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Silver Lane is a premier M&A advisor to the financial services industry. From offices in New York, San
Francisco, and Chicago, the firm serves a broad range of financial services clients, including investment and wealth management firms, multifamily offices, brokerage firms, private and commercial banks, trust and insurance companies, and financial technology firms.
Seward & Kissel LLP, founded in 1890, is a leading
U.S. law firm with an international reputation for excellence. The firm has offices in New York City and
Washington, D.C. and a practice primarily focused on corporate, litigation and restructuring/bankruptcy work for clients seeking legal expertise in the financial services, corporate finance and capital markets areas.
Silver Lane advises on mergers & acquisitions, divestitures and sale transactions, recapitalizations, and joint ventures/ strategic alliances. The firm also provides valuations, internal ownership transition planning, due diligence, special committee advice and fairness opinions, and market entry strategies.
For additional information, please contact Peter
Nesvold, Managing Director (212-883-9409, pnesvold@silverlane.com).
The firm is particularly known for its representation of investment advisers and related funds (including hedge funds, private equity funds and mutual funds), institutional investors, commercial and investment banks, fund administrators, broker-dealers and shipping companies. The firm’s Business
Transactions Group, which specializes in M&A, private equity and other transactional matters, publishes the IM Deals blog (www.imdealsblog.com) covering deals involving investment managers.
For additional information, please contact partners
Jim Abbott (212-574-1226, abbott@sewkis.com),
Craig Sklar (212-574-1386, sklar@sewkis.com), or
David Mullé (212-574-1452, mulle@sewkis.com).
Silver Lane Insights: 2015 Outlook

} Up or Out: Strategic Alternatives for Subscale Bank-Owned RIAs
aspects are so compelling that many bank CEOs with whom we meet cite wealth management as a key strategic priority for driving long term growth.
Ask your local banker about the robustness of the post-crisis economic recovery, and you may just face a blank stare. The last five years have proven to be a difficult operating environment for the traditional banking model. Even as equity markets have tripled off 2009’s lows, the banking industry has battled through an era of low interest rates, compressed net interest margins, and anemic loan growth. Couple these sustained economic headwinds with heightened regulatory pressures— on fees, capital requirements, and compliance costs—and it’s a small wonder that banks continue to seek new sources of fee-based revenues and other noninterest income to reinvigorate profitability.
Among other paths, this search has led many industry CEOs to the land of wealth management.
Banks acquired 47 registered investment advisors
(RIAs) and trust companies in 2014, nearly double the total in 2013 and a dramatic step up from only
18 in 2010.
Despite these advantages, some banks struggle to scale their wealth management units to levels that capture the full impact of these expected synergies.
Silver Lane Insights: 2015 Outlook explores why this is so, and proposes strategic alternatives for bank CEOs with subscale wealth management units.
First, we outline why it can—and does—make sense strategically to align a bank with a wealth management platform. Second, we describe common reasons why some banks struggle to capitalize fully on the market opportunities that these combinations create. Lastly, we suggest three solutions for bank CEOs who face subscale wealth management units with slowing growth prospects:
1) double down on the wealth management investment to achieve sufficient scale; 2) divest the unit to improve cost efficiency and replace the offering with an outsourced solution; or 3) integrate the wealth operations fully into the bank. In a nutshell, it’s up or out.
It’s easy to understand why. On its surface, wealth management screens well for banks: the business is capital efficient; it leverages the bank’s physical infrastructure and regional brand; earnings are stable and insensitive to interest rates; and it captures more wallet share, thereby increasing customer switching costs. In a nutshell, wealth management generates attractive returns despite a lower risk profile than traditional lines. These
Why do bank CEOs increasingly cite wealth management as a key strategic priority? Relative to core bank offerings, the profitability of wealth management is attractive—with strong underlying fundamentals in large, underserved markets where banks have preexisting customer relationships.
Even as a standalone business, wealth management is a compelling model. The typical firm enjoys recurring revenue streams, high customer retention, attractive margins, and substantial
Silver Lane Insights: 2015 Outlook
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} Up or Out: Strategic Alternatives for Subscale Bank-Owned RIAs 3 operating leverage.
1
In addition, most firms can stabilize margins and cash flows during prolonged market downturns by resetting headcount and/or compensation; these expenses frequently represent the majority of a firm’s cost structure.
2
Lastly, RIAs also typically generate strong financial returns, as dayto-day capital requirements are relatively modest.
(particularly at the mass affluent level), these relationships are a powerful differentiator against even the most formidable competitors. Moreover, banks that successfully cross-sell with their RIA subsidiaries capture more wallet share, increasing customer switching costs.
Wealth management also offers ample opportunity for growth and further consolidation. In the United
States alone, approximately 11,000 RIAs manage more than $50 trillion of client money.
3
The 10 largest firms control only about 20% of the market, while some 3,000 firms thrive in a robust middle market with $8.3 trillion (or 17%) of assets under management (AUM).
4
Moreover, banks are uniquely positioned to capitalize on this market opportunity, as combining banking and wealth management can make tremendous sense strategically. Countless retail and small business customers have already developed trusted relationships with their local banks. A bank parent can offer its wealth management division regional brand strength, an established branch distribution network, trust capabilities, and—most importantly—these core customer relationships. In a market crowded with offerings that at times can seem commoditized
1 According to a benchmarking study from The Boston Consulting
Group (BCG), recurring revenues totaled about 80% of the global asset management industry’s total revenue pool, translating into an industry-wide average operating margin of 37%. The Boston
Consulting Group, Global Asset Management 2013: Capitalizing on
Recovery , pg. 12-13. This margin can vary depending on a particular manager’s business model and size. Id.
Silver Lane’s proprietary research suggests operating margins average approximately 31% in the lower/middle market.
2
For instance, BCG’s study shows a 39% average improvement in
U.S. managers’ profit pools from 2008 and 2010, even as average
AUM was generally flat in the “bookend years” before and after the financial crisis. Id.
at pg. 19, Figure 11.
3
U.S. Securities and Exchange Commission.
4
Id.
Silver Lane defines middle market RIAs as those managing between $500 million and $10 billion of AUM.
The public markets share this appreciation for wealth management, as RIA-driven income streams generally command higher valuation multiples than those that are banking based. For instance, small and mid-cap banks might only trade at roughly 14x-
15x forward earnings, whereas it is not unusual for public asset and wealth management firms to command a 25%-plus premium to that valuation.
We attribute this premium largely to asset and wealth management’s sticky pricing, with revenues that are fee-based, capital efficient, and highly predictable.
Despite this long list of tangible benefits, many bank-owned RIAs struggle to achieve critical mass . Perhaps cross-selling to bank customers hasn’t worked. Some loan officers may not even know where to refer a high-net-worth client or—in the extreme—may worry about the wealth team poaching or fumbling the relationship. Consequently, growth at the RIA has started to lag, just as the bank begins to rein in spending to hold margins.
Welcome to the “Valley of Death.”
5
In many cases, these symptoms materialize when the wealth unit has grown AUM to somewhere between $500 million and $1 billion. If the unit is running independently, this is around the time that the business’ needs change and operational holes materialize. Perhaps the firm has harvested the low hanging fruit in terms of client flows and therefore requires a dedicated marketing resource—yet the business is not yet at the appropriate scale to hire
5 Credit for the term “Valley of Death” in situations such as these goes to former senior executives at Charles Schwab & Co., Inc.
Silver Lane has also referred to this dynamic as a firm hitting
“terminal velocity.”
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} Up or Out: Strategic Alternatives for Subscale Bank-Owned RIAs 4 an experienced professional until AUM is well north of $1 billion. Since it’s difficult to add “half a person,” significant hires such as these often mean that the firm must sacrifice near-term profitability in anticipation of future AUM growth.
Nevertheless, many firms simply won’t reinvest— effectively hitting terminal velocity—particularly if the strategic vision of combining retail banking and wealth management has yet to materialize. As a result, the RIA’s business development efforts languish and the bank resorts to just clipping coupons at $500 million of AUM because it lacks the appetite to reinvest into infrastructure to bust through the $1 billion mark. Even still, banks that fall into this trap face a drain on management time and resources.
The Valley of Death is not the sole reason why some bank-owned RIAs struggle to scale.
Some banks jump into wealth management with silo or legacy banking methods and therefore do not optimize their presence. The problem is, best practices in banking do not always reconcile to those at RIAs. Wealth management is unusually service intensive—particularly compared to most retail banking products. Consequently, the key value driver for an RIA is often its people, whereas for a bank it typically is the quality of its loan portfolio. This divergence commands different compensation and incentive structures. If, for instance, the bank acquired an RIA rather than building the capabilities de novo , consider whether the principals that liquidated or no longer own a material equity stake lack sufficient incentive to grow the business. For this reason, the purchase of
100% of the equity of an RIA is less likely today compared to a decade ago, unless the business is fully integrated into the bank.
Another reason why some bank-owned RIAs struggle to optimize growth and margins is that management at the parent company level has yet to outline an overall vision for managing the two businesses cohesively. Ideally, a bank that optimizes its wealth management operations should be agnostic to whether the client is invested in the market or has the money in deposits. Too often, however, each side of the house develops separate initiatives to source clients; they rarely coordinate marketing programs and hesitate to even refer business internally.
There are a variety of reasons why this can happen, the most common of which is the lack of proper incentives to encourage cross selling. People may also be unwilling to relinquish control of client relationships, investment activities, and so on. This, in turn, can create standoffs between organizational silos within the bank. When clients are not integrated across traditional channels, the broader enterprise may lose opportunities to fully leverage organizational strengths and to optimize the client’s experience.
Unfortunately, it may be difficult for many CEOs— caught up in the day-to-day nuances of the business—to recognize the extent of the organizational challenges that the bank faces.
Consider some of the following questions:
§ Does the bank maintain duplicate productbased tools , or do clients have access to a single view of their account balances, activities, and fees? Banks that lack an integrated solution will not only cede share to firms with optimized offerings, but also will have redundant platform costs.
§ Do clients have online and real-time access to these accounts? Many clients—particularly those in the high net worth segment—expect a high degree of transparency not only into how their assets are currently invested, but also regarding various investment products, portfolio
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} Up or Out: Strategic Alternatives for Subscale Bank-Owned RIAs 5 modeling and planning tools, and the ability to execute securities trades.
§ Are products unnecessarily segmented across various business lines?
For instance, are the investment solutions offered to trust clients at least comparable to those offered within the bank?
§ Are bank and wealth statements formatted differently?
Do they use similar asset classification schemes? Is performance reporting comparable? Even an inconsistent look and feel of collateral across business lines can suggest splintered execution.
§ Is the organization structured around a single sales force, or are top producers constrained by channel, product, or some other factor?
Similarly, does a primary relationship manager serve as the first point of contact for client access to broader products and services that the bank offers?
§ How is employee compensation structured?
Is it sufficiently linked to growth in fee-based
AUM revenue and/or client satisfaction and retention? Does it incent, rather than impede, cross-selling opportunities?
§ Who’s on your board? How expert are your
§ board of directors in the nuances of the wealth management industry?
Do the bank’s wealth management clients view themselves as only clients of that division, or do they associate their experience with the entire bank?
In a twist of irony, growth provided by a wealth management division can even become a hindrance for the bank’s client service when the organization struggles to scale its operations to accommodate higher transaction volumes. Wealth management tends to be a labor-intensive business, with internal processes that require a large staff to execute. In some cases, volumes may be growing faster than the bank is willing to add headcount.
Even if hiring is keeping pace with volumes, adding more people can breed complexity and command more resources in anticipation of future growth.
So what should a bank do if it currently has suboptimal scale in this business? We recommend one of three solutions: 1) get bigger by reinvesting more resources into the wealth solution in order to gain sufficient scale; 2) divest the wealth unit, redeploy proceeds into core activities, and outsource the offering; or 3) integrate the wealth solution back into the bank.
If a bank-owned RIA is currently operating at a suboptimal scale, two obvious questions might be,
“What would this business look like if it were scaled?” and “How far away am I from that level?”
Getting bigger by reinvesting more resources into the RIA may be a practical way of scaling the business in a relatively short period of time. Some bank CEOs will undoubtedly ask, “Am I throwing good money after bad?” After all, this edition of
Silver Lane Insights focuses on
RIAs owned by banks. underperforming
Nevertheless, a key reason why wealth management was attractive to the bank in the first place is its ability to scale. Layering in an additional
$50 million of client assets typically requires only modest incremental investment (depending partly on the firm’s service model). It’s M&A 101: If an acquisition can enable a business to significantly increase its combined scale of operation, then the business can spread out its fixed costs over a larger output. Each tranche of client assets drives down average unit costs, thereby increasing the business’ overall profitability.
Some may question whether this tenant of M&A law applies to the wealth management industry, particularly as compensation can represent half of a
Silver Lane Insights: 2015 Outlook

} Up or Out: Strategic Alternatives for Subscale Bank-Owned RIAs 6 firm’s cost structure. Our view is that it does, particularly for firms trapped in the so-called “Valley of Death.” An acquisition that pushes AUM to a level north of $1 billion can jump start an RIA by leveraging the scale economies that kick in at around this point. Larger acquisitions can be outright transformational; the unit’s growth trajectory can change materially through the addition of new talent, systems, processes, and/or leadership.
Boston Private’s management identified a need to streamline wealth management operations and to integrate past acquisitions. In one move, the
Banyan deal doubled Boston Private’s assets under management and advisement to approximately $9 billion—making it one of the larger wealth management companies in the United States—and created an opportunity to establish a new subsidiary that combines each firm’s wealth operations.
The deal also increased Boston Private’s consolidated, non-spread revenue to approximately 45% of total revenue—significantly advancing the bank’s strategic vision of creating a more fee-weighted revenue stream. The benefits were not one-sided, however, as Banyan gained access overnight to private banking and trust services—a logical extension for serving its clients and capital for subsequent acquisitions.
If the bank is unwilling to reinvest into its wealth operations, we suggest that the business consider divesting the unit in order to harvest potential cost savings and replacing its offerings with a variety of available outsourced solutions. For many CEOs, it may seem counterintuitive to divest an annuity business. While the income stream might not be growing, it contributes to pre-tax earnings and therefore at least supports market valuations, the thinking goes.
Recurring fee streams, however, have a dark side— particularly when they lead to diseconomies of scale.
Some CEOs may be familiar with the old saying,
“complexity is the enemy of execution.” The larger an organization becomes, the more complex it is to manage and run such scale. This complexity incurs a cost, which eventually may come to outweigh the benefits gained from running annuity businesses. In other words, such streams cannot be gleaned forever. Ultimately, our view is that a bank should consider divesting the business if it does not have the core competency to grow fee income. Although the RIA might look profitable at the segment level, consider the costs to support redundant platforms, tools, and personnel.
Last, but not least, current market conditions are highly amenable to RIA divestitures—even those involving operations that are subscale on a standalone basis. As such, selling and outsourcing the operations has the added benefit of capitalizing on a robust M&A market for such assets.
After a decade of a successful partnership, the profitability of A.R. Schmeidler &
Co. (ARS), Hudson Valley’s RIA and broker-dealer subsidiary, was starting to wane; the business required additional capex to grow while the needs of the bank’s customer base had expanded, thereby demanding a broader service offering than what ARS historically provided. The bank faced three options: 1) squeeze cash flows from the business for as long as possible, albeit at the sacrifice of client service; 2) reinvest into the business to build out what the customer base really needed; or 3) find a partner for the subsidiary. Hudson
Valley Bank hired Silver Lane Advisors to help management evaluate the various options and concluded that a sale to a partner who could provide greater services was the best scenario for all constituents. The structuring and sale process of a triparty agreement (i.e., management, the selling bank, and the buyer) was further complicated by an unexpected twist—half-way through the process, Hudson Valley
Bank’s board of directors agreed to sell the parent company.
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} Up or Out: Strategic Alternatives for Subscale Bank-Owned RIAs 7
Bank CEOs that are willing to neither double down, nor exit, subscale wealth management operations generally have one last option: integrate these operations into the bank where feasible and identify any efficiencies and revenue enhancements by aligning each wealth offering internally.
The bank wealth offering is often comprised of some combination of an investment management group, a trust department, and a broker-dealer, all of whom may find themselves competing internally for the same clients. In reality, many clients do not knowingly choose which channel they come into the bank—more often than not, the deciding factor is a relationship, a life event, or some informal segmentation model. The client, in such circumstances, might have multiple points of contact, and therefore client experiences.
The solution may be an integrated wealth solution.
This often requires eliminating redundant sales teams, investment management processes, and operational infrastructures—thereby maximizing the scale and cost structures that are essential to remain competitive while (at times) competing for the same accounts and relationships. More often than not, a successful strategy must be transformative in nature.
The biggest downside risk to this option is disenfranchisement. Integration comes at a cost and can generate some collateral damage.
Significant cost savings may require meaningful personnel changes, which can drive some clients and/or managers to seek a new home.
Restructuring is never an easy process.
Growing and maintaining assets sourced through the wealth channel is a strategic priority of a growing number of banks. Those banks that have struggled to achieve critical mass in their wealth management units should consider one of three options: 1) get bigger by reinvesting more resources into the wealth solution in order to gain sufficient scale; 2) divest the wealth unit in order to harvest capital and outsource the offerings to an external provider; or 3) integrate the wealth solutions by folding them into the bank.
To learn more about Silver
Lane’s bank M&A practice, please contact Jeff Brand at
(312) 667-4721 or at jbrand@silverlane.com.
For additional information about other practice areas at Silver
Lane, please contact Peter
Nesvold at (212) 883-9409 or at pnesvold@silverlane.com
© Silver Lane Advisors LLC. All rights reserved.
This material has been prepared for general informational purposes and is not intended to be relied upon as accounting, financial, tax,
Silver Lane Insights: 2015 Outlook

} Hot Topics in SEC Enforcement for 2015
As 2015 begins, investment advisers are facing a challenging compliance landscape. Institutional investors are focusing more resources on operational due diligence, regulators are becoming more vigorous, and the regulations have become more complex. This article highlights some of the compliance issues that we expect will be a focus for regulators and investors in 2015. Three areas are, in our view, of particular importance: 1) cybersecurity, 2) expense allocations, and 3) best execution reviews.
In 2014, the Securities and Exchange
Commission’s (the “SEC”) Office of Compliance
Inspections and Examinations (“OCIE”) began an initiative to assess cybersecurity preparedness throughout the securities industry—an initiative that we expect to be of heightened focus this year.
Therefore, investment advisers should examine their current practices with respect to cybersecurity and ensure that their practices and policies are adequate to protect their systems.
A key component of the review process will be identifying the correct people in an investment adviser’s organization to participate in the process.
Those involved should have a deep understanding of computers and networks, the data that the investment adviser maintains, and the role that the investment adviser’s technology plays in its broader business.
It is equally important to ensure that the individuals conducting the review are being overseen by and reporting to the appropriate people within each investment adviser’s organization. In many circumstances, the Chief Compliance Officer and senior management should oversee the review process. This will enable the investment adviser to ensure that the cybersecurity review is being carried out in a manner that is consistent with the investment adviser’s broader compliance program and that the review fully encompasses all of the various business units and divisions within the investment adviser.
In March 2014, the SEC held a Cybersecurity
Roundtable at which the SEC staff stressed that investment advisers should be reviewing, testing, and updating their cybersecurity policies and procedures. The review should include a risk assessment which identifies both cybersecurity threats and physical threats that may affect cybersecurity. In addition to the risk assessment, the investment adviser should also conduct penetration tests and tests of their cybersecurity procedures. The findings of the risk assessment and testing should be documented.
The SEC has indicated that it expects an investment adviser’s cybersecurity procedures to be standards based. Therefore, the investment adviser should take into account any applicable standards such as those issued by the National Institute of
Standards and Technology (“NIST”) and the
International Organization for Standardization. In addition, it appears likely that investment advisers will need to demonstrate that their existing security procedures are comprehensive for the scope of
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} Hot Topics in SEC Enforcement for 2015 9 their respective businesses, that data is protected, that data destruction is effective, and that data access controls are in place. A particular challenge which an investment adviser faces is ensuring that its vendors and other third parties do not pose a risk to the security of the investment adviser’s systems and data. This risk is heightened for many investment advisers because of the broad scope of functions for which they often use third parties.
Finally, the SEC staff has indicated that it believes that training is a key component of an effective cybersecurity program. An investment adviser’s employees should be trained on how to treat sensitive information and how to comply with security procedures to protect that information such as safe usage and storage of sensitive information.
Each employee should also be aware of the steps they should follow when dealing with third parties in order to protect both the information of the investment adviser as well as the information of the investment adviser’s clients.
During recent exams and enforcement actions, the SEC has focused both on the allocation of expenses between investment advisers and their clients, as well as the allocation of expenses among clients of the adviser. The SEC is evaluating the reasonableness of the expenses—including both the size and nature of expenditures. In addition to
SEC examiners insisting on clients being repaid in connection with expenses that the examiners feel such clients should not have borne, the SEC has also brought enforcement actions based on allocation decisions made by investment advisers.
There are inherent conflicts of interest that arise when investment advisers make expense allocation decisions. First, any expenses charged to clients will, by definition, reduce the expenses borne by the investment adviser. Second, an investment adviser arguably will have an incentive to favor client accounts in which its principals have greater ownership levels. Third, an investment adviser may be incentivized to favor a fund that it is actively marketing over other clients. Finally, a client may have a contractual agreement with the investment adviser to limit the expenses it will be charged. In those instances, the investment manager would have an incentive to allocate expenses to client accounts which do not have similar limitations.
The best way for investment advisers to manage these conflicts of interest is through disclosure to clients and the implementation of policies and procedures.
Disclosure is critically important when an investment adviser is making allocation decisions.
Examining the disclosure made to clients in a fund’s offering documents or in a managed account agreement is the first step in the allocation decisionmaking process. However, because it is difficult for an investment adviser to anticipate or foresee all possible expenses, there will inevitably be expenses that are not explicitly referenced in the disclosure. In such cases, it will be necessary to interpret the disclosure in order to make certain allocation decisions. When examining allocation decisions, the SEC will generally ask whether a reasonable investor would expect to be charged for the expense based on the disclosure which was provided by the investment adviser.
Early in 2014, the SEC issued an administrative order against Clean Energy Capital LLC (“CEC”).
The SEC accused CEC of misappropriating more than $3 million from the private funds CEC managed through expense allocations that were improper and not accurately disclosed to investors.
When making allocations, CEC divided expenses into three groups: manager expenses, fund expenses, and mixed expenses. CEC absorbed
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} Hot Topics in SEC Enforcement for 2015 10
100% of the manager expenses. The adviser then allocated 100% of fund expenses to such funds, plus allocated 70% of the mixed expenses to the funds—leaving 30% of the mixed expenses with
CEC. Included in the mixed expenses for which the funds bore 70% of the cost were: CEC employee salaries and executive bonuses, CEC health benefits and retirement benefits, CEC’s rent, education costs for CEC employees, bottled water, office lunches, car washes, car insurance, and costs related to bringing the principal’s daughter to and from school.
The SEC noted in the administrative order that the disclosure in the CEC offering documents did not match the actual allocation of expenses. For example, many of the CEC offering documents stated that CEC would compensate its own employees. In fact, employee salaries and benefits were the largest portion of the expenses improperly designated as mixed expenses. And perhaps it is not surprising that none of the CEC offering documents indicated that the funds would bear a portion of the costs of personal, family-related travel.
In addition to ensuring that all expense allocation decisions are consistent with the disclosures made to clients, investment advisers must also verify that they are making expense allocation decisions in accordance with their respective compliance policies and procedures. Every investment adviser should have a systematic approach to the allocation of expenses. This will facilitate consistent and fair determinations. The investment adviser’s Chief
Compliance Officer should perform reviews to confirm that the policies and procedures are being followed and should retain documentation of the results. The Chief Compliance Officer should also periodically review the policies and procedures to ensure that they are still appropriate for the investment adviser’s business.
The importance of an investment adviser following its policies and procedures was illustrated late last year when the SEC charged Lincolnshire
Management Inc. (“LMI”) with breaching its fiduciary duty to two funds under advisement due to improper expense allocations. According to the SEC, LMI integrated two portfolio companies, each of which was previously owned by a different fund advised by LMI. However, LMI failed to allocate the expenses relating to the integrated company in accordance with LMI’s expense policies. As part of its settlement with the SEC (in which LMI neither admitted nor denied wrongdoing), LMI disgorged
$1.5 million, paid prejudgment interest of $358,112, and paid a civil penalty of $450,000 to the SEC. The
LMI case is significant because there was no allegation of fraud and there was no allegation that the allocation decisions made by LMI benefited LMI or any of its employees. This suggests that the SEC has expanded the range of violations it will refer to its Enforcement Division for failure to follow allocation procedures even in the absence of fraud.
As noted above, an investment adviser may face conflicts of interest when allocating expenses among its clients. Although investment advisers have traditionally not disclosed their procedures for allocations among client accounts in the funds’ offering documents, that tradition is beginning to fade as a result of the heightened scrutiny from the
SEC. However, even if the methodology is not disclosed in the offering documents, an investment adviser with more than one client account should have written allocation policies in place to ensure that all clients are treated fairly and consistently. For instance, the allocation policies should be based on objective criteria. If an expense should be properly charged to more than one client, the allocation policies of most investment advisers will allocate the
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} Hot Topics in SEC Enforcement for 2015 11 cost pro rata based on assets under management.
But an investment adviser is not required to use that approach and could determine that a different methodology is more equitable so long as it is reasonable and applied consistently.
An investment adviser owes a fiduciary duty to its clients to achieve best execution when placing trades. The SEC describes best execution as a duty to execute transactions for a client so that the client’s costs or proceeds in each transaction are the most favorable under the circumstances.
When evaluating whether an investment adviser has achieved best execution under the circumstances, the investment adviser should consider not only the commission rates, but also other factors such as the quality and variety of the services offered by the broker that can impact overall quality of execution.
In 2011, the SEC brought an action against
Pegasus Investment Management LLC (“PIM”) for, among other charges, not adequately discharging its obligation of best execution. PIM entered into an agreement with a broker whereby PIM was paid a portion of the trading commissions that a private fund advised by PIM paid to the broker. In addition to alleging that the payment to PIM constituted fraud because PIM was receiving benefits that were generated by the use of fund assets, the SEC also alleged that the receipt of the rebate made it difficult or impossible for PIM to satisfy its best execution obligation. The SEC alleged that PIM could not have avoided accepting the payment it received from the broker every time the fund traded when the investment adviser was choosing which broker to execute the fund’s trades.
In order to ensure that an investment adviser is fulfilling its best execution obligations, it is necessary to adopt policies and procedures that state the factors the investment adviser will use when choosing brokers. The investment adviser should conduct reviews to evaluate whether it is obtaining best execution for its clients and whether its policies and procedures are being followed. The ultimate goal of the review is to determine whether the totality of the services received by the investment adviser and its clients were adequate in light of the commissions paid.
A complete best execution analysis involves both quantitative and qualitative analysis. On the quantitative side, an investment adviser should consider, among other factors, price and commission rates. From a qualitative perspective, investment advisers should also examine the broker’s ability to handle complex trades, ability to borrow securities for short sales, knowledge of and access to market participants, ability to commit capital and its financial stability, reputation, and overall knowledge of the market. Investment advisers should also consider the broker’s research capabilities and the brokerage services that the broker provides.
An investment adviser should choose a review process that fits its organization, although for many advisers the process begins with the traders submitting evaluations of the firm’s brokers. The investment adviser can then compare the results of the evaluations to the amount of trading activity carried out with each broker. Further inquiry would be warranted if there is a disparity between the broker evaluations and the order flow. The best execution review should also include an examination of any potential conflicts. This includes monitoring gifts that brokers send to the staff of the investment adviser, as well as monitoring any personal or familial relationships between a staff member of the investment adviser and employees of the broker.
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} Hot Topics in SEC Enforcement for 2015
In most instances, the best execution review should be done by a committee. Depending on the structure of the investment adviser, the ideal composition of the committee will vary. But in general, the committee should include representatives from the compliance staff, the trading staff, and the portfolio management staff.
Finally, as part of the best execution review, the investment adviser should also confirm that the disclosures made to clients in the investment adviser’s Form ADV, fund offering documents, and client contracts all accurately describe the trading activities of the investment adviser.
The compliance landscape that investment advisers face continues to be challenging.
Evolving technology has created newer initiatives for the SEC, such cybersecurity. Other initiatives— including expense allocation and best execution— are long-standing areas of focus that continue to garner attention. Steward & Kissel would be pleased to help investment advisers better understand where they have compliance risks and opportunities.
© Seward & Kissel LLP. All rights reserved.
This material has been prepared for general informational purposes and is not intended to be relied upon as accounting, financial, tax, legal, or other professional advice. Please refer to your advisors for specific advice.
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Silver Lane Insights: 2015 Outlook