a potential acquisition of Zale. Although the meeting was later disclosed to Zale in connection with preparation of the preliminary proxy statement (after the merger agreement was signed), and although the transaction was ultimately approved by a majority of stockholders, Plaintiffs claimed that Zale’s board breached its duty of care by failing to identify financial advisor’s alleged conflict, and that financial advisor aided and abetted that breach by failing to disclose it prior to its engagement.

b. In its initial decision on the defendants’ motions to dismiss, In re Zale Corp. Stockholders Litig., C.A. No. 9388-VCP, 2015 WL 5853693 (Del. Ch. Oct. 1, 2015), the Court dismissed plaintiffs’ claim against the board for breach of the duty of care pursuant to Zale’s exculpatory provision, id. at *12-14, but declined to dismiss the aiding and abetting claim against the financial advisor, applying the Revlon standard of care to determine the reasonableness of the board’s conduct. Id. at *20-22.

c. However, following the Delaware Supreme Court’s ruling

in Corwin v. KKR Financial Holdings, LLC, 125 A.3d 304 (Del. Oct. 2, 2015) (confirming that business judgment rule applies when reviewing board actions approved by vote of fully informed stockholders), financial advisor successfully moved for reargument. 2015 WL 6551418, at *1-5, aff’d, Singh v. Attenborough, No. 645, 2015 (Del. May 5, 2016) (en banc).

d. Nevertheless, the trial court reiterated its view that financial

advisor “would have better served the Zale stockholders” if it had “disclosed the Signet presentation to the Board up front.” Id. at *5.

11. In re Del Monte Foods Company S’holders Litig., Consol. C.A. No. 6027-VCL (Feb. 14, 2011) (Laster, V. C.).

a. Bank allegedly put the company in play, maneuvered to get the buy-side financing (and a big fee), and allowed potential buyers to club together to reduce competition, in violation of Del Monte’s confidentiality agreement and


with no benefit to Del Monte.

b. Del Monte board was in the dark; when the board told the banker to stand down, it continued its efforts.

c. Revlon transaction in which Del Monte adopted a single-

bidder strategy with a go-shop run by the banker.

d. Del Monte spent $3M on a second banker for a second fairness opinion

e. The court found that there was a reasonable probability that

plaintiff would succeed on the merits of a Revlon claim because the board failed to oversee the conflict – board was passive in its oversight; it did not question the club arrangement or the bank providing financing.

f. The court found that the banker was so conflicted that the

entire process was tainted; “for purposes of equitable relief, the Board is responsible”– the court delayed the shareholder vote for 20 days to allow a topping bid to arise – during that delay, the buyer’s deal protections (no-shop, match rights, and breakup fee) could not be enforced

g. No topping bid arose, and the case settled post-closing for

$89.4M with about $20M in attorney fees.

12. In re El Paso Corporation Shareholder Litigation, , C.A. No. 6949-CS (Del. Ch. February 29, 2012).

a. El Paso hired a financial advisor to help with a spin-off of a portion of its business – banker had a $4B (19%) equity position and two board seats in Kinder Morgan, the party that offered to buy the entire company

b. A second banker was brought in, but with a fee only if the whole company was sold – as a result, both bankers allegedly were incentivized to push for a sale of the whole company to the counterparty.

c. Neither El Paso nor its bankers did a soft market check on

the Kinder Morgan price – the board knew of the first banker conflict, but according to the court did not deal with it because it allowed that banker to continue to analyze whether a spin-off was an appropriate alternative


d. One member of the banking team also held a small position in Kinder Morgan securities that was not disclosed to El Paso.

e. Court did not enjoin the deal because no other bid was on

the table, and blocking the deal would ultimately harm El Paso shareholders more than letting the offer go to vote

f. Kinder Morgan (as owner of El Paso) ultimately settled for

$110M, and did not pay the first banker its $20M fee or any indemnity payments.

b. Implications:

i. The Delaware Supreme Court’s rejection of “gatekeeper” duties for non-

fiduciary third-parties should provide some comfort for financial advisors by establishing limits to their potential aiding and abetting liability.

ii. The Delaware Chancery Court appears to require a showing of gross malfeasance on the part of the fiduciary to find aiding and abetting liability. For example, in Mesirov, the Court found liability where the fiduciary manipulated valuations, based its fairness opinions on those valuations, and did so to maintain a relationship with the company.

iii. Sellers are pushing harder in engagement letters for some or all of:

1. representations that banker has not had prior discussions with any other parties about the deal within the two to three years.

2. representations about any current or past discussions or relationships between the banker and certain potential counterparties.

3. representations about stock ownership by the bank or certain individuals of potential counterparties.

4. banker’s agreement to not communicate with any other party about the transaction, except as directed by the board.

5. banker’s covenant not to provide financing or other financial advisor services to buyers without board consent.

6. banker’s agreement to share the fee if another banker is necessary due to a conflict.

7. prohibitions on banker assisting in a clubbing arrangement without board permission.

8. banker’s covenant to advise the board of any expression of interest. 9. banker’s covenant to promptly advise the board of any future

perceived conflict. 10. elimination of any tail fee if the financial advisor has materially

breached any such representation or covenant.


iv. In light of recent rulings confirming that aiding and abetting claims against financial advisors may be maintained even where claims for directors’ predicate breaches are precluded by the exculpatory provisions common in Delaware companies, there continues to be potential exposure.

1. When presented with the opportunity to advise multiple participants in a transaction, financial advisors must evaluate carefully whether a potential conflict exists (or could appear to exist) and how it can be appropriately managed.

2. Be mindful that the question of when routine marketing becomes a conflict-creating “pitch” continues to be the subject of debate in Delaware.

3. While the retention of a secondary/conflicts financial advisor may be prudent, it should not be counted on. Indeed, the secondary advisor may itself face liability for its conduct.

4. A financial advisor’s best defense against a claim of aiding and abetting fiduciary breaches is to prospectively disclose its potential and actual conflicts and avoid the appearance of improper dealings.

v. Fairness Opinions. FINRA Rule 5150 requires FINRA members who issue fairness opinions that are included in a proxy statement to disclose in the opinion any material relationships with the companies involved in the transaction (for example, offering stapled financing). FINRA Rule 5150 also requires disclosure of (i) whether the advisor is being compensated with success fees; (ii) whether a “material relationship” has existed between the investment bank and any of the parties to the transaction within the previous two years or whether the investment bank anticipates developing such a “material relationship”; (iii) whether the company supplied the investment bank with information constituting a “substantial basis” for the fairness opinion and whether the bank independently verified the accuracy of such information; and (iv) whether the investment bank’s fairness committee approved of or issued the fairness opinion. FINRA Rule 5150 also requires certain procedures be implemented by the investment bank relating to its fairness committee.2

II. BROKER-DEALER CONFLICT MANAGEMENT SYSTEMS

2 Delaware courts also have held that disclosure of conflicts is a key element of disclosure relating to fairness opinions, including disclosure related to fees, buy-side relationships and contacts and even potential buy-side business. The Delaware Chancery Court granted a preliminary injunction in In re Atheros Commc’ns, Inc. S’holder Litig., Consol. No. 6124-VCN (Del. Ch. Mar. 4, 2011), preventing the target’s board of directors from proceeding with a vote to approve a sale of the company to a strategic partner. The injunction was based on the inadequate disclosure by the board of the financial advisor ’s fee, which was largely contingent on closing of the contemplated transaction.


a. SEC Guidelines i. On June 5, 2019, the SEC adopted Regulation Best Interest, which

establishes a new standard of conduct under the Securities Exchange Act of 1934 (“Exchange Act”) for broker-dealers and natural persons who are associated persons of a broker-dealer (“associated persons”) when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer. The effective date for the Regulation was September 10, 2019 and the compliance date is June 30, 2020.

ii. The SEC outlined four specified component obligations that must be complied with in order to satisfy the general obligation for broker-dealers. Those obligations are:

1. Disclosure Obligation: the broker-dealer must provide certain required disclosure of material facts relating to the scope and terms of the relationship with the customer and facts related to conflict of interest that are associated with the recommendation before or at the time of the recommendation;

2. Care Obligation: the broker-dealer must exercise reasonable diligence, care, and skill in making the recommendation so that the retail customer understands the potential risks, rewards, and costs associated with the recommendation;

3. Conflict of Interest Obligation: the broker-dealer disclose or eliminate conflicts of interest and disclose any non-cash compensation that the broker-dealer might receive based on the sale of securities; and

4. Compliance Obligation: the broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to achieve compliance with Regulation Best Interest.

iii. Implications of the Adoption of the Regulation

1. Application of Regulation BI. The Regulation applies to services such as ongoing account monitoring.

a. While many broker-dealers currently do not formally agree to provide account monitoring, the concept of implicit hold recommendations introduces new considerations for brokerage agreements and policies and procedures. A broker-dealer that does not formally provide account monitoring services should consider adding explicit provisions to its brokerage agreements whereby a retail customer agrees that the broker-dealer has no obligation to


monitor the account and has no obligation to revisit past recommendations or otherwise provide recommendations about the retail customer’s account.3 It may be beneficial for firms to move services such as financial planning and portfolio monitoring out from the broker-dealer and to the RIA.

2. Firms will want to analyze what types of communications would

go beyond solicitation or marketing of services and be viewed as a recommendation.4

3. Disclosure Review Process. Firms should consider developing a process to evaluate and review disclosures on an ongoing basis, as well as processes for providing updated disclosures at the time of the recommendation, whether with supplemental materials or oral disclosures.5

4. Expansion of Obligations. This Regulation expands the quantitative obligation to all retail customer relationships, not only to situations where a broker-dealer exercises actual or de facto control over an account.6

5. Violations of Regulation BI. A violation of this Regulation could plausibly be shown solely on the existence of a broker-dealer’s inadequate policies and procedures, as has been the case with policies and procedures on the handling of material nonpublic information required by Exchange Act Section 15(g) and Advisers Act Section 204A, as well as the Advisers Act rule on policies and procedures, Rule 206(4)-7.7

b. FINRA Guidelines

i. Topic: In October 2013, FINRA released a report on conflicts of interest in the retail broker-dealer context. The report focused on identifying and managing conflicts in a firm’s three critical areas: (1) enterprise level frameworks to identify and manage conflicts; (2) approaches to handling conflicts of interest; and (3) compensation for associated persons. The report provides retail broker-dealers with summaries of how the industry manages and mitigates conflicts of interest.8

3 In Focus: What Regulation Best Interest Means for Retail Broker-Dealers, June 26, 2019, https://www.jdsupra.com/legalnews/in-focus-what-regulation-best-interest-85698/. 4 Id. 5 Id. 6 Id. 7 Id. 8 FINRA, REPORT ON CONFLICTS OF INTEREST (Oct. 2013) (the “FINRA Conflicts Report”),http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p359 971.pdf.

https://www.jdsupra.com/legalnews/in-focus-what-regulation-best-interest-85698/

http://www.finra.org/web/groups/industry/@ip/@reg/@guide/documents/industry/p359


ii. Elements of an Effective Conflicts Management Model. FINRA

concluded the key elements of a conflicts management process include:

1. Defining conflicts of interest in a way that is relevant to a firm’s business and which helps staff identify conflict situations;

2. Articulating employees’ roles and responsibilities with respect to identifying and managing conflicts;

3. Establishing mechanisms to identify conflicts in a firm’s business as it evolves;

4. Defining escalation procedures for conflicts of interest within and across business lines;

5. Avoiding severe conflicts, even if that avoidance means foregoing an otherwise attractive business opportunity;

6. Disclosing conflicts of interest to clients, taking into consideration the different needs of retail and institutional clients;

7. Training staff to identify and manage conflicts in accordance with firm policies and procedures; and

8. Reporting on significant conflicts issues, including on a firm’s own measures to identify and manage conflicts, to the Chief Executive Officer (CEO) and board.

iii. Distributed vs. Centralized Conflicts Management Models. FINRA found

that many retail broker-dealers use a distributed model to address conflict management where identification and oversight of conflicts is spread within the firm and conflicts are handled by different senior level committees. By contrast, other firms use a centralized approach where a “conflicts department” handles all conflicts. Deciding which approach to use may depend on the size of the investment adviser, the nature of its business and the overhead required. For example, larger firms may have the luxury (and need) of hiring employees specifically to address conflicts. Smaller firms may require their employees to wear multiple hats and serve on an ad hoc conflicts committee. Neither FINRA nor the SEC prescribe any specific conflict management system.

1. Distributed Model. FINRA found that the most common approach

to conflicts management was a distributed model, where responsibility for identification and oversight is spread within a firm with no single office or department having overall ownership. The business lines typically bear front-line responsibility for identifying and managing conflicts. Various senior-level committees address conflicts specific to their scope of responsibilities and the control functions support both the business lines and the committees in varying degrees. Policy ownership for conflicts issues is diffused among these same functions.


a. Distributed Model Benefits. One benefit of this approach FINRÅ identified is that it places responsibility for identifying and managing conflicts with those individuals most directly familiar with the details of a firm’s business and who are in a position to take measures to mitigate those conflicts. In addition, a firm does not need to create new structures or reporting lines which can be a challenging and time-consuming process.

b. Potential Distributed Model Downsides. FINRA found that

the potential downside to the distributed approach is that individuals within a business line may be unaware of conflicts in their business that arise because of activities in other business lines. In addition, individual business lines may handle similar types of conflicts in different ways without a conscious decision that those differences are appropriate for the specific situation. Furthermore, firms’ management teams may have difficulty remaining focused on conflicts issues among the myriad other issues competing for their time and attention. Finally, varying degrees of commitment to identifying and mitigating conflicts may exist across the firm.

2. Centralized Conflicts Management Model. The second approach

uses a centralized conflicts office to manage a firm’s conflicts framework. Firms that take this approach emphasize that although they operate a centralized office, responsibility for identifying conflicts rests first and foremost with the business. FINRA observed this model in two versions.

a. In one version, a dedicated conflicts office is part of firm

management. The office has both a transactional and business practice focus. In the former role, the office oversees the firm’s conflict management framework and works with business units to manage potentially significant conflicts within, and across, business units. In the latter role, the office works with business units to review and assess business practice conflicts on an ongoing basis, as well as to support presentation of thematic conflicts reviews to a senior firm management committee.

b. In the second version of the centralized approach, conflicts

management is integrated into anexisting, compliance-related group. This office is responsible for, among other things, the firm’s Code of Ethics and certain other enterprise-level conflicts policies. The office coordinates


line of-business “conflicts officers” and works with business units to identify and manage unique conflict situations. The office maintains a log of non-standard conflicts, in part to help identify areas where training may be needed. In contrast to the dedicated conflicts office approach, the integrated conflicts office does not operate the firm’s transactional review process.

c. Both centralized models use a network of “conflicts

officers” in the business units to help address conflicts that may arise in the normal course of business. The “conflicts officers” act as a resource to the business unit in managing conflicts issues, are a point of contact for individuals who wish to raise potential conflicts concerns and can also escalate conflicts as warranted. These individuals may be part of either the risk or compliance functions.

d. Potential Benefits. There are several potential benefits of a

centralized, enterprise-level approach to conflicts management. First, the office creates a platform to maintain a sustained, firm-wide focus on conflicts issues. A similar focus may be difficult to achieve when driven by multiple firm-level management committees. Second, creating a dedicated office sends a strong message to firm employees about the importance of conflicts issues to executive management. Third, if established at an appropriate level within a firm, the office provides visibility on conflicts issues to executive management and, as appropriate, the board. Fourth, a centralized office can help ensure a consistent approach to conflicts management across the enterprise.

e. Potential Downsides. FINRA noted a number of

downsides. First, it may diminish the sense of responsibility for conflicts in the business lines. Firms using the centralized model acknowledge that potential, but also emphasize that their approaches are designed to prevent this from happening. Second, establishing a centralized model can be a significant undertaking. Firms will likely need to create new policies and processes and implement technology programs to support the operation of the conflicts office. In particular, the conflicts office may need a broad array of information about a firm’s business activities to evaluate the conflicts the firm may face.


III. MANAGING COUNTERPARTY CONFLICTS AND MNPI

a. Managing exposure to trading counterparties can create potential conflicts. For example, broker-dealers may come into possession of MNPI through nonpublic investment banking relationships with the issuer. Firms sometimes are faced with the question of whether they can manage their trading exposure to a particular issuer based on MNPI. Rule 10b-5 prohibits trading on MNPI, so firms are limited in how they can actively trade to manage exposure. Nothing in Rule 10b¬5, however, requires that a broker enter into a new trade. Brokers also come into possession of material information about an issuer outside the context of a formal confidential relationship. Firms must then decide whether they will use that information to manage their exposure to the issuer.

b. Veleron Holding, B.V. v. Morgan Stanley Capital Servs., Inc., 117 F.Supp.3d 404 (S.D.N.Y 2015).

i. Veleron was a Dutch company created as an investment vehicle for

Russian tycoon Oleg Deripaska. Deripaska used Veleron to invest in shares in auto parts maker Magna International.

ii. The investment was financed with a $1.2 billion loan from BNP Paribas, with Veleron’s shares in Magna serving as collateral.

iii. Morgan Stanley was not directly involved in the loan, but entered into a

swap agreement with BNP Paribas under which it assumed some of the risk of the loan in exchange for fixed payments. Morgan Stanley’s participation also included acting, if necessary, to dispose the pledged collateral.

iv. The relevant ISDA Master Agreement governing the swap did not contain

a confidentiality provision. The 2003 ISDA Credit Derivatives Definitions specifically provided that “a party receiving information from the other party...shall not become subject to any obligation of confidentiality.” 117 F.Supp.3d 404, 418.

v. On September 29, 2008, in the midst of the financial crisis, BNP sent a written notice of a margin call to Veleron, demanding payment of $92 million to cover the shortfall.

vi. BNP notified Morgan Stanley as required under their swap agreement and

the next morning, the margin call information was forwarded from Morgan Stanley global capital markets to one of its equity traders. The trader was responsible for managing Morgan Stanley’s risk in connection with the BNP credit default swap.

vii. The trader immediately began short-selling. Morgan Stanley stood to lose


$6.6 million, but mitigated losses and offset $4.6 because of the short-selling. By day end on September 30, 2008, Morgan Stanley had sold short 191,505 shares.

viii. Morgan Stanley argued that it had no duty to Veleron that could give rise

to an insider trading claim, and that it was simply hedging against its exposure to risk.

ix. On summary judgment, the Court held that there were issues of fact

regarding whether the information Morgan Stanley received was material and whether Morgan Stanley had a duty to keep Veleron’s information confidential. The case went on to trial.

x. At trial, the jury found that Morgan Stanley had not acted with the

required scienter. During deliberations, a note from the jury asked whether Veleron had to prove whether Morgan Stanley had a specific intent to defraud. The Judge replied “yes,” but “specifically in the sense that the material, non public information must be misappropriated from Veleron.” 694 Fed. Appx. 858, 861 (2d Cir. 2017). Shortly thereafter, the jury returned a unanimous verdict for Morgan Stanley, concluding they had not acted with scienter.

IV. INVESTMENT ADVISORS, RETAIL BROKER-DEALERS AND

CONFLICTS MANAGEMENT

a. In the Matter of The Robare Group Ltd., Mark Robare and Jack Jones i. The SEC charged the Robare Group (“TRG”) and two of its principals,

Mark Robare and Jack Jones, with a failure to adequate disclose conflicts of interest inherent in an arrangement whereby the TRG received compensation from Fidelity Investments (“Fidelity”), the custodian of its clients’ accounts, for maintaining client assets in certain investments.

ii. TRG was required to disclose this arrangement, but its Form ADV failed to do so for many years.

iii. Undisclosed compensation was considered a “material conflict” because reasonable investors would have considered the payments TRG received from Fidelity important in evaluating the investment decisions being made on their behalf.

iv. The SEC found that TRG was an investment advisor with fiduciary obligations to its clients, and failed to disclose material conflicts of interest. As such, the SEC found TRG liable under Section 206(2) of the Advisers Act.

b. Halbert v. Credit Suisse AG, 402 F. Supp. 3d 1288 (N.D.A.L. 2019)


i. This case arises from a claim that Credit Suisse sold plaintiffs high-risk securities leading up to a volatility spike in the market in an effort to facilitate the collapse of these securities by hedging them.

ii. Plaintiffs claim that Credit Suisse materially omitted or misinformed Plaintiffs and failed to disclose conflicts of interest, violations of Section 11 of the Securities Act or 10(b) of the Exchange Act.

iii. With respect to these claims against Credit Suisse, the court found that the

claims were unfounded because “the Offering Documents were transparent about the nature of Credit Suisse’s activities, the potential adverse consequences for investors, [conflicts of interest], and the significant risks of acceleration and loss.”

c. In the Matter of BlackRock Advisors, LLC and Bartholomew A. Battista, April

20, 2015

i. The SEC charged BlackRock with breaching its fiduciary duty by failing to disclose a conflict of interest created by the outside business activity of a portfolio manager, Daniel J. Rice, III. Rice managed energy-focused registered funds, private funds, and separate accounts. In 2007, Rice founded Rice Energy, L.P. – a Rice family-owned-and-operated oil and natural gas production company. Rice was the general partner of Rice Energy and personally invested approximately $50 million in the company.

ii. In February 2010, Rice Energy formed a joint venture with Alpha Natural Resources, Inc. (“ANR”), a publicly-traded coal company held in the BlackRock funds and accounts managed by Rice. By June 30, 2011, ANR stock was the largest holding (9.4%) in the Rice-managed $1.7 billion BlackRock Energy & Resources Portfolio, BlackRock knew of Rice’s involvement with and investment in Rice Energy as well as the joint venture with ANR, but failed to disclose Rice’s conflict of interest to the BlackRock funds’ boards of directors or to BlackRock advisory clients.

iii. The SEC’s order finds that BlackRock knew and approved of Rice’s

investment and involvement with Rice Energy as well as the joint venture, but failed to disclose this conflict of interest to either the boards of the BlackRock registered funds or its advisory clients.

iv. BlackRock consented to the entry of the SEC’s order finding that the firm

willfully violated Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7. In addition, this was the first SEC matter to charge a firm with violations of Rule 38a-1 for failing to report a material compliance matter such as violations of the adviser’s policies and procedures to a fund board.


d. In the Matter of Merrill Lynch, Pierce, Fenner & Smith Incorporated, August 20,

2018 i. The SEC charged Merrill Lynch with failure to disclose a conflict of

interest arising out of its own business interests in deciding whether to continue to offer clients products managed by an outside third-party advisory firm.

ii. Merrill put new investments into these products on hold due to pending management changes at the third party, and Merrill’s governance committee planned to vote on a recommendation to terminate the products and offer alternatives to investors. The third-party manager sought to prevent termination and contacted senior Merrill executives, including making an appeal to consider the companies’ broader business relationship. Following those communications, and in a break from ordinary practices, the governance committee did not vote and chose to defer action on termination. The governance committee later lifted the hold and opened the third-party products to new Merrill accounts. Merrill failed to disclose to its clients the conflicts of interest in Merrill’s decision-making process.

iii. The SEC found the undisclosed conflict was in violation of Section

206(2) and 206(4) of the Advisers Act, and Rule 206(4)-7.

e. In the Matter of WCAS Management Corporation, April 24, 2018

i. The SEC charged WCAS, an investment adviser, with a failure to disclose conflicts of interest between the adviser and its private equity fund clients and fund investors in connection with an agreement (the “WCAS Services Agreement”) between the adviser and a group purchasing organization (the “GPO”). WCAS is the investment adviser to various private equity funds which owned portfolio companies that used the GPO, which is a company that aggregates companies’ spending to obtain volume discounts from participating vendors. Under the WCAS Services Agreement, the GPO paid WCAS compensation based on a share of the fees the GPO received from vendors as a result of the WCAS portfolio companies’ purchases through the GPO.

ii. WCAS did not disclose the conflicts of interest associated with the WCAS Services Agreement, and could not effectively consent on behalf of its private equity fund clients.

iii. The SEC found that WCAS breached its fiduciary duty to its private

equity fund clients in violation of Section 206(2) of the Advisers Act, and also violated 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.


f. SEC v. Goldman Sachs & Co. and Fabrice Tourre, April 15, 2010, Release 2010-59

i. The SEC alleged that Goldman Sachs structured and marketed a synthetic

collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS) and that Goldman failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

ii. The marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleged that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

iii. After participating in the portfolio selection, Paulson effectively shorted

the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman to buy protection on specific layers of the ABACUS capital structure. The SEC alleged that given that financial short conflict of interest, Paulson had an economic incentive to select RMBS that it expected to experience credit events in the near future.

iv. The SEC's complaint charged Goldman and Tourre with violations of

Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5.

g. In the Matter of PNC Investments LLC, Release No. 83004 April 6, 2018

i. The SEC alleged that, from at least 2012 to 2016, PNCI invested advisory

clients in mutual fund share classes with 12b-1 fees instead of available lower-cost share classes of the same funds without 12b-1 fees. PNCI financially benefitted from investing advisory clients in mutual fund share classes with 12b-1 fees, which created a conflict of interest that PNCI failed adequately to disclose in its Forms ADV or otherwise.

ii. During the period of review, the SEC found that PNCI received marketing support payments from three mutual fund complexes. The mutual fund complexes paid PNCI over $497,000 in marketing support payments, which were due only when PNCI invested its advisory clients in mutual fund share classes that charged 12b-1 fees. PNCI did not receive such fees when it invested advisory clients in share classes that did not charge 12b-1


fees. PNCI never disclosed this conflict of interest in its Forms ADV or otherwise.

1. PNCI had entered into marketing support agreements with these

three mutual fund complexes. Each of the MSAs specified the method for calculating the fees paid to PNCI for marketing support. Pursuant to the terms of the MSAs, the fund complexes paid fees to PNCI based either on the total assets invested by PNCI’s advisory clients or the total sales of the mutual fund shares sold to PNCI’s advisory clients. The MSAs specified that fees would be paid only on the share classes that charged 12b-1 fees. No MSA fees would be paid on shares that did not pay 12b-1 fees.

iii. The SEC concluded that each of the MSAs presented a conflict of interest

for PNCI because each gave PNCI an additional economic incentive to sell advisory clients more expensive share classes so that PNCI could receive marketing support payments. From 2012 through 2016, PNCI received $497,144 in marketing support payments under the terms of the three MSAs as a result of the share classes purchased or owned by its advisory clients.

h. In the Matter of Geneos Wealth Management, Inc. Release No. 4877 April 6,

2018

i. The SEC alleged that from February 2012 through April 2017 Geneos invested certain advisory clients in mutual fund share classes that charged 12b-1 fees when these clients were eligible to invest in cheaper share classes of the same funds that did not charge such fees. Geneos financially benefitted from investing advisory clients in mutual fund share classes with higher fees, which created a conflict of interest that Geneos failed to adequately disclose in its Forms ADV, Part 2A (“firm brochures”) or otherwise.

1. Geneos generally disclosed in its firm brochures that it “may”

receive 12b-1 fees from the sale of mutual funds and that the availability of such fees created a conflict of interest. However, Geneos failed to disclose that it had a conflict of interest as a result of the additional compensation it received for investing advisory clients in a fund’s 12b-1 fee paying share class when a cheaper share class was available for the same fund. Geneos also failed to adequately disclose that it would and did select share classes paying 12b-1 fees when less expensive share classes were available to certain of Geneos’ Advisory Clients for the same fund

ii. The SEC also alleged that from February 2012 through January 2018

Geneos failed to disclose to its clients compensation that it received


through agreements with two third-party broker-dealers (“Clearing Brokers”) and conflicts arising from that compensation. Pursuant to the agreements, the Clearing Brokers agreed to share with Geneos certain revenues that the Clearing Brokers received from the mutual funds in the Clearing Brokers’ no-transaction-fee mutual fund programs (“NTF Programs”). These payments, totaling $386,185.77, created a conflict of interest in that they provided a financial incentive for Geneos to favor the mutual funds in the NTF Programs over other investments when giving investment advice to its advisory clients.

1. Geneos did not disclose that it received payments from the

Clearing Brokers based on Geneos client assets invested in the NTF Programs or that these payments presented a conflict of interest.

i. Research. In the Matter of Goldman, Sachs & Co., Release No. 34-66791 (Apr.

12, 2012). In 2012, the SEC brought charges against Goldman Sachs under section 15(b) of the Exchange Act out of concern that its weekly “huddles” of traders created a risk of sharing material nonpublic information in violation of section 15(g). Huddles were a practice in which Goldman’s equity research analysts met to provide their best trading ideas to firm traders and a select group of top clients. The SEC charged that Goldman did not establish, maintain, and enforce adequate policies and procedures to prevent any misuse of material nonpublic information concerning Goldman’s published research. Goldman agreed to settle the charges and pay a $22 million penalty.

j. Research. Toys “R” Us. On December 11, 2014, FINRA fined ten broker dealers

a total of $43.5 million for allegedly allowing their equity research analysts to solicit investment banking business and for offering favorable research coverage in connection with the 2010 planned initial public offering of Toys “R” Us. In April 2010, Toys “R” Us and its private equity owners (sponsors) invited the firms to compete for a role in Toys “R” Us’ planned IPO. Toys “R” Us asked equity research analysts from each of the ten firms to make separate presentations to its management and sponsors for the purpose of ensuring that the analysts' views on key issues, including valuation factors, were aligned with the views expressed by the firms' investment bankers. Each firm allegedly understood that the performance of their analysts at the presentations would be a key factor in determining whether the firm received an underwriting role in the IPO. FINRA concluded that the firms implicitly or explicitly at these meetings or in follow-up communications offered favorable research coverage in return for a role in the IPO. FINRA found that six of the firms had inadequate supervisory procedures related to research analyst participation in investment banking pitches.9

9 FINRA Fines 10 Firms a Total of $43.5 Million for Allowing Equity Research Analysts to Solicit Investment Banking Business and for Offering Favorable Research Coverage in Connection With Toys"R"Us IPO, FINRA Press Release (December 11, 2014), http://finra.org/newsroom/2014/finra-fines-firms-total-435-million.

http://finra.org/newsroom/2014/finra-fines-firms-total-435-million.


k. SEC Publishes Guidance on Investment Adviser Disclosure of Conflicts of

Interest i. The Division of Investment Management issued guidance on October 18,

2019 regarding the obligation of investment advisers to disclose financial conflicts of interest. This is the first time the staff of the Division of Investment Management is affirmatively addressing disclosure obligations.10

ii. Broadly, the Guidance recommends the following:11 1. Consider all direct and indirect compensation. Although the

Guidance focuses on disclosure of conflicts of interest associated with the receipt of 12b-1 fees and revenue sharing, “many of the same principles and disclosure obligations apply to other forms of compensation,” including service fees from clearing brokers, marketing support payments, compensation designed to defray the cost of educating and training sales personnel, and transaction fees. Importantly, the staff refers to “compensation” broadly to include the reduction or avoidance of expenses that the investment adviser incurs or would otherwise incur.

2. Form ADV Disclosure. Form ADV disclosure should be “concise, direct, appropriate to the level of financial sophistication of the adviser’s clients and written in plain English. As a result, longer disclosures may not be better disclosures.”

3. Material Facts to be Disclosed. The Guidance provides examples of material facts that the SEC believes should be disclosed in connection with the receipt of 12b-1 fees and revenue sharing payments including but not limited to:

a. The existence and effect of different incentives and resulting conflicts;

b. The fact that different share classes are available and that different share classes of the same fund represent the same underlying investments;

c. How differences in sales charges, transaction fees and ongoing fees would affect a client’s investment returns over time;

d. The fact that the adviser has financial interests in the choice of share classes that conflict with the interests of its clients;

e. Any agreements to receive payments from a clearing broker for recommending particular share classes;

f. The nature of the conflict; and g. How the adviser addresses the conflict

10 SEC Staff Publishes Guidance on Investment Adviser Disclosure of Financial Conflicts of Interest, Nov. 13, 2019, https://globalcompliancenews.com/sec-staff-publishes-guidance-investment-adviser-disclosure-financial-conflict-interest-20191928/. 11 Frequently Asked Questions Regrading Disclosure of Certain Financial Conflicts Related to Investment Adviser Compensation, SEC, Oct. 18, 2019, https://www.sec.gov/investment/faq-disclosure-conflicts-investment-adviser-compensation.

https://www.sec.gov/investment/faq-disclosure-conflicts-investment-adviser-compensation

https://www.sec.gov/investment/faq-disclosure-conflicts-investment-adviser-compensation


l. Amendments to Regulation ATS

i. On July 18, 2018, the SEC approved a final rule amending Regulation

ATS to require ATSs that trade national market system stocks to file with the SEC new Form ATS-N to begin operations or, for currently operating ATSs, to continue operations. Form ATS-N will provide for enhanced disclosures regarding the ATS’s operations and relationship with its broker-dealer operator relative to current Form ATS and will be publicly available.

ii. In developing this rule the SEC is seeking to foster greater transparency in the market for NMS stocks and to enhance oversight of those ATSs that trade NMS stocks. The final rule is designed to allow institutional investors in particular to compare operations and conflicts of interest among various ATSs and national securities exchanges used by their executing brokers. The final rule will provide market participants information about how orders interact, match and execute on ATSs that trade NMS stocks, along with details about the activities of the broker-dealer operator and its affiliates in order to further assess conflicts of interest and information leakage.

iii. The Final Rule continues the SEC’s focus on enhancing transparency and

addressing potential conflicts of interest in the equity markets and will in particular work hand-in-hand with the amendments to Rules 605 and 606 under Regulation NMS, which require additional disclosures by broker-dealers to customers – including new disclosures to institutional customers – about the broker-dealer’s routing decisions and executions. Combined, the rule changes will shed light on the manner in which broker-dealers and trading centers execute, in particular, institutional customer orders, allowing institutional investors and other market participants to evaluate broker-dealers to more readily assess the quality of services offered by their brokers.

m. SEC Withdraws Proxy Firm No Action Letters

i. When adopting Rule 206(4)-6, the SEC stated in its release that

investment advisers have a fiduciary duty of care and loyalty to their clients with respect to proxy voting and emphasized that their policies and procedures must address how they resolve material conflicts of interest with clients before voting their proxies. The release goes on to state that an investment adviser could demonstrate that a vote of client securities was not a product of a conflict of interest if it voted, in accordance with a pre-determined policy, based upon the recommendations of an “independent” third party.


ii. The SEC produced two No Action Letters – Egan-Jones and ISS – to further clarify the role of proxy advisors and the RIA’s potential for conflicts of interest.

1. In Egan-Jones the SEC provided guidance on the circumstances under which a third party, such as a proxy voting firm, may be considered “independent” under Rule 206(4)-6 and the steps an investment adviser should take to verify that the third party is in fact independent in order to cleanse the vote of any conflict

a. The SEC stated that “the mere fact that the proxy voting firm provides advice on corporate governance issues and receives compensation from the Issuer for these services generally would not affect the firm’s independence from an investment adviser.”

b. The SEC further noted that the RIA must (1) ascertain whether the proxy voting firm has the “capacity and competency” to analyze proxy issues and can make recommendations in an impartial manner and in the best interests of the clients and (2) have procedures requiring the proxy voting firm to disclose “any relevant facts concerning the firm’s relationship with an Issuer, such as the amount of the compensation that the firm has received or will receive from an Issuer.”

2. In ISS the SEC concluded that “a case-by-case evaluation of a proxy voting firm’s potential conflicts of interest is not the exclusive means by which an investment adviser may fulfill its fiduciary duty of care to its clients in connection with voting client proxies according to the firm’s recommendations.” The SEC further stated that steps taken by an adviser to fulfill this fiduciary duty to clients may include a “thorough review of the proxy voting firm’s conflict procedures and the effectiveness of their implementation.”

iii. Over the years, investment advisers have embraced a view that their reliance on the voting recommendations of proxy voting firms will insulate their client voting decisions from any conflicts of interest. The impact the withdrawal of the no-action letters will have on shareholder activism is unclear. While large institutional investors are becoming less dependent on proxy voting firms, the influence wielded by the voting recommendations of these firms on the outcomes of contested elections is not insignificant. Investment advisers may now face uncertainty as to whether their continued reliance on these voting recommendations creates a conflict of interest.

n. FINRA Targeted Examination Letter on Order Routing Conflicts


i. Around November 2017 FINRA published a Targeted Examination Letter indicating that FINRA would conduct a review concerning the impact of the receipt of order routing inducements, such as payment for order flow and maker-taker rebates, on the reviewed firm’s order routing practices and decisions.

ii. Among other things, the Letter asks the firms to describe how the firm manages the conflict of interest that exists between the firm’s duty of best execution to customers and the firm’s own financial interest in situations where the firm routes customer orders to market center that pay order routing inducements.

V. SECURITIES OFFERINGS AND CONFLICTS MANAGEMENT

a. FINRA Rule 2720(f)(5) provides that a “conflict of interest” exists if, at the time

of a member’s participation in an issuer’s public offering, any of the following four conditions apply:

i. the securities are to be issued by the member;

ii. the issuer controls, is controlled by, or is under common control with the member or the member’s associated persons;

iii. at least five percent of the net offering proceeds, net of underwriting compensation, is intended to be used either to reduce or retire the balance of a loan or credit facility extended by the member, its affiliates, and its associated persons (in the aggregate) or otherwise be directed to the member, its affiliates, and associated persons (in the aggregate); or

iv. as a result of the public offering and any transactions contemplated at the

time of the public offering, the member will be an affiliate of the issuer, the member will become publicly owned, or the issuer will become a member or form a broker-dealer subsidiary.

b. Rule 2720 provides that no member that has a conflict of interest may participate

in a public offering unless the offering complies with either Rule 2720(a)(1) or 2720(a)(2), each of which requires disclosure of the conflict of interest.

c. Under FINRA Rule 2720(a)(1), an offering in which it is determined that a member has a conflict of interest will be exempt from the filing requirements of FINRA Rule 5110 and the obligation to retain a QIU, but not other requirements otherwise applicable with respect to escrows and discretionary accounts, if one of the following conditions is satisfied:

i. The member(s) primarily responsible for managing the public offering

does (do) not have a conflict of interest, is not an affiliate of any member that does have a conflict of interest, and meets the requirements for being


a QIU;

ii. the securities offered have a “bona fide public market”; or

iii. the securities offered are investment grade rated or are securities in the same series that have equal rights and obligations as investment grade rated securities.

d. A common stock initial public offering of an affiliate of the lead, book-running

underwriter would, therefore, require the use of a QIU. However, many other kinds of offerings generally will be able to satisfy at least one of the above conditions and be able to avoid the filing requirements of FINRA Rule 5110.

e. If the offering does not meet at least one of the conditions set forth in new Rule 2720(a)(1), then a QIU must participate in the preparation of the registration statement and the offering document and must exercise the usual standards of “due diligence” in respect of the offering. There must also be “prominent disclosure” of the nature of the conflict of interest as well as disclosure of the name of the member acting as QIU, and a brief general statement regarding the role and responsibilities of a QIU. Further, even if the offering might otherwise be exempt from filing under FINRA Rule 5110, the offering must be filed and subject to FINRA’s review of the fairness and reasonableness of the underwriter compensation.

f. FINRA Report on Examination Findings 2018 - Reasonable Diligence for Private Placements

i. FINRA has observed instances where some firms that have suitability

obligations under FINRA Rule 2111 (Suitability) failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110 (Supervision). FINRA Regulatory Notice 10-22 describes the circumstances under which firms have an obligation to conduct a “reasonable investigation” by evaluating “the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of proceeds of the offering.”

ii. Among other things Some firms used third-party due diligence reports that issuers paid for or provided in their due diligence analysis. While some of these reports provided valuable and relatively objective information, in some cases, firms did not consider the related conflicts of interest in their evaluation and assessment of the reports’ conclusions and recommendations.

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