The SEC settled administrative proceedings against three registered investment advisers over shortcomings in their compliance programs. These settlements resulted from an initiative by the Asset Management Unit of the SEC’s Division of Enforcement that involves working closely with SEC examiners to ensure that firms have viable compliance programs. This article describes the SEC’s findings in the settlement orders, which the respondents neither admitted nor denied.
The first settlement involved an adviser with nearly $27 million in assets under management according to its most recent form ADV filing. The firm’s only employee providing investment advice to clients was its owner, manager and Chief Compliance Officer (“CCO”).
The SEC staff examined the firm in 2007 and 2009.
CCO. The SEC cited the fact that the CCO had no prior experience in compliance and, other than discussions with the compliance consultant the firm engaged in connection with the SEC examinations, did not prepare himself to assume the position. The CCO also did not participate in any training or continuing education regarding compliance matters after becoming CCO.
Annual Reviews. In 2008, the firm failed to conduct an annual review of its compliance program as required under Rule 206(4)-7. The deficiency letter from the SEC staff’s 2009 examination assessed the 2009 annual review as inadequate, consisting of a summary of policies and procedures followed by a risk management review matrix, which listed and described what types of forensic testing the firm could perform. The SEC examination staff also found that the 2009 annual review was not customized to reflect the firm’s business risks and did not adequately describe records reviewed, analysis performed or findings resulting from the review. In 2010, the firm failed to conduct an annual review.
Code of Ethics. The firm adopted its first code of ethics pursuant to Rule 204A-1 under the Advisers Act in May 2007 in response to comments from the SEC examination staff. The firm’s response to the examination staff’s deficiency letter for the 2007 examination, written by the firm’s consultant and signed by the CCO, stated that the CCO would ensure that all personal trading and holding reports pursuant to the code of ethics were collected and reviewed. However, prior to March 2011, the firm did not collect quarterly transactions reports from any of its access persons. Over the same period, the firm also failed to collect written acknowledgements that the firm’s staff had received the firm’s code of ethics and did not pre-clear any of its access persons’ transactions in initial public offerings collect from its staff or limited offerings, as required under Rule 204A-1.
Responding to Deficiency Letters. The firm did not amend its compliance manual to incorporate comments made by the SEC examination staff during the 2007 examination until the SEC staff announced that it would be conducting the 2009 examination. The firm did not incorporate the SEC staff’s comments from the 2009 examination until nine months after it received the deficiency letter relating to that examination.
Violations and Sanctions. The SEC found that the adviser had violated Adviser Act rules relating to adviser compliance programs (Rule 206(4)-7) and written codes of ethics (Rule 204A-1). The firm agreed to withdraw its registration, transfer its clients to another adviser and pay a civil money penalty of $20,000.
The next settlement involved an adviser with approximately $65 million in assets under management, whose sole owner and CEO (the “CEO”) also served as the firm’s CCO during the relevant period. The CEO also held ownership positions in, and was associated with, two SEC-registered brokers, and had “a disciplinary history relating to his supervisory responsibilities.”
The firm was examined by the SEC staff in 2007 and 2010.
Compliance Program. The SEC staff’s deficiency letter relating to its 2007 examination noted several issues, including the fact that the firm had failed to conduct an adequate annual review of its compliance program. In its 2010 examination, the SEC staff determined that the firm had not updated its Form ADV to reflect the departure of the prior chief compliance officer in September 2008 and that between September 2008 and November 2010 (a) the firm had no CCO, (b) the firm’s advisory representatives were unsupervised and (c) the firm had conducted no annual reviews of its compliance program. During the 2010 examination, the firm was unable to provide evidence of any compliance manual or compliance policies in effect between September 2008 and November 2010, and determined that the compliance manual dated November 2010 appeared be an “off-the-shelf” compliance manual addressing both broker-dealer and investment adviser regulations that had not been specifically tailored to the firm’s business. The November 2010 compliance manual named the CEO, who had been in Brazil on a religious mission since June 2008, as CCO. The SEC found that the CEO failed to perform any supervisory or compliance activities between November 2010 and August 2011 other than requiring (in his role as CCO) that the firm’s two advisory representatives acknowledge receipt of the latest version of the firm’s compliance manual. (The firm withdrew its registration as an investment adviser in August 2011.)
Code of Ethics. The SEC found that the firm failed to enforce its code of ethics because the CCO never performed functions such as reviewing access persons’ reports, assessing whether access persons were following required internal procedures and evaluating transactions to identify any prohibited practices.
Recordkeeping. In May 2011, the SEC issued a subpoena for documents relating to the CEO’s work as CCO beginning in November 2010. Among the documents produced were advisory agreements that evidenced the CEO’s signed approval as required by the firm’s compliance procedures. The SEC subsequently discovered that the CEO had backdated his signatures on the agreements, having in fact executed them the day before their production to the SEC staff.
Violations and Sanctions. The SEC found that the firm had violated Advisers Act rules relating to adviser compliance programs (Rule 206(4)-7), written codes of ethics (Rule 204A-1) and recordkeeping with respect to client agreements (Rule 204-2(a)(10)), and that the CEO had aided and abetted those violations. Among other sanctions, the advisory firm and CEO were censured and ordered to cease and desist from further violations. In addition, the CEO agreed to a civil penalty of $50,000 and various securities industry bars. (Between September 2008 and August 2011, the CEO earned approximately $12,800 from his ownership of the firm.)
The third settlement involved a firm registered both as a broker-dealer and investment adviser. The firm has two principal lines of business – a brokerage and advisory business and an equity capital markets business. The brokerage component, representing approximately $1.2 billion in assets, accounts for approximately 70% of the firm’s revenue. The advisory component, representing approximately $108 million in non-discretionary assets under management, contributes approximately 10% of the firm’s revenue. The firm’s advisory business originated as an accommodation to clients who preferred to pay a single asset-based (wrap) fee rather than transaction by transaction commissions (that in part enabled the firm to rely on the broker-dealer exception to the definition of “investment adviser” in Section 202(a)(11)(C) of the Advisers Act to the extent it provided those clients with investment advice). The growth of its accounts paying wrap fees caused the firm to register as an adviser with the SEC in February 2008. The SEC observed, however, that despite their status as advisory accounts, the firm and its registered representatives treated the wrap fee accounts the same as the firm’s brokerage accounts.
The firm’s equity capital markets business, contributing about 10% of its revenues, includes a market making segment, which makes a market in about eighty small- to mid-cap equity securities.
The SEC staff examined the firm in August 2009 and June 2010.
Compliance Manual. During the relevant timeframe, the firm had a single compliance manual for both its brokerage and advisory businesses. The SEC described the manual as “an off-the-shelf manual purchased, customized and periodically updated” and concluded that the “firm essentially treated its brokerage and advisory accounts the same for compliance purposes.” In a December 2009 deficiency letter, the SEC staff observed that the firm’s compliance manual did not adequately address the following areas: (1) pre-trade disclosure and consent for principal trades with advisory clients; (2) monitoring and reviewing the execution of cross trades; (3) ensuring the accuracy of quarterly advisory fees; (4) ensuring best execution; and (5) monitoring bond pricing for trades executed through the bond desk.
In April 2011, in response to the SEC staff’s examinations and investigation, the firm adopted a new and separate compliance manual for its advisory business.
Annual Review. The firm first learned of the annual compliance program review requirement under Rule 206(4)-7 from the SEC examination staff and conducted its first review in November 2010, having previously reviewed its overall compliance program on an annual basis using a FINRA checklist.
Principal Transactions. Between January 2008 and March 2011, the firm knowingly engaged in approximately 1,634 principal transactions with its advisory accounts without disclosing in writing the principal nature of the transactions and obtaining client consent before the trades were completed as required by Section 206(3) of the Advisers Act. Although the firm’s trade confirmations identified the transactions as “principal,” they contained no other information about the capacity in which the firm was acting or the clients’ ability to withhold consent. Roughly two-thirds of the principal transactions were in securities in which the firm made a market. No mark-ups or mark-downs were charged on these transactions; some, but not all, of the transactions were riskless. The remainder of the principal transactions involved initial public offerings from which the firm received aggregate sales credits of $96,143. In April 2010, in response to SEC staff comments, the firm revised its trade execution procedures so that advisory trades in securities for which it made a market would no longer be made on a principal basis.
Commissions Charged to Wrap Fee Clients. The SEC staff alerted the firm to undisclosed commissions of $46,384 on 1,073 transactions that were improperly charged to client accounts paying wrap fees between January 2008 and June 2011. The SEC attributed the improper charges to instances in which advisory representatives entered commission amounts in the wrong fields in the firm’s system “so that [the firm’s] exception reports did not detect the billing errors.” The firm subsequently transferred all of its advisory accounts to a new clearing platform separate from its brokerage accounts that, among other things, provides reporting functions for the compliance department.
Code of Ethics. The firm did not develop a written code of ethics as required by Rule 204A-1 under the Advisers Act until June 2010, during the course of the second examination by SEC staff. The firm did not implement the code until March 2011 around the same time it adopted its compliance manual for its advisory business.
Violations and Sanctions. The SEC found that the firm had violated (a) provisions of the Adviser Act relating to (i) principal transactions (Section 206(3)) and (ii) transactions, practices or courses of business that operate as a fraud or deceit upon clients (Section 206(2)), and (b) Advisers Act rules relating to (X) adviser compliance programs (Rule 206(4)-7) and (Y) written codes of ethics (Rule 204A-1). Among other sanctions, the firm has undertaken to (1) retain an independent compliance consultant, (2) pay disgorgement of $142,527 and prejudgment interest of $10,645 and (3) pay a civil penalty of $50,000. The settlement reflects the SEC’s consideration of remedial acts promptly undertaken by the firm and cooperation it afforded the SEC staff.
The Asset Management Unit of the Division of Enforcement continues to pursue its initiative regarding compliance programs.