On February 23, 2015, the SEC’s Division of Investment Management issued guidance concerning the conflict of interest that arises when persons doing business, or hoping to do business, with a fund provide gifts, entertainment or other favors to personnel of the fund’s investment adviser. The guidance cautions that fund advisory personnel’s acceptance of gifts or entertainment could violate provisions of the Investment Company Act of 1940 (the 1940 Act) and notes that funds’ compliance policies should address this risk.
Section 17(e)(1) of the 1940 Act prohibits affiliated persons of a fund, such as a fund’s investment adviser and its personnel, from accepting any sort of compensation for the purchase or sale of property to or for the fund.
As noted in the guidance, this is a broad prohibition. While, for instance, Financial Industry Regulatory Authority (FINRA) regulations permit broker-dealer staff to engage in gift giving of items totaling less than $100 annually and provide (in relation to the business of the recipient’s employer) “ordinary and usual business entertainment” such as taking a client out to dinner or a sporting event, the guidance suggests that section 17(e)(1) is potentially far more prohibitive. The SEC has noted, by way of example, that “if a fund’s portfolio manager accepts any gifts or entertainment from a broker-dealer for the purchase or sale of the fund’s portfolio securities, the portfolio manager has violated section 17(e)(1).” Although there must be some nexus between the “compensation” received (meaning any economic benefit paid directly or indirectly to an adviser) and the “property bought or sold” (i.e. the purchase or sale of securities), establishing a violation does not require proof of intent to influence or injury to the fund, or that the person receiving the compensation influenced the fund. Once a conflict of interest between the adviser and the fund is established, the burden of proof shifts and the party in conflict must demonstrate that its actions did not violate section 17(e)(1).
The guidance goes on to state that, in the SEC staff’s view, a fund’s compliance policies should address receipt of gifts by fund advisory personnel. Under rule 38a-1 of the 1940 Act, a fund’s board of directors must approve, and the fund must adopt and implement, policies and procedures reasonably designed to prevent violations of federal securities laws. The guidance suggests that, depending on the circumstances, either a blanket prohibition on receipt of gifts or use of pre-clearance mechanisms may be appropriate.
The guidance signals that the SEC may take a much closer look at the receipt of gifts and entertainment by fund advisory personnel in the future and suggests that funds and advisers revisit their compliance practices in this area.
Practice Point: Language from the U.S. Court of Appeals for the Second Circuit in United States v. Deutsch, a case cited by the SEC in the guidance and past enforcement action, further illustrates the nature of this potential pitfall. The court wrote that, in the 17(e)(1) context, “paying of compensation is an evil in itself, even though the payor does not corruptly intend to influence the affiliated person’s acts, for it tends to bring about preferential treatment in favor of the payor which can easily injure the beneficiaries of investment companies.”
Also of interest is the reference to undefined “favors” in the first paragraph of the guidance. That paragraph notes that “gifts, favors or other forms of consideration” could create a conflict of interest. Because favors are less easily identifiable and more difficult to assign value than conventional gifts and entertainment, they could present a greater compliance challenge in the 17(e)(1) context.