OCC Bulletin 2008-5| March 6, 2008
Conflicts of Interest: Risk Management Guidance – Divestiture of Certain Asset Management Businesses
Chief Executive Officers of National Banks, Department and Division Heads, All Examining Personnel, and Other Interested Parties
Purpose and Scope
This bulletin describes the potential risks associated with a national banking organization's strategic divestiture of certain asset management business lines. Specifically, this issuance focuses on the potential conflicts of interest that national banks, as fiduciaries, may encounter when an affiliated mutual fund complex and/or its associated investment adviser are sold to unaffiliated parties. The bulletin provides guidance on risk management controls that have proven to be effective in evaluating, managing, and addressing the risks posed by such a divestiture.
The OCC broadly defines asset management as the business of providing financial products and services to a third party for a fee or commission. Asset management activities are varied and include trust and fiduciary services, investment management and advice, retail securities brokerage, investment company services, custody, and other asset servicing functions that are offered to individuals and institutions.
The asset management industry is undergoing considerable consolidation. Management at both bank and nonbank entities is evaluating the long-term profitability of various asset management business lines. Recently, several banking organizations have sold either all, or portions of, their investment management businesses to unaffiliated third parties. The rationales provided by banking organizations for divesting their affiliated mutual fund complexes and associated registered investment advisers include:
- Inability to achieve the investment performance needed to grow these advised funds to an economically feasible scale.
- Increased regulatory requirements and related compliance costs, which directly impact the profitability of investment advisers and their advised funds.
- Strategic decision to focus on distributing best-in-class investment products rather than manufacturing products. This decision generally leads to the adoption of an "open architecture" investment model that uses unaffiliated providers' products and services for fiduciary and other asset management clients.
Bank divestitures of affiliated funds and advisers can raise potential conflicts of interest and self-dealing opportunities that concern the OCC. These arrangements may include certain contractual terms and conditions that provide financial incentives to a selling bank that could unduly influence the bank's fiduciary investment decision process. The OCC has identified both pre- and post-transaction risk controls that, when implemented, should mitigate risks to both the bank and its fiduciary clients in these divestiture situations. This guidance describes risk management controls banks should have in place when contemplating such a divestiture.
A transaction that raises the potential of a conflict of interest or self-dealing elevates the bank's reputation, compliance, and strategic risk exposures. As required by 12 CFR 9.12, national banks must ensure that they act in the best interests of their fiduciary clients and do not engage in self-dealing or conflicts of interest. This fiduciary duty applies not only when a bank or its affiliate structures a transaction to sell an affiliated investment management business, but also following investment of client assets with the successor fund manager1. The OCC has identified several issues with divestitures that could result in a bank placing its interests ahead of the interests of that institution's fiduciary customers.
Financial Incentives that Could Lead to a Potential Compromise of Fiduciary Duty
Transactions that include contractual terms or conditions with financial incentives to the bank selling its adviser or fund assets raise potential conflict of interest issues. Financial incentives and stipulations could influence a bank's current and future discretionary investment decisions. Examples of contractual terms and conditions that raise concerns include:
- Up-front payments and ongoing financial incentives to maintain or increase the assets under management (AUM) levels in successor funds paid both at deal closing and over specified future time periods.
- Noncompete clauses and penalties for declines in AUM that result from future mergers or acquisitions either by the bank or its affiliates that include a fund family.
- Purchaser payment of transaction costs contingent upon maintenance of specific AUM levels.
- Revenue sharing arrangements in which the purchaser pays certain fund level fees to the seller in order to induce the seller to retain assets in the funds. These include 12b-1 fees, shareholder servicing fees, marketing allowances, and administrative fees.
Inadequate Planning, Minimal Due Diligence, and Ineffective Risk Controls
Transactions with ineffective planning and implementation processes raise concerns and could include the following:
- Lack of a comprehensive plan that addresses all applicable legal considerations. For example:
- Engagement of bank counsel too late in the process to effectively address identified concerns.
- Overreliance by selling banks and related organizations on advice of counsel from the purchasing adviser and fund complex instead of obtaining independent advice.
- Inadequate or untimely information and disclosures provided to client-directed accounts that prevent account holders from voting their proxies on an informed basis.
- Failure to obtain affirmative consents from those clients who exercise sole or shared investment discretion.
- Due diligence performed by the bank or the selling affiliate that focuses on a single purchaser rather than soliciting competing offers.
- Post-transaction due diligence processes for selecting, maintaining, and eliminating investments appropriate for fiduciary accounts that appear to be unduly influenced by the financial incentives and stipulations incorporated in the terms of the transaction.
- Failure to provide timely and effective employee training about the divestment and the effect it would have on fiduciary and other customers.
Risk Management Guidance
The OCC expects those national banks that contemplate divestiture of affiliated funds and associated advisers, whether directly, or through their broader corporate organizations, to evaluate the risks associated with these transactions and to implement effective risk management controls. National banks should work with their affiliated entities to implement effective due diligence processes prior to, during, and after a fund/adviser divestiture.2
Because bank fiduciaries are required to act in the best interests of their clients, they must identify and address any potential conflicts of interest, ideally prior to any divestiture. Bank fiduciaries should become familiar with the specific terms and conditions of any divestiture and, most importantly, must adhere to their fundamental obligations to their fiduciary customers.
National banks should adopt the following risk management practices. OCC management believes that a bank fiduciary that follows these practices, while not a complete list, will have a framework for effective management of potential conflicts of interest.
Pre-transaction risk controls:
- Early in the due diligence process, obtain a legal opinion from an independent external source that focuses on the appropriateness of the proposed transaction and effective implementation of any recommended action. Recommended actions could include indemnification clauses, rebate of fees to fiduciary clients, disclosures, and other contractual provisions. The bank should not rely on legal or other guidance from the purchasing entity.
- When ERISA (Employee Retirement Income Security Act of 1974) accounts are involved, the OCC expects bank boards and management to ensure that all issues under ERISA are identified. Legal counsel with ERISA expertise should be retained to assist the bank in ensuring compliance with these laws. A variety of issues are raised under the prohibited transaction rules of ERISA when employee benefit accounts are part of these transactions. This guidance is not intended to address these issues.
- As required by applicable law, obtain affirmative consents from those fiduciary clients who have an investment in a fund to be divested, after the bank first provides timely and meaningful notice to those clients.
- Prior to executing a divestiture contract, conduct a thorough, documented, due diligence evaluation of multiple firms. A bank should not focus exclusively upon the terms offered by a single acquirer. As part of this evaluation, the bank should consider both quantitative and qualitative factors associated with the sale.
- Ensure that the due diligence process focuses on meeting the needs and objectives of the bank's fiduciary clients that are invested in the affected funds.
- Hire an independent fiduciary to vote proxies for discretionary holdings of affected mutual fund shares. This is particularly important when there are: (1) concentrations of discretionary fiduciary accounts; (2) ERISA accounts; (3) holding company-sponsored plans; or (4) IRAs, when independent customer direction is not possible.
Post-transaction risk controls:
- Implement a well-documented, disciplined asset selection and monitoring process that applies consistent criteria to all investment advisers and funds used for fiduciary accounts.
- Establish an ongoing oversight function to ensure the integrity of the due diligence process and to ensure that post-divestiture investment decisions are not compromised by financial incentives that are provided in order to retain fiduciary assets with the successor advisor or mutual funds.
Bank fiduciaries are required to act in the best interests of their clients and should work to ensure that no divestiture transaction, either in the bank or an affiliated entity, creates the potential for unauthorized conflicts of interest or self-dealing opportunities.
For further information, please contact Asset Management at (202) 649-6360.
Kerri R. Corn
Director for Credit and Market Risk
2The OCC recognizes that in some situations, these transactions will be structured by a bank affiliate and the bank may have little or no opportunity to weigh in on the due diligence process or contractual terms.