March/April 1996
Addressing Potential Conflicts of Interest
Bank Management
As banks become increasingly involved in mutual fund and other money management activities, bank managers need to be attentive to the potential for conflicts of interest that, if not handled properly, can harm customers and expose the bank to potential liability under state and federal laws.
Conflicts of interest can arise when banks engage in mutual fund activities through their trust departments or brokerage and investment advisory affiliates. But not all conflicts are improper or illegal, if proper steps are taken to deal with them.
REGS ARE FAMILIAR TO BANKS
Bank trust departments of course are accustomed to operating under strict fiduciary duties that impose a duty of loyalty to avoid any transactions in which the bank's interest and its fiduciary obligations conflict. In addition, the Comptroller of the Currency's trust regulation expressly forbids self-dealing by national bank trust departments. ERISA also prohibits self-dealing by employee benefit plan fiduciaries.
Even in contexts when a bank is not exercising investment discretion, however -- such as when a bank is acting as agent for a customer in purchasing mutual funds -- the bank has a duty to avoid acting in a way that would adversely affect its principal's interests. The Securities and Exchange Commission has long held that an investment adviser owes a fiduciary duty to its customers, for example.
Banks also are subject to strict limitations on transactions with affiliates that apply in the mutual fund context. Sections 23A and 23B of the Federal Reserve Act, for example, limit a bank's ability to engage in transactions with an affiliated mutual fund, which includes any fund for which the bank or its affiliate acts as investment adviser. Section 225.125 of the Federal Reserve Board's rules imposes even stricter affiliate transaction limitations on bank holding companies that act as investment advisers. ERISA prohibits virtually any transaction between a plan and a party in interest.
FOCUS: FIDUCIARY ASSETS
The conflict of interest most often faced by banks involved in mutual fund activities arises when a bank invests fiduciary assets in a mutual fund from which it receives a fee for acting as investment adviser, administrator, or shareholder servicing agent. Such investments raise conflict of interest issues under all of the above laws. Fortunately, these laws do not prohibit such investments if certain conditions are met.
For example, the Comptroller of the Currency has allowed a national bank fiduciary to invest in a proprietary mutual fund if the investment is authorized by the trust instrument, local law, beneficiary consent, or court order. Many states have enacted statutes specifically authorizing such investments. The Department of Labor has adopted a class-exemption (77-4) under which investments of ERISA assets in a proprietary mutual fund are permissible if the investment is approved by an independent fiduciary and the plan beneficiaries are not charged additional fees. Section 23B of the Federal Reserve Act specifically prohibits investments of fiduciary assets in proprietary mutual funds, but provides an exemption when the investment is duly authorized.
For the most part, banks have learned to live with these restrictions and appear to be conducting their activities in compliance with these laws. Consequently, there hasn't been a significant number of complaints or enforcement actions against banks for conflicts of interest.
In contrast, there has been a spate of actions under the securities laws against securities firms for conflict of interest violations. Indeed, the SEC's most recent enforcement focus has been on cases in which investment advisers were alleged to have unlawful conflicts of interest. In view of the increasing affiliations between banks and non-bank investment advisers, banks need to be aware of the compliance risks that these affiliates may pose under the securities laws.
KEY SEC TARGETS
The most frequent actions by the SEC recently have involved cases of alleged self-dealing, undisclosed execution of trades through affiliated brokers, and personal trading in securities by mutual fund advisers.
Self-dealing. The self-dealing cases involved mainly smaller advisers. Among the conflicts were the sale to a fund of shares of a private corporation owned by the president of the fund at an inflated price; the undisclosed hiring by a fund of a market research company owned by the wife of the fund's president for insubstantial services as well as the use of advisee assets for personal expenses; the commingling of client funds with an investment adviser's personal securities account and use of client funds for payment of personal expenses; and the making of an undisclosed personal loan by an investment company to the president of the company.
Undisclosed trades through affiliated brokers. The cases involving execution of trades through affiliated brokers involved larger firms. For example, in one case, an investment adviser subsidiary of a securities firm allegedly executed principal transactions on a discretionary basis for its clients through its affiliated broker. The SEC found that the adviser violated the Investment Advisers Act by failing to properly disclose to its clients in writing before the completion of each transaction the capacity in which the broker was acting and failing to obtain client consent for the transactions.
Personal trading. In the area of personal trading, one notable case involved a portfolio manager in the high-yield bond department of a registered investment adviser which managed certain unregistered investment funds. The manager allegedly caused the funds to purchase certain subordinated notes issued by a company which the manager learned had issued certain warrants for which there was no active market and which would have enhanced the value of the notes that the funds owned. The manager purchased warrants not for the funds but for herself and made a $210,000 profit in one month on a $12,500 investment. The SEC barred the manager from the securities industry, stating that "as a fiduciary and agent, an investment adviser owes its clients a duty of loyalty which, among other things, requires an adviser to offer its clients investment opportunities before taking such opportunities for itself."
In another case, the SEC indicated that personal transactions may be considered fraudulent even if they are reviewed and approved by legal counsel and even if they are profitable for clients.
While these cases involved securities firms and not banks, they demonstrate the wide range of potential conflicts of interest than can arise in the money management business.
CODES OF ETHICS: INVESTMENT MANAGERS
In response to complaints of conflicts of interest in connection with personal trading by mutual fund managers, the SEC last year proposed a new Rule 17j-l that would require mutual funds and their investment advisers to adopt codes of ethics reasonably designed to prevent such conflicts. The new rule would increase the oversight role of mutual fund boards of directors in reviewing problems arising under the code of ethics and enhance the reporting of personal securities transactions by investment management personnel.
The Comptroller of the Currency and the Federal Reserve Board also have emphasized the need for written policies and procedures at banks to avoid conflicts of interest by bank personnel who engage in personal securities transactions. A recently proposed revision to the OCC's regulations, for example, would require banks to adopt policies and procedures regarding the supervision of employees who transmit orders to broker-dealers or execute customer securities transactions and crossing of buy and sell orders on a fair and equitable basis. The Fed has proposed similar regulatory provisions.
Rules of both the OCC and the Federal Reserve currently require all bank employees to report to the bank all personal securities transactions if the employees make investment recommendations or decisions for customer accounts, participate in the determination of such recommendations or decisions, or "in connection with their duties, obtain information concerning which securities are purchased, sold, or recommended." This latter category of employee is very broad and could include top management officials as well as secretaries. No report is required for transactions in mutual funds or government securities or transactions that aggregate below $10,000 per quarter.
Conflicts of interest can arise when banks engage in mutual fund activities through their trust departments or brokerage and investment advisory affiliates. But not all conflicts are improper or illegal, if proper steps are taken to deal with them.
REGS ARE FAMILIAR TO BANKS
Bank trust departments of course are accustomed to operating under strict fiduciary duties that impose a duty of loyalty to avoid any transactions in which the bank's interest and its fiduciary obligations conflict. In addition, the Comptroller of the Currency's trust regulation expressly forbids self-dealing by national bank trust departments. ERISA also prohibits self-dealing by employee benefit plan fiduciaries.
Even in contexts when a bank is not exercising investment discretion, however -- such as when a bank is acting as agent for a customer in purchasing mutual funds -- the bank has a duty to avoid acting in a way that would adversely affect its principal's interests. The Securities and Exchange Commission has long held that an investment adviser owes a fiduciary duty to its customers, for example.
Banks also are subject to strict limitations on transactions with affiliates that apply in the mutual fund context. Sections 23A and 23B of the Federal Reserve Act, for example, limit a bank's ability to engage in transactions with an affiliated mutual fund, which includes any fund for which the bank or its affiliate acts as investment adviser. Section 225.125 of the Federal Reserve Board's rules imposes even stricter affiliate transaction limitations on bank holding companies that act as investment advisers. ERISA prohibits virtually any transaction between a plan and a party in interest.
FOCUS: FIDUCIARY ASSETS
The conflict of interest most often faced by banks involved in mutual fund activities arises when a bank invests fiduciary assets in a mutual fund from which it receives a fee for acting as investment adviser, administrator, or shareholder servicing agent. Such investments raise conflict of interest issues under all of the above laws. Fortunately, these laws do not prohibit such investments if certain conditions are met.
For example, the Comptroller of the Currency has allowed a national bank fiduciary to invest in a proprietary mutual fund if the investment is authorized by the trust instrument, local law, beneficiary consent, or court order. Many states have enacted statutes specifically authorizing such investments. The Department of Labor has adopted a class-exemption (77-4) under which investments of ERISA assets in a proprietary mutual fund are permissible if the investment is approved by an independent fiduciary and the plan beneficiaries are not charged additional fees. Section 23B of the Federal Reserve Act specifically prohibits investments of fiduciary assets in proprietary mutual funds, but provides an exemption when the investment is duly authorized.
For the most part, banks have learned to live with these restrictions and appear to be conducting their activities in compliance with these laws. Consequently, there hasn't been a significant number of complaints or enforcement actions against banks for conflicts of interest.
In contrast, there has been a spate of actions under the securities laws against securities firms for conflict of interest violations. Indeed, the SEC's most recent enforcement focus has been on cases in which investment advisers were alleged to have unlawful conflicts of interest. In view of the increasing affiliations between banks and non-bank investment advisers, banks need to be aware of the compliance risks that these affiliates may pose under the securities laws.
KEY SEC TARGETS
The most frequent actions by the SEC recently have involved cases of alleged self-dealing, undisclosed execution of trades through affiliated brokers, and personal trading in securities by mutual fund advisers.
Self-dealing. The self-dealing cases involved mainly smaller advisers. Among the conflicts were the sale to a fund of shares of a private corporation owned by the president of the fund at an inflated price; the undisclosed hiring by a fund of a market research company owned by the wife of the fund's president for insubstantial services as well as the use of advisee assets for personal expenses; the commingling of client funds with an investment adviser's personal securities account and use of client funds for payment of personal expenses; and the making of an undisclosed personal loan by an investment company to the president of the company.
Undisclosed trades through affiliated brokers. The cases involving execution of trades through affiliated brokers involved larger firms. For example, in one case, an investment adviser subsidiary of a securities firm allegedly executed principal transactions on a discretionary basis for its clients through its affiliated broker. The SEC found that the adviser violated the Investment Advisers Act by failing to properly disclose to its clients in writing before the completion of each transaction the capacity in which the broker was acting and failing to obtain client consent for the transactions.
Personal trading. In the area of personal trading, one notable case involved a portfolio manager in the high-yield bond department of a registered investment adviser which managed certain unregistered investment funds. The manager allegedly caused the funds to purchase certain subordinated notes issued by a company which the manager learned had issued certain warrants for which there was no active market and which would have enhanced the value of the notes that the funds owned. The manager purchased warrants not for the funds but for herself and made a $210,000 profit in one month on a $12,500 investment. The SEC barred the manager from the securities industry, stating that "as a fiduciary and agent, an investment adviser owes its clients a duty of loyalty which, among other things, requires an adviser to offer its clients investment opportunities before taking such opportunities for itself."
In another case, the SEC indicated that personal transactions may be considered fraudulent even if they are reviewed and approved by legal counsel and even if they are profitable for clients.
While these cases involved securities firms and not banks, they demonstrate the wide range of potential conflicts of interest than can arise in the money management business.
CODES OF ETHICS: INVESTMENT MANAGERS
In response to complaints of conflicts of interest in connection with personal trading by mutual fund managers, the SEC last year proposed a new Rule 17j-l that would require mutual funds and their investment advisers to adopt codes of ethics reasonably designed to prevent such conflicts. The new rule would increase the oversight role of mutual fund boards of directors in reviewing problems arising under the code of ethics and enhance the reporting of personal securities transactions by investment management personnel.
The Comptroller of the Currency and the Federal Reserve Board also have emphasized the need for written policies and procedures at banks to avoid conflicts of interest by bank personnel who engage in personal securities transactions. A recently proposed revision to the OCC's regulations, for example, would require banks to adopt policies and procedures regarding the supervision of employees who transmit orders to broker-dealers or execute customer securities transactions and crossing of buy and sell orders on a fair and equitable basis. The Fed has proposed similar regulatory provisions.
Rules of both the OCC and the Federal Reserve currently require all bank employees to report to the bank all personal securities transactions if the employees make investment recommendations or decisions for customer accounts, participate in the determination of such recommendations or decisions, or "in connection with their duties, obtain information concerning which securities are purchased, sold, or recommended." This latter category of employee is very broad and could include top management officials as well as secretaries. No report is required for transactions in mutual funds or government securities or transactions that aggregate below $10,000 per quarter.
* * *
As banks expand their activities in the money management business and become affiliated with securities firms, bank management needs to concern itself with the increased potential for conflicts of interest.
Banking and securities regulators increasingly are holding managers and compliance personnel accountable for failure to adequately supervise and prevent breaches that result in conflicts…a subject that deserves an entire article to itself.
