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Dual-Hatted CCO and Under-Resourced Compliance Function Result in Fine/Censure for BD

The SEC fined and censured a broker-dealer because its under-resourced compliance function failed to implement adequate employee and information monitoring procedures.  The firm’s Chief Compliance Office, who also served as a relationship manager, was initially appointed despite a lack of compliance experience.  He pleaded for more compliance resources, including the use of a third party compliance consultant, to monitor the firm’s 45+ registered representatives, but the CEO refused because the firm “needed to generate more revenue before it could spend more money on compliance.”  As a result, the broker-dealer failed to review employee securities trading, review a sufficient number of emails, and monitor information barriers.

OUR TAKE: Registered advisers and broker-dealers should retain a fully-committed CCO – either through hiring or by retaining a third party compliance firm – that has significant compliance experience.  Dual-hatting an unqualified internal employee will not satisfy the regulators.  Also, firms must adequately resource the compliance function.  Based on previous benchmarking studies, most SEC-regulated entities spend between 7%-20% of total operating costs on compliance, with a minimum of 5% of revenues.

https://www.sec.gov/litigation/admin/2017/34-81719.pdf

Wrap Sponsor Failed to Update Compliance Policies for Lower Share Classes

The IA/BD subsidiary of a large bank agreed to pay almost $1.3 Million in disgorgement and a $1.1 Million fine for putting wrap fee clients in funds that paid a 12b-1 fee back to the selling reps.  The SEC faults the firm for failing to recommend that clients move assets into lower-fee share classes as those classes became available over time.  Although the firm disclosed that it may receive 12b-1 fees, it did not disclose that it actually received those fees and that lower classes were available.  The SEC noted that the IA/BD made changes to qualified accounts but failed to implement similar changes to non-qualified accounts.  In addition to best execution, fiduciary, and disclosure violations, the SEC criticized the firm’s compliance program because the respondent failed to update its compliance policies and procedures as institutional share classes became available.

OUR TAKE: A compliance program is not a static exercise that you can set and forget.  As the markets and the business changes, firms must continuously review policies and procedures to determine if they still make sense given new realities.   In this case, the wider availability of institutional share classes necessitated changes to the firm’s compliance practices.

https://www.sec.gov/litigation/admin/2017/34-81611.pdf

RIA’s Affiliate Private Fund Manager Wrongly Claimed Registration Exemption

The SEC censured and fined a fund manager and its principal and barred the principal from serving as a chief compliance officer for incorrectly claiming exemption from Advisers Act registration and its requirements.  The SEC contends that the principal, which managed a registered investment adviser, created an affiliate to manage two private funds and then claimed an exemption from registration because the funds had less than $150 Million.  The SEC maintains that the affiliate was required to register because it was under common control with the registered adviser and shared office space, employees and technology.  The SEC alleges that the private fund adviser hoped to avoid the custody rule’s audit requirements and compliance requirements.  The SEC cites Section 208(d) of the Advisers Act, which prohibits a person from doing indirectly any act which would be unlawful if done directly.

OUR TAKE: This case has significant implications for larger organizations.  If a firm operates a registered investment adviser affiliate, the SEC, based on this action’s reasoning, would prohibit the firm from claiming an exemption registration for an unregistered fund manager under the same roof.  The SEC is using the regulatory flexibility to integrate advisers under one Form ADV as a regulatory weapon to force registration on otherwise exempt affiliates.

 https://www.sec.gov/litigation/admin/2017/ia-4733.pdf

The Friday List: 10 Ways Compliance Contributes to Firm Value

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.

Senior executives may view spending on compliance as a necessary evil or a cost of doing business.  While compliance spending is certainly necessary and a cost, the compliance function, properly structured and implemented, can significantly contribute to a firm’s value.  We believe the added value can actually exceed the cost, and compliance spending can be viewed more broadly as an investment in the business.  So, for today’s list, we offer 10 ways that compliance contributes to firm value.

 

10 Ways Compliance Contributes to Firm Value

 

  1. Avoid Fines and Penalties:  All firms want to avoid the punitive and unplanned fines, penalties, and disgorgement associated with enforcement actions that a good compliance program can prevent.
  2. Protect Individual Reputations:  The SEC names a corporate officer in over 80% of enforcement actions.  Your name in an enforcement action could be career-ending, especially if you are barred from the industry.
  3. Attract Institutional Clients: Most institutional investors conduct Operational Due Diligence that includes an in-depth review of the compliance program.  A weak compliance program can disqualify a firm regardless of investment performance history.
  4. Increase Firm Multiple: Potential acquirers will assess a firm’s compliance program as a factor in the multiple offered.  An inadequate compliance program means more risk, and more risk means a lower multiple.
  5. Improve Operations:  Very often, the compliance procedures serve as a starting point for operational and desk procedures.  Also, the discipline of drafting and implementing procedures will serve as an example for finance, portfolio management, and product development.
  6. Reduce Executive Time:  Fewer compliance problems and the associated decline in operational problems means less time spent by executives dealing with non-productive headaches.
  7. Lower Legal Expenses:  A good compliance function will reduce the number of questions requiring outside counsel.  Firms will incur significant legal expenses when confronted with an avoidable enforcement action.
  8. Preserve Reputation:  An enforcement action undermines a firm’s reputation, the most valuable asset of any investment management firm.  Blue chip firms like to do business with other blue chip firms that have a reputation for integrity.
  9. Attract Employees: A quality compliance program will create a credible firm attractive to quality employees.  A “cowboy culture” will repel the top-notch employees needed to grow into an institutional franchise.
  10. Freedom from Fear:  You wouldn’t drive a car without good brakes.  Just like good brakes, a good compliance program allows firm management to move fast and seek new opportunities without fear of an unknown regulatory breakdown.

Brokers Can Block Disbursements to Senior Investors Under New FINRA Rule

 

Following recent SEC approval, FINRA’s new rule allowing firms to block disbursements to senior investors goes into effect on February 5, 2018.  The rules allow members to put a 25-day hold on suspicious disbursements of funds for any customers over the age of 65 and for any other customer that the member reasonably believes has a relevant mental or physical impairment.  The rule allows, but does not require, a member to hold funds if the member “reasonably believes that financial exploitation…has occurred, is occurring, has been attempted, or will be attempted.”  During the hold, the member must try to contact the designated “Trusted Contact Person” previously named by the account holder.  To enforce the rules, members must adopt and implement applicable written supervisory procedures and ensure retention of relevant records.

 

OUR TAKE: The new rules create significant compliance obligations for account opening, procedures, testing, and record retention.  They also will likely require a process to resolve potential conflicts between senior investors and the brokers that hold their assets.

 

http://www.finra.org/sites/default/files/Regulatory-Notice-17-11.pdf

Large IA/BD Fined $8 Million for Failing to Implement Suitability Procedures

The SEC fined a large IA/BD $8 Million because it failed to implement compliance policies and procedures for the sale of single-inverse ETFs.  Following warnings from FINRA and SEC OCIE staff, the respondent adopted policies and procedures requiring (i) every client to sign a Client Disclosure Notice and (ii) a supervisor to review all recommendations for suitability.  However, over a 5-year period thereafter, the SEC maintains that 44% of clients did not sign a Disclosure Notice and most did not undergo adequate supervisory reviews.  Consequently, the firm made several unsuitable recommendations including to retirement account clients.  The SEC cites violations of the Adviser’s Act’s compliance rule (206(4)-7), which requires advisers to adopt and implement policies and procedures reasonably designed to ensure compliance with the Advisers Act.

OUR TAKE: The SEC will severely punish recidivists who were notified of deficiencies during a prior exam.  In this case, the IA/BD specifically undertook to fix the identified suitability concerns but failed to implement those policies, thereby allowing the violative conduct to continue.

https://www.sec.gov/litigation/admin/2017/ia-4649.pdf

SEC Publishes List of Most Cited Exam Deficiencies

The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert listing the 5 most frequently identified compliance topics: weak compliance programs, insufficient and late filings, violations of the custody rule, Code of Ethics compliance deficiencies, and books and records.  OCIE highlights specific compliance problems including untailored “off-the-shelf” manuals, weak or absent annual reviews, and failure to follow procedures.  OCIE cited Form ADV and Form PF failures including inaccurate disclosures and late filings.  Other common deficiencies include failures (i) to follow the custody rule due to lack of knowledge about its requirements, (ii) to identify access persons, and (iii) to maintain complete and accessible books and records.

OUR TAKE: Compliance with the Advisers Act is not intuitive.  It requires a thorough knowledge of the specific requirements of the statute and all its rules.  Firms must hire a regulatory professional or a compliance services firm to assist with compliance or face significant exam deficiencies or an enforcement action.

https://www.sec.gov/ocie/Article/risk-alert-5-most-frequent-ia-compliance-topics.pdf

Large Wrap Sponsor Pays $18.3 Million for Compliance Problems in Business Sold 8 Years Ago

mousetrap

A large dually registered adviser/broker-dealer agreed to pay over $18 Million to settle charges that it overbilled clients in a wrap program that it sold off in 2009, although it maintained an interest through 2013.  The SEC charges that the respondent overbilled clients by failing to (i) input lower negotiated fees into its system, (ii) track transferred accounts, (iii) rebate prepaid fees after termination; (iv) benefit investors when rounding, and (v) track lower rates when switching platforms.  The SEC faults the firm for failing to implement adequate compliance policies and procedures (Rule 206(4)-7) that would have required sample testing to discover the over-billing.  The SEC also charges violations of the books and records rule (204-2) because the respondent could not locate over 83,000 advisory contracts.

OUR TAKE: Selling or terminating a business line does not cut off regulatory liability for prior events.  Also, this case is a good example of how overbilling could occur and how to test for irregularities.

http://www.sec.gov/litigation/admin/2017/34-79882.pdf

SEC Chief of Staff Outlines Compliance Challenges

rolling-ball-uphill

SEC Chief of Staff Andrew (Buddy) Donohue recently described the future challenges facing compliance officers.  Mr. Donohue expressed concern about shrinking top-line growth in the asset management industry that could compromise the ability of compliance officers to obtain the funding necessary to implement the compliance program.  He also questioned the emerging trend of compliance taking a more active role to ensure compliance rather than assisting in identifying regulatory issues and developing policies and procedures.  Mr. Donohue warned that compliance must be viewed as a partner, not a “scapegoat or cost center.”  Mr. Donohue also inventoried the ever-expanding knowledge required including laws of multiple jurisdictions, overlapping statutes, and new technologies.  He advised compliance officers: “It is critical that you make it a priority to develop the necessary technical expertise, keep up with changing market dynamics, fully appreciate all of the firm’s businesses and follow regulatory developments and their impact on your firm and its operations.”  Despite his comments, Mr. Donohue expressed hope that his comments won’t “scare you away from a career in compliance.”

OUR TAKE: With over 40 years’ industry and regulatory experience, Mr. Donohue is a respected voice on regulatory and compliance issues.  Every CEO and Board should read this speech and ask whether their CCOs have the attention and resources to meet these challenges.

https://www.sec.gov/news/speech/remarks-at-the-national-society-of-compliance-professionals-2016.html

Compliance Outsourcing Has Doubled in Last 3 Years

outsourcing

A recent survey of registered investment advisers sponsored by WealthManagement.com and LPL Financial reports a significant increase in the number of firms outsourcing compliance and other non-revenue generating functions.  The percentage of firms outsourcing compliance has doubled over the last 3 years.  Nearly 1 in 5 RIAs now outsource compliance, a function deemed to be “necessary, but behind-the-scene activit[y] with less direct linkage to the customer experience.”  Other often-outsourced activities include HR, taxes, and bookkeeping, as advisors become more “focused on the activities that are most critical to their businesses” while “it is getting increasingly efficient to outsource those functions less important to growth and client satisfaction.”

OUR TAKE: Outsourcing compliance has become an accepted practice especially for advisers that don’t have the resources to hire and retain internal compliance talent.  A third party firm brings on-demand knowledge, scale, depth, experience, and independence.

https://www.wealthforge.com/hubfs/WM-2016-RIA-Trend-Report.pdf?t=1476715934334