Views on improving the integrity of global capital markets
08 August 2019

Ethics in Practice: Investment Adviser Affiliations. Case and Analysis–Week of 5 August

Check the analysis of this week’s case (5 August) to see if you made the right choice.

Case

Vincent is a 50% owner and managing partner of Paragon Capital, an investment adviser firm, and VP Capital, a broker/dealer. Paragon’s only active advisory clients are three registered investment companies (mutual funds), which have their own boards, trustees, officers, and compliance staff separate from Paragon. An investment committee at Paragon that includes Vincent and other Paragon staff recommends and approves all investments made by the mutual funds. Over time, the committee approves multiple investments and reinvestments in promissory notes issued by Aquarius Capital Management based on trade receivables. The mutual funds invest approximately 15% of their net assets in the Aquarius securities.

Vincent and Aquarius both hold ownership stakes in Willow Grove Equity Solutions, a holding company established to invest in other investment adviser firms. Aquarius grants Willow Grove a $10 million line of credit, which Willow Grove regularly accesses. Aquarius also pays VP Capital, the broker/dealer, fees for referring investors, other than Paragon clients, to invest in the securities issued by Aquarius. These referral fees amount to approximately $1 million per year. Paragon’s regulatory filings and marketing brochures describe Paragon’s and Vincent’s affiliations with VP Capital and Willow Grove. Paragon provides these documents to the mutual funds’ compliance staff each year when they conduct their annual due diligence visits to Paragon’s offices. Vincent’s actions are

  1. acceptable because the referral fees paid by Aquarius to VP Capital exclude Paragon clients.
  2. unacceptable because Vincent violates his duty of loyalty to Paragon by investing in other investment adviser firms through Willow Grove.
  3. acceptable because Paragon provides disclosure to the mutual funds’ compliance personnel about the affiliations with VP Capital and Willow Grove when they conduct due diligence.
  4. unacceptable because Vincent and Paragon’s disclosures are incomplete.
  5. none of the above.

Analysis

This case relates to the disclosure of conflicts of interest. CFA Institute Standard VI(A): Disclosure of Conflicts requires CFA Institute members to make full and fair disclosures of all matters that could reasonably be expected to impair their independence and objectivity or interfere with their duties to clients. In this case, Vincent’s financial interests are aligned with those of Aquarius through their common ownership stakes in Willow Grove. Vincent and Paragon advise their mutual fund clients to invest their money in Aquarius while Aquarius is paying fees and providing credit to firms partly owned by Vincent. In addition, Aquarius is paying referral fees to a brokerage firm partly owned by Vincent. These circumstances give Vincent a material financial interest in supporting Aquarius by having Paragon’s mutual fund clients invest in Aquarius. Vincent thus has a conflict of interest related to Paragon’s clients’ investments in Aquarius promissory notes.

Vincent and Paragon did not provide the advisory clients with sufficient information about the financial ties to Aquarius so the clients could understand those conflicts. Although Vincent and Paragon provide disclosures related to the affiliation between VP Capital and Willow Grove, the disclosures do not cover the nature, magnitude, or extent of the financial ties between Aquarius, Willow Grove, VP Capital, Paragon, and Vincent. Failure to disclose the conflicts renders the due diligence by the mutual funds’ compliance staff ineffective. Excluding the mutual funds from the referral fee arrangement does not effectively address the conflicts of interest. The fact that Vincent has ownership interest in multiple investment adviser firms through Paragon and Willow Grove may give rise to loyalty concerns, but there are no facts presented supporting any potential unethical conduct relating to conflicts among the advisory firms. Answer D is the best choice.

This case relates to a question submitted to the CFA Institute Ethics Help Desk.

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Have an idea for a case for us to feature? Send it to us at ethicscases@cfainstitute.org.


More About the Ethics in Practice Series

Just as you need to practice to become proficient at playing a musical instrument, public speaking, or playing a sport, practicing assessing and analyzing situations and making ethical decisions develops your ethical decision-making skills. The Ethics in Practice series gives you an opportunity to “exercise” your ethical decision-making skills. Each week, we post a short vignette, drawn from real-world circumstances, regulatory cases, and CFA Institute Professional Conduct investigations, along with possible responses/actions. We then encourage you to assess the case using the CFA Institute Ethical Decision-Making Framework and through the lens of the CFA Institute Code of Ethics and Standards of Professional Conduct. Then join the conversation and let us know which of the choices you believe is the right one and explain why. Later in the week, we will post an analysis of the case and you can see how your response compares.


Image Credit: ©CFA Institute

About the Author(s)
Jon Stokes

Jon Stokes is the Director of Ethics and Standards Education at CFA Institute. His responsibilities include design and creation of on-line ethics education, development and maintenance of the CFA Institute Code of Ethics and Standards of Professional Conduct, and the design and management of the CFA Institute Ethical Decision-Making and Giving Voice to Values education programs. Stokes holds a JD degree.

1 thought on “Ethics in Practice: Investment Adviser Affiliations. Case and Analysis–Week of 5 August”

  1. Devin says:

    C.

    Vincent’s actions are acceptable because Paragon provides disclosure to the mutual funds’ compliance personnel about the affiliations with VP Capital and Willow Grove when they conduct due diligence each year.

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