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Dual-Hat CCO and Partner Failed to Disclose Financial Interests to Clients

 

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

Private Fund Manager Completely Shirked His Compliance Obligations

 

The SEC fined a now-defunct fund manager for ignoring its compliance obligations.  The SEC charges that the firm never delivered audited fund financials within 120 days as required by the custody rule (206(4)-2).  Although the firm did hire an auditor, the firm never received an opinion that the financials were prepared in accordance with GAAP.  Instead, the audit firm issued reports stating that it was unable to express such an opinion.  In addition, the SEC charges the firm with violating the compliance rule (206(4)-7) because the principal, who also served as the Chief Compliance Officer, failed to adopt and implement policies and procedures and disregarded his obligation to conduct annual compliance reviews.

When you register as an investment adviser, you subject yourself to the full panoply of substantive regulation imposed by the Investment Advisers Act.  To comply and continue as a going concern, you need to hire a competent Chief Compliance Officer to help you meet the regulatory requirements.  Otherwise, you may end up either in your next career or in jail.

Dual-Hat Principal/CCO Caused Multiple Compliance Violations

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.

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.