NASAA Investment Adviser Training Workshop August 4, 2009 Conflicts of Interest Brian S. Hamburger,...

NASAA Investment Adviser Training WorkshopAugust 4, 2009

Conflicts of InterestBrian S. Hamburger, JD, AIFA®, CRCP

Managing Director

Conflicts of Interest

“Having a conflict of interest is not like being a thief or holding a grudge. One can have a conflict of interest without being in the wrong. To have a conflict of interest is merely to have a moral problem. What will be morally right or wrong, or at least morally good or bad, is how one responds to the problem.”

- NCSP Currents March/April 2004, quoting “Report on Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services” (1939).

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Conflicts of Interest

Conflicts of interests have always been the centerpiece of investment adviser regulation.

One of the most challenging issues in IA compliance. Detection relies upon a learned analysis; not memorization. There are a lot of new entrants that are not used to such

stringent treatment of conflicts.

History of IA Conflicts

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Testimony of first hearing on IAs (1939): IA could not completely perform its basic functions of furnishing

competent and unbiased advice to clients, unless all conflicts between the adviser and the client were removed.

The most fundamental problem IAs faced was the unethical fringe that falsely represented itself as investment counsel.

A professional adviser is “utterly unbiased.” IAs are professionals known for the nature of their advice – like

physicians and lawyers. The RAND Report (2008)

Found that retail investors had difficulty distinguishing between investment advisers and broker-dealers and understanding the varying affiliations and other relationships among the different firms.

Defining a Conflict of Interest

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Working definition: Some activity or relationship involving an investment adviser or its

employees that has or has the potential of favoring the interests of the investment adviser, or its employees or affiliates, over the interests of the investment adviser’s clients or some other person to whom the investment adviser owes a fiduciary duty.

Only concerned with those conflicts that are “material.” Something is material “. . . if there is a substantial likelihood that a

reasonable investor would consider the information to be important in making an investment decision.” Basic, Inc. v. Levinson 485 U.S. 224 (1988).

SEC vs. Capital Gains Research Bureau

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SEC alleged: IA was engaged in scalping its clients. An IA may be motivated to recommend securities because of their

potential for short-run price increases, which would benefit the adviser, rather than because of their potential for long-term benefit to the client.

IA argued: Its advice was sound and not offered for the purpose of furthering his

own pecuniary objectives. Court held:

Conduct violated § 206(2) of the Advisers Act because the IA failed to disclose the material conflict of interest caused by this activity.

Detecting Conflicts of Interest

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You should search for those business practices that have the potential to sacrifice the interests on one set of customers in favor of the interest of another.

You should also identify any situations in which the firm could place its or its employees’ interest ahead of the firm’s customers.

Remarks of Stephen M. Cutler

Former Director of Enforcement

U.S. Securities and Exchange Commission


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Think in very realistic terms. Consider the types of abusive conduct that regulators have

already identified in enforcement actions – but be more expansive in your analysis.

Think about service providers and how their conduct – or misconduct – might harm the adviser’s clients.

Consider establishing committees and enlisting outside assistance.

Remarks of Lori Richards

Director of OCIE

U.S. Securities and Exchange Commission


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See Proposed Amendments to Form ADV (Part 2) for some guidance (Release No. IA-1862).

Most common sources: Financial interests Family connections


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Documents alone usually point to conflicts: Form ADV or disclosure document Client contracts Client complaints Contracts with outside parties Outside business activities Financial records

Check registers Receipts and disbursements

Policies and procedures Correspondence Marketing materials

Resolving Conflicts of Interest

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Avoidance Disclosure Management


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Avoidance Subject of the conflict is simply removed from the conflicted matter. Most effective resolution. Beware of breaching an adviser’s “duty of care.”

Disclosure Management


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Avoidance Disclosure

An IA fulfills its fiduciary obligation if it properly discloses the conflict to the affected clients and obtains the clients’ consents before engaging in the conflicted activity.

Most widely adopted by IAs. Does not cure the conflict. Must be deemed “effective” to, well, be a resolution. Beware of “boilerplate” disclosure!

Management

Zion Capital Management, LLC et. al.

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IA traded in an omnibus account and allocated the trades once he could determine their profitability.

Profitable trades were generally directed to an account where the IA took a performance allocation; and away from a hedge fund the IA managed.

Fund’s offering circular stated: The IA “is or may in the future sponsor, manage or participate in other

securities investment activities and programs unrelated to the [fund’s] business” and “the other activities of the [IA] may create conflicts of interest with the [fund].”

Disclosure included only potential conflicts of interest when, the IA had an actual conflict of interest.

Alliance Capital Management, L.P.

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IA entered into arrangements with market timers in which the IA provided “timing capacity” in certain of its mutual funds in exchange for negotiated levels of “sticky money” in other funds.

Because of these arrangements, funds had highly volatile fund flows.

Prospectuses for the funds actually stated that the IA sought to restrict timing.


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Has the client been notified of the conflict? Nature of the conflict must be clearly and fully disclosed

Has the client consented to a transaction despite the disclosure?

Was the client in a position to evaluate the effect of the conflict on their account? Did the client know the full fiscal impact of the conflict? Did the client have any alternative to the conflict? In the law, we call that “informed consent”


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Avoidance Disclosure Management

Should be utilized along with other options to increase effectiveness. Least desirable option on its own. It neither removes the impediments to the decision-maker’s judgment

nor eliminates the danger of deceit and breach of trust. Often used as a last resort when exigent circumstances make

avoidance and disclosure impossible.

Common Conflicts of Interest

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Conflicts exist everywhere. They are inherent in the advisory relationship. Advisory Fees

Performance-based Wrap fee Commissions (securities / insurance / mortgage) % of AUM Hourly Fixed Fee debits Advance vs. arrears Basis for fee calculation Conditions for fee adjustment


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Contractual Arrangements Hedge Clauses

Adviser is not liable for any loses resulting from Adviser’s actions unless Adviser has acted with “gross negligence” or “willful misconduct.”

Adviser shall not be liable for losses from actions taken in “good faith.” Arbitration Provisions

SEC has taken provision that these are hedge clauses and violate the Advisers Act.

U.S. Supreme Court has held that pre-dispute agreements to arbitrate are enforceable under both the Securities Exchange Act of 1934 and Securities Act of 1933.


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Financial Interests Financial Interest with an Issuer

Mutual fund where IA is the fund’s adviser Partnership where IA is the general partner or adviser IPO where affiliate is involved with underwriting Public offering where IA has a direct financial interest in the company Inflating the values of customer assets to encourage more investing

and hence, higher fees Personal Trading Abuses

Front-running Side-by-side investing in the same or related securities


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Brokerage Practices Soft dollars Brokerage for client referrals Negotiating or managing trading costs Directed brokerage

Permit Regular practice


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Brokerage Practices Commission recapture Commissions earned by IA or affiliates

Including trailing commissions (such as 12b-1 fees) Common control with a broker-dealer Self-custody of assets


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Proxy Voting Commission recapture Commissions earned by IA or affiliates

Including trailing commissions (such as 12b-1 fees) Common control with a broker-dealer Self-custody of assets


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Referral Arrangements Financial Industry Activities and Affiliations

Broker-dealers Other IAs

Referrals quid pro quo Accountants Attorneys

Solicitors When using non-affiliated solicitors, IA must enter agreement with the

solicitor and disclose that referral fees were paid, and whether it increased the client’s fee.


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Wrap Fee Programs A wrap program is:

“a program under which any client is charged a specified fee or fees; not based directly upon transactions in a client's account; for investment advisory services (which may include portfolio

management or advice concerning the selection of other investment advisers); and execution of client transactions.”

Conflicts: The adviser has an incentive to trade less because it will mean less

expenses that the adviser is responsible for. The adviser has a greater incentive to go with the cheapest execution

for a client regardless of whether it is “best execution.”


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Controls over Valuation Currently one of the SEC’s “hot topics”. Emphasis should be placed on controls when pricing

structured products, illiquid securities, and other difficult to price securities.

Adviser has the ability to overstate the value of securities, thereby increasing its own compensation.

Brian Hamburger is the Founder and Managing Member of the Hamburger Law Firm. Brian is also the Founder and Managing Director of MarketCounsel, an

affiliated business, regulatory, and compliance consulting firm for entrepreneurial investment advisory firms nationwide. MarketCounsel and the Hamburger

Law Firm are the result of an incessant entrepreneurial spirit and genuine desire to provide an unexpected level of value and service. Together, the

consulting and law firms represent an unparalleled combination of preeminent counsel and uncompromising service to the retail securities industry.

Previously, Mr. Hamburger was an attorney with the securities practice group of a large New Jersey law firm. While there, he practiced in the area of

securities law, concentrating in investment adviser and broker-dealer registration and compliance matters as well as broker transition and practice

management issues. Prior to that post, Brian served as a law clerk in the Enforcement Division of the U.S. Securities & Exchange Commission. He was

also a judicial intern at the U.S. District Court for the Southern District of Florida and then, the State of Florida Third District Court of Appeal. Earlier, Brian was

the chief compliance officer of an SEC-registered investment adviser. In addition to his father's lifelong influence, Brian’s involvement in the securities industry started before he

could even drive a car. Since then, he has been involved in a myriad of areas within the industry, posting a rich diversity of experiences with investment adviser and financial

planning firms.

Mr. Hamburger is admitted to the bars of New Jersey, New York, Pennsylvania, Massachusetts, the District of Columbia, as well as the U.S. Supreme Court. He is a member of

the American Bar Association (Business Law Section) and other bar associations; the Securities Industry and Financial Markets Association, Compliance & Legal Division;

National Society of Compliance Professionals; Financial Planning Association; and Society of Financial Service Professionals. Brian has been appointed to the American Bar

Association’s Committees on Federal Regulation of Securities; State Regulation of Securities; and Professional Conduct; and is a Platinum and Gold Key Member of the New

York Chapter of the Investment Management Consultants Association and New Jersey Financial Planning Association, respectively. He has also heeded the call of the

Certified Financial Planner Board of Standards to sit on various task forces to shape industry-wide initiatives.

Brian is a frequent lecturer to regional and national groups in the securities industry including members of the wealth management, investment management, financial planning,

accounting, and insurance professions. His forums have ranged from delivering the keynote address to the country's state securities regulators to addressing school-age

children on career and entrepreneurial issues. For the past several years, he has been engaged by the North American Securities Administrators Association (NASAA) to train

state securities examiners on the intricacies of Form ADV and investment adviser client contracts. Mr. Hamburger proudly sits on several boards of directors and advisory

boards. He maintains his FINRA securities licenses (Series 7, 63 and 65), is a member of the FINRA Dispute Resolution Board of Arbitrators and served as an arbitrator for the

New York Stock Exchange.

A graduate of Quinnipiac College, Mr. Hamburger received his B.S. with the school's first dual major in Economics and Financial Management. He went on to earn his Juris

Doctor from the University of Miami School of Law where he was the recipient of a Dean’s Service Scholarship and the President's Pinnacle Award for his role as Editor-in-

Chief of the Res Ipsa Loquitur, the Bi-Weekly Journal of the University of Miami School of Law. Brian was among the first to earn the designation of Certified Regulatory and

Compliance Professional (CRCP) by the Wharton School and the FINRA Institute after completing his residency at the Wharton School of the University of Pennsylvania. He

was recently awarded the Accredited Investment Fiduciary Analyst™ (AIFA®) designation by the Center for Fiduciary Studies. AIFA designees have the knowledge necessary

to understand and implement a prudent investment process for investment advisers, investment managers, and investment stewards and can perform a fiduciary assessment

to verify or certify an entity's conformity to a "global fiduciary standard of excellence.“Brian is an active member of the US Coast Guard Auxiliary. He lives with his wife, Kari,

their daughter, Ella, and sons, Jacob and Sidney, in New Jersey.

Brian S. Hamburger, JD, CRCP, AIFA®

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© 2009 MarketCounsel, LLC. All rights reserved.

No portion of this presentation may be reproduced without the express written consent of the author. MarketCounsel is a consulting firm, is not affiliated with any government entity, and does not render legal or investment advice.

MarketCounsel is affiliated with the Hamburger Law Firm, LLC.

ContributorsSpeaker

Alyssa M. Kolber, JDBrian S. Hamburger, JD, AIFA®, CRCP

NASAA Investment Adviser Training Workshop August 4, 2009 Conflicts of Interest Brian S. Hamburger,...

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