Home » supervision

Tag: supervision

Adviser Ignored Compliance Consultant’s Supervision Recommendations

 

The SEC censured and fined an investment adviser for failing to supervise one of its employees who engaged in an unauthorized cherry-picking scheme.  Although the adviser had procedures requiring preclearance of personal trades, the SEC asserts that the firm failed to implement the preclearance procedures even after a third party consulting firm notified the firm of its failures to implement.  As part of the settlement, the adviser will deliver the order to each of the affected clients.

When you hire a compliance consultant, you should not ignore their recommendations.  The SEC will likely assert that you have displayed an unwillingness to implement a legitimate compliance program. 

SEC Inspections Staff Chides Advisers for Weak Supervision and Compliance

The staff of the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert reporting significant compliance and supervision deficiencies.  Based on data collected from a 2017 sweep of over 50 advisers, OCIE found significant weaknesses in how firms hired, supervised, and disclosed information about employees with disciplinary histories.  The OCIE staff also cited frequent compliance deficiencies including failures to supervise how fees are charged, what marketing materials are distributed, and whether remote workers complied with firm policies.  OCIE also discovered that many advisers allocated compliance responsibilities but failed to assign those responsibilities or neglected to require documentation.  The OCIE staff recommends that advisers “reflect on their practices” and implement such best practices as enhanced hiring due diligence, background checks, heightened supervision, and remote-office monitoring.

 

How many times must OCIE warn the industry about compliance, and how many enforcement actions will it take, before firms implement a legitimate compliance program?  An investment adviser should spend at least 5% of revenue on compliance, hire a dedicated Chief Compliance Officer, adopt tailored policies and procedures, test the program every year, and prepare a written compliance report of deficiencies and remediation. 

Portfolio Manager Blows Up His Firm With Swap Pricing Scheme

 A private fund portfolio manager was barred from the industry and ordered to pay $749,000 in disgorgement and fines for intentionally inflating swap valuations and concealing his activities.  According to the SEC, the PM, whose compensation was directly tied to fund performance, convinced management to use a discretionary valuation model for certain swaps and swaptions.  Without telling management, he then began using discretionary inputs rather than default values for pricing.  The SEC asserts that he used different discount curves to maximize valuations, fund performance, and his own compensation.  The SEC further alleges that he hid his activities by lying to the fund administrator and third party brokers.  Within 16 months after discovery of the mispricing, the firm reimbursed clients, shut down what had been a $375 Million fund, and ceased operations.

Firms should seriously re-consider tying portfolio management compensation directly to fund performance, especially where the PM is responsible for Level 3 (non-exchange traded) fair-valued securities.  For both the C-suite and compli-pros, this case shows how a failure to properly supervise one bad employee can blow up your firm.  As for the PM (and any other potential wrongdoer), the industry bar will make it difficult to find a job to get out of the six-figure hole resulting from the wrongdoing. 

BD Pays $26.4 Million for Failing to Conduct Targeted Email Reviews

 

A large broker-dealer agreed to pay $26.4 Million in client reimbursements and fines for failing to supervise traders that lied to customers about CMBS and RMBS transactions over a multi-year period.  The SEC asserts that the traders misled customers about bond prices, bids/offers, compensation, and ownership in very opaque secondary trading markets.  The SEC alleges that targeted reviews of electronic correspondence would have uncovered the illegal activity, thereby constituting a failure to supervise in violation of Section 15(b)(4)(E) of the Exchange Act.  As part of the remediation, the firm has implemented additional procedures for targeted reviews of communications relating to transactions that fall within certain risk-based parameters.

The most interesting legal point is that the SEC argues that the failure to implement compliance policies and procedures that would have uncovered wrongdoing can serve as a predicate for a failure to supervise charge.  In the past, the regulators generally separated the compliance program from the supervisory obligations.  Does this mean that a compli-pro can be charged with aiding and abetting his/her firm’s failure to supervise if the compliance monitoring program fails to detect wrongdoing?

BD Fined $2 Million for Under-Resourcing Compliance Monitoring

FINRA fined a large broker-dealer $2 Million for under-resourcing its compliance function, thereby allowing unlawful short-selling.  As the firm’s trading activity increased, the firm continued to rely on a primarily manual system to monitor compliance with Regulation SHO’s requirements.  The handful of employees tasked with monitoring trading requested more resources as their 12-hour workdays could not adequately surveil the activity of 700 registered representatives.  FINRA alleges that the firm routinely violated Regulation SHO by failing to timely close-out positions, illegally routing orders, and failing to issue required notices.  As part of the settlement, the broker-dealer also agreed to hire an independent compliance consultant.

OUR TAKE: Firms need to track business activity to ensure that compliance and operations infrastructure keep up with the business.  A good metric is whether the firm spends at least 5% of revenues on compliance infrastructure including people and technology. 

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. 

BD Fined $2.75 Million for Omitting Customer Complaints from Forms U4 and U5

 

FINRA fined a large broker-dealer $2.75 Million for failing to include customer complaints on Forms U4 and U5 and for neglecting to file Suspicious Activity Reports for cyber-related events.  FINRA examined a small sample of customer complaints and found that the firm should have reported more than 22% of its customer complaints on Forms U4 and U5.  Extrapolating the small sample that FINRA reviewed, the firm should have reported nearly 300 customer complaints over the 2013-2016 period.    The firm erroneously construed the filing requirement by declining to report customer complaints unless the customer expressly requested more than $5000 in compensation.  FINRA also faults the firm for providing inaccurate guidance to supervisory personnel and thereby failing to file more than 400 SARs to report cyber intrusions or attempts.

 FINRA requires firms to heighten supervision over bad brokers.  To ensure compliance, FINRA needs to make sure that Forms U4 and U5 include all customer complaints and other reportable activity.  Compli-pros should err on the side of reporting notwithstanding the objections of producers and their supervisors.   

Large Fund Company Pays Over $2 Million for Allowing Cross-Trades

 

A large mutual fund company agreed to pay a $1 Million fine and reimburse clients another $1.095 Million for failing to stop a portfolio manager from engaging in unlawful cross-trades.  The SEC also fined and barred the portfolio manager.  The SEC alleges that the portfolio manager interpositioned a friendly broker to execute cross-trades between clients in a scheme that benefited buying clients over selling clients.  Such cross-trades – which were not conducted at the bid-ask spread and which paid commissions – violated the Investment Company Act’s affiliated transactions rules and did not comply with the Rule 17a-7 safe harbor.  The SEC faults the firm and its compliance function for failing to further investigate responses from the portfolio management team that uniformly contended that the questioned trades were not prearranged.  The SEC also criticizes the compliance function for failing to properly monitor trading practices and for neglecting to train employees.

OUR TAKE: Compliance testing and monitoring does not stop when a questioned employee (with an incentive to engage in violative transactions) denies wrongdoing. While this may avoid personal responsibility in the corporate blame game, it will not satisfy the regulators or fulfill a compli-pro’s obligations to implement reasonable policies and procedures.

RIA Failed to Identify or Stop Cherry-Picking

The SEC fined and censured an investment adviser for insufficient supervision and compliance procedures, which allowed one of its investment advisers to cherry-pick trades for the benefit of favored accounts.  The adviser used an omnibus brokerage account to allocate profitable trades to favored accounts to the detriment of other accounts, notwithstanding the firm’s policies and procedures and Form ADV that indicated that it would allocate trades fairly and equitably.  The SEC acknowledges that the firm did conduct daily reviews of the trading but focused on suitability and concentrations, rather than trade allocation.

OUR TAKE: Failure to prevent wrongdoing creates a burden and inference that your compliance policies and procedures do not measure up.  In this case, the SEC did not offer insight into how the firm should conduct allocation testing or whether such testing would have stopped the misconduct.  Instead, the SEC argues that the cherry-picking itself proves that the firm failed to implement reasonable policies and procedures.  This is why firms need to implement testing and monitoring and not just write a nice policy.

 

Global Firm Gutted Valuation Control Function

 

The SEC fined a large broker-dealer $5.75 Million for failing to allocate sufficient resources to its valuation control function, thereby allowing rogue traders to inflate securities valuations and positions.  The firm eliminated 15 valuation control positions as part of a global efficiency initiative, which, according to the SEC, left the control function understaffed and under-trained to adequately implement the firm’s valuation supervision policies.  One manager complained internally that four staff members were tasked with verifying prices for more than 20 trading desks that held over $200 Billion in Level 2 and 3 securities.  The SEC alleges violations of the books and records and supervision rules.

OUR TAKE: Having a valuation control function is not the same as having an effective valuation control function.  Global firms must consider metrics before gutting compliance and supervisory functions that could ultimately allow bad actors to put the firm at risk.  Firm leaders should think of compliance and supervision as the defense to protect assets and the firm’s reputation.  And, defense wins championships.