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Dual-Hat CCO and Weak Supervision Allowed Rogue Trader to Harm Clients

FINRA faulted a firm’s supervisory structure and unqualified Chief Compliance Officer for failing to prevent its CEO/Head Trader from engaging in a scheme that inflated bond prices to the detriment of clients.  FINRA alleges that the Trader engaged in pre-arranged trades with a third-party broker dealer to inflate and deflate bond prices to enrich both parties and circumvent an agreement with a client that capped bond commissions at 15 basis points.  FINRA asserts that the firm failed to supervise the trading and that the CCO did not have the “requisite qualifications, experience and training” to properly supervise the trading activities.  In addition to paying restitution and a fine, the firm hired a dedicated CCO that was not also working for an affiliated bank.

Broker-Dealers and advisers must abandon the dual-hat compliance model, the practice of naming a non-regulatory professional with multiple executive roles.  Firms must retain a competent and dedicated Chief Compliance Officer either by hiring a full-time employee or by retaining the services of an industry-recognized outsourcing firm. 

Insufficient Compliance Resources Cost Firm and CEO

The SEC fined an investment adviser $400,000 and fined and censured its CEO for failing to devote sufficient resources to compliance, thereby contributing to the firm’s failure to uncover an offering fraud.  The firm appointed a portfolio manager, who did not have regulatory experience, to assume the Chief Compliance Officer role in addition to his other duties.  The PM/CCO highlighted several compliance deficiencies and pleaded for more resources, but the CEO did not address his concerns, and, in fact, cut the compliance budget.  The SEC maintains that the under-resourced compliance program contributed to the firm’s failure to conduct promised due diligence, which may have uncovered the offering fraud that harmed clients.

 

 Based on our experience and several industry studies, registered investment advisers should spend at least 5% of revenue on compliance infrastructure.  Also, firms should appoint a fully engaged and experienced regulatory professional to serve as Chief Compliance Officer and avoid the cheaper dual-hat model that puts both the firm and the CCO at risk.  Compli-pros should take solace that the SEC did not name the CCO, presumably because he highlighted the compliance deficiencies and advised the firm on how to remediate.

Adviser Marketed Misleading Hypothetical Backtested Performance

 

The SEC censured and fined an investment adviser and its principal for misleading advertisements that utilized hypothetical backtested performance.  According to the SEC, the adviser continually updated its models but failed to fully disclose that the models’ out-performance resulted from these post hoc revisions.  The SEC alleges that the respondents revised the models to specifically account for unforeseen events such as market movements.  The SEC charges the firm and the principal, who also acted as the Chief Compliance Officer, with engaging in manipulative practices and for failing to implement a reasonable compliance program.  As part of the settlement, the firm agreed to retain a dedicated Chief Compliance Officer and an outside compliance consultant.

OUR TAKE:  As we have advised many times in the past: (i) do not advertise hypothetical backtested performance and (ii) retain a dedicated Chief Compliance Officer that has regulatory credentials.  Also, rather than continue to bring these cases whereby a dual-hatted principal continues to fail as Chief Compliance Officer, the SEC should solve this pandemic by requiring all advisers to undergo periodic third party compliance reviews.

 

The Friday List: The Risks of the Dual-Hat Model for CCO and/or FINOP

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.

We hate the practice of dual-hatting i.e. appointing a senior executive with non-regulatory responsibilities as a Financial and Operations Principal or Chief Compliance Officer.  The SEC, through several enforcement actions, also appears to dislike the practice, which it alleges to have caused a wide variety of regulatory breakdowns.  The dual-hat model also exposes senior executives to direct personal liability.  In today’s list, we offer 10 significant risks of the dual-hat model identified in a series of SEC enforcement actions.  For reference, we have included links to our blog posts where you can read more.

 

10 Risks of the Dual-Hat CCO or FINOP Model

  1. Failure to supervise executive conduct.
  2. Taking undisclosed fees and/or overbilling.
  3. Under-resourcing the compliance function.
  4. Ignoring cited exam deficiencies.
  5. Engaging in conflicts of interest.
  6. Inadequate disclosure.
  7. Not conducting required annual compliance reviews.
  8. Using a stock “off-the-shelf” compliance manual.
  9. Failure to implement compliance policies and procedures.
  10. Not properly calculating net capital.

SEC Fines Dual-Hat CEO/FINOP for Incorrect Net Capital Calculations

The SEC censured and fined a broker-dealer and its dual-hatted CEO/FINOP for failing to properly calculate and report its required net capital.  The firm executed transactions with foreign banks which would have required a $250,000 minimum net capital rather than the reported $5000 minimum net capital.  The firm also failed to properly accrue for legal liabilities.  The CEO, a certified public accountant, also served as the firm’s financial and operations principal.  As part of the settlement, the firm agreed to hire a FINOP acceptable to the Commission.

OUR TAKE: Firms should not “dual-hat” C-suite executives to serve in regulatory roles such as FINOP or Chief Compliance Officer.  The dual-hat model exposes senior executives to significant regulatory risk and shortchanges the required functions.  If you can’t afford a full-time person, engage a third party firm that offers these services.

https://www.sec.gov/litigation/admin/2018/34-82951.pdf

Dual-Hat Principal/CCO Ignored SEC’s Compliance Deficiencies

The SEC has commenced enforcement proceedings against a fund manager and its principal/CCO for ignoring exam deficiencies about its compliance program and other violations.  The SEC examined the respondents in 2010 and 2014 and noted several compliance deficiencies, which the SEC asserts the respondents ignored.  The SEC charges the dual-hatted principal with failing to perform any work on the compliance program, adopting a stock manual that was not properly tailored to the business, or conducting any compliance review.  The SEC also faults the respondents for charging compliance costs to the funds.  The SEC additionally charges undisclosed conflicts of interest, misrepresentations, and valuation issues.

OUR TAKE: The SEC doesn’t always give you a second chance to fix cited deficiencies.  But when they do and you don’t, expect an enforcement action.  Also, this is another example of the failure of the dual-hatted CCO model, where an executive ignored his compliance responsibilities.  Penny wise and pound foolish.

 

IA/BD Failed to Supervise Its CEO/CCO

The SEC fined and censured an IA/BD for failing to supervise its CEO/CCO who was ultimately criminally convicted of stealing from clients.  The CEO/CCO used the firm’s consolidated reporting system, which allowed manual inputs of outside investments, as a way to mislead clients about false investments that he siphoned off into his own account.  The SEC faults the firm for failing to implement reasonable policies and procedures to review the consolidated reports, which, according to the SEC, would have quickly uncovered the obvious scheme.  The SEC charges violations of the antifraud rules and the compliance rule (206(4)-7), which requires firms to adopt and implement reasonable compliance policies procedures to prevent violations of the securities laws.

OUR TAKE: It’s never good when the CEO (or any other revenue-producing individual) also serves as the CCO.  Such a structure virtually ensures a lack of proper supervision.  Firms must ensure that the CCO, whether inside or outsourced, has significant independence from management and the revenue-producing function.  The SEC has brought several enforcement actions against dual-hatted CCOs, who also serve in a management capacity.

 

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.

 

SEC Bars Dual-Hatted Executive for Inadequate Form ADV Disclosures

CCO Wearing too Many Hats 

The SEC barred the principal/chief compliance officer of an investment adviser for inadequate ADV disclosure about revenue sharing and the firm’s financial condition.  The SEC also revoked the firm’s registration.  The SEC alleges that the firm’s ADV failed to disclose that the principal received revenue sharing out of 12b-1 fees paid on client assets even though lower-expense share classes of the same funds were available.  The SEC also faults the principal and the firm for failing to disclose its deteriorating financial condition including its difficulties meeting payroll and rent obligations.  The SEC explained, “As the sole owner and chief compliance officer, it was [the respondent’s] responsibility to review and ensure the accuracy” of Form ADV.  The executive “should have known that the Forms ADV contained materially misleading statements and omitted material facts” but he “failed to exercise reasonable care in reviewing and signing” the ADV.

OUR TAKE: Advisers should have a dedicated chief compliance officer that knows the rules and can act as a check against conflicts of interest.  The SEC has brought several enforcement cases against dual-hatted executives that short-change compliance.