In January, the U.S. Securities and Exchange Commission settled charges against a former Blackrock portfolio manager for failing to disclose a conflict of interest associated with investments in a film distribution company.
The film distribution company had provided support to the manager's daughter in connection with her aspiring acting career. Notably, the film distributor had apparently indicated his willingness to support the daughter irrespective of an investment by Blackrock. The facts of this matter reminded us of the liberal application of the conflicts disclosure standard applicable to asset managers.
The Actors
The matter involved Randy Robertson, the former co-manager of the Blackrock Multi-Sector Investment Trust, or BIT, and its investment related to Aviron, a film distribution company. Aviron, now defunct, was founded by William Sadleir.
Beginning in 2015, BIT provided funding to Aviron and its subsidiaries pursuant to a lending facility.
The Scene
In early 2014, Robertson began exploring investment opportunities for BIT in the print and advertising sector.
That April, Robertson brought his daughter to the first meeting with Sadleir, and after the meeting, he acknowledged Sadleir's support of his daughter. Sadleir emailed Robertson to note that his firm would be helpful to Robertson's daughter "irrespective" of BlackRock's investment decision.
Over the next year, as Robertson and Aviron were engaged in discussions about investment opportunities, Sadleir presented a variety of opportunities in the film industry to Robertson's daughter. None of these led to anything for her.
In October 2015, BIT extended a $38 million lending facility to Aviron, which would be approved on a film-by-film basis by BlackRock.
In subsequent years, Robertson recommended an expansion of the lending facility, making Aviron BIT's largest investment. For about three years, Robertson's daughter had limited interaction with Aviron.
In 2018, an Aviron executive helped Robertson's daughter obtain a role in a film. Then in early 2019, Aviron informed BlackRock that it needed BIT to provide $10 million in funding to support the distribution of that film.
Robertson apparently presented a grim picture for BIT's Aviron investment if it did not approve the $10 million for the film and apparently recommended the funding be supplied, which was approved. Aviron failed to repay the loan, and Robertson was terminated by BlackRock after it learned of the conflict in connection with litigation against Aviron.
The settlement order notes that Robertson did not take any steps to disclose the role to BIT's board, specifically referencing that he did not seek guidance from legal and compliance personnel.
The Plot Twist
Due to the conduct illustrated in the settlement order, Robertson agreed to a finding that he violated the anti-fraud provision of the Investment Advisers Act of 1940.[1]
The SEC also included a common footnote in the settlement order to specify that "[s]cienter is not required to establish a violation of Section 206(2), which may rest on a finding of simple negligence."
This led us to reflect on the scope of the conflicts of interest disclosure standard under the Advisers Act.
Would regulators expect that Robertson should have disclosed Aviron's efforts to support his daughter even before recommending the initial investment by BIT? Even if so, would regulators have sought a fine against Robertson absent the nondisclosure as to the 2018 film?
The seminal case propounding the conflicts disclosure standard applicable to investment advisers is SEC v. Capital Gains Research Bureau Inc., in which the U.S. Supreme Court in 1963 ruled that the Advisers Act and its fraud provisions reflect an intent to "eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested."[2]
The language "all conflicts of interest" has been broadly construed to include even nonmonetary conflicts, as is evident from the settlement order.
And, the SEC has interpreted an adviser's fiduciary duty of loyalty to include the obligation to eliminate any conflict of interest or, at a minimum, make full and fair disclosure such that a client can provide informed consent.[3] To that end, the SEC has long held that potential conflicts of interest, such as an investment adviser's financial interest in investments recommended to clients, must be disclosed and consented to by the client.[4]
Moreover, guidance issued by the SEC recognizes that among other things, "gifts, entertainment, meals, travel, and related benefits, including ... attendance at third-party sponsored trainings and conferences" that result from the financial professional's other business, personal relationships or relationships with third parties may give rise to conflicts under the Advisers Act.[5]
As the contents of the settlement order suggest, the SEC will read liberally the verbiage in Capital Gains to include all conflicts that "might" cause an adviser to "render advice which is not disinterested," even if the adviser does not recognize that the advice is conflicted.
It then becomes apparent that the commission's interpretation of the conflicts of interest required to be disclosed under the Advisers Act expands beyond tangible monetary benefits and may include personal favors, disciplinary history or potentially even affiliations with outside groups or charities. As a result, the language used by the Supreme Court in Capital Gains may also be read to apply regardless of whether the advice was acted upon.
It is important for firms and individual advisers to carefully consider their potential conflicts of interest and the materiality of such conflicts in rendering advice to clients.
Avoid Appearing in the Sequel
In our experience, both as a regulator and as defense attorneys, the vast majority of financial professionals actually want to do the right thing. However, their client-oriented mindset can sometimes create a blind spot because the adviser or firm does not even consider doing something against their clients' interests.
As such, potential conflicts may not get properly recognized or are regarded as immaterial.
The problem: Irrespective of an adviser's actual intent and actions, a regulator might contend that the adviser's duties required disclosure.
So, in closing, we offer some practical considerations for advisers and firms looking to avoid being found to have failed to disclose a conflict.
Recognize Conflicts
The key to properly managing conflicts of interest is recognizing them, and this task is unique for every investment adviser, whether it be a firm or an individual adviser:
- Define conflicts of interest in a manner that takes into account the unique nature of your firm's business, including the individual advisers and their known outside activities, affiliates, compliance team and unique risks of your client base;
- Create a process for identifying conflicts of interest that can be implemented and updated periodically that takes into account your firm's unique definition of conflicts of interest;
- Establish and maintain a system to internally publish and communicate training programs regarding conflicts of interest that keeps the firm's personnel knowledgeable about their individual roles in preventing or eliminating such conflicts.
Disclose Conflicts
Under an adviser's duty of loyalty, "an adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship."[6]
According to the SEC, whether disclosure is "full and fair" will depend upon several factors, including the sophistication of the relevant client, the scope of the services provided to the client, and the nature of the conflict and its complexity. Further, in order for a disclosure to be full and fair, "it should be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent."[7]
In crafting disclosures, advisers should use caution if relying on disclosures used by other firms or even other circumstances at your firm. A disclosure that is adequate under certain circumstances may not be sufficient in your current situation. The sophistication of your audience and how the conflict is presented can be critical.
They must also differentiate between potential and actual conflicts. A conflict that exists might be regarded as an actual conflict — even if it is not expected to or does not enter the adviser's conscious decision making.
And for a conflict that actually exists, advisers should avoid saying the conflict "may" exist.
Further, a key to disclosure of conflicts of interest is ensuring that the disclosure is "designed to put a client in a position to be able to understand and provide informed consent to the conflict of interest."[8] Indeed, a disclosure's efficacy is sure to be questioned where an adviser is deemed to have been aware that a client did not understand the disclosure.
Eliminate Conflicts Where Disclosure Is Not Sufficient
Where full and fair disclosure cannot be made, "the adviser should either eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible."[9]
Notably, while some conflicts are difficult to fully and fairly disclose or otherwise eliminate, advisers should also consider the option of refraining from providing the conflicted advice or recommendations to avoid violating their fiduciary obligations under the Advisers Act.
Supervise
The SEC has reiterated that firms are expected to identify conflicts and, "as part of designing their written compliance policies and procedures, should first identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm's particular operations."[10]
Advisers should develop policies and procedures for the identification of conflicts of interest; plan to review such policies and procedures, no less than annually, to ensure they are effective and evolve with changes in the firm's business; and enforce their policies and procedures strictly even in situations where no undue benefit or client harm is identified.
[1] As is common in SEC Orders, the Settlement Order states generally that Robertson violated Section 206(2) of the Advisers Act, "As a result of the conduct described above…" It is not clear if the SEC reasoned that Robertson violated 206(2) for not disclosing the pre-2018 support offered by Aviron also or just as to the 2018 Film recommendation after his daughter received a role in the film based on Aviron's introduction.
[2] SEC v. Capital Gains Research Bureau Inc., 375 U.S. 180, 191-92 (1963) (emphasis added).
[3] See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Release No. IA-5248, p. 6, 84 FR 33669, 33670 (June 5, 2019) (available at: https://www.sec.gov/rules/interp/2019/ia-5248.pdf)
[4] Vernazza v. SEC, 327 F.3d 851, 856 (9th Cir. 2003).
5] Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest, SEC at FAQ 2 (Modified: Aug. 3, 2022) (available at: https://www.sec.gov/tm/iabd-staff-bulletin-conflicts-interest#_ftnref4).
[6] Investment Advisers Act Release No. IA-5248 at pp. 21-22.
[7] Id. at p. 24
[8] Id. at p. 27.
[9] Id. at 28.
[10] Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest, SEC at FAQ 3 (Modified: Aug. 3, 2022) (citing Advisers Compliance Rule Adopting Release, supranote 10, at 74716) (available at: https://www.sec.gov/tm/iabd-staff-bulletin-conflicts-interest#_ftnref10).