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Adviser and CCO Son Were Unaware of Advisers Act

 

The U.S. District Court for the Northern District of Illinois ordered an investment adviser to pay over $1.8 Million in disgorgement and penalties for multiple violations of the Investment Advisers Act.  The SEC asserts the adviser ignored the Advisers Act’s custody, recordkeeping, valuation, and disclosure rules while commingling assets and engaging in insider transactions.  When confronted with the deficiencies following an SEC exam, the firm’s principal said that he was unaware of the existence of the Investment Advisers Act or the duties it imposed upon the firm and its principals.  The founder’s son who served as Chief Compliance Officer was barred from the industry earlier this year.

Ignorance of the law is no excuse, and naivete will not insulate a Chief Compliance Officer from liability.  When operating in a regulated industry, failure to retain competent regulatory advisers will result in a date with a federal judge. 

Chief Compliance Officer, Protégé of CEO, Failed to Stop Client Overbilling

 

The Chief Compliance Officer of a registered investment adviser was barred from the industry and faces criminal sentencing for wire fraud for his role in overbilling clients over $11 Million over a 10-year period.  The CCO, a 5% owner of the firm and a protégé of the firm’s CEO/principal, implemented several of the billing practices directed by the firm’s principal and 90% owner.  Overbilling practices included double billing clients, charging the wrong fee, charging a management fee instead of a performance fee, failing to prorate fees, and billing for services not performed.  The CCO admitted that he knew there was a high probability that the CEO was defrauding clients, but the CCO deliberately avoided learning the truth.

There is no “just following orders” defense for employees of registered investment advisers.  We can appreciate the conundrum when your boss and mentor engages in wrongdoing; but, failing to resign and call out the wrongdoing can lead to significant civil and criminal penalties. 

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.

Chief Compliance Officer Helps Firm Avoid Bigger Fine

 

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. 

Chief Compliance Officer Stole Employee Information to Bid at Auctions

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 Friday List: 10 Reasons Outsourcing Compliance Beats Hiring an In-House Chief Compliance Officer

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. 

Over the last several years, an increasing number of investment management firms have chosen to outsource the Chief Compliance Officer role and associated compliance function.  In our experience, these firms make this decision for rational business reasons based on an assessment that outsourcing the compliance function is better than hiring a full-time employee.  Usually, firms consider outsourcing because of an external event such as a less-than-perfect SEC exam or an institutional due diligence process that suggests unknown weaknesses.  Some firms decide to outsource after yet another internal CCO changes jobs.  Other times, firm management simply gets frustrated with the inherent limitations of the one internal compliance person.  Regardless, we list below the top 10 reasons investment firms should outsource the CCO role and compliance function rather than hire an in-house employee.

10 Reasons Outsourcing Compliance Beats Hiring an In-House CCO

  1. Experience: A team of professionals can draw on decades of aggregate compliance experience to address a firm’s regulatory challenges.
  2. Knowledge: No one person can provide the depth of knowledge of several compliance professionals working collaboratively. 
  3. Independence: A third party firm offers investors and other stakeholders an independent assessment of a firm’s compliance strengths and weaknesses.
  4. Industry best practices: A multi-person team working with multiple clients across the country has the industry vision to inform the compliance program.
  5. Accountability: A compliance firm stands behind its work and advice with a service level agreement and professional liability insurance. 
  6. 24/7/365 support: A person may take PTO, but a team of professionals is available at all times for any emergency including unplanned client due diligence and SEC exams.
  7. Personal liability: Serving as CCO involves significant personal liability, which is better left to professionals that understand and accept the regulatory and career implications. 
  8. Frees up internal resources: Internal personnel can focus on core activities such as portfolio management and fund-raising.   
  9. Management: Senior managers can avoid the confusing and time-consuming process of hiring, retaining, and managing an internal CCO, only to start the process anew in the event the CCO leaves. 
  10. Cost savings: Because of program efficiencies, outsourcing generally costs less than hiring a full-time employee. 

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. 

Deficient Compliance Will Cost RIA/BD $600,000; CCO Must Undergo Training

 A dually registered RIA/BD agreed to pay approximately $600,000 in disgorgement, penalties and interest because a deficient compliance infrastructure failed to ensure full disclosure of revenue sharing.  According to the SEC, the respondent engaged in a scheme since 1999 whereby its clearing broker would kick back a $20 markup fee on trades.  The clearing broker also paid trailer fees on NTF mutual funds.  The SEC alleges that the firm failed to properly disclose the revenue sharing and, in many cases, reps who didn’t know better told clients that the firm did not receive compensation from the clearing broker.  The SEC charges that the firm did not have adequate compliance policies and procedures and ordered the Chief Compliance Officer, the firm’s former receptionist, to complete 30 hours of compliance training.  The firm also agreed to hire an independent compliance consultant.

“We’ve always done it this way” is not a legitimate excuse for failing to comply with regulatory requirements.  The firm engaged in the undisclosed revenue sharing for nearly 20 years before the SEC uncovered the conflict of interest.  Perhaps, the firm never considered that its longstanding practice violated the securities laws.  This is why we recommend retaining a fully-dedicated and experienced chief compliance officer either as a full-time employee or through a compliance services firm. 

CCO Fined and Barred for Failing to Conduct Rule 144 Due Diligence

 

A broker-dealer Chief Compliance Officer was fined $50,000 and barred from the industry for failing to implement procedures to prevent the unlawful liquidation of microcap securities.  FINRA asserts that the firm and its principals liquidated 74 million shares of microcap securities without satisfying Rule 144, thereby distributing securities in violation of the Securities Act.   The firm’s Written Supervisory Procedures designated the CCO as the person responsible for Rule 144 compliance.  FINRA rejected the CCO’s defense that the WSPs did not reflect how the firm actually operated.  FINRA also faulted the CCO for adopting inadequate WSPs, which failed to outline procedures to conduct adequate due diligence.

The CCO should review the compliance manual or WSPs and ensure s/he understands and undertakes all designated responsibilities.  If the CCO can’t or won’t follow the procedures, then s/he must revise the procedures to satisfy regulatory requirements while reflecting the firm’s accurate allocation of authority.