By James Hamilton, J.D., LL.M.
SEC Enforcement Director Linda Chatman Thomsen believes there really is nothing new under the sun when it comes to conflicts of interest in the financial services industry. In remarks before a recent IA Week and Investment Adviser Association summit, Thomsen explained how the staff "follows the money" to uncover the variations on age old themes of misconduct. Thomsen's prepared remarks are on the SEC's Web site.
One area in which the interests of a mutual fund adviser may conflict with the interests of its clients is distribution, according to Thomsen. The staff has seen problems where advisers face conflicts with respect to payments made for distribution but fail to disclose the information to the fund boards. She gave an example of a recent series of cases brought against fund advisers that used brokerage to satisfy their own revenue sharing obligations with select broker-dealers, but failed to disclose the practice to the boards or shareholders.
Thomsen doubts these cases will be the last in which mutual fund advisers have found ways to benefit from distribution payments without disclosing the information. She urged compliance professionals to look for variations on this theme.
Thomsen said the SEC also remains concerned about advisers that use their influence to structure or to recommend mutual fund service arrangements in a way that benefits the adviser at the expense of the funds. She cited the case against Citigroup as an example. Compliance officers should be vigilant in looking for instances of overreaching, she said, and should ensure that adequate controls are in place to prevent it.
The staff also has followed the money to hedge funds, Thomsen reported. There are numerous examples of fraud by hedge fund managers, including the theft of assets, fraudulent valuations of the securities held by the fund, and false information about performance. Thomsen said that in some cases, the managers started out with the intent to deceive investors, but in most cases, managers got in over their heads and tried to cover their tracks.
The staff has seen an increase in trading violations by hedge fund managers, according to Thomsen. The violations include market manipulation, deceptive market timing and late trading, illegal short selling and insider trading. The staff is also concerned about conflicts that exist when an advisory firm manages hedge funds or other highly profitable accounts as well as other client accounts. This arrangement can provide a powerful incentive to benefit the hedge fund over the other clients through trading strategies or allocation practices, she explained.
Brokerage is a client asset, Thomsen said, and it must be treated that way. There are many temptations to use client brokerage in a manner that benefits the advisers and their personnel at the expense of clients, she warned. She said similar concerns may be raised with soft dollars. The staff has uncovered aggressive undisclosed soft dollar practices that violate the law, she advised.
Thomsen said that one of her pet peeves is firms that turn a blind eye to how big producers are making their money. These big producers often became big by engaging in misconduct, she noted. Some firms appear to want to avoid questioning the "cash cow" too closely, she explained, and some firms become complicit in the misconduct. She reminded management that it is responsible for ensuring that all employees, including the top producers, are complying with the federal securities laws. If the staff finds situations where management has turned a blind eye to misconduct, Thomsen it will seek to hold management and the firm accountable.