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Adviser and CCO Son Were Unaware of Advisers Act

 

The U.S. District Court for the Northern District of Illinois ordered an investment adviser to pay over $1.8 Million in disgorgement and penalties for multiple violations of the Investment Advisers Act.  The SEC asserts the adviser ignored the Advisers Act’s custody, recordkeeping, valuation, and disclosure rules while commingling assets and engaging in insider transactions.  When confronted with the deficiencies following an SEC exam, the firm’s principal said that he was unaware of the existence of the Investment Advisers Act or the duties it imposed upon the firm and its principals.  The founder’s son who served as Chief Compliance Officer was barred from the industry earlier this year.

Ignorance of the law is no excuse, and naivete will not insulate a Chief Compliance Officer from liability.  When operating in a regulated industry, failure to retain competent regulatory advisers will result in a date with a federal judge. 

Chief Compliance Officer, Protégé of CEO, Failed to Stop Client Overbilling

 

The Chief Compliance Officer of a registered investment adviser was barred from the industry and faces criminal sentencing for wire fraud for his role in overbilling clients over $11 Million over a 10-year period.  The CCO, a 5% owner of the firm and a protégé of the firm’s CEO/principal, implemented several of the billing practices directed by the firm’s principal and 90% owner.  Overbilling practices included double billing clients, charging the wrong fee, charging a management fee instead of a performance fee, failing to prorate fees, and billing for services not performed.  The CCO admitted that he knew there was a high probability that the CEO was defrauding clients, but the CCO deliberately avoided learning the truth.

There is no “just following orders” defense for employees of registered investment advisers.  We can appreciate the conundrum when your boss and mentor engages in wrongdoing; but, failing to resign and call out the wrongdoing can lead to significant civil and criminal penalties. 

Chief Compliance Officer, a Former SEC Staffer, Indicted for Stealing Confidential Investigation Information

 

The U.S. Attorney for the Eastern District of New York has indicted the former Chief Compliance Officer of a private equity firm for obstructing justice and illegally accessing confidential government information.  According to the indictment and press accounts, the defendant misused his position and access as an SEC employee to obtain information about a pending investigation of the private equity firm while negotiating his new position.  The firm itself is being investigated for sales practice violations. The defendant faces more than 20 years in prison.

This case is Exhibit A for why there should be limits on the revolving door between the regulators and firms they are charged with regulating.  An inherent conflict of interest exists when a former regulator represents a firm being examined or investigated.  The Project On Government Oversight (POGO) published a report in 2013 titled “Dangerous Liaisons: Revolving Door at SEC Creates Risk of Regulatory Capture,” outlining the scope of the problem.  At the very least, we would recommend a 12-month cooling-off period before a private firm could hire a former regulator and an outright ban if the firm is currently under investigation. 

Chief Compliance Officer Helps Firm Avoid Bigger Fine

 

The SEC fined a BDC sponsor for violating its exemptive order, but the firm received credit for self-remediation after the Chief Compliance Officer discovered the missteps and reported them to the Board.  According to the SEC, the firm engaged in several impermissible joint transactions while seeking an exemptive order to engage in the transactions.  Also, the firm engaged in transactions that specifically violated the Order because it did not disclose certain conflicts of interest.  The SEC lauds the firm’s Chief Compliance Officer who identified the conflicts issue and informed the firm’s Board of Directors.  The firm was fined $250,000, but the SEC specifically considered the remedial acts undertaken by the respondent.

Credit to the CCO for likely saving his firm from a much larger fine had the firm not taken action. 

Chief Compliance Officer Stole Employee Information to Bid at Auctions

FINRA barred a Chief Compliance Officer for using his access to confidential employee records to create false online bidding accounts at auction houses. The respondent, who also served as the firm’s president, used his access as CCO to obtain employees’ driver’s license and passport information to impersonate those employees so that he could bid and acquire auction items. The auction houses had previously banned him because he successfully bid on items and did not pay for them.

The Chief Compliance Officer has extraordinary (and in some cases, unwarranted) access to employee records in addition to other confidential information such as executive meetings and emails. Firms should pursue enhanced background due diligence on potential CCO candidates, create information barriers so that the CCO does not have access to non-regulatory information, and implement a supervisory structure that ensures CCO accountability. Alternatively, consider outsourcing to a third-party firm that has limited access to firm systems as well as direct legal liability for breaches of confidentiality.

The Friday List: 10 Reasons Outsourcing Compliance Beats Hiring an In-House Chief Compliance Officer

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic. 

Over the last several years, an increasing number of investment management firms have chosen to outsource the Chief Compliance Officer role and associated compliance function.  In our experience, these firms make this decision for rational business reasons based on an assessment that outsourcing the compliance function is better than hiring a full-time employee.  Usually, firms consider outsourcing because of an external event such as a less-than-perfect SEC exam or an institutional due diligence process that suggests unknown weaknesses.  Some firms decide to outsource after yet another internal CCO changes jobs.  Other times, firm management simply gets frustrated with the inherent limitations of the one internal compliance person.  Regardless, we list below the top 10 reasons investment firms should outsource the CCO role and compliance function rather than hire an in-house employee.

10 Reasons Outsourcing Compliance Beats Hiring an In-House CCO

  1. Experience: A team of professionals can draw on decades of aggregate compliance experience to address a firm’s regulatory challenges.
  2. Knowledge: No one person can provide the depth of knowledge of several compliance professionals working collaboratively. 
  3. Independence: A third party firm offers investors and other stakeholders an independent assessment of a firm’s compliance strengths and weaknesses.
  4. Industry best practices: A multi-person team working with multiple clients across the country has the industry vision to inform the compliance program.
  5. Accountability: A compliance firm stands behind its work and advice with a service level agreement and professional liability insurance. 
  6. 24/7/365 support: A person may take PTO, but a team of professionals is available at all times for any emergency including unplanned client due diligence and SEC exams.
  7. Personal liability: Serving as CCO involves significant personal liability, which is better left to professionals that understand and accept the regulatory and career implications. 
  8. Frees up internal resources: Internal personnel can focus on core activities such as portfolio management and fund-raising.   
  9. Management: Senior managers can avoid the confusing and time-consuming process of hiring, retaining, and managing an internal CCO, only to start the process anew in the event the CCO leaves. 
  10. Cost savings: Because of program efficiencies, outsourcing generally costs less than hiring a full-time employee. 

SEC Alleges that RIA and Principal Ignored Compliance Obligations

The SEC has commenced enforcement proceedings against an adviser and its principal for disregarding its compliance obligations for over 10 years.  The SEC alleges that the firm did not even draft or adopt compliance procedures until an SEC examination commenced in 2015, 11 years after it initially registered.  The SEC also asserts that the principal named two individuals on Form ADV as Chief Compliance Officers even though neither person had responsibility for compliance, and one of the individuals did not even know that he was named as CCO.  The SEC also charges the firm with failing to conduct annual compliance reviews, comply with the custody rule, and maintain required books and records. 

The SEC will offer no quarter to RIAs who ignore their basic compliance responsibilities.  At a bare minimum, firms must appoint a dedicated and qualified CCO, adopt tailored policies and procedures, annually test the program, and generally attempt to comply with the Advisers Act.  The initiation of proceedings, rather than a settled order, suggests that the SEC intends to pursue aggressive penalties. 

Deficient Compliance Will Cost RIA/BD $600,000; CCO Must Undergo Training

 A dually registered RIA/BD agreed to pay approximately $600,000 in disgorgement, penalties and interest because a deficient compliance infrastructure failed to ensure full disclosure of revenue sharing.  According to the SEC, the respondent engaged in a scheme since 1999 whereby its clearing broker would kick back a $20 markup fee on trades.  The clearing broker also paid trailer fees on NTF mutual funds.  The SEC alleges that the firm failed to properly disclose the revenue sharing and, in many cases, reps who didn’t know better told clients that the firm did not receive compensation from the clearing broker.  The SEC charges that the firm did not have adequate compliance policies and procedures and ordered the Chief Compliance Officer, the firm’s former receptionist, to complete 30 hours of compliance training.  The firm also agreed to hire an independent compliance consultant.

“We’ve always done it this way” is not a legitimate excuse for failing to comply with regulatory requirements.  The firm engaged in the undisclosed revenue sharing for nearly 20 years before the SEC uncovered the conflict of interest.  Perhaps, the firm never considered that its longstanding practice violated the securities laws.  This is why we recommend retaining a fully-dedicated and experienced chief compliance officer either as a full-time employee or through a compliance services firm. 

CCO Blamed for Signing Certifications that Facilitated Unlawful Securities Lending

 

The SEC censured and fined the Chief Compliance Officer of a broker-dealer for signing certifications that she knew, or should have known, were inaccurate, thereby enabling her firm to engage in unlawful securities lending transactions.  The CCO signed certifications to third party depositaries that confirmed her firm complied with certain ADR pre-release agreements that required that her firm hold ordinary shares that evidenced ADRs.  The SEC maintains, however, that the CCO knew the firm did not comply with those agreements because she participated in drafting the firm’s procedures for acquiring pre-release ADRs and knew that the firm did not comply with the pre-release agreements.  The SEC charges the CCO with causing her firm’s violations of the Exchange Act’s antifraud provisions.

OUR TAKE: Compliance officers should avoid signing certifications that facilitate securities transactions.  If the situation requires a certification, a CCO must conduct adequate due diligence to ensure the accuracy of all statements made.  Also, we would recommend that a CCO obtains back-up certifications from others in the organization.