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Conflict Advisory Review Services – Best Practice to Mitigate Risk

26 Jul 2023

In a complex investment environment focused on regulatory compliance and independent oversight, it is well understood that investment advisors operating under the Investment Advisers Act of 1940 (the "Advisers Act") face an additional compliance burden in relation to conflict review and affiliate trading.  As managers look to grow their business in increasingly volatile markets, there are significant benefits in leveraging specialist independent expertise in this area.

Investment advisors have a unique relationship with clients.  Having been delegated the responsibility of managing their assets, the advisor may occasionally have to effect an investment transaction for a client while acting as principal for its own account, or as a broker for a person other than the client.  This presents a number of complexities and related obligations on the investment advisor.  Understanding and mitigating risk in this regard, the Maples Group's independent conflict advisory review services team has vast experience as well as the technical and operational capability to help alleviate this burden on investment advisors, while ensuring the interests of the investment advisors' clients are being cared for.

Off-Market and Self-Dealing

Investment advisors may be engaged in various types of off-market transactions in managing investments for the benefit of their clients.  These transactions, which do not take place on a securities exchange and where fair value is not readily available, can involve investment advisors acquiring investments from a client's fund portfolio or, conversely, disposing of an investment from their own inventory to a client portfolio.  Investment advisors may also be arranging for off-market transactions between different advisory clients or between a brokerage customer and an advisory client. 

These principal and agency transactions, collectively referred to as "affiliated trades" can be initiated either on an 'ad-hoc' or daily basis by many investment advisors, as part of their investment strategy.  Nonetheless, by trading securities for their own benefit, as well as that of their clients, affiliated trades can create an inherent conflict of interest between the investment advisor and its client, as it allows investment advisors to engage in self-dealing.

Self-dealing can manifest itself in a negative way, leading to potential abuse by the investment advisor in the following ways:

  • Price manipulation
  • Placing unwanted securities in client accounts
  • Facilitating agency transactions with the primary intent of earning additional compensation

To address this inherent conflict, global regulatory authorities have created specific legislation to mitigate the risk.  Notably, in the United States, section 206(3) of the Advisers Act was enacted to target affiliated trades.  The intent was not to prohibit investment advisors entirely from engaging in principal and agency transactions with their clients, especially as the trades may be in their clients' best interests, but rather to implement a regime of advisor disclosure and client consent.

Key US Legislation 

The Advisers Act addresses this potential conflict by imposing a prior consent requirement on any investment advisor that acts as principal in a transaction with a client, or that acts as an agent in connection with a transaction for, or on behalf of, a client.  Prior to the settlement of an affiliated trade, the investment advisor must disclose in writing to the client, the potential conflicts of interest and the terms of the transaction.  The client's written consent to waive the conflicts of interest must be obtained to proceed with the transaction.

In addition to disclosing the potential conflict of interest, the investment advisor should provide the client with sufficient information regarding the transaction, including information regarding pricing, to enable the client to make an informed decision on whether to consent to the transaction.  It should also be made clear to the client they can withhold their consent and they are under no obligation to provide it.

Practical Aspects

From a client standpoint, industry best practice is for the client to either form a committee, made up of large shareholders or the directors, or to appoint a third party agent to provide consent to each affiliated trade.  The Maples Group's extensive experience in acting as a dedicated agent by reviewing the conflicting trade and, where appropriate, providing consent, has provided investment advisors with a practical and efficient solution to meeting the requirements of section 206(3) and other codes and regulations which require independent trade reviews.

Some hurdles arise as a result of the "disclosure and consent" requirement.  On the one hand, it may prove difficult to contact some clients within a short space of time and obtain consent prior to the settlement of the transaction.  Furthermore, during the time between providing the disclosure and awaiting the client's consent, the market may fluctuate materially and the transaction information may no longer be accurate. 

These instances can make appointing a dedicated third party agent to provide consent the preferred method.  As a single point of contact, the dedicated agent should be able to provide consent in a timelier manner, than a disparate group of clients.

The Maples Group is able to draw on a wide pool of experienced authorised signatories, and is typically able to provide consent within 24 to 48 hours, and, if required, on an even more expedited basis to meet the specific needs of an investment advisor.  Our service offering can also be tailored to each investment advisor, be it providing consent for one-off or block trades, and / or transactions of varied complexity.

Limitations to Consent

It is important to note there are some limitations to the nature of the client's consent being provided by the dedicated agent.  The dedicated agent is not making investment recommendations or commenting on the merits of the advisor's investment recommendations, nor will it provide any opinion as to the fair value of off-market securities at the transaction date.  They should also not be seen as advising the investment advisor's client in any way.

Furthermore, the service being offered by a dedicated agent is different from independent pricing verification, recalculation or a full audit of the asset valuation.  The pricing support only provides a rationale for the determined price.  Lastly, the dedicated agent is not expected to provide any assurance as to the validity of the pricing support provided.  What is considered appropriate and reasonable supporting documentation would have been agreed with the investment advisor at the outset of the engagement. 

Mitigating Risk

Principal and agency transactions are a part of the ordinary course of doing business for many investment advisors; however, affiliated trades have an inherent risk for potential manipulation and abuse.  Far from looking to prohibit affiliated trades by investment advisors, section 206(3) of the Advisers Act sets out to require that investment advisors disclose to their clients the details of any affiliate trade and to obtain their clients' written consent to trade prior to the settlement of the transaction.  The appointment of our conflict advisory review team as a dedicated agent to provide trade consents can help streamline the consent and approval process, while ensuring the investment advisor adheres to the requirements of the legislation.

Related Services

Conflict Review and Advisory Services

Today's complex regulatory focus on affiliate trading requires special attention. Our dedicated conflict review and advisory team has the technical and operational excellence to deliver a highly responsive and independent service.