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.
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.
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.
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.
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.
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.
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.
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.
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.