The SEC issued an order (the “Order”) settling administrative proceedings against a registered investment adviser (the “Adviser”), its chief executive officer (the “CEO”) and its chief compliance officer until February 2010 (the “CCO”) relating to SEC findings that (a) the Adviser had provided incorrect responses to inquiries from prospective clients about the Adviser’s experience with SEC examinations; (b) the Adviser had failed to comply with Rule 206(4)‑2 (the “Custody Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) with respect to its two “private hedge funds;” and (c) the Adviser had failed to comply with Advisers Act requirements regarding annual acknowledgement of the Adviser’s code of ethics by the Adviser’s employees. This article provides highlights of the SEC’s findings, which the respondents neither admitted nor denied.
Background. The CEO and the CCO co-founded the Adviser in 1997. The Adviser is a registered investment adviser managing approximately $7 billion for retail and institutional clients and two hedge funds. During the relevant period, the CEO managed all aspects of the Adviser and was solely responsible for all investment decisions. The CCO, who also served as the Adviser's general counsel and CFO, was primarily responsible for directing the Adviser’s backroom operations.
Failure to Disclose SEC Examination Findings. The SEC found that between 2005 and 2008 the Adviser gave incorrect responses to requests for proposal (“RFPs”) from clients and prospective clients inquiring about whether the Adviser had received any “findings,” “deficiencies,” or “corrective actions required” in connection with an SEC examination. Although it had received a 7-page deficiency letter addressed to the CCO following a 2005 examination, the Adviser responded to the foregoing RFP’s variously by (1) stating that there were no significant findings in its most recent SEC examination; (2) not answering the question; (3) referring the client or prospective client to the Adviser’s broker-dealer subsidiary; and/or (4) providing a copy of an SEC deficiency letter and reply for the broker‑dealer affiliate. The SEC also took issue with the Adviser’s implementation of its compliance policies under which the CCO was supposed to review responses to RFPs to correct misleading statements. The SEC noted that the Adviser made a concerted effort in 2005-2008 to attract institutional clients with the result that assets under management grew from $225 million in 2005 to over $9 billion in 2008.
Custody Rule Compliance. The SEC found that having elected to comply with the Custody Rule with respect to its two hedge funds by distributing annual audited financial statements to the fund investors within 120 days of fiscal year end, the Adviser had failed to meet the 120-day deadline from 2003 to 2008, with financial statements delivered to investors from 1½ to 14 months late. The SEC attributed the late delivery of financial statements to a variety of factors, including failure to pay the funds’ auditors in a timely manner, not having the funds’ books and records properly organized for fund auditors, problems with portfolio management software and the CEO’s and CCO’s desire to complete other audits or reviews first.
Code of Ethics Acknowledgements. The SEC found that the Adviser had failed to secure employee acknowledgements of receipt of the Adviser’s code of ethics as required by the code and failed to maintain those acknowledgements as required under Advisers Act Rule 204A-1. From 2005 through 2007, the Adviser did not secure any of the required acknowledgments and, for 2008 and 2009, only secured acknowledgments from two employees. Between 2005 and 2009, the Adviser had between 14 and 28 employees. Although advised in the 2005 deficiency letter about the lack of any employee annual acknowledgements with respect to the Adviser’s code of ethics, and despite having adequate time to secure acknowledgements, the Adviser failed to correct the deficiency by year end. The SEC further noted that despite have received a second deficiency letter from the SEC examination staff in 2008 citing the failure to secure employee acknowledgements of the Adviser’s code of ethics, the Adviser failed to secure code of ethics acknowledgements from its employees in 2008 and 2009.
Remedial Efforts and Sanctions. In determining to accept the offer of settlement, the SEC considered certain remedial actions, including cooperation afforded the SEC staff and the Adviser’s decision to (i) hire an independent consultant during the course of the SEC’s investigation to evaluate its compliance practices and procedures and (ii) implement the consultant’s recommendations. Among other sanctions, the SEC ordered the Adviser to pay a civil penalty of $200,000 and the CEO and CCO to each pay civil penalties of $100,000, and the Adviser to continue its engagement of the compliance consultant. The SEC also ordered the Adviser to incorporate a significant portion of the Order, including the SEC’s detailed findings regarding violations of the Advisers Act, into the Adviser’s Form ADV, which the Adviser was to send to each of its existing clients and to any new client that engages the Adviser or the CEO in the following year. The Order also requires the Adviser to post a copy of the Order on the Adviser’s website for a period of six months.