Last year marked a watershed for fines and other sanctions imposed on advisory firms and their individual principals by the Securities and Exchange Commission.
Several individuals agreed to pay fines of $50,000 or more, while their firms also paid fines of similar amounts. Furthermore, several of those firms agreed to notify each of their clients of their lapses, and one firm was shut down completely.
Most firms were required to hire outside consultants to oversee mitigation efforts. Stiff penalties, indeed.
What were the chief underlying lapses in these cases?
Insider trading? Complex financial instrument chicanery?
No, these enforcement cases often involved investment advisers' failure to develop and maintain compliance programs as required by Rule 206(4)-7 under the Investment Advisers Act of 1940.
Although in the past, many advisory firms relegated the development and maintenance of their compliance manual — and the administration of it by the chief compliance officer — to the back burner, the SEC's message is getting increasingly blunt. Buying an “off the shelf” manual, failing to tailor it to the registered investment adviser's business, not updating it as the business changes, and diminishing the CCO's role can all lead to significant financial and reputational sanctions against both firms and their principals.
The trend is clear.
Prior to last year, it was rare to see more than one enforcement case a year settled by the SEC in which a violation of Rule 206(4)-7 played a significant role. In fact, it is difficult to find more than one such case from 2006 through 2008.
Enforcement increased in 2010, with three proceedings based, at least in part, on 206(4)-7 violations.
However, last year, the SEC staff settled seven such administrative actions, with two additional actions pending. With this year still young, there is no better time to reassess your firm's compliance program.
THE CHECKLIST
Annual updates. After a firm develops its compliance manual, the rule requires federally registered advisers to review their manual annually, something to which the SEC staff pays particular attention. Financial advisers should consider whether there have been any changes in their business or personnel over the past year that would trigger modifications. Similarly, compliance manuals need to be updated whenever regulations change, which has occurred at a high rate during the past few years. As with most other matters concerning a compliance program, this annual review — and the steps taken resulting from it — should be well-documented.
Training. You can invest considerable resources in developing a quality manual, but if you don't adequately train your staff and regularly update them on their compliance responsibilities, you expose your firm to reputational and financial loss.
Off-the-shelf manuals. With the steady rate of RIAs' stepping out on their own, many opt to save valuable startup capital by buying an off-the-shelf compliance manual without investing time and money into appropriately customizing the materials to fit the RIA's particular business. This is a mistake, according to the SEC staff. In addition to the truism that you, indeed, get what you pay for, having a cookie-cutter manual subjects you to sanction by the SEC both because your manual is incomplete and because it may contain requirements that don't pertain to your business. The SEC staff is notorious for penalizing advisers for not following what is actually in their compliance manual, so when you use a vanilla manual that contains superfluous requirements, you only increase your regulatory burden. Furthermore, the manual must track all of the changes in the law.
The CCO of last resort. Especially in smaller firms, it is tempting to assign the CCO duties to someone who is more junior. After all, the firm principals often excel at attracting and maintaining clients. However, if the CCO isn't empowered or doesn't devote sufficient time to his/her CCO duties, the chances increase that your firm could experience a loss of reputation, time and resources dealing with regulatory criticism and/or sanction.
During the past several years, the SEC staff has warned that it is enhancing its scrutiny of RIAs' compliance programs — a trend boosted through the financial crisis — and the commission administrative proceedings settled last year certainly bear that out. Individuals who fulfill management functions in RIAs need to understand that not only can their firms face significant penalties for compliance-related lapses, they can also be personally fined for failing to devote sufficient time and resources to their compliance program.
Dan Peterson leads Husch Blackwell LLP's investment management practice group.
