The SEC has filed a lawsuit against a lawyer that operated an investment adviser that allegedly defrauded former NFL players and misled them about the credentials of one of the principals. The lawyer represented the players in class action concussion litigation against the NFL and then solicited them to invest in private funds that purportedly invested primarily in securities. However, the SEC asserts that the fund primarily served to advance settlement payments to other clients in the litigation. Also, the SEC charges that the respondents failed to disclose that the lawyer’s investment partner had a long regulatory and criminal history that included an industry bar and jail time. Disclosure documents described the partner as an adviser and consultant when in fact he managed the funds and shared profits with the lawyer. Item 9 of Form ADV requires disclosure of disciplinary information for any current employee, officer, partner, or “any person performing similar functions.”
The SEC views Item 9 disciplinary disclosures as critical to Form ADV because it provides potential clients with a window on an adviser’s reputation. A person with a regulatory history can’t avoid disclosure simply by becoming a “consultant” when the actual duties and financials show otherwise.
Just because you abandon your car before the police can stop you doesn’t mean that you can’t get arrested. It appears that the respondent’s efforts to avoid prosecution by withdrawing may have exacerbated their SEC problems by making them look more guilty.
This case is similar to an action against another bank-affiliated broker-dealer back in 2017. Large firms with multiple regulated affiliates must ensure compliance with each regulatory regime. Compliance with one financial services statute does not necessarily mean compliance with another. Firms should hire compliance specialists with substantive backgrounds in the applicable laws and regulations.
The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert reporting significant compliance and supervision deficiencies. Based on data collected from a 2017 sweep of over 50 advisers, OCIE found significant weaknesses in how firms hired, supervised, and disclosed information about employees with disciplinary histories. The OCIE staff also cited frequent compliance deficiencies including failures to supervise how fees are charged, what marketing materials are distributed, and whether remote workers complied with firm policies. OCIE also discovered that many advisers allocated compliance responsibilities but failed to assign those responsibilities or neglected to require documentation. The OCIE staff recommends that advisers “reflect on their practices” and implement such best practices as enhanced hiring due diligence, background checks, heightened supervision, and remote-office monitoring.
How many times must OCIE warn the industry about compliance, and how many enforcement actions will it take, before firms implement a legitimate compliance program? An investment adviser should spend at least 5% of revenue on compliance, hire a dedicated Chief Compliance Officer, adopt tailored policies and procedures, test the program every year, and prepare a written compliance report of deficiencies and remediation.
The most interesting legal point is that the SEC argues that the failure to implement compliance policies and procedures that would have uncovered wrongdoing can serve as a predicate for a failure to supervise charge. In the past, the regulators generally separated the compliance program from the supervisory obligations. Does this mean that a compli-pro can be charged with aiding and abetting his/her firm’s failure to supervise if the compliance monitoring program fails to detect wrongdoing?
On the positive side, requiring what amounts to a net capital penalty should get the attention of senior leaders at these problem firms. On the other hand, FINRA needs to be careful that such a firm doesn’t make a cold calculation to hire a bad broker if the broker’s production offsets the additional financial obligation.
broker-dealer was fined and censured for failing to act against a longtime broker
charged with participating in pump-and-dump transactions. The SEC faults the firm for ignoring red flags
including emails outlining the illegal activity, FINRA arbitrations, and
customer complaints. One supervisor
explained that he did not act more aggressively because the broker worked at
the firm for 30 years and her business partner was a partial owner of the firm.
The SEC asserts that the firm’s supervisory system “lacked any reasonable
coherent structure to provide guidance to supervisors and other staff for
investigating possible facilitation of market manipulation.” The SEC also maintains that the firm “lacked
reasonable procedures regarding the investigation and handling of red flags.”
Reasonable policies and procedures must do more than simply restate the law and the firm’s commitment to comply with the law. The compliance manual or WSPs must specifically describe HOW a firm will prevent and address regulatory misconduct.