Over the past several weeks, I have written articles exploring conflicts of interest that could challenge a variety of financial industry participants. Those articles explored potential conflicts for fund investment advisers, securities broker-dealers, attorneys, and accountants. In this final article of the series, I will be discussing some of the conflicts of interest that officers and directors of investment companies might encounter, as well as a few of the issues that have arisen over the years involving conflicts related to other service providers. I will approach this discussion from a perspective that fund directors might find helpful.

Funds have a unique structure, as they typically do not have any staff or officers that they employ. Rather, funds rely on others—investment advisers, administrators, and more—to provide them with the services and personnel necessary for their operations. In previous articles we have principally focused on the potential conflicts that organizations might face; today we will focus on the conflicts that certain individuals, as officers or directors of a fund, might run into. It is important to remember that individuals who are employed by a fund service provider but also serve as an officer of a fund share any potential conflicts with that service provider.

Officers and directors of a fund have responsibilities to the fund under both state law and the Investment Company Act of 1940[1] and other federal securities laws. Typically, under state law officers and directors have a duty of loyalty and a duty of care. These duties obligate an officer or director not to put their interests above those of the fund, to be informed, and to use care in making decisions. The duty of loyalty does not permit an officer or director to divert to themselves any business opportunity that rightfully belongs to the fund. In addition, officers and directors are frequently advised to fully disclose any potential conflict and recuse themselves from participating in the matter. As stated, they also have obligations under the 1940 Act and other securities laws, which we will explore in this article.

Fund Officers & Directors

A number and variety of officers work with mutual funds, including a president, chief executive officer, vice president, secretary, chief financial officer, chief legal officer, and chief compliance officer. The responsibilities of these officers are typically set forth in the fund’s by-laws, although the 1940 Act and other securities laws can add to those.

An officer of a fund is considered an “affiliated person”[2] of the fund and therefore subject to the variety of restrictions and responsibilities contained in the 1940 Act, including the restrictions contained in Section 17 and the fund’s code of ethics under rule 17j-1, among others. In addition, certain officers of the fund can be subject to additional provisions, such as Section 406 of the Sarbanes-Oxley Act of 2002, which requires that the fund have a code of ethics that applies to certain senior officers, including the president/principal executive officer and treasurer/principal financial officer. That code of ethics contains provisions dealing with honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships.

Like a fund officer, a fund director is considered an “affiliated person” of the fund and subject to similar restrictions as well as other provisions of the 1940 Act. While the 1940 Act places limitations on the percentage of interested directors a fund might have and imposes certain additional approval obligations on the independent directors, all fund directors can encounter conflicts of interest. Under state law, directors generally are subject to the duties of loyalty and care and must act in a manner they believe to be in the best interest of the fund.

Potential for Conflict

The conflicts of interest that fund officers and directors might encounter can arise from several sources, including:

• Financial interests, where the officer or director has a financial interest in a matter involving the fund; these conflicts can emerge based on investments, financial incentives, or other factors.
• Personal interests, where the officer or director has a personal interest in a person or matter involving the fund.
• Conflicting obligations, where the officer or director finds that he or she has obligations to differing parties that are in conflict with each other.
• Family interests, where a family member (or close personal relation) of the officer or director has an interest in a matter that involves the fund.

Let us review a few examples of those potential conflicts.

1. The fund is exploring some companies to hire as the fund’s transfer agent. An officer of the fund who is on the team exploring potential candidates has one of the following potential conflicts:
   • She is employed by a company that is a candidate.
   • She is employed by a company that, while not a candidate, is a transfer agent. While exploring potential transfer agent candidates for the fund, she likely will acquire considerable valuable competitive information regarding her company’s competitors.
   • She has a brother who works for one of the transfer agents that is under consideration.
   • She has an investment in a large financial services firm that owns a transfer agent that is a candidate.
   • She is considering applying for a position with one of the transfer agent candidates.
2. The fund holds a few investments that require “fair value” determinations. The fund has elected to have the fund directors determine the “fair value,” but a fund director has the following potential conflicts:
   • She owns shares of the fund that holds positions in the investments that are being “fair valued.”
   • She owns interests in the investments that require “fair value” determinations, separately from the fund.
   • She has a relative or close friend who works at one of the investments to be “fair valued.”
3. The fund officer is employed by the fund’s investment adviser, and the fund officer, in connection with her activities as a fund officer, becomes aware of a potential new strategy that would be of potential benefit to the fund. The fund’s investment adviser, however, has several other potential candidates for the new strategy.
4. Fund directors are evaluating the proper level of compensation for the members of the fund board, as well as other provisions directly applicable to them.
5. Fund officers are evaluating and recommending to fund directors, and fund directors are considering, the approval of certain fund policy changes that might benefit one fund and its shareholders but potentially harm another fund and its shareholders.
6. A fund director, who sits on the board of an unaffiliated fund, has learned information at that unaffiliated fund that is material to a matter currently under consideration at the fund.
7. The investment adviser is not aware that a fund director’s sister-in-law is a securities trader at a dealer that the investment adviser is now considering using for the fund. 

Facing, Dealing with Conflict

We typically hear that the best way to deal with conflicts of interest is to either avoid them or recuse ourselves when we encounter them. That is wise advice that unfortunately is often not possible to follow. As we have explored conflicts of interest, we have observed that they present themselves in a variety of ways and are prevalent in the financial services industry. This is especially the case with funds, which typically have no employees and engage service providers to supply officers and perform activities on their behalf.

So how should fund directors consider handling conflicts of interest that might exist involving themselves or the officers of their funds? Here are a few thoughts for your consideration:

• Have a detailed director questionnaire completed annually by directors and reviewed carefully by counsel and others to identify potential conflicts of interest.
• Be thoughtful about the potential conflicts of interest that might exist involving the fund’s officers and how those conflicts might affect the ability of the officers to properly discharge their duties on behalf of the fund.
• Remember that early identification of potential conflicts is frequently a prerequisite to their proper resolution.
• Be open with the fund officers about the potential conflicts of interest that they might encounter and encourage them to identify and discuss them with you.
• Consider asking the service provider that employs the fund’s officers to provide you with an analysis of how they identify and seek to resolve any potential conflicts.
• Think about conducting a review of conflicts that might arise and how best to deal with them if the fund is considering requesting that fund officers undertake a specific project.
• Recognize that just because you might be considered an independent director, that does not mean that you won’t have some potential conflicts of interest; be on alert for identifying and resolving them.
• Be mindful when encountering potential conflicts of interest involving directors that there are often state laws and federal securities laws that impact the way they are addressed and resolved.
• Rely on the advice of experienced and knowledgeable counsel.
• Keep in mind that just because there are provisions in the 1940 Act that prohibit certain actions involving officers and directors that are “affiliated persons” of the fund, it does not mean that actions that are not expressly prohibited are necessarily acceptable.
• Remember that where appropriate, the best resolution of a conflict of interest is to avoid it.

Many of the conflicts discussed above can be easily resolved by the recusal of the individual who has the conflict. Unfortunately, that is not always possible. I often consider conflicts of interest related to an officer’s or director’s conflicting obligations more difficult to resolve. As you might imagine, where an officer or director has an obligation to act in the best interest of both a fund and another entity, those interests might not necessarily be aligned. When that conflict may be common to many directors, recusal may not be a viable option to resolve the matter. In those cases, be mindful that there may be state or federal requirements that affect the manner in which the matter is addressed and be guided by the advice of experienced counsel.   

More on Service Providers

In addition to this article considering fund officers and directors, previous articles have explored conflicts of interest involving investment advisers, broker-dealers, attorneys, and accountants. There are other types of fund service providers that were not addressed specifically, but which certainly also have conflicts of interest. I thought I might provide two examples of conflicts that were not managed properly involving other service providers, one regarding a fund administrator and another involving a fund transfer agent.

In the first case, a fund administrator entered into side agreements with 27 fund advisers that obligated the fund administrator to rebate a portion of its administration fee to those fund advisers. Under the agreement, the fund advisers would continue to recommend the administrator to the fund boards, while utilizing the rebates to pay for marketing.[3] 

In the second case, a fund investment adviser placed its own interest ahead of the fund’s when the adviser recommended that the fund replace the current fund transfer agent with an affiliate of the adviser. In this case, the existing transfer agent would function as a sub-transfer agent, performing almost all the same services it had previously performed but at a deeply discounted rate. The affiliated transfer agent then captured most of the discount for itself and made a high profit for performing limited work. The adviser misled the board by omitting material facts, thereby permitting the adviser and its affiliate to profit at the expense of the funds[4].

In these cases, either: (1) revenues were being paid by the fund for one service and then being utilized for a quite different purpose, or (2) costs for services were being negotiated and then when they were significantly reduced, that reduced cost was captured by the adviser affiliate and not by the fund. In both cases, the fund boards were misled by the parties involved.

Final Thoughts

Conflicts of interest are quite common in the financial services industry, and they have often resulted in harm to funds, fund investors, and the financial markets when they have not been identified and addressed properly. This is an important topic to which all of us, especially fund directors, should be sensitive. I often reflect on the fact that so many of the problems that have occurred in the financial markets can be traced back to conflicts of interest that were not properly identified and resolved.

Conflicts of interest are a necessary condition for funds, their service providers, and their officers and directors, and we deal best with them when we recognize their existence and resolve them accordingly. I hope that you have found the articles on conflicts of interest interesting, informative, and helpful.