Prudential Subsidiaries Rack Tax Benefits, Get Whacked

Once upon a time, Prudential Financial Inc. had two subsidiaries, AST Investment Services Inc. and PGIM Investments LLC, that served as investment advisers to 94 insurance-dedicated mutual funds. Shares in these funds were offered as investment options to purchasers of some variable annuity and variable life insurance contracts. These mutual funds were registered investment companies until 2006, when they were reorganized into partnerships so Prudential could take advantage of some tax benefits. All of that was very legal and very cool.

According to the SEC, though, some issues soon arose. First, from 2005 to 2015, AST and PGIM “directed the Funds’ securities lending agent to recall securities on loan from the Funds in advance of the securities’ dividend record dates.” This sounds very esoteric and boring, but the idea was to increase the tax benefit to Prudential and Prudential’s insurance affiliates. Also, the funds actually liked having those securities on hand because they could loan them out and make money doing that. In fact, if they had had those securities on hand, they would have made about $72 million in the ten years this went on. Meanwhile, Prudential did receive more than $229 million in tax benefits from this recall practice. Again, maybe all of this would have been fine, but allegedly AST and PGIM “failed to disclose the conflict of interest between Prudential and the Funds resulting from the recall practice to the Funds’ boards of trustees, or to the variable annuity and variable life insurance contract holders who were the beneficial owners of the Funds’ shares . . . .” You can disclose your way around lots of things in the investment adviser space, but here the SEC says AST and PGIM didn’t do that.

Second, from 2006 to 2018, AST and PGIM “failed to reimburse the Funds as promised for higher taxes in certain foreign jurisdictions.” Specifically, with the change in status from registered investment companies to partnerships, it was clear that the funds would receive worse tax treatment in some foreign jurisdictions. So the advisers told the boards – in a memo and in two meetings – that Prudential would reimburse the funds for these additional taxes and other adverse effects resulting from the reorganizations. Basically, because the reorganizations were being proposed for Prudential’s benefit, Prudential would make the Funds whole. 

SEC Narrator: They didn’t make the Funds whole. Instead, they allegedly held onto more than $58 million in foreign tax payments that they’d promised to pay out. At the same time, the Funds missed out on about $25 million in additional investment income they would have earned on that money. Also, it’s not like the Funds just forgot about this money. Oh, no. They kept detailed records on it and just called the ever-increasing number receivables. Eventually, in June 2018, Prudential did reimburse the Funds all of that money – over $83 million.

The Funds were ordered to pay disgorgement of $27 million and a civil penalty of $5 million, based on its alleged violations of Sections 206(2) and 206(4) of the Advisers Act, as well as Rules 206(4)-7 and 206(4)-8. The administrative order’s penalty analysis is interesting. Prudential gets some credit for “self-reporting” these violations. But the self-reports came in two waves. At some point, “[a]fter the conflict of interest related to their securities lending practices was identified to Respondents’ CCO, Prudential and Respondents conducted an internal investigation and self-reported the facts to Commission staff.” Once the SEC started investigating the securities lending business, and as Prudential did its own investigation, Prudential learned about the tax issues and self-reported those. I guess that’s sort of self-reporting, once the SEC’s Enforcement Division is in your shop and trying to be sure everything is covered. Also, as the order says:

1. “[T]he misconduct related to the recall practice continued and harmed the Funds despite the issue being raised on several occasions . . . .” Who raised the issue? On how many occasions? Who did they tell? And . . .

2. “In 2014, [the] securities lending practices for the Funds were the subject of an examination by the Commission. During the examination, Respondents’ personnel, including some who were aware of the recall practice, did not disclose or fully describe the recall practice in their responses to questions from the Commission examination staff regarding Respondents’ securities lending practices.”

I mean, one would have to know what the questions were to get self-righteous on this issue. But . . . what were the questions? Which personnel were aware of the recall practice, heard those questions, and decided not to say anything? Did they at least elevate any questions internally? It’s a little mysterious, but AST and PGIM did have to pay a $5 million penalty. This was probably some strong work by Prudential’s counsel.