OPERATIONAL DUE DILIGENCE Breakfast Briefing Final.pdf · Breakfast Briefing December 13, 2018...

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OPERATIONAL DUE DILIGENCE Breakfast Briefing December 13, 2018 Moderated by: Greg Florio Jim Leahy

Transcript of OPERATIONAL DUE DILIGENCE Breakfast Briefing Final.pdf · Breakfast Briefing December 13, 2018...

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OPERATIONAL DUE DILIGENCE

Breakfast Briefing

December 13, 2018

Moderated by:

Greg Florio

Jim Leahy

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Table of Contents

About Orical………………………………………………………………………………….……3

About Orical’s Operation Due Diligence Breakfast Briefings………………………..…..........….4

Topic 1: SEC Examinations…………………………..……………………...……………………5

Summary of the SEC’s 2018 Examination Priorities…………………………...…………5

SEC Risk Alerts……………………………………………………………………………5

ODD Questions to Ask…………………………………………………………………….8

Topic 2: SEC Enforcement Actions…………………………………………………………….…9

Summary of SEC Annual Report, Division of Enforcement………………….…………..9

Topic 3: Fiduciary Duty and Conflicts of Interest…………………………………………...……11

Summary of the SEC’s Proposed Commission Interpretation Regarding Standard of

Conduct for Investment Advisers.…………………………………………………..……11

Orical Article, Undisclosed Conflicts, by James Leahy………………………Attachment 1

Enforcement Actions Related to Conflicts of Interest………………………….…………12

ODD Questions to Ask………………………………………………………...…………16

Attachment 1: Orical Article, Undisclosed Conflicts, by James Leahy...….....……………..……17

Attachment 2: Orical Service Descriptions and Partner Bios.………………....……….…………21

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About Orical

The Orical family of companies provides investment advisory legal and compliance

services, as well as leading investment management compliance technology, in one unified

offering1. Orical LLC is an investment management compliance consulting firm founded in 2010.

With clients in the U.S. and abroad, Orical services some of the financial industry’s most well-

respected firms, including investment managers, broker/dealers, family offices and banks. The

premier law firm and extensive in-house industry experience of our professionals enables Orical

to provide timely, practical advice and hands-on assistance that reflects a comprehensive

understanding of the real-world issues facing today’s industry participants. Our business model is

to provide extremely responsive and cost-effective expert compliance services. Orical, together

with its affiliates, Florio Leahy LLP, an investment management law firm, and Real World

Compliance LLC, a compliance software firm, provides a full suite of investment management

services, including the following:

• Registration Services with low Start-Up Costs (RIA, CPO/CTA, B/D);

• Development and Administration of Customized Compliance Programs that Represent

the Industry’s Best Practices;

• Compliance Software;

• Forensic Trading Reviews (Anti-Insider Trading and Market Manipulation Surveillance);

• Assistance with Investor Due Diligence;

• Assistance through Regulatory Examination;

• Mock Examinations (SEC/FINRA/CFTC);

• CCO Training Programs, Guidance and Education;

• Periodic Regulatory Updates;

• Compliance Training;

• Compliance Initiatives, Including in the Areas of Marketing and Performance Reporting,

Investment Allocation, Expense Allocation, Conflicts of Interest, Disclosure, SEC

Readiness, Custody, Cybersecurity, Disaster Recovery and Books and Records

Compliance; and

• Expanding the Bandwidth of our Client’s Internal Personnel.

1 Legal services are provided by Florio Leahy LLP and compliance technology is provided by Real World

Compliance LLC, both of which are under common ownership and control with Orical LLC.

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About the Operational Due Diligence Breakfast Briefings

Orical’s Operational Due Diligence Breakfast Briefings are a series of informative conferences

designed to cover the topics of most significance to the alternative asset operational due diligence

community and investors. Briefings are open to all alternative asset ODD professionals, as well as the

principals and operational staff of Orical’s clients, which include hundreds of alternative assets managers.

Topics are chosen with input from the ODD professionals, Orical’s clients and Orical’s broader network,

with 2-3 topics to be covered in each Briefing.

Orical’s goal in conducting the Briefings is to foster an exchange of information in an open and

“off-the-record” format, to help those who participate obtain a better understanding of how the industry’s

best practices apply in different settings, and, ultimately, to increase the likelihood of success for alternative

asset ODD professionals, investment managers and investors alike.

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Topic 1: SEC Examinations

• Summary of the SEC’s 2018 Examination Prioritieshttps://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2018.pdf

In February 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”)

announced its 2018 Examination Priorities. Its interests this year will be tailored to matters

involving critical market infrastructure, duties to retail investors, and developments in

cryptocurrency, initial coin offerings and secondary market trading. OCIE broke down its

priorities into five categories: (1) compliance and risks in critical market infrastructure; (2)

matters of importance to retail investors, including seniors and those saving for retirement; (3)

FINRA and MSRB; (4) cybersecurity; and (5) anti-money laundering programs. In regard to

protecting retail investors, OCIE will focus examinations on the disclosure and calculation of

fees, expenses, and other charges investors pay, the supervision of representatives selling

products and services to investors, and the execution of customer orders in fixed income

securities. When examining cybersecurity, OCIE will put an emphasis on governance and risk

assessment, access rights and controls, data loss prevention, vendor management, training, and

incident response. Examiners will review for compliance with applicable anti-money

laundering requirements, including whether firms are appropriately adapting their AML

programs to address their regulatory obligations.

• SEC Risk Alerts

✓ Advertising, https://www.sec.gov/ocie/Article/risk-alert-advertising.pdf

On September 14, 2017, OCIE provided a list of the most frequently cited compliance

issues related to Rule 206(4)-1, which prohibits any advertisement that contains any untrue

statement of material fact or that is otherwise false or misleading. The most frequently

cited compliance issues included the use of: (1) misleading performance results (e.g.

providing gross performance without also including net, lack of disclosures when

comparing performance to a benchmark, use of hypothetical or back-tested performance

results without disclosure of how such results were generated, etc.); (2) misleading one-

on-one presentations where fees and expenses were not deducted from displayed results;

(3) misleading claim of compliance with voluntary performance standards; (4) cherry-

picked profitable stock selections; (5) misleading selection of recommendations (e.g.,

displaying only certain specific recommendations and not all in order to illustrate a specific

strategy, and providing the best performing holdings without providing an equal amount

of worst performers); (6) lacking, or failing to adhere to, policies and procedures

reasonably designed to prevent deficiencies; (7) misleading use of third party rankings or

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awards; (8) misleading use of professional designations; and (9) published testimonials of

clients attesting to services provided.

✓ Advisory Fee and Expense Compliance Issues, https://www.sec.gov/files/ocie-risk-alert-

advisory-fee-expense-compliance.pdf

On April 12, 2018, OCIE issued a Risk Alert outlining the most frequent issues identified

during examinations. The list included: fee-billing based on incorrect account valuations

due to the use of a different metric or valuation process than what was specified in a client’s

advisory agreement; billing fees in advance or with improper frequency; applying incorrect

fee rate; omitting rebates and applying discounts incorrectly; disclosure issues involving

advisory fees; and adviser expense misallocations. OCIE put an emphasis on advisers

adopting and implementing written policies and procedures that are reasonably designed

to prevent any violation of the Advisers Act due to a failure to adhere to terms of an

advisory agreement related to a client’s advisory fees and expenses, as well as language set

in Form ADV and other materials provided to clients.

✓ Best Execution, https://www.sec.gov/files/OCIE%20Risk%20Alert%20-

%20IA%20Best%20Execution.pdf

In July 2018, OCIE issued a Risk Alert to inform investment advisers of the most common

deficiencies cited by examiners in relation to best execution obligations. As a fiduciary,

advisers have an obligation to obtain “best execution” of client trades and must execute

securities transactions in a manner that is most favorable in terms of client’s total costs or

proceeds for each transaction. An adviser should consider, among other things, the value

of research provided as well as execution capability, commission rate, financial

responsibility, and responsiveness to the adviser. Examples of common deficiencies

included: (1) not periodically and systematically performing best execution reviews; (2)

not considering materially relevant factors during best execution reviews such as,

evaluating qualitative factors like execution capability, financial responsibility, or

responsiveness to the adviser, as well as advisers not reviewing input from traders and

portfolio managers; (3) not seeking comparisons from other broker-dealers initially and/or

on an ongoing basis; (4) not fully disclosing best execution practices; (5) not providing a

full and fair disclosure of soft dollar arrangements; (6) not properly administering mixed

use allocations; and (7) advisers having inadequate policies and procedures relating to best

execution or not following their best execution policies and procedures.

✓ Cash Solicitation, https://www.sec.gov/files/OCIE%20Risk%20Alert%20-

%20Cash%20Solicitation.pdf

In October 2018, OCIE issued a Risk Alert to advise investment advisers of the most

common deficiencies observed by OCIE staff relating to Rule 206(4)-3, or the Cash

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Solicitation Rule. Registered investment advisers are generally prohibited from directly or

indirectly paying a cash fee for soliciting clients for the adviser, unless certain conditions

are met. When using a third-party solicitor, the Cash Solicitation rule requires the

following: (1) the solicitation agreement contains certain provisions such as compensation

to be received; (2) the agreement requires that a copy of the adviser’s brochure and a

separate, written disclosure document are provided to the client at the time of any

solicitation activities; (3) the adviser must receive acknowledgement of aforementioned

items; and (4) the adviser must make a bona fide effort to ascertain the solicitor has

complied with the agreement. The most common deficiencies of the Rule include: (1)

advisers whose third-party solicitors provided solicitor disclosure documents without all of

the required info to prospective clients, or none at all; (2) acknowledgements of adviser

brochure and disclosure documents were not received timely or were incomplete; (3)

advisers paid cash fees to solicitors without an agreement or pursuant to an agreement not

containing specific provisions; and (4) no efforts by advisers to confirm compliance with

agreements.

✓ RIC Initiative, https://www.sec.gov/files/OCIE%20Risk%20Alert%20-

%20RIC%20Initiatives_0.pdf

In November 2018, OCIE published a Risk Alert on conducting examination initiatives

focused on mutual funds and exchange-traded funds (“Funds”). The following topics will

be generally covered in the initiatives: (1) policies and procedures of Funds and/or advisers

to ensure they address risks and conflicts; (2) Fund disclosures to investors and shareholder

communications, and by advisers to Funds’ boards regarding risks and conflicts; and (3)

processes by Funds, advisers, and boards to assess practices and controls pertaining to risks

and conflicts. More specific focus areas of the initiatives include: (1) Index Funds that track

custom-built indexes and the unique risks and challenges of advisers and index providers

relating to the selection and weighting of these indexes; (2) compliance risks, conflicts, and

practices related to smaller and/or thinly traded ETFs; (3) factors of a mutual funds’

aberrational underperformance relative to their peer groups; (4) the policies, practices,

governance, and disclosures to investors of mutual funds with higher allocations to certain

securitized assets and/or their advisers; (5) Allocation practices, disclosures, policies and

procedures, etc., for addressing conflicts of interest and other risks associated with side-

by-side management of mutual funds and private funds; and (6) Funds managed by advisers

that are relatively new to managing registered investment companies.

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ODD Questions to Ask

Preparation: What have you done to prepare for the inevitable SEC exam?

✓ Conduct SEC readiness exercises

✓ Identify the SEC response team, including your administrator

✓ Conduct mock exams with interviews

✓ Make sure conflicts are disclosed, follow the money, find the conflict

✓ Respond to testing recommendations

Presentation: How will your firm handle an actual exam?

✓ Be Present

✓ Create a First Day Presentation and subject matter slides

✓ Who will be the quarterback

✓ Prepare your witnesses

✓ Review every submission

✓ Be timely

✓ Communicate

✓ Never back date

✓ Provide all responsive documents

✓ No cover-ups, don’t be evasive

✓ Seek assistance from experienced professionals

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Topic 2: SEC Enforcement Actions

Summary of SEC Annual Report, Division of Enforcement

The SEC recently published its Agency Financial Report for Fiscal Year 20182 (“SEC Report”) as well as

the Annual Report of the Division of Enforcement 20183 (“Enforcement Report”). In the SEC Report,

Chairman Clayton reiterated the SEC’s three-part mission which is to (i) protect investors, (ii) maintain

fair, orderly and efficient markets, and (iii) facilitate capital formation. The Chairman also indicated that

the SEC has three strategic goals for the next four years (2018-2022): the first goal is to focus on the

interests of Main Street investors. The second goal is to be innovative and responsive to the changing

nature of markets, particularly as a result of technological advancements. And finally, the third goal is to

increase the SEC’s performance by using technology, data analytics and human capital.

As of September 30, 2018, the SEC employed as staff of approximately 4,500 people. Of that number,

approximately 1300 were assigned to the Division of Enforcement (“Enforcement”) and 1100 were

assigned to the Office of Compliance Inspections and Examinations (“OCIE”). The Enforcement Report

indicates that personnel resources are down in Enforcement by approximately 10% since late 2016 as a

result of an SEC-wide hiring freeze.

As of September 2018, there were approximately 13,200 investment advisers registered with the SEC.

These advisers reported regulatory assets under management of nearly $80 trillion. The number of

registered advisers (“RIAs”) increased by approximately 5% during the year. Despite that increase, the

SEC was able to examine 17% of the RIA population during fiscal 2018. To put that number in

perspective, the SEC examined only 8% of RIAs in FY 2012. The number of SEC exams that get referred

to Enforcement continues to hover around 10%.

The Enforcement Report cites Main Street investors as a principal focus. Enforcement was able to return

$794 million to harmed investors. The Retail Strategy Task Force was formed and the Share Class

Selection Disclosure (“SCSD”) was announced. The SCSD program is designed encourage RIAs to self-

report undisclosed conflicts of interest related to marketing fees and expenses associated with the

selection of mutual fund share classes. Scores of RIAs participated.

The Enforcement Division’s Cyber Unit became fully operational and began to prosecute cases related to

digital assets and initial coin offerings. Enforcement is also leveraging enhanced data analytics to pursue

insider trading and allocation of investment opportunity (cherry picking) cases.

2 See https://www.sec.gov/reports-and-publications/annual-reports/sec-2018-agency-financial-report.

3 See https://www.sec.gov/files/enforcement-annual-report-2018.pdf.

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During FY 2018 Enforcement brought 821 actions (490 of which were stand-alone) and obtained

judgements and orders totaling more than $3.9 billion in disgorgement of ill-gotten gains and penalties. It

also returned $794 million to harmed investors, suspended trading in nearly 300 companies and obtained

approximately 550 bars and suspensions.

A breakdown of the 490 stand-alone actions in FY 2018 is as follows:

Actions Percent

Securities Offerings 121 25%

RIA/Inv. Company 108 22%

Reporting & Disclosure 79 16%

Broker Dealer 63 13%

Insider Trading 51 10%

Market Manipulation 32 7%

Public Finance Abuse 15 3%

FCPA 13 3%

Misc. 3 1%

NRSRO 2 0%

Transfer Agent 2 0%

SRO or Exchange 1 0%

Total 490 100%

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Topic 3: Fiduciary Duty and Conflicts of Interest

Summary of the SEC’s Proposed Commission Interpretation Regarding Standard of

Conduct for Investment Advisers https://www.sec.gov/rules/proposed/2018/ia-4889.pdf

On April 18, 2018, the SEC issued a release (the “Proposal”), entitled, “Proposed Commission

Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on

Enhancing Investment Adviser Regulations”. All investment advisers that are subject to the

Advisers Act should take note of the Proposal because it is proposing to:

1. Define, consolidate and codify the attributes of the federal fiduciary standard

applicable to investment advisers; and

2. Greatly enhance the regulatory requirements applicable to investment advisers.

I. Summary of the Standard of Conduct

The proposals stated objective is “to reaffirm—and in some cases clarify—certain aspects of

the fiduciary duty that an investment adviser owes to its clients under section 206 of the

Advisers Act.” It reaffirms that the Advisers Act fiduciary duty derives from common law

principles. It draws heavily from SEC v. Capital Gains Research Bureau, Inc., the 1963

Supreme Court opinion commonly cited for having held that the Advisers Act imposes a

fiduciary standard on registered investment advisers. The Adviser Conduct Proposal

describes a two-pronged fiduciary standard that includes (1) a duty of care and (2) a duty of

loyalty.

Duty of Care

Duty to provide advice that is in the best interest of the client, including duty to:

• Provide personalized investment advice that is suitable for and in the best interest of the

client based on the client’s investment profile, and to update such profile from time to

time;

• Seek best execution of a client’s transactions, and

• the duty to provide ongoing advice and monitoring.

Duty of Loyalty

• An investment adviser must put its clients’ interests ahead of its own;

• Must not unfairly favor one client over another;

• Must make full and fair disclosure of all material facts relating to the advisory

relationship.

• Must seek to avoid conflicts, and, at a minimum, make full and fair disclosure of all

material conflicts of interest that could affect the advisory relationship;

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• May not favor proprietary accounts over client accounts (for example, in connection with

allocations of investment opportunities) and may not favor certain client accounts that

pay higher fee rates over other client accounts.

• Disclosure to be clear and understood by clients in order to satisfy Section 206 and the

duty of loyalty, such that

▪ The client is able to understand the adviser’s conflicts of interest and business

practices well enough to make an informed decision

▪ The SEC states that disclosure that a conflict “may” exist is not sufficient if the

conflict actually exists.

• A client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit, although an adviser cannot infer consent if the facts and circumstances indicate that the client did not understand the nature and importance

of the conflict.

• The SEC also noted that there may be circumstances with some complex or extensive

conflicts where it may be difficult to provide disclosure that is sufficiently specific, but

also understandable to clients.

II. Request for Comment on Enhanced Investment Adviser Regulation

• Federal Licensing and Continuing Education

• Provision of Account Statements

• Financial Responsibility (Net Capital Requirements)

Orical Article, Undisclosed Conflicts, by James Leahy

✓ See Attachment 1

Enforcement Actions Related to Conflicts of Interest

✓ In the Matter of Kohlberg Kravis Roberts & Co. L.P., Advisers Act Release No. 4131 (Jun. 29,

2015) https://www.sec.gov/litigation/admin/2015/ia-4131.pdf

• KKR misallocated $17.4m in broken dealer expenses to private equity fund instead of co-

investment vehicle and did not disclose this allocation to its co-investors.

• Violation of Section 206(2) of the Advisers Act, prohibiting an investment adviser,

directly or indirectly, from engaging “in any transaction, practice, or course of business

which operates as a fraud or deceit upon any client or prospective client.”

• Paid over $18m in disgorgement and other penalties.

✓ In the Matter of THL Managers V, LLC and THL Managers VI, LLC, Advisers Act Release No.

4952 (Jun. 29, 2018) https://www.sec.gov/litigation/admin/2018/ia-4952.pdf

• THL provided inadequate pre-commitment disclosure of certain accelerated fees received

from portfolio companies and failed to obtain fund advisory committee consent as a

result of the potential conflict of interest posed by negotiating and receiving accelerated

fees.

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• Inadequate disclosure of fees was in violation of Section 206(4) and Rule 206(4)-8 of the

Advisers Act, and failure to obtain consent and approval from Funds’ LPAC was a

violation of Section 206(2) and a negligent breach of fiduciary duty.

• Paid over $5m in disgorgement and other penalties.

✓ In the Matter of VOYA INVESTMENTS, LLC and DIRECTED SERVICES LLC, Advisers Act

Release No. 4868 (Mar. 8, 2018) https://www.sec.gov/litigation/admin/2018/34-82837.pdf

• Voya Holdings Inc. failed to disclose conflicts of interest and made misleading

disclosures in connection with their practice of recalling securities on loan so their

affiliates could receive tax benefits. This resulted in the loss of securities lending income

of the Funds and individuals invested in those Funds when securities were recalled.

• This was in violated Sections 206(2) and 206(4) of the Advisers Act, and Rule 206(4)-8.

• Paid over $3m in disgorgement and other penalties.

✓ SEC v. Strong Investment Management, et al., Civil Action No. 8:18-cv-00293 (C.D. Cal. filed

Feb. 20, 2018) https://www.sec.gov/litigation/complaints/2018/comp24054.pdf

• SEC filed complaint against Strong Investment Management and its president, Joseph

Bronson, for operating a “cherry picking” scheme, in which Bronson was allocating

profitable trades to himself and unprofitable trades to Strong's clients for over 4 years.

CCO, John Engebretson discharged his duties as CCO, by not conducting the required

reviews of trades and ignoring red flags.

• Bronson and Strong are charged with violation of Section 10(b) of the Securities

Exchange Act and Rule 10b-5 thereunder, for cherry picking and misleading clients and

compliance consultants. Also charged with violation of Sections 17(a)(1) and 17(a)(2) of

the Securities Act, for fraud, and Sections 206(1), 206(2), and 207 of the Advisers Act for

false and misleading statements in the ADV and to clients. SEC also charged Bronson

and Engebretson for aiding and abetting those violations.

✓ In the Matter of NORMAN M.K. LOUIE and MOUNT KELLETT CAPITAL MANAGEMENT LP,

Advisers Act Release No. 4968 (Jul. 16, 2018) https://www.sec.gov/litigation/admin/2018/34-

83637.pdf

• Portfolio manager, Norman Louie (“PM”) made an undisclosed, undocumented personal

$3m loan to the chairman of the BOD of Energy XXI Ltd. (“EXXI”), that Mount Kellett

had made a substantial fund investment in. The PM then began a successful email

campaign to become an independent member of EXXI’s board (aided by a vote from the

loan beneficiary) and made operational and personnel changes at EXXI to improve its

financial performance and stock price.

• As a result of the PM’s failure to disclose the loan to Mount Kellett and EXXI, EXXI

filed an inaccurate and misleading Form 8-K announcing the PM’s appointment to the

EXXI board as an “independent” director. The PM also caused a failure by Mount Kellett

to disclose the conflict of interest created by the loan to its clients.

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• Mount Kellett failed in its beneficial ownership reporting obligations under Section 13(d)

of the Exchange Act requiring any person or group, who directly or indirectly acquires

beneficial ownership of more than 5% of a class of certain equity securities to file a

Schedule 13D (within 10 days), disclosing the purpose of the acquisition of securities,

and any plans to affect the issuer’s BOD.

• Louis paid $100,000 civil money penalty and Mount Kellett $160,000.

✓ In the Matter of LENDINGCLUB ASSET MANAGEMENT, LLC, f/k/a LC ADVISORS, LLC,

RENAUD LAPLANCHE, and CARRIE DOLAN, Advisers Act Release No. 5054 (Sept. 28, 2018) https://www.sec.gov/litigation/admin/2018/ia-5054.pdf

• LendingClub Asset Management LLC (“LCA”), and its president, Renaud Laplanche,

caused a private fund that LCA managed to purchase interests in loans that were at risk of

going unfunded in order to benefit the parent company instead of the fund, in breach of

LCA’s fiduciary duty.

• For improper valuation of LCA funds and disclosures regarding the private fund’s assets

and its valuation, Section 206(1) and 206(2) of the Advisers Act were violated, as well as

Section 207 and Section 204(a) of the Advisers Act and Rule 204-1(a) thereunder.

Section 206(4) of the Advisers Act and Rules 206(4)-7 and Rule 206(4)-8, thereunder

were also violated.

• Paid over $4.2m in penalties in total, as well as $1m to reimburse investors.

✓ In the Matter of Blackstone Management Partners L.L.C., Blackstone Management Partners III

L.L.C., and Blackstone Management Partners IV L.L.C., Advisers Act Release No. 4219 (Oct. 7,

2015) https://www.sec.gov/litigation/admin/2015/ia-4219.pdf

• Three private equity advisers within The Blackstone Group were charged with breaches

of fiduciary duty. According to the SEC Order, Blackstone terminated certain portfolio

company monitoring agreements between Blackstone and its funds’ portfolio companies,

and accelerated the payment of future monitoring fees.

• Although Blackstone disclosed in its offering documents that it might receive monitoring

fees from portfolio companies, it failed to disclose to its funds, and the limited partners

prior to their commitment of capital, that it might accelerate future monitoring fees upon

termination of the monitoring agreements.

• Blackstone breached its fiduciary duty to the funds, violating Section 206(2) and Section

206(4) of the Advisers Act and Rule 206(4)-8 thereunder. Section 206(4) and Rule

206(4)-7 thereunder were also violated.

• Paid over $28.9m in disgorgement and other penalties.

✓ In the Matter of Apollo Management V, L.P., Apollo Management VI, L.P., Apollo Management

VII, L.P. and Apollo Commodities Management, L.P., Advisers Act Release No. 4493 (Aug. 23,

2016) https://www.sec.gov/litigation/admin/2016/ia-4493.pdf

• In 2016, an SEC Order was issued against Apollo Management for similarly terminating

certain portfolio company monitoring agreements and accelerating the payment of future

monitoring fees provided for in the agreements but failing to adequately disclose to its

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funds, and to the funds’ limited partners prior to their commitment of capital, that such

acceleration of fees may occur.

• Apollo’s actions resulted in violation of Section 206(2) and Section 206(4) of the

Advisers Act and Rule 206(4)-8 thereunder, as well as Section 206(4) of the Advisers Act

and Rule 206(4)-7 thereunder.

• Paid over $40m in disgorgement and other penalties, as well as $12.5m in civil money

penalties.

✓ In the Matter of TPG Capital Advisors, LLC, Advisers Act Release No. 4830 (Dec. 21, 2017)

https://www.sec.gov/litigation/admin/2017/ia-4830.pdf

• In 2017, again at issue in the SEC Order against TPG Capital Advisors was a failure to

adequately disclose or obtain consent prior to receipt of accelerated monitoring fees.

While TPG’s receipt of the accelerated monitoring fees was disclosed in its Form ADV

filings, as well as in reports to funds’ limited partner advisory committees, these

disclosures were provided only after limited partners had made capital commitments to

the funds.

• TPG’s inadequate disclosure resulted in a breach of its fiduciary duty to the funds,

violating Section 206(2) and Section 206(4) of the Advisers Act, and Rule 206(4)-8

thereunder.

• Paid over $9 in disgorgement and other penalties, as well as $3m in civil money

penalties.

✓ In the Matter of Fenway Partners, LLC, Peter Lamm, William Gregory Smart, Timothy Mayhew,

Jr., and Walter Wiacek, CPA, Advisers Act Release No. 4253 (Nov. 3, 2015)

https://www.sec.gov/litigation/admin/2015/ia-4253.pdf

• In 2015, the Commission charged Fenway Partners and four executives with failing to

disclose several conflicts of interest to a private equity fund they advised. Fenway

Partners had initially entered into monitoring agreements with its portfolio companies,

and the resulting fees paid to Fenway Partners were offset against Fenway Partners’

management fee paid by the fund.

• According to the SEC Order, Fenway Partners and four executives caused certain

portfolio companies to terminate their payment obligations to Fenway Partners and enter

into consulting agreements with an affiliated entity named Fenway Consulting Partners

LLC. Fenway Consulting Partners provided similar services to the portfolio companies,

often through the same employees, but the fees paid to Fenway Consulting Partners were

not offset against the management fee that the fund paid to Fenway Partners. This altered

arrangement was not disclosed to the limited partner advisory committee or investors.

• Paid over $1.5 in disgorgement and other penalties.

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ODD Questions to Ask

✓ How does the adviser monitor for conflicts of interest?

✓ Is there any process in place to evaluate the accuracy and completeness of disclosures

related to conflicts of interest?

✓ What are the adviser’s and its supervised persons sources of revenue?

✓ What fee sharing arrangement does the adviser maintain?

✓ What are outside business activities of the adviser’s supervised persons?

✓ What private interests do the adviser’s supervised persons hold?

✓ How does the advisor monitor for fair and equitable investment allocations?

✓ Do some clients have a higher incentive allocation than others?

✓ How does the advisor monitor expense allocations and reimbursements?

✓ Have any clients negotiated a cap on certain expenses?

✓ Ask for numeric examples of complicated fee structures and offsets.

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Orical LLC Commitment, Responsibility, Expertise, Service, Trust

370 Lexington Avenue

Suite 511

New York, NY

10017

(212) 257-5790

www.orical.org

17

ATTACHMENT 1

Undisclosed Conflicts

Jim Leahy

December 10, 2018

For registered investment advisers (“RIAs”), recognizing, mitigating and disclosing potential, apparent

and actual conflicts of interest is a vital component of a viable compliance program and an essential

component of running a successful advisory business. Conflicts may arise from a variety of sources that

must be continuously monitored. By way of example, RIAs have built in conflicts merely by virtue of

having more than one client, particularly if multiple clients have similar investment objectives. In this

context, the adviser’s first conflict and challenge is how to allocate his time. Advisers need to be fair to

all clients and not spend a disproportionate amount of time on one client to the detriment of other

clients. The adviser also needs to consider how much time he will dedicate to all of his clients in the

aggregate versus the time he will spend on outside business interests. As a fiduciary1, the RIA’s first

obligation is to his clients. As a result of having multiple clients, other potential conflicts arise in making

investment and expense allocation decisions. Trades between clients are also a concern.

Each year, many advisers either (i) fail to adequately disclose conflicts or (ii) fail to follow their policies

and procedures with respect to resolution or mitigation of conflicts that have been disclosed.

Conflicts often arise in situations where a supervised person or firm has an incentive to serve one

interest at the expense of another interest. This incentive is frequently financial but could also be the

result of a personal, family or business relationship. The conflict might be an incentive to serve the

interest of the firm over that of a client; alternatively, it could be an incentive to serve the interest of

one client over that of another client. A conflict could also arise when a particular supervised person

places his own interest above those of the firm or its clients.

Conflicts are like viruses. They come in a vast array of constantly mutating forms; if they are not

eliminated, mitigated or disinfected by exposing them to sunlight (disclosed), even the simplest virus

1 For a general discussion of registered investment advisers as fiduciaries, see Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Advisers Act Release No. 4889 (Apr. 18, 2018).

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Orical LLC Commitment, Responsibility, Expertise, Service, Trust

370 Lexington Avenue

Suite 511

New York, NY

10017

(212) 257-5790

www.orical.org

18

poses a mortal threat to the health and wellbeing of the RIA.2 Nearly all bad behavior and violations of

the securities laws by registered investment advisers can be explained in terms of conflicts of interest.

As a practical matter, an RIA must periodically assess the risks of running his business and then update

disclosures in relevant offering documents and in the RIA’s public registration statement on Form ADV.3

Significant regulatory problems develop when important conflicts of interest are not disclosed and the

RIA’s investors are not aware of them. Undisclosed conflicts are the basis for dozens of SEC enforcement

actions every year. Full disclosure requires not only that the adviser identify the conflicts it has or is

likely to have but also how such conflicts are mitigated or handled. This generally involves disclosure of a

specific policy or procedure, trade allocation, for example. It is absolutely essential that an adviser’s (i)

policies and procedures, (ii) disclosures in client governing documents and (iii) disclosures in Form ADV

(particularly in Part 2A) are consistent and that they are followed.

A recent SEC case4 stated that: “A ‘fundamental purpose of [the Advisers Act is] to substitute a

philosophy of full disclosure for the philosophy of caveat emptor [or buyer beware] and thus to achieve

a high standard of business ethics in the securities industry.’5 Accordingly, Section 206 [of the Advisers

Act] imposes ‘federal fiduciary standards’ on investment advisers,6 which means they have ‘an

affirmative duty of “‘utmost good faith, and full and fair disclosure of all material facts.’”7 Because

Section 206 was designed ‘to eliminate, or at least expose, all conflicts of interest which might incline an

investment adviser—consciously or unconsciously—to render advice which was not disinterested,’8 the

“[f]ailure by an investment adviser to disclose potential conflicts of interest to its clients constitutes

fraud within the meaning of Sections 206(1) and (2).’”9

General Instruction 3 of Form ADV Part 2A is instructive: “Under federal and state law, you are a

fiduciary and must make full disclosure to your clients of all material facts relating the advisory

relationship. As a fiduciary, you also must seek to avoid conflicts of interest with your clients, and, at a

minimum, make full disclosure of all material conflicts of interest between you and your clients that

2 See October 22, 2012 speech by Carlo V. di Florio on Conflict of Interest and Risk Governance to the National Society of Compliance Professionals https://www.sec.gov/news/speech/2012-spch103112cvdhtm. 3 The Compliance Rule (Advisers Act Rule 206(4)-7) requires RIAs to implement written policies and procedures reasonably designed (based on the risks of their particular business) to prevent violations of the Advisers Act. Those policies and procedures must be reviewed at least annually. Form ADV must be updated within 120 days of the end of the RIA’s most recent fiscal year. Part 2A of Form ADV (the “Brochure”) places a significant emphasis on identifying conflicts as well as how those conflicts are handled or mitigated by the RIA. General Instruction No. 2 of Part 2A cautions advisers against saying that they “may” have a conflict when in fact such conflict exists. For a case discussing the inappropriate use of “may” see In the Matter of Jan Gleisner and Keith D. Pagan, Advisers Act Release No. 4537 (Sept. 28, 2016). 4 In the Matter of The Robare Group, Ltd., Advisers Act Rel. No. 4566 November 7, 2016. 5 SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963). 6 Transamerica Mortg. Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979). 7 Capital Gains, 375 U.S. at 194; see also Montford & Co., Inc., Advisers Act Release No. 3829 (May 2, 2014) (“Section 206 prohibits ‘failures to disclose material information, not just affirmative frauds.’”) 8 Capital Gains, 375 U.S. at 191-92. 9 Fundamental Portfolio Advisors, Inc., Exchange Act Release No. 48177 (July 15, 2003).

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Orical LLC Commitment, Responsibility, Expertise, Service, Trust

370 Lexington Avenue

Suite 511

New York, NY

10017

(212) 257-5790

www.orical.org

19

could affect the advisory relationship. This obligation requires that you provide the client with

sufficiently specific facts so that the client is able to understand the conflicts of interest you have and

the business practices in which you engage, and can give informed consent to such conflicts or practices

or reject them….”

In addition to identifying and describing applicable conflicts, many specific items of Form ADV Part 2A

also require RIAs to explain how those conflicts are addressed, handled or mitigated. In other words, it is

not enough to simply identify that a conflict exists.

Consequently, every decision that a supervised person makes needs to be scrutinized to see if this

critical question can be answered affirmatively: “Am I acting in the best interest of my firm’s clients?” If

a supervised person is about to embark on a course of action that relates to or affects the RIA’s clients

but is based on any factor other than the best interest of that client—perhaps because it will also

benefit a friend, business partner or business interest or a family member—then the supervised person

should pause and bring this matter to the attention of the firm’s Chief Compliance Officer and senior

management. This pause for review could result in concluding that the specific conflict that arises from a

particular course of action is already disclosed to the RIA’s investors through an offering document or in

Form ADV. The result might be that the firm either amends its conflict disclosures or perhaps makes a

different decision. Proper disclosure of conflicts can both powerfully protect an RIA and permit its

investors to make an informed decision about whether or not to invest.

What follows is a suggested list of areas to review. Each RIA should conduct its own enterprise risk

assessment and periodically monitor any conflicts of interest that are identified. RIAs cannot be

complacent about known conflicts because changes in the business such as new supervised persons,

funds, managed accounts, products, markets, sources of investment ideas, counterparties, affiliates, to

name just a few, could sufficiently alter the conflict landscape to warrant alteration of an existing

disclosure or policy or even necessitate new disclosures and policies.

In subsequent articles, we shall endeavor to highlight relevant SEC enforcement actions where an RIA

failed to meet its obligations concerning conflict disclosure particularly with respect to the following

areas:

Allocation of investment opportunities and expenses

Valuation

Conflicted Transactions: Principal Trades, Cross Trades, Agency Cross Transactions

Affiliations with and compensation from broker dealers, portfolio companies and other third parties

Incentives to benefit certain affiliates or invest in certain types of investments

Compliance program, including policies and procedures tailored to identified and monitored risks

Identification of specific authorization for all fees and expenses (including acceleration of fees) charged

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Orical LLC Commitment, Responsibility, Expertise, Service, Trust

370 Lexington Avenue

Suite 511

New York, NY

10017

(212) 257-5790

www.orical.org

20

Outside business interests such as the making of personal loans or serving on boards of directors of

portfolio companies

Proxy Voting

In conclusion, RIAs need to be ever vigilant when it comes to conflicts. Existing conflicts evolve as the

RIA’s business changes. New conflicts come to the fore with the addition of new clients, new products,

new markets and new counterparties. Hopefully supervised persons will be sufficiently trained to detect

and report any potential conflicts as they go about trying to serve their firm’s clients and investors in the

best possible way. The solution for almost all conflicts that cannot be eliminated is to put policies and

procedures in place to mitigate them and to thoroughly disclose the conflict. As Supreme Court Justice

Louis D. Brandies once said: “Sunlight is the best disinfectant.”

If you have any questions about this article please contact:

Jim Leahy Greg Florio 212-257-5783 212-257-5781 [email protected] [email protected]

Orical provides this information as a service to clients and other friends for educational

purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client

relationship.

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Extensive Legal & Operational Experience P A R T N E R - L E V E L R E S P O N S I V E N E S S O N E V E R Y M A T T E R

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21

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22

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CONTACT US370 LEXINGTON AVENUE TH, 5 FLOOR, NEW YORK, NY 10017 212 257 5790

[email protected]

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23

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Owner Biographies

Gregory L. Florio, Founder, Co-Managing Partner/Member

Gregory L. Florio is the founder of Florio Leahy LLP and Orical LLC. With over 20 years

of legal and regulatory experience, Mr. Florio is an expert in all aspects of investment

management law and regulation, including the Investment Advisers Act of 1940, the

Investment Company Act of 1940 and all other laws, rules and regulations that govern the

securities industry. His practice focuses on the private fund industry, including formation,

structuring, offering terms, private funds, separately managed accounts, compliance

programs, regulatory examinations, investigations, enforcement actions and compliance technology. He

routinely advises and represents investment mangers, broker/dealers, family offices and other financial

institutions in connection with their legal and compliance needs. Mr. Florio also directs the Firm’s technical

solutions effort, Real World Compliance LLC (“REAL”), a product he designed and developed. Before

founding the Firms in 2010, Mr. Florio was a Senior Counsel and the Chief Compliance Officer of a multi-

billion-dollar global fund manager, Marathon Asset Management, LP (“Marathon”). Before joining

Marathon, Mr. Florio was an associate and regulatory specialist in Seward & Kissel (“S&K”) LLP’s

Investment Management Division and, before S&K, was an attorney for the Investment Funds Group at

Sidley Austin LLP. After graduating from Fordham University School of Law in 1995 with honors, Mr.

Florio began his career serving as an assistant district attorney in New York City. Mr. Florio holds a

Bachelor’s degree in Consumer Economics from Cornell University and is a member of the New York State

Bar Association.

Experience Highlights

• Successfully assisted hundreds of firms through the SEC/CFTC registration and examination

process;

• Assisted Marathon through the financial crisis commonly referred to as the “Great Recession”,

during which time the firm not only gained assets, but was also selected to manage assets for the

U.S. Treasury as part of the U.S. Government’s Legacy Securities Public-Private Investment

Program, after an application process that included well over 100 institutional asset manager

applicants;

• Qualified as an expert witness in high profile criminal cases related to SEC enforcement actions;

• Commonly referenced as an expert in investment adviser regulatory compliance, and anti-insider

trading and market manipulation surveillance;

• Since 2002, has been a leader in designing technical solutions to address operational difficulties in

the investment adviser and broker/dealer compliance arenas, including designing and developing

Orical’s compliance software, REAL.

24

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James M. Leahy, Co-Managing Partner/Member

James M. Leahy is Co-Managing Partner of Florio Leahy LLP and Co-Managing Member

of Orical LLC with 29 years of capital markets, securities, operations, and legal experience.

Mr. Leahy prepares his clients for and assists them with regulatory examinations. He has

extensive experience assisting firms to identify enterprise and compliance risks and

conflicts; he also assists with the development, implementation and testing of firm-specific

policies, procedures and disclosures tailored to mitigate those risks and conflicts. Mr.

Leahy is a frequent author and speaker concerning regulatory developments impacting the fund industry.

He conducts due diligence for several active fund investors, drafts fund offering documentation and

negotiates a variety of contracts on behalf of funds and fund service providers.

Prior to joining Orical in 2013, Mr. Leahy served as Chief Financial Officer of Marathon Asset

Management, LP where he managed teams of professionals responsible for tax, accounting, operations and

internal audit. Mr. Leahy’s responsibilities included monitoring cash, profit and loss as well as financing

lines and relations with external service providers such as prime brokerage, ISDA counterparty, audit,

valuation and fund administration. Mr. Leahy met regularly with investor due diligence teams. He also

spent significant time on governance, conflicts, allocation, valuation, best execution, cross trade, side

pocket and liquidating fund issues, particularly during the last financial crisis. Prior to Marathon, Mr.

Leahy was a Vice President, Senior Credit Officer and Team Leader at Moody's Investors Service and was

also a member of the CDO team. He helped found the Hedge Fund Operations Quality business where his

group was responsible for assigning Operational Quality Ratings to hedge funds. Prior to Moody’s, Mr.

Leahy was a lawyer at Skadden, Arps, Slate, Meagher & Flom LLP and Milbank, Tweed, Hadley & McCloy

LLP in New York City. His legal practice involved corporate, securities and financing transactions. He

has comprehensive knowledge regarding public and private placements of securities and has negotiated

many lending facilities, debt instruments and structured finance transactions. Prior to practicing law, Mr.

Leahy was a Surface Warfare Officer in the United States Navy. He served aboard three warships, designed

curriculum and taught at the Navy’s Gas Turbine Engineering School in Newport, Rhode Island. Mr. Leahy

holds an honors law degree from Boston College Law School and an undergraduate degree in English from

Dartmouth College. Mr. Leahy is a member of the Bar in New York and Massachusetts.