Advisers Fined $5 Million for Disclosure and Compliance Violations Related to Securities Lending and Unreimbursed Tax Expenses for Mutual Fund Clients

September 23, 2019

On September 16, 2019, the SEC issued a settled order (the “Order”) describing violations of the Investment Advisers Act of 1940 (“Advisers Act”) and rules thereunder by two registered advisers for undisclosed conflicts of interest and misleading disclosures relating to certain securities lending practices, and misleading disclosures and deficient policies and procedures relating to unreimbursed tax expenses with respect to mutual funds managed by the advisers (the “Funds”).1 The Funds were underlying investment options for variable annuity and variable life insurance contracts sold by insurance company affiliates of the advisers and other participating insurance companies, with Fund shares held by the insurance companies in separate accounts for the benefit of the contract holders.

For federal tax law purposes, the participating insurance companies owned the Funds’ shares and paid any corresponding taxes on Fund income. In 2005, the Funds were converted from regulated investment companies into partnerships for the specific purpose of increasing the tax benefits for the advisers’ parent and affiliates. Information presented to the Funds’ boards regarding the conversion stated that the Funds would not bear any costs associated with the conversion, and would be reimbursed by the advisers’ parent company for higher tax rates to which they may be subject in certain foreign jurisdictions by virtue of being partnerships.

The Funds engaged in portfolio securities lending to achieve additional revenue. As described in the Order, the Funds’ portfolio securities on loan were recalled in advance of dividend record dates so that the advisers’ parent and insurance company affiliates could receive dividends-received deduction (“DRD”) tax benefits. This created a conflict of interest in that the advisers had an incentive to recall the Funds’ securities on loan in advance of a dividend to increase tax benefits to their parent and affiliates while causing the Funds to lose securities lending revenue during that time period. According to the Order, this conflict was not adequately disclosed (i) to the Funds’ boards, (ii) to the SEC during an exam, or (iii) in the Funds’ offering documents, despite having been raised by an employee of the Funds’ affiliated securities lending agent with knowledge of the conflict. Specifically, materials submitted to the Funds’ boards in the context of advisory and subadvisory contract renewals required by Section 15(c) of the Investment Company Act of 1940 and renewals of the affiliated securities lending agency agreement either did not disclose the recall practice, or the conflict. The advisers’ responses to questions about the Funds’ securities lending program during an SEC exam focused on securities lending practices did not adequately describe the practice to the SEC examiners. The Funds’ disclosures in their registration statements and shareholder reports described the securities lending program, but were materially misleading because they did not disclose the recall practice or the advisers’ conflict of interest in initiating the recalls.

In addition, the advisers delayed causing the Funds to be reimbursed for increased foreign tax rates to which they were subject as a result of the conversion, and the delays in payments were estimated to cost the Funds $25 million in foregone income. Although the advisers had adopted policies and procedures to cover the reimbursements, the policies were not reasonably designed and implemented.

Key Takeaways

Although the SEC acknowledged in its Order that the advisers and their affiliates had cooperated in self-reporting and promptly remediating the identified violations, the SEC assessed a $5 million civil penalty, noting that the advisers had failed to describe the recall practice fully during the SEC exam (when such exam was specifically focused on securities lending practices). The nature of this action has potential implications for larger advisory complexes, where business lines may be siloed, and their need to maintain conflict identification and resolution processes that can assess conflicts and present those to advisory clients for appropriate consideration.

The Order is also significant in that:

  • it shows that conflicted arrangements undertaken to benefit a fund affiliate without an obvious benefit to the fund, even if otherwise permissible, will be closely scrutinized on an ongoing basis and have consequences if the arrangement results in harm to the fund;
  • the tax benefits that accrued to the insurance company affiliates greatly exceeded the lost revenue to the Funds from the recall practice, potentially complicating the SEC’s disgorgement and penalty determinations; and
  • it notes the advisers and their affiliates cooperation in “proactively identifying key documents, witnesses and facts.” The Order does not mention whether or not the advisers waived privilege. However, to the extent that an adviser can cooperate with the SEC while also preserving privilege (an issue called into question, to an extent, recently by an opinion in SEC v. Herrera, No. 17-cv-20301 (S.D. Fla. Dec. 5, 2017)), the Order shows that such cooperation can be a mitigating factor.

If you have any questions regarding the matters covered in this e-mail, please contact Paul M. Miller (202-737-8833,, Christopher D. Carlson (202-661-7165, or Lancelot A. King (202-661-7196,


1 In the Matter of AST Investment Services, Inc. and PGIM Investments LLC, SEC Rel. No. IA 5346 (Sept. 16, 2019), available at The settlement order is similar to that involving Voya Investments, LLC in 2018 for its securities lending practices. See In the Matter of Voya Investments, LLC and Directed Services LLC, SEC Rel. No. IA 4868 (March 8, 2018), available at


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