It comes as no surprise that investment advisers have a range of potential conflicts of interest as they provide investment advice to their clients. These conflicts relate to individuals who work at the adviser, to advisory activities, trade execution, and other services provided by the adviser and its affiliates, as well as to other areas. In any case, it is extremely important that the adviser identify, disclose, and properly address any potential conflicts. In this article, we will explore many of those conflicts, the issues they raise, and how they are dealt with within the regulatory framework that applies to investment advisers and their clients. We will pay particular attention to the perspective that fund directors might employ as they consider the potential conflicts that investment advisers have with their funds.

Before Congress enacted the Investment Advisers Act of 1940 (Advisers Act) and the Investment Company Act of 1940 (1940 Act), legislators and others were concerned about a considerable number of abuses by investment advisers and other insiders. The Securities and Exchange Commission documented those abuses in a report,[1] and in his April 1940 testimony before Congress, SEC Commissioner Robert Healy bluntly outlined the concerns.[2]

Those abuses, which typically involved funds but are equally relevant to other clients, included but weren’t limited to:

• Unloading of worthless securities and other investments of doubtful value upon funds,
• Loans by funds to insiders;
• Bailouts of insiders by funds of dubious and illiquid investments;
• Financing banking clients of insiders by funds;
• Funds financing companies in which insiders had an interest;
• Funds organized as discretionary brokerage accounts with insiders earning brokerage commissions;
• Funds used to further the banking business of insiders to obtain control of various enterprises, banks, and insurance companies; and
• Insiders trading in fund securities to the detriment of the fund without any risk to the insiders.

Addressing Potential Conflicts

While these abuses, as they affected funds, were addressed by certain provisions of the 1940 Act, the Advisers Act did not specifically address the abuses as they relate to non-fund advisory clients. One element common to these and many other conflicts is that the adviser was placing its own interests above those of its clients. That perspective is important to keep in mind as we explore investment adviser conflicts of interest.

If you are a fund director, you are well aware of the provisions of the 1940 Act that are intended to address many of the conflicts of interest involving fund advisers. Advisers to the fund are considered as both an affiliated person[3] and an interested person[4] of the fund, and the provisions of Sections 10 (affiliations or interest of directors, officers, and employees), 15 (investment advisory and underwriting contracts), and 17 (transactions of certain affiliated persons and underwriters) address many, but certainly not all of the potential conflicts that advisers have relating to funds. The Advisers Act, however, deals with potential adviser conflicts of interest in quite a different manner.

The Advisers Act principally relies on the notion that advisers are fiduciaries[5] owing duties of care and loyalty to their clients. It requires an adviser to adopt the principal’s goals, objectives, or ends and at all times serve the best interest of its client and not subordinate its client’s interest to its own.[6] The courts have stated that Congress intended “to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render investment advice that was not disinterested.”[7] The SEC and the courts have employed this approach through the years by applying the anti-fraud provisions contained in Advisers Act Section 206. Quite simply, where there is a potential conflict of interest, the Advisers Act requires advisers to provide full and fair disclosure of the potential conflict and then obtain the informed consent of the client.

To identify many of the potential conflicts of interest that investment advisers currently have, you might consider reviewing the most recent ADV Part 2 (Brochure) filed by the investment adviser with the SEC, especially Items 11, 12, 13, and 14. A recent review I made of a few of those documents identified a number of the broad areas of potential conflicts, including, among others:

• Potential conflicts relating to the investment adviser’s employees, its advisory activities, or its handling and execution of trades;
• Potential conflicts that arise with respect to services provided by or through various affiliated entities;
• Potential conflicts resulting in inducement;
• Client confidentiality, information asymmetry, and availability of proprietary information;
• Certain principal and proprietary transactions of the adviser and affiliates;
• Potential conflicts relating to securities lending services, other investment products, or the structuring of investments;
• Pricing and valuation of securities and other investments;
• Selection of brokers, dealers, and other trading venues and methods;
• Trade reporting;
• Research and “soft dollars”;
• Access fees paid to, and discounts provided by, ECNs, derivatives clearing firms, and other trading systems;
• Directed brokerage;
• Payments to the adviser by a non-client in connection with advice provided to a client;
• Endorsement, introduction or placement arrangements; and
• Voting client securities.

While this list is considerable, it is but a portion of the potential conflicts of interest that an investment adviser might have.

A Deeper Dive

Let us explore some examples of the potential conflicts that advisers might have that can adversely impact their ability to properly serve the best interests of their clients. After all, the adviser is running a business, and the interests of that business are often not fully aligned with the interests of the adviser’s clients.

• Fees. Clearly that is the case with the level of fees the adviser is charging its clients but also can be implicated regarding the structure of that fee. Performance fees can lead an adviser to adopt a more aggressive posture in managing that client’s account. It can also lead to an incentive for the adviser to allocate its best investment ideas, opportunities, and trades to those accounts having such a fee to the detriment of its other accounts.
• Compensation of personnel. Advisers’ compensation of its personnel can often create potential conflicts of interest, especially when it is not properly aligned with the interests of the clients. For example, disproportionately weighing performance-based compensation on short-term performance can provide an incentive for investment personnel to take risks to improve short-term performance over longer-term performance or to reduce risk toward the end of the measuring period if a performance goal has been achieved. Compensation of investment personnel might also include an incentive to build the business or involve stock or options tied to the performance of the organization, which may not be aligned with the client’s best interest.
• Soft dollars. In the United States, advisers commonly use “soft dollars” to obtain investment research from brokers. This practice typically involves utilizing the services of particular brokers to effect equity securities trades for clients, who may end up paying higher commissions than they might otherwise pay in order for the adviser to acquire investment research. That investment research is then available for use by the adviser with respect to all of its clients. Thus, in addition to reducing the costs the adviser might otherwise incur to acquire or produce investment research, those client accounts that engage in more active equity securities trading likely are disproportionately bearing the expense for research that also benefits accounts that may trade less.
• Competing investment products. Investment advisers often create, manage, or provide advice to investment products that compete with investment products they manage for other clients. This can have a negative impact on the prospects of the other investment product. Are the fees the same? Is the degree of support from the adviser the same? Are there other conflicts involved?
• Allocation of trades. In responsibly managing the investments of their clients, advisers often exercise discretion in determining where to allocate investment ideas and how to allocate securities trades, as well as, when there might be a limited capacity for investment or strategy, how to allocate that limited capacity. 
• Cross-trades. Investment advisers often have their clients engage in cross trades whereby the securities owned by one client are acquired by another client. While there can be benefits derived by each client from such trades, the adviser is in a conflicted position when making the decision on behalf of each client to engage in those trades.
• Affiliated products. Advisers often utilize collective investment products for their clients. The decision to do so can involve additional cost to the client and less effort by the adviser. The adviser may also have to decide whether to use certain affiliated products. The compensation and other benefits that might be derived by the adviser and its affiliates might also be a factor.
• Different client priorities. Advisers frequently manage investments on behalf of clients in diverse types of securities of the same entity or where other clients may already have investments. The interests of different clients in those circumstances may then not be aligned and the adviser may, therefore, be in a conflicted position.
• Other activities of the adviser and its affiliates. Advisers are often part of a much larger financial firm that can be engaged in underwriting, investment banking, lending, and other activities that can, at times, be in conflict with the interests of the advisers’ clients. There are a host of potential conflicts that can arise from this, including, among others, clients participating in affiliated underwritings, determining which area within the organization provides services to particular clients, how proxies for client securities are voted, whether an affiliated broker is used for trades by clients, and whether affiliated service providers are used to provide services to clients, to name a few.
• Securities lending. Advisers or an affiliate may act as an agent for securities lending by clients. In doing so, the securities lending agent is often compensated by participating in the earnings the client receives from that activity but does not participate in losses the client might incur. In addition to the conflict the adviser has in determining whether the client should engage in that activity and on what basis and with whom, the adviser has an incentive to be aggressive in earning income from the activity.
• Sub-advisers. Advisers often employ the services of sub-advisers to manage all or a portion of a client’s account. Where the adviser is compensating the sub-adviser there is obviously a financial incentive to select a less expensive sub-adviser, but there can be other conflicts that enter into that decision.
• Reciprocals. In the financial services industry, there are any number of reciprocal practices or other arrangements that can create conflicts of interest for the adviser, whether occasioned by business relationships, level of fees that fluctuate based on other clients’ participation, or otherwise.
• Valuation of portfolio securities. Valuation and pricing of portfolio securities and other investments can also cause conflicts for advisers, especially as advisers have an incentive to deliver superior performance to clients.

I could continue on, but I am sure that everyone gets the idea. This is an area that presents a large variety of opportunities for advisers to have potential conflicts of interest.

Over the years the SEC has brought a variety of cases against investment advisers involving potential conflicts of interest and the violation of the anti-fraud provisions in Section 206 of the Advisers Act. These cases go back at least to the 1960s when the U.S. Supreme Court decided the Capital Gains case. Since then, numerous cases have been brought defining a variety of potential conflicts involving investment advisers that require full and fair disclosure by the adviser and informed consent by the client. I would recommend that everyone keep an eye on these cases as they are instructive, and that landscape continues to evolve.

Managing the Conflicts

Advisers have developed a variety of means to manage the conflicts of interest they have. They adopt a code of ethics to address potential conflicts arising from personal investing by their employees. To address principal investing by their firm, and the operation of its business activities involving investment banking, lending, brokerage, and other activities that might cause conflicts, advisers often utilize a distinct separation of functions and information barriers. For other conflicts, especially those arising between clients, advisers address those potential conflicts through the adoption of policies and procedures that define exactly how they manage those conflicts. In other cases, advisers may just eliminate the conflict. It is therefore quite important to understand not just the conflicts the adviser has but also the manner in which the adviser seeks to manage those conflicts.

So, what should we consider doing? Looking at this from the perspective of the investment adviser, I would suggest a comprehensive review of operations and the identification of every area where the adviser might have a potential conflict of interest. I would do this with an appreciation of the business and operations of not just the adviser but also that of its employees and affiliates. Then, having identified these potential conflicts, I would assess their materiality to the interests of the adviser’s clients and the potential impact the conflicts might have on the advice that is being provided and on the duty of loyalty the adviser owes the client. I would then identify whether the potential conflicts can be eliminated or what can be done to properly mitigate or otherwise manage them.

Then, the question is how best to disclose the conflicts fully and fairly to clients, how the adviser manages those conflicts, and how to secure the clients’ informed consent. I would always bear in mind that a key issue is whether the conflict does, or might, compromise the advice that is being provided to the clients or otherwise adversely impact the interests of the clients. I would also focus on the need to disclose the material facts fully and fairly and in a manner that enables the clients to understand the conflicts and provide their informed consent. The concept is simple; successfully implementing it is a bit more of a challenge.

Now looking at this from the client’s perspective, or as a fund director, I likely would find the process a bit more difficult. You cannot be expected to know all of the operations, arrangements, or potential conflicts that the adviser, its employees, or its affiliates might have or the impact those potential conflicts might have on the advice being provided. Here are a few suggestions for your consideration: First, understand the functions that the investment adviser will be performing for you and then use that vantage point to evaluate the potential conflicts of interest that the adviser might have. Next, bear in mind that a question to consider in addition to whether the adviser, its employees, or affiliates could benefit themselves—financially or otherwise—is whether the potential conflict of interest could adversely impact the ability of the adviser to provide disinterested advice or otherwise adversely affect the client. Then, carefully review the disclosures the adviser has provided regarding the potential conflicts it might have and how the adviser manages those conflicts.

The evaluation of the conflicts, and the manner of addressing those conflicts, should be done in light of the services being provided and the potential impact they might have on the advice being provided, or otherwise on the client. Don’t be shy in asking questions so you can fully appreciate the potential conflicts, how they might impact the advice being provided or otherwise affect the client, and the adviser’s manner of addressing those conflicts. Only when you have done that can you really provide the requisite informed consent to the conflict.

Investment adviser conflicts of interest can seem to be incredibly complicated but really can be viewed through a simple lens. Are there circumstances where the investment adviser’s ability to provide disinterested advice or otherwise fulfill its duty of loyalty to the client might be compromised? If so, then: What are the conflicts? What is their potential impact? How are they managed by the adviser?

*This is the first in a series of five articles that will examine potential conflicts of interest in specific areas of the financial services industry. Each article will discuss the areas where potential conflicts may exist, some abuses involving conflicts that have arisen, some resolutions that have been employed to resolve those conflicts, and the legal and regulatory standards, if any, that may apply.

Andrew J. Donohue (Buddy), who has almost 50 years of experience in the financial services industry, is currently the chair of the Mutual Fund Directors Forum and an independent director of various BNY Mellon Funds. He previously served as chief of staff, from 2015 to 2017, and director of the Investment Management Division, from 2006 to 2010, at the Securities and Exchange Commission. Donohue also was executive vice president and general counsel at OppenheimerFunds, global general counsel at Merrill Lynch Investment Managers, and managing director and investment company general counsel at Goldman Sachs.