SEC Enforces Compliance Program Rule Violation Against Adviser and CCO

Steve KingLegal Insights

small sec building

By Practus Partner Steve King, Financial Services Attorney

SEC Enforces Action Against Investment Adviser and its CCO

What a Violation of the Compliance Program Rule Looks Like

On September 17, 2020, the Securities and Exchange Commission (SEC) announced settled charges against a dually-registered investment adviser and broker-dealer (Adviser), and its Chief Compliance Officer (CCO), for failing to follow the Adviser’s compliance policies and procedures relating to the review of brokerage commissions paid and portfolio turnover in client accounts.1

According to the SEC’s order, from 2017 through early 2018, the Adviser and the CCO failed to conduct reviews of the Adviser’s accounts for excessive commissions and trading, as required by the Adviser’s policies and procedures.  These reviews were particularly important because the Adviser charges its clients no asset-based management fee but only commissions on their trades, and the firm’s trading strategy involves frequent trading.

(Securities and Exchange Commission)SEC building front

FINRA Exam

In late 2016, the Financial Industry Regulatory Authority (FINRA) notified the Adviser of certain deficiencies in its compliance program relating to the supervision of its trading activity.  The Adviser undertook to implement policies and procedures requiring the CCO to conduct monthly reviews of the cost-to-equity ratio and turnover rate in client accounts and to document the reviews.  The policies and procedures required, among other things, that accounts with a cost-to-equity ratio over 6% be escalated to management. 

SEC Exam

In November 2017, the SEC staff began an examination of the Adviser, and in connection with the examination, requested that the CCO produce all reports documenting the monthly cost-to-equity and turnover rate reviews, including a written explanation of processes or procedures performed, the frequency and parameters of any such reviews, and documents supporting any recent reviews or testing.  The CCO had failed to conduct these reviews and, consequently, in instances where an account had a cost-to-equity ratio over 6%, no escalation to management had occurred.  

In response to the SEC staff’s requests, the CCO created reports for the period from January to November 2017, removed the “as of” dates from the reports (so that it was not clear that they had just been created), and produced the reports to the staff.2  These same reports were later produced in connection with the SEC Enforcement staff’s investigation of the Adviser.  In sworn testimony during the investigation, the CCO admitted that these reports had been altered.

Violations

The SEC found3 that as a result of this conduct, the Adviser had willfully violated Section 206(4) of the Investment Advisers Act of 1940 (Advisers Act), and Rule 206(4)-7 thereunder, because the Adviser had failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.  The SEC also found that the CCO willfully aided and abetted the Adviser’s violations.  Notably, the SEC did not find that the Adviser’s failure had resulted in any other violations of the Advisers Act or the rules thereunder.

Sanctions

The Adviser and the CCO were censured, ordered to cease and desist from committing or causing any violation and any future violations of Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, and required to pay civil money penalties of $1,700,000 and $45,000, respectively.  In addition, the CCO was barred from the industry.

Takeaways

This enforcement action is noteworthy in that it is rare for an enforcement proceeding to be based solely on the inadequacies of a firm’s compliance program.  Typically, there are other violations of the substantive provisions of the federal securities laws.  Some of the lessons to be learned from this proceeding are:

  • An adviser’s written compliance policies and procedures should always reflect the actual practices at the firm.
  • Advisers and their CCOs should always ensure that commitments made in response to prior examination deficiencies have been implemented (even if the examination was conducted by another regulator).
  • If the firm or its CCO fails to carry out and/or document required reviews, do not exacerbate the problem by creating records that create the appearance that contemporaneous reviews were conducted.

Conclusion 

This enforcement action shows that, although rare, the SEC will initiate an enforcement action based solely on a firm’s deficient compliance program, even in the absence of fraudulent activity.  The SEC has also stated that enforcement actions against CCOs will generally not result solely because the CCO fails to effectively carry out the compliance process, but that CCOs who affirmatively participated in the misconduct, misled regulators, or completely failed to carry out their responsibilities risk being the target of an enforcement action.4  The CCO in this matter was fortunate that the staff didn’t take additional action given the attempt to deceive the examination and enforcement staff with respect to the reports that were produced to them. 

If you would like to discuss this enforcement action and the SEC’s expectations of chief compliance officers in more detail, please contact the author of this Legal Insight or one of the Practus attorneys with whom you work.

Steve King Practus PartnerAbout the Author

Financial Services lawyer, Steve King, has over 20 years of experience providing legal advice to investment advisers, investment funds, and independent directors. He specializes in a broad range of legal and regulatory matters arising under the federal securities and commodities laws.

Steve has significant experience in matters relating to the use of derivatives by registered investment companies, cross-trading, trade allocation policies, trade error policies, and affiliated transactions, particularly those involving fixed income investments.

 

Attorney Phone Email
Steve King (949) 245-2700 Stephen.King@Practus.com

Article Footnotes


  1. In the Matter of Gilder Gagnon Howe & Co. LLC and Bonnie M. Haupt, Advisers Act Rels. No. 5582 (Sept. 17, 2020), available at https://www.sec.gov/litigation/admin/2020/ia-5582.pdf.
  2. According to the SEC’s findings, the CCO also made handwritten notations on the reports to give the impression that she had reviewed them earlier in the year.
  3. In settled administrative proceedings such as this, the parties neither admit nor deny the SEC’s findings in the settled order, except as to the SEC’s jurisdiction over them and the subject matter of the proceedings, which are admitted.
  4. See Andrew Ceresney, Director of the Division of Enforcement, Keynote Address at 2015 National Society of Compliance Professionals National Conference (Nov. 4, 2015), available at https://www.sec.gov/news/speech/keynote-address-2015-national-society-compliance-prof-cereseney.html.