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Month: April 2016

Affiliated Sub-Adviser Can Avoid Surprise Custody Exam 

The staff of the Division of Investment Management has published its position of no-action which relieve certain sub-advisers from the custody rule’s surprise examination requirement.  The staff will not require sub-advisers, who are only deemed to have custody due to an affiliation with an adviser, to obtain a surprise exam so long as the affiliated adviser obtains the required surprise exam by an outside auditor.  The staff also requires that the sub-adviser does not have custody itself and that it obtains the required internal control report.

OUR TAKE: This removes an otherwise redundant requirement that should have been addressed in the Rule.  There would be no investor protection goal accomplished by requiring two separate surprise exams of affiliated advisers.


Firm Principals Prosecuted for CCO’s Wrongdoing

The SEC barred and fined the 2 principals of a registered investment adviser for failing to properly supervise the firm’s Chief Compliance Officer, who was indicted for misappropriating client assets.  The SEC asserts that the respondents “did nothing…to ensure that [the CCO] carried out his responsibilities” and “never provided any funding, training, or resources to support” the CCO.  Specifically, the SEC alleges that the respondents failed to ensure (i) compliance with the custody rule by confirming that a surprise custody exam occurred, (ii) that the CCO implemented relevant policies and procedures, and (iii) that the firm performed annual compliance reviews.  The SEC asserts violations of the compliance rule (206(4)-7), the custody rule (206(4)-2), and the supervision rule (203(e)(6)).

OUR TAKE: Firm principals do not absolve themselves of compliance responsibility by simply hiring a Chief Compliance Officer.  They must continue to supervise the CCO to confirm proper implementation (and prevent wrongdoing) while also ensuring that the compliance function has sufficient resources and support.


Self-Reporting and Remediating Allows Firm to Avoid Fines 

A bank-affiliated broker-dealer agreed to pay restitution and interest, but avoided other financial penalties, by self-reporting mutual fund sales charge violations to FINRA.  According to the AWC, the firm began a review of mutual fund sales charges in 2015 and discovered that over 1500 accounts over a 6-year period did not receive mutual fund sales charge waivers to which they were entitled.  The respondent agreed to pay over $1.4 Million in restitution and interest.  Although FINRA charged the firm with failing to supervise and implement adequate policies and procedures, it did not impose additional penalties in light of the firm’s “extraordinary cooperation” in initiating and detecting the issues, establishing a remediation plan, and self-reporting.

OUR TAKE: What are the implications of self-reporting to regulators?  In this case, the firm avoided more significant regulatory penalties, although it was still forced to sign a publicly-available AWC that cites the firm for a series of regulatory violations.

BB&T Finra order

Failed Manual Processes Result in $1 Million Fine for Large BD

A large broker-dealer, together with its affiliate clearing firm, were fined $1,025,000 for several technical violations resulting from manual processes.  FINRA charges the respondents with failing to (i) send investment objective change letters to customers, (ii) review outside brokerage accounts, (iii) send account opening letters, and (iv) send transaction confirmations.  According to FINRA, the firm had relevant policies and procedures in place but failed to enforce those policies as a result of manual processes that allowed for human error.

OUR TAKE:  This shows how operational holes can cause compliance violations.  The firm had adequate policies but fallible humans that owned key steps in the process failed to fulfill their responsibilities.


Broker/Custodian Flagged Alleged Cherry-Picker at Least 21 Times 

The SEC has charged the principal of an RIA with allocating profitable day trades to four favored accounts by using a master account at the broker/custodian.  The SEC asserts that the broker/custodian’s trade surveillance flagged the adviser at least 21 times, and the broker/custodian warned the respondent 5 times via telephone calls.  The SEC argues that the out-performance of the favored accounts could not have happened randomly.

OUR TAKE:  Partially as a result of SEC pressure, broker/custodians and other gatekeepers have stepped up monitoring activities in an effort to avoid working with bad actors.


Adviser Barred/Fined for Securities Fraud related to Cherry-Picking 

The SEC accused, fined, and barred the principal of a state-registered investment adviser for engaging in securities fraud by conducting a “cherry-picking” scheme i.e. allocating profitable trades to proprietary accounts and unprofitable trades to client accounts.  According to the SEC, the respondent manually allocated trades rather than using the broker-custodian’s trading platform, thereby allowing him to determine intraday price movements before allocating the trades.  The SEC avers that the proprietary accounts averaged a first-day gain of 0.26% while the client accounts lost 1.02%.  The SEC argues that the trade allocations did not comply with ADV statements about fair trade allocation.  The SEC charges violations of Rule 10b-5 – fraudulent conduct in connection with the purchase/sale of securities – as well as the Advisers Act’s antifraud rules.

OUR TAKE: The SEC doesn’t often utilize Rule 10b-5 against advisers because, although it can seek more significant penalties, a securities fraud claim is more difficult to prove than breach of fiduciary duty or other violations of the Advisers Act.  It is unclear whether this suggests a new enforcement tactic for the SEC or whether the SEC needed Rule 10b-5 in this case because the adviser was state registered.


SEC Chair Acknowledges Compliance Outsourcing

At the recent SEC meeting for compliance officers, SEC Chair Mary Jo White re-iterated the Commission’s acceptance of outsourcing as a viable structure to implement effective compliance programs.  Ms. White said that compliance officers play a “critical role” whether the compliance functions are in-house or firms “rely on contractors, consultants, or other third party vendors.”  Ms. White noted that firms that use an outsourced compliance solution do not outsource the ultimate responsibility for adopting and implementing an adequate compliance program.

OUR TAKE: Ms. White’s statement is consistent with the SEC’s November Alert on outsourcing, which described how firms could successfully outsource the CCO role.  (See http://blog2.cipperman.com/2015/11/sec-offers-guide-to-outsourcing-compliance/).  It appears that the only people opposed to the outsourcing model are those small compliance consultants that do not have the resources to satisfy the SEC’s due diligence, documentation, and on-site testing requirements.


SEC Allows Adviser to Purchase Fractional Shares Directly from Client Accounts

The SEC has issued no-action relief allowing an adviser and its affiliates to purchase fractional shares directly from client accounts in connection with an associated sale or transfer of whole shares.  Without no-action relief, such a principal transaction with a client would violate Section 206(3) of the Advisers Act.  The no-action relief requires that (i) the fractional shares are purchased on the same day as the whole shares at the same price or the market price, as the case may be, (ii) no commissions are paid, (iii) the adviser includes relevant disclosure in its Form ADV, and (iv) the value of the fractional shares would be “immaterial” to the client and the adviser.

OUR TAKE: We expect that others might request the SEC to extend this no-action relief to principal transactions in whole shares, assuming the other conditions are met.


Compliance Survey: CCO Fear and Insufficient Resources Causing Talent Drain

A compliance survey sponsored by law firm DLA Piper reports that concerns about personal liability and resources are driving talent out of the profession.   According to the survey, 65% of respondents said that “increased scrutiny would have an impact on their decisions to remain CCOs or to accept new CCO positions.”  Compounding the problem, only 1/3 of respondents claimed to have sufficient resources to do their jobs.  DLA Piper asserts that the tension between heightened personal liability and stunted resources “could drain the industry’s talent pool, for instance, acting as a deterrent for early-to-mid career professionals.”

OUR TAKE: Firms should spend at least 5% of revenues on compliance resources including salaries and technology.  The talent drain also suggests that firms consider other alternatives to compliance staffing such as outsourcing and co-sourcing.


Firm Principal/CCO Barred for Violating Custody Rule

A fund manager’s principal, who also served as the Chief Compliance Officer, was barred from the industry and fined for failing to understand, and comply with, the Advisers Act’s custody rule (206(4)-2).  The SEC asserts that the firm, under the control of the respondent, violated the custody rule by keeping certificates in lockboxes and bank and brokerage accounts under the respondent’s control, failing to properly engage a surprise third party audit, and failing to understand which securities fell within the custody rule.  The SEC faults the respondent for not having knowledge of the rule “that would be expected of a compliance professional.”  Before re-applying to the SEC, the respondent will have to certify that he completed at least 30 hours of compliance training.

OUR TAKE: Ignorance of the law is no excuse.  Registered investment advisers must retain a qualified and knowledgeable compli-pro (internally or externally) to execute a reasonable compliance program.  The SEC will not give a pass for technical violations even though most firm leaders will not know or understand the esoteric minutiae of the custody rule.  A firm leader that blithely assumes compliance responsibility puts the firm franchise at risk.