Advisers Act

A Framework for the DOL’s New Proxy Voting Rule

The U.S. Department of Labor (DOL) has finalized a rulemaking that pertains to proxy voting and the exercise of other shareholder rights with respect to employee benefit plans subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule applies to plans directly, as well as to commingled investment funds that hold “plan assets.”2 Plan sponsors, investment advisers registered with the U.S. Securities and Exchange Commission (SEC), and other service providers that either exercise shareholder rights on behalf of plans or who appoint those who do should pay particular attention to this final rule.3

As with the DOL’s recent Financial Factors rulemaking, this rule’s genesis was probably the DOL’s concern over the striking growth of environmental, social & governance (ESG) investing. Engagement with a company’s board, for example, is a popular method used by managers to address ESG concerns. But both rules apply much more broadly, including to those managers and mandates that do not take ESG factors into account. Neither this rule nor the Financial Factors rule, is limited to ESG.

The exercise of shareholder rights, including proxy voting, has long been considered fiduciary conduct under ERISA. This rule retains that characterization and defines the scope of responsibilities. In doing so, the rule supersedes DOL Interpretive Bulletin 2016-01 and the relevant portions in DOL Field Assistance Bulletin 2018-01.

As discussed more fully below, fiduciaries of plans and plan asset vehicles will need to review their proxy voting policies and practices regarding their use of proxy advisors, especially when those advisors offer voting recommendations or their platforms pre-populate votes.4 With this rule, proxy advisory firms continue to face increased scrutiny from U.S. regulators, notably the SEC and DOL, over their practices and influence.

From a substantive standpoint, the rule compels fiduciaries to only exercise shareholder rights, including proxy voting, if they are undertaken solely in accordance with the economic interests of the plan and its participants and beneficiaries. This entails the fiduciary discerning some economic benefit to the plan, beyond the plan merely being a shareholder, resulting from the exercise of shareholder activities by the plan alone or together with other shareholders.5 Fiduciaries may consider the longer-term consequences and potential economic impacts from the exercise of such rights, even if they are not currently readily quantifiable, which should strengthen (or at least not hinder) proxy voting and engagement related to material ESG issues.6 Importantly, a discernible economic benefit to the plan must be initially identified to pass muster under the rule, even if the shareholder activity does not result in a direct or indirect cost to the plan.

In the DOL’s view, for example, a fiduciary may have to vote against a shareholder proposal that would result in the issuer incurring direct or indirect costs if such proposal did not also describe “a demonstrable expected economic return” to the issuer. On the other hand, “the costs incurred by a corporation to delay a shareholder meeting due to lack of a quorum is an example of a factor that can be appropriately considered as affecting the economic interest of the plan.”

The costs of proxy voting and other shareholder rights must also be considered, as they too affect the economic interest of the plan. These costs may include direct costs to the plan, such as expenditures for analyzing portfolio companies and the matters to be voted on, determining how the votes should be cast, and ultimately submitting proxy votes to be counted. Moreover, the DOL notes that “[i]f a plan can reduce the management or advisory fees it pays by reducing the number of proxies it votes on matters that have no economic consequence for the plan that also is a relevant cost consideration.”7 Indirect costs are also relevant. For example, the fiduciary should consider the opportunity costs of the exercise of shareholder rights, such as opportunity costs for the client resulting from restricting the use of securities for lending to preserve the right to vote.8

The rest of the rule is more process-oriented, which speaks to how fiduciaries can satisfy these substantive obligations in practice.

First, fiduciaries need to evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder rights. Here, fiduciaries should consider material information that is known by, available to, or reasonably should be known by the fiduciary. In this respect, the DOL pointed to the fact that, under recent SEC guidance, clients of proxy advisory firms may become aware of additional information from an issuer that is the subject of a voting recommendation, and that an ERISA fiduciary would be expected to consider the relevance of such additional information if material.

Second, fiduciaries must maintain records on proxy voting activities and other exercises of shareholder rights. For fiduciaries that are SEC-registered investment advisers, the DOL intends that these recordkeeping obligations would be applied in a manner that aligns to similar proxy voting recordkeeping obligations under the U.S. Investment Advisers Act of 1940, as amended (Advisers Act).

Third, and as applicable, fiduciaries must exercise prudence and diligence in the selection and monitoring of (i) investment managers charged with proxy voting and (ii) proxy advisory firms selected to advise or otherwise assist with exercises of shareholder rights, such as providing research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, and recordkeeping and reporting services. The fiduciary should consider the qualifications of the service provider, the quality of services being offered, and the reasonableness of fees charged in light of the services provided. ERISA fiduciaries should also ensure that, when considering proxy recommendations, they are fully informed of the potential conflicts of interest of proxy advisory firms and the steps such firms have taken to address them (e.g., reviewing proxy advisor conflict of interest disclosures, etc.). Finally, fiduciaries should review the proxy voting policies and/or proxy voting guidelines and the implementing activities of the service provider; this requirement, however, does not require use of custom policies.

Fiduciaries may adopt proxy voting policies pursuant to a safe harbor and, if so, review them periodically for compliance with the rule (e.g., every two years). These policies may not preclude (i) submitting a proxy vote when the fiduciary prudently determines that the matter being voted upon is expected to have a material effect on the value of the investment or the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager) after taking into account the costs involved, or, conversely, (ii) refraining from voting when the fiduciary prudently determines that the matter being voted upon is not expected to have such a material effect after taking into account the costs involved. The rule specifically provides two safe harbors, either or both of which may be utilized when deciding whether to vote. The safe harbors are not the exclusive means to satisfy the rule or represent minimum requirements.

  1. Safe Harbor #1: A policy to limit voting resources to particular types of proposals that the fiduciary has prudently determined are substantially related to the issuer’s business activities or are expected to have a material effect on the value of the investment. The reference to the value of the investment rather than the plan’s total investment is intended to make clear that the evaluation could be at the investment manager level dealing with a pool of investor’s assets or at the aggregate plan level. The DOL expects that proposals relating to corporate events (e.g., mergers and acquisitions, dissolutions, conversions, or consolidations), buybacks, issuances of additional securities with dilutive effects on shareholders, or contested elections for directors, are the types of votes that would materially affect the investment.
  2. Safe Harbor #2: A policy of refraining from voting on proposals or particular types of proposals when the plan’s holding in a single issuer relative to the plan’s total investment assets is below a quantitative threshold that the fiduciary prudently determines, considering its percentage ownership of the issuer and other relevant factors, is sufficiently small that the matter being voted upon is not expected to have a material effect on the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager).

In response to concerns raised by some commenters, the safe harbors in the final rule are intended to be flexible enough to clearly enable fiduciaries to vote to establish a quorum of mutual fund shareholders or on other fund matters. On this point, the DOL noted that fiduciaries may also adopt voting policies that consider the detrimental effect on the plan’s investment due to the costs (direct and indirect) incurred related to delaying a shareholders’ meeting. The rule envisions fiduciaries having considerable flexibility in fashioning proxy voting policies and the opportunity to deviate from the policies in certain instances.

Proxy advisors remain top-of-mind for the DOL. The safe harbors are intended to provide fiduciaries the ability to operationalize the rule without having to seek recommendations on a vote-by-vote basis from proxy advisors. The rule prohibits fiduciaries from adopting a practice of following the recommendations of a proxy advisory firm without first determining that such firm or service provider’s proxy voting guidelines are consistent with the fiduciary’s obligations under the rule.9 As with the SEC, the DOL expects fiduciaries, under certain circumstances, to conduct a more particularized voting analysis than what may be conducted under the general guidelines. The DOL acknowledged that some plans rely on proxy advisory firms’ pre-population and automatic submission mechanisms for proxy votes but noted that adopting such a practice for all proxy votes effectively outsources their fiduciary decision-making authority.

The rule continues to recognize and account for the fact that an investment manager of a plan asset pooled investment vehicle may be subject to an investment policy statement that conflicts with the policy of another plan investor. In this case, compliance with ERISA requires the investment manager to reconcile, to the extent possible, the conflicting policies (assuming compliance with each policy would otherwise be consistent with ERISA). In the case of proxy voting, the investment manager generally must vote (or abstain from voting) the relevant proxies to reflect such policies in proportion to each plan’s economic interest in the investment vehicle. Investment managers of pooled funds, however, typically develop an investment policy statement and require participating plans to accept the investment manager’s proxy voting policy as a condition to subscribe, which remains permitted under the rule. The investment manager’s policies would need to comply with this rule, and the fiduciary responsible for the plan’s subscription in the fund would be obligated to assess whether the investment manager’s policies are consistent with this rule before subscribing in the fund.10

As noted above, the rule does not directly apply to investment vehicles that do not hold plan assets, such as mutual funds. The rule, for example, does not require ERISA fiduciaries to scrutinize a mutual fund’s voting practices in which the plan has an investment. The DOL does, however, contemplate that ERISA fiduciaries will consider the mutual fund’s voting policies as part of its overall consideration of the mutual fund as a prudent investment in accordance with the Financial Factors rule. Thus, fiduciaries should consider whether the investment fund’s voting policies are expected to have a material effect on the risk and/or return of an investment.

The rule’s compliance date is Jan. 15, 2021, subject to the following:

  • All fiduciaries should begin to review their proxy voting policies and practices in light of the new rule, especially plan investment committees and investment managers of separate accounts.
  • Fiduciaries that are investment advisers registered with the SEC must comply by Jan.15, 2021, with respect to the requirements to (i) evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder right and (ii) maintain records on proxy voting activities and other exercises of shareholder rights. The DOL intends that these requirements align with existing obligations under the Advisers Act, including Rules 204-2 and 206(4)-6 thereunder and the 2019 SEC Guidance and 2020 SEC Supplemental Guidance. Other types of fiduciaries have until Jan. 31, 2022, to comply with these requirements.
  • All fiduciaries shall have until Jan. 31, 2022, to comply with the requirements that they not adopt a practice of following the recommendations of a proxy advisory firm or other service provider without a determination that such firm or service provider’s proxy voting guidelines are consistent with the rule. Fiduciaries of pooled investment vehicles also have until that date to confirm the fund’s proxy voting policies with the rule.

1 The rule does not apply to the exercise of shareholder rights on behalf of non-ERISA plans, such as IRAs and governmental plans.

2 Investment companies registered under the U.S. Investment Company Act of 1940, as amended, do not hold plan assets and thus not subject to ERISA or this rule. Hedge funds and other commingled vehicles that fail to satisfy one of the exceptions set forth in the DOL’s plan assets regulation, on the other hand, are subject to ERISA and this rule. Similarly, bank-maintained collective investment trusts are subject to ERISA and this rule.

3 The rule does not apply to proxy voting that is passed through to participants and beneficiaries with accounts holding such securities in an individual account plan.

4 Firms that agree to act as “investment managers,” within the meaning of Section 3(38) of ERISA, should ensure the investment management agreement is clear on who has the responsibility to exercise shareholder rights on behalf of the plan. When the authority to manage plan assets has been delegated to an investment manager, the investment manager has exclusive authority to vote proxies or exercise other shareholder rights, except to the extent the plan, trust document, or investment management agreement expressly provides that the responsible named fiduciary has reserved to itself (or to another named fiduciary so authorized by the plan document) the right to direct a plan trustee regarding the exercise or management of some or all of such shareholder rights.

5 The proposed rule included a requirement that the fiduciary consider only factors that they prudently determine will affect the economic value of the plan’s investment based on a determination of risk and return over an appropriate investment horizon consistent with the plan’s investment objectives and the funding policy of the plan. The DOL eliminated this condition because of its potential compliance costs and that it may not be apparent that a particular vote will affect the plan’s investment return. A similar revision was made to the final Financial Factors rulemaking; thus, even the DOL admits fiduciaries need not be clairvoyant in evaluating how an investment decision, or the exercise of shareholder rights, on some basis (ESG or not) will materially affect the plan’s return in the future. Instead, fiduciaries should follow a thoughtful, prudent process in reaching the position that an investment, or the exercise of rights appurtenant to such investment, is in the economic interests of the plan.

6 As with the Financial Factors rulemaking, the DOL cautioned fiduciaries against taking too elastic an interpretation of economic benefits that could flow to the plan, by noting that “vague or speculative notions that proxy voting may promote a theoretical benefit to the global economy that might redound, outside the plan, to the benefit of plan participants would not be considered an economic interest under the final rule.”

7 The DOL also noted that it would “not be appropriate for plan fiduciaries, including appointed investment managers, to incur expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors.” It is questionable whether this assertion is supported by the rule itself.

8 The DOL acknowledged that multiple investment managers may be responsible for managing a plan’s assets, and accordingly revised the rule to permit each investment manager to apply the rule to its specific mandate. The DOL noted, however, that “where the plan’s overall aggregate exposure to a single issuer is known, the relative size of an investment within a plan’s overall portfolio and the plan’s percentage ownership of the issuer, may still be relevant considerations in appropriate cases in deciding whether to vote or exercise other shareholder rights.”

9 The fiduciary selecting and using a proxy advisor, therefore, must review the proxy advisor’s voting guidelines against this rule in addition to separately determining whether a specific recommendation necessitates a particularized analysis. The review of the proxy advisor proxy voting guidelines should be addressed at the outset of the relationship with the proxy advisor and when the proxy advisor updates its guidelines (e.g., annually).

10 Uniform policies utilized by the investment manager across client accounts are still permissible under the rule, provided the policies comply with this rule.

Webcast Available Now – ESG Regulatory Lens – A Guide for Private Fund Managers

In this webcast, we:

  • Provide an overview of ESG and how the strategies apply to the various types of private fund managers.
  • Give an update on the regulatory climate and legal developments for ESG from the US to Europe and Asia.
  • Provide a framework for approaching the development of an ESG process, including where to access useful tools and resources.

Presenters:

Trysha Daskam, Director & Head of ESG Strategy, Silver Regulatory Associates

John P. Hamilton, Counsel, Stradley Ronon

George Michael Gerstein, Co-Chair, Fiduciary Governance, Stradley Ronon

Replay

Surviving Election Season: Refresher on Pay-to-Play Rules for Investment Advisers

Election season is already in full swing. As a result, investment advisers may wish to increase their attention to applicable pay-to-play compliance obligations, as further described herein.

I. Background on the Rule

In connection with political contributions, registered investment advisers, certain exempt reporting advisers and foreign private advisers (collectively referred to herein as “advisers”),1 as well as their “covered associates”2 (which is broadly defined), are subject to Rule 206(4)-5 of the Advisers Act, otherwise known as the “pay-to-play” rule. The purpose of the rule is to curtail “pay-to-play” practices by advisers seeking to manage the assets of state and local governments (e.g., public pension funds and investments by public universities) in return for political contributions. The SEC does not have to show any intent or quid pro quo to allege a violation of this anti-fraud rule. Penalties imposed by the SEC in connection with violations of the rule are severe even for foot-faults. Such penalties generally include disgorgement of any advisory fees received from such governmental entities, as well as the imposition by the SEC of civil monetary penalties (which are regularly in the hundreds of thousands of dollars).3

II. Prohibitions

     A. Ban on Fees Following Contributions

As a general matter, the rule prohibits advisers and their covered associates from making political “contributions”4 to any “official”5 of a “government entity”6 who was, at the time of the contribution, an incumbent, candidate or successful candidate for an elective office of a government entity if that office could influence the hiring of an investment adviser for such entity or have authority to appoint a person who could have such influence. If such a political contribution is made, the adviser is prohibited from receiving any compensation from advisory services to that government entity for two years thereafter – otherwise known as the “time-out” period. The adviser can still provide uncompensated advisory services to such entity during the time-out period, or provide uncompensated advisory services until the entity locates a replacement adviser. Note that an adviser to a “covered investment pool”7 in which a government entity invests or is solicited to invest shall be treated as though that adviser was providing or seeking to provide investment advisory services directly to the entity.

     B. Ban on Using Third Parties to Solicit Government Business

The rule further prohibits an adviser from providing payment8 to (or agreeing to pay), directly or indirectly, any person to solicit9 a government entity for advisory services on behalf of the adviser. However, such solicitation is not prohibited if the person is a (1) “regulated person”10 (such as a registered investment adviser, broker-dealer or municipal adviser) or an (2) executive officer, general partner, managing member, similar person or employee of the adviser. The rule also prohibits an adviser from coordinating or soliciting a person or PAC to: (1) contribute to an official of a government entity to which the adviser provides or seeks to provide advisory services or (2) make a payment to a political party of a state or locality in which the adviser provides or seeks to provide advisory services to a government entity.

     C. Catchall Ban

As a sort of catchall provision, the rule prohibits any acts done indirectly which, if done directly, would violate the rule. For example, the SEC staff has indicated that while a covered associate’s contribution to a PAC generally would not trigger the two-year time-out, if the contribution is earmarked or known to be provided for the benefit of a particular political official, it would implicate the catchall provision because the covered associate would be doing indirectly what it could not do directly.11

III. Exceptions and Exemptions from the Rule

     A. Exception for Certain New Covered Associates

Whereas the rule requires a two-year look-back for all covered associates who solicit clients, it only requires a six-month look-back for “new” covered associates who do not solicit clients. The “look-back” period will follow covered associates that change advisers, such that a prohibited contribution by a covered associate will result in a “time out” for the covered associate’s new firm for the remainder of the two-year or six-month period, depending on whether the covered associate solicits clients for the new firm. To prevent advisers from channeling contributions through departing covered persons, if a covered person makes a prohibited contribution and then leaves the employ of that adviser, the former adviser will also still be subject to the two-year time-out period, despite the departure of the covered associate who made the contribution.

     B. De Minimis Exception

The primary exception to the pay-to-play rule is the de minimis exception. The de minimis exception allows an adviser’s covered associate that is a natural person to contribute: (1) up to $350 to an official per election (with primary and general elections counting separately) if the covered associate is entitled to vote for the official at the time of the contribution; and (2) up to $150 to an official per election (with primary and general elections counting separately) if the covered associate is not entitled to vote for the official at the time of the contribution. Most firms implement pre-clearance requirements in connection with covered person political contributions in order to ensure compliance with this exception. Any contribution above such de minimis amounts, no matter how small, can trigger a violation of the rule.

     C. Returned Contribution Exception

If a covered associate makes a contribution that triggers the two-year time-out period solely because he or she was not entitled to vote for the official at the time of the contribution, the adviser can undo the contribution under very narrow circumstances. To be eligible for the returned contribution exception, the contribution had to be less than $350, the adviser must have discovered the contribution within four months of the date of such contribution, and the adviser must cause the contributor to re-collect the contribution within 60 days after the adviser discovers the contribution. However, an adviser can only rely on the returned contribution exception on limited occasions (for advisers with fewer than 50 employees, twice in a 12-month period; for advisers with more than 50 employees, three times in a 12-month period), and an adviser can never use the returned contribution exception for the same covered associate twice. Again, this exception is only applicable if the violation is discovered and remedied on a timely basis.

     D. Request for Exemptive Relief

In extremely narrow circumstances, the rule also allows an adviser to apply for an order exempting it from the two-year time­out requirement in the event of an inadvertent violation that falls outside of the exceptions set forth above. The SEC will grant orders only when, according to the SEC, the imposition of the time-out provision is unnecessary to achieve the rule’s intended purpose.12 Advisers applying for an order must do so through an application process that exposes the firm and the covered associate to public scrutiny.

IV. Recordkeeping Requirements

As part of their recordkeeping requirements under the pay-to-play rule, advisers must collect and maintain:

  • the names, titles and business and residence addresses of all covered associates;
  • all government entities to which the adviser provides or has provided investment advisory services, or which have been investors in any covered investment pool to which the adviser provides or has provided investment advisory services, in the last five years;
  • all direct and indirect contributions made by the adviser or its covered associates to an official of a government entity or direct or indirect payments made to a political party or PAC; and
  • the name and business address of each regulated person to which the adviser agrees to provide direct or indirect payment to solicit a government entity.

V. Summary

If an investment adviser would like to remain eligible to bid for government contracts, it should take affirmative steps to ensure that the firm and its covered persons do not violate the pay-to-play rule. Robust pay-to-play policies and procedures, as well as pre-clearance of political contributions, are recommended best practices for advisers that seek government clients. Re-education of adviser personnel and covered associates as to the requirements of the rule, especially in light of the upcoming election season, is also advised.13 An adviser should also consider pre-screening new covered person candidates for the applicability of the rule. Finally, it may be helpful to conduct periodic checks of campaign contribution databases, as well as require quarterly pay-to-play compliance reporting. The SEC may bring enforcement actions for even minor foot-fault violations of the rule. Such cases generally result in disgorgement and fines. Compliance with the relevant recordkeeping obligations is also important, as the SEC regularly reviews pay-to-play recordkeeping as part of adviser exams.


The rule applies to all investment advisers registered (or required to be registered) with the Securities and Exchange Commission (SEC), or unregistered in reliance on the exemption available under section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act) (15 U.S.C. 80b-3(b)(3)), or that is an exempt reporting adviser, as defined in section 275.204-4(a) – which includes venture capital fund advisers and private fund advisers.

A “covered associate” broadly includes (1) a general partner, managing member, executive officer or other individual with a similar status or function; (2) any employee who solicits a governmental entity for the adviser (and any person who supervises, directly or indirectly, such an employee); or (3) a political action committee (PAC) controlled by the adviser or by any of its covered associates.

3 See e.g., In the Matter of Ancora Advisors LLC, SEC Administrative Proceeding File No. 3-18937 (Dec. 18. 2018), found here.

4 The definition of “contribution” is broad and encompasses any gift, subscription, loan, advance or deposit of money or anything of value made for (1) the purpose of influencing any election for federal, state or local office; (2) payment of debt incurred in connection with any such election; or (3) transition or inaugural expenses of the successful candidate for state or local office.

5 An “official” means any person (including any election committee for the person) who was, at the time of the contribution, an incumbent, candidate or successful candidate for elective office of a government entity, if the office: (1) is directly or indirectly responsible for, or can influence the outcome of, the hiring of an adviser by a government entity; or (2) has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity.

A “government entity” means any state or a political subdivision of a state, including: (1) any agency, authority or instrumentality of the state or a political subdivision, (2) a pool of assets sponsored or established by the state or political subdivision or any agency, authority or instrumentality thereof, including, but not limited to a “defined benefit plan” as defined in section 414(j) of the Internal Revenue Code (26 U.S.C. 414(j)), or a state general fund; (3) a plan or program of a government entity; and (4) officers, agents, or employees of the state or political subdivision or any agency, authority or instrumentality thereof, acting in their official capacity.

7 “Covered investment pool” means: (1) an investment company registered under the Investment Company Act of 1940 (Investment Company Act) that is an investment option of a plan or program of a government entity; or (2) any company that would be an investment company under section 3(a) of the Investment Company Act, but for the exclusion provided from that definition by either section 3(c)(1), 3(c)(7) or 3(c)(11) of that Act.

8  “Payment” means any gift, subscription, loan, advance, or deposit of money or anything of value.

9  “Solicit” means: (1) with respect to investment advisory services, to communicate, directly or indirectly, for the purpose of obtaining or retaining a client for, or referring a client to, an adviser; and (2) with respect to a contribution or payment, to communicate, directly or indirectly, for the purpose of obtaining or arranging a contribution or payment.

10 “Regulated person” means: (1) a registered investment adviser that has not (and whose covered persons have not) made, coordinated or solicited a contribution within the last two years that would violate the rule; (2) a broker-dealer that is a member of a registered national securities association, so long as such association’s rules prohibit members from engaging in distribution or solicitation activities after making political contributions and the SEC finds, by order, that such rules are at least substantially equivalent to the restrictions imposed on advisers under the rule; and (3) municipal advisors registered under section 15B of the Securities Exchange Act of 1933 and subject to pay to play rules adopted by the Municipal Securities Rulemaking Board (MSRB), provided that the MSRB rules: A) impose substantially equivalent or more stringent restrictions on municipal advisors than the pay to play rule imposes on investment advisers and B) are consistent with the objectives of the pay to play rule.

11 Staff Responses to Questions about the Pay to Play Rule.

12 The rule outlines a number of factors that the SEC will consider, including an assessment of the adviser’s compliance environment, the nature of the contribution and the covered associate’s intent in making the contribution. Since the rule’s adoption, the SEC has granted 16 exemptive orders. See e.g. In the Matter of D.B. Fitzpatrick & Co., Inc., Investment Advisers Act Release No. 5496 (May 5, 2020) (order), found here; D.B. Fitzpatrick & Co., Inc., Investment Advisers Act Release No. 5475 (Apr. 9, 2020) (notice of application), found here; In the Matter of D.B. Fitzpatrick & Co., Inc., File No. 803-253 (Apr. 9, 2020) (application), found here.

13 For example, even though the rule applies to advisers seeking to influence state and local entities and not federal entities, if a state office holder that has influence over the selection of investment advisers, which could include a sitting state governor, were to be nominated as a Vice Presidential running mate, contributions to that ticket could implicate the rule.

Authors
Nicole Kalajian
Aliza Dominey
Sara Crovitz

Lessons from the SEC’s Private Fund Adviser Risk Alert: Conflicts of Interest and the Importance of Disclosure

On June 23, the SEC’s Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert discussing three general areas of deficiencies identified by OCIE staff in recent examinations of hedge fund and private equity managers: (1) conflicts of interest, (2) fees and expenses and (3) policies and procedures relating to material non-public information. This note will focus on certain observations from OCIE with respect to conflicts of interest and the related lessons in terms of investor disclosure, which are rooted in the concept of “informed consent,” as discussed in the SEC’s June 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers (the 2019 Release).

While the Risk Alert describes deficiencies observed in examinations of registered investment advisers, the fiduciary duty and anti-fraud provisions cited by OCIE[1] apply equally to “exempt reporting advisers.” As such, below are selected topics from the Risk Alert for private fund advisers to consider in reviewing conflicts of interest-related disclosure provided to investors.

Allocation of Investments. OCIE staff raised concerns about private fund advisers’ inadequate disclosure with respect to allocation of investment opportunities among various clients, including flagship funds, co-investment vehicles, separately managed accounts (SMAs), and employee or partner vehicles. The SEC has previously noted, in the 2019 Release, that an adviser “need not have pro rata allocation policies, or any particular method of allocation…” Further, “[a]n adviser and a client may even agree [emphasis added] that certain investment opportunities or categories of investment opportunities will not be allocated or offered to a client.” In the Risk Alert, however, OCIE staff described instances of allocations in inequitable amounts among clients “without providing adequate disclosure about the allocation process…thereby causing certain investors…not to receive their equitable allocations of such investments.”

Preferential Liquidity Terms. The Risk Alert described conflicts related to preferential liquidity rights granted to certain investors in side letters, as well as conflicts related to advisers that had set up SMAs that invest alongside flagship funds without providing sufficient disclosure to fund investors of the SMAs’ preferential liquidity terms. In OCIE’s view, such advisers’ “[f]ailure to disclose these special terms adequately meant that some investors were unaware of the potential harm that could be caused by selected investors redeeming their investments ahead of other investors, particularly in times of market dislocation where there is a greater likelihood of a financial impact.”

Seed and other Strategic Investors. In addition, OCIE highlighted seed investor arrangements and other economic relationships between advisers and certain fund investors as another area of insufficient transparency, noting that “[f]ailure to provide adequate disclosure about these arrangements meant that other investors did not have important information related to conflicts associated with their investments.”

Co-Investment Opportunities. With respect to co-investments, OCIE cited observations of private fund advisers with inadequate disclosure regarding agreements to provide preferential access to such opportunities to a subset of investors. As such, those investors may not have understood “the scale of co-investments and in what manner co-investment opportunities would be allocated among investors.” There were also failures to follow disclosed policies in allocating investments, including between flagship funds and dedicated co-investment vehicles.

[1] The Risk Alert cites an investment adviser’s fiduciary duty under Section 206 of the Investment Advisers Act of 1940, as amended (Advisers Act), as well as advisers’ obligations under Advisers Act Rule 206(4)-8, which is an anti-fraud provision aimed specifically at protecting pooled investment vehicles and their investors.