The SEC fined an investment adviser and its two principals, including its dual-hatted Chief Compliance Officer, for failing to disclose the principals’ financial interest in a recommended investment. The two principals provided consulting services to a public company that they recommended to clients for investment. The principals received common stock in the company as compensation and also bought stock directly. The SEC alleges that neither the firm nor its principals disclosed their financial interests to clients who collectively owned 8.7% of the company. The SEC also accuses the principals with misleading an outside compliance consultant by failing to respond to requests for information about any business in which the principals had a financial interest.
This case shows the importance of hiring a full-time, independent Chief Compliance Officer who can dispassionately review firm and principal transactions and implement necessary procedures and disclosures. The dual-hat model, where a firm principal or executive officer half-heartedly owns compliance, does not work in today’s regulatory environment where the SEC and institutional clients demand an independent and experienced compliance officer
A fund sponsor agreed to pay over $32.5 Million in disgorgement and penalties because its tax planning strategy harmed the funds it managed. In 2005, the fund manager caused the underlying funds to convert to partnerships in order to benefit from certain deductions. However, the deductions required the unwinding of securities lending transactions that benefited the funds. The SEC asserts that the fund sponsor did not disclose this conflict of interest to the Board or the shareholders. The firm failed to resolve the internal dispute between the tax department and the securities lending group, until (10 years later) the securities lending group informed the Chief Compliance Officer, who prompted an internal investigation. The SEC also faults the firm for not reimbursing the funds for certain foreign taxes paid as a result of the conversion to a partnership. The SEC gave credit, which resulted in a lower fine, to the CCO and the firm for initiating the internal investigation and the self-reporting.
It’s never a good idea to keep Compliance in the dark about internal conflicts of interest. The Chief Compliance Officer is in the best position to protect the long-term interests of the firm and clients.
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.
The SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert describing failures by investment advisers to comply with regulatory requirements when engaging in principal and agency-cross transactions. OCIE found that many advisers did not even recognize that they were engaging in principal (direct transaction with client) or agency cross (receiving compensation on behalf of third party) transactions. For example, many advisers faltered by not recognizing that a significant ownership interest in a private fund made them principals. Also, advisers with broker-dealer affiliates often ran afoul of the agency-cross rules. The OCIE staff also criticized advisers for failing to observe the significant notice and transaction-by-transaction consent requirements. In response to this Risk Alert, OCIE “encourages advisers to review their written policies and procedures and the implementation of those policies and procedures.”
Very often, these Risk Alerts immediately precede a specialized sweep exam or a focus during regular exams. We would recommend that all advisers and compli-pros take a hard look at their principal and agency-cross transaction practices and policies.
The SEC fined an investment adviser and its two principals for failing to disclose compensation received for recommending a third-party investment fund and for not registering as a broker-dealer. The adviser received a 1.25% up-front payment and trailing fee from the manager of a private fund that the respondents recommended. The adviser did disclose that it would receive compensation but did not disclose the conflict of interest resulting because the fees received exceeded its customary 1.00% asset management fee, thereby creating a financial incentive to recommend the fund. Because the compensation was transaction-based, the respondent was required to register as a broker-dealer, and the principals needed to obtain their relevant securities licenses.
The interesting twist here is that the SEC doesn’t really describe why the compensation should be characterized as transaction-based, triggering broker-dealer registration, rather than permissible asset-based compensation. Instead, the SEC relies more on the source of the compensation (e.g. the product sponsor) rather than a direct fee charged to the client. Could the firm have avoided the broker-dealer registration charges if it assessed the 1.25% fee on the client rather than collect it as revenue sharing from the product sponsor? This may be an economic distinction without a difference, but the SEC will view it through a different regulatory lens.
A large REIT manager, together with its CEO and CFO, agreed to pay over $60 Million in disgorgement, interest and penalties for inflating incentive fees and taking reimbursement for significant expenses. The SEC asserted that the defendants, contrary to disclosures and agreements, used their insider positions to calculate incentive fees in a manner that unjustly enriched themselves over the investors to whom they owed a fiduciary duty. The SEC also charged the defendants with collecting millions in expense reimbursements as part of various merger transactions. The SEC accused the defendants of securities fraud and falsifying books and records.
Firms should use some third party (e.g. fund administrator, LPA committee) to calculate, or at least confirm calculations, of fees collected from clients. When management can exercise arithmetic discretion to pay itself, regulators will scrutinize the calculations.
An investment adviser and its principal agreed to pay over $1.3 Million in disgorgement, interest and penalties for misleading clients about the adviser’s relationship with a lender. Following the action, the adviser was sold to another adviser, and the principal was barred from the industry. According to the SEC, the adviser, through the principal, advised clients to invest in the lender’s promissory notes without telling them that the loan’s repayment terms depended on the amount invested. The adviser characterized its relationship with the lender as a “strategic affiliation.” The SEC also maintains that the principal misled a client into investing in the adviser for the purpose of acquiring other advisers but the client’s investment was instead used to pay the principal’s personal expenses. The scheme was uncovered following the SEC’s action against the lender for fraudulent securities sales.
Don’t engage in direct transactions with your clients. We do not believe any amount of disclosure could adequately mitigate such a significant conflict of interest and resulting breach of fiduciary duty.
The SEC fined a hedge fund $5 Million, and its Chief Investment Officer another $250,000, for failing to properly value portfolio securities. The SEC maintains that the firm over-relied on the discretion of traders to value Level 3 mortgage-backed securities rather than use required observable market inputs. The SEC contends that the firm consistently undervalued bonds to maximize profit upon sale. The SEC faults the CIO for failing to properly review valuation decisions and ensure that the traders followed the firm’s valuation procedures. The SEC asserts violations of the compliance rule (206(4)-7) because the firm failed to implement reasonable policies and procedures to ensure fair valuation of portfolio securities. As part of the settlement, the firm hired an experienced Chief Compliance Officer rather than rely on its prior Risk Committee comprised of executives with limited regulatory and valuation experience.
Valuation is about process. Firms that buy Level 3 securities must create a consistent, documented and contemporaneous process based on objective criteria in order to defend pricing decisions. For compli-pros, one way to test valuation is to sample whether liquidation prices vary consistently (either always higher or lower) than the firm’s internal valuations before liquidation.
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 SEC charged an investment adviser’s principal, who also served as the firm’s Chief Compliance Officer, with multiple compliance violations. The SEC charges the respondent with (i) overcharging his client, (ii) overstating his assets under management, (iii) failing to disclose two client lawsuits, (iv) misrepresenting the reason he switched custodians, and (v) neglecting to maintain required books and records. The SEC also alleges that the principal aided and abetted violations of the compliance rule (206(4)-7) by purchasing a template compliance manual, omitting required policies and procedures, and failing to implement required procedures. The firm ultimately ceased operations, and the respondent agreed to pay over $500,000 in fines, disgorgement and interest.
The dual hat CCO model (i.e. a senior executive also serving as the Chief Compliance Officer) doesn’t work. The dual-hat CCO usually does not have the time, expertise, or interest to do the job properly. Also, a CCO must have enough independence from the business to properly enforce the applicable regulatory and compliance obligations.