For a registered investment adviser to ignore an SEC examiner’s deficiency findings has long been an invitation to action by the Division of Enforcement. In more recent times, that truth has been given a title — the SEC’s “Compliance Program Initiative” — and wider publicity.1
Some years ago, when the SEC’s enforcement priorities were more tightly tied to the anti-fraud provisions, it was news when a deficiency in policies and procedures that was not linked to a more serious violation or investor loss resulted in an enforcement proceeding. That time has passed and independent of the merits of a “broken windows” enforcement policy2, proceedings based on compliance failures are no longer novel.3
Presumably not by accident, the SEC announced the most recent proceedings in the Compliance Program Initiative on the day after Chair Mary Jo White spoke to the annual meeting of the National Society of Compliance Professionals (the “NSCP”).4 There, she pointed to the Compliance Program Initiative as a “good example of our cross-agency collaboration” and foreshadowed the announcement of the following day. She added, “[t]hrough this joint effort, the Enforcement Division’s Asset Management Unit, the examination staff and others are teaming up to identify and recommend enforcement actions against registered advisers who have failed to adopt or implement an adequate compliance program after being notified repeatedly of deficiencies by our staff.”
In the main, the proceedings announced on October 23rd are unremarkable illustrations of repeated compliance failures and the perils of recidivism.5
In each instance, the adviser, among other things, failed to conduct any compliance review in at least two years, notwithstanding the mandate of Advisers Act Rule 206(4)-7 that requires such a review and deficiency letters identifying the shortcoming.
In one of the proceedings, Modern Portfolio Management, the adviser’s management failed to determine whether the designated chief compliance officer was familiar with SEC guidance governing performance advertising, but nonetheless made the chief compliance officer responsible for the review and approval of such advertising. In the other proceeding, Equitas Capital Advisors, the chief compliance officer was found to have “aided, abetted and caused the compliance-related violations.”
Two other recently settled SEC proceedings, although not brought under the banner of the Compliance Program Initiative, also involved allegations that the adviser failed to conduct annual reviews of its compliance program.6 In one of those proceedings, the SEC alleged that the adviser’s chief compliance officer did not have the requisite knowledge or experience and failed to undergo any compliance training to become knowledgeable.7 Both of the proceedings also involved the familiar remedy of an undertaking to retain a compliance consultant.
The proceeding against the chief compliance officer in Equitas Capital Advisors is an interesting juxtaposition to the staff’s recent reassurance that compliance and legal personnel should not be frightened off by the risk of liability in a SEC proceeding. As the staff stated in recently posted guidance, such a compliance officer (or lawyer) can provide advice and counsel to business line personnel without being considered a supervisor for purposes of “failure to supervise” liability.8 To be sure, that guidance was given in the context of broker-dealer personnel, but the statutory provisions are parallel and the director of the Office of Compliance Inspections and Examinations understandably suggested at the NSCP Conference that the concepts are applicable in the adviser context as well.9
However, the chief compliance officer in Equitas Capital Advisors allegedly had responsibilities that went beyond advising management to include the implementation of recommended enhancements to the compliance practices. It may not be comforting for a chief compliance officer to know that even absent any intentional misconduct or personal gain, a failure to follow through can lead to public proceedings and a civil penalty. Nevertheless, this is a matter of enforcement policy, and not a novel application of the failure to supervise doctrine.
The proceedings brought as part of the Compliance Program Initiative, Equitas Capital Advisors and Modern Portfolio Management, also involved the familiar remedy of an undertaking to retain a compliance consultant. The role of the compliance consultant in Modern Portfolio Management, however, differed from the more typical undertaking to have the compliance consultant review and make recommendations with respect to certain compliance matters. The firm was required to adopt and implement recommendations made by its current compliance consultant. In addition, the firm undertook to retain its current compliance consultant or an independent compliance consultant to “render compliance services for a period of at least three (3) years...” with the services being identified by reference to a contract that the firm had with its current compliance consultant. Allowing the continued use of an existing consultant may encourage firms that recognize the need to strengthen compliance policies and procedures to retain a compliance consultant in advance of an enforcement proceeding because of the lessened risk that the firm might have to “start over” and bear the expense of a second consultant.
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1 See http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540008287; See also http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370540098359.
2 http://www.sec.gov/News/Speech/Detail/Speech/1370539872100#.UnK0tdIjLTo. “Broken Windows” refers to the theory that when a window is broken and later fixed, the message is that disorder will not be tolerated. Conversely, when a broken window is not fixed, it sends the message that the breaking of windows will bear no consequences. See also http://www.theatlantic.com/magazine/archive/1982/03/broken-windows/304465/.
3 See In re Modern Portfolio Management, Inc., Investment Advisers Act Release No. 3702; In re Equitas Capital Advisors, LLC, Investment Advisers Act Release No. 3704, Securities Exchange Act Release No. 70743; In re Gisclair, Investment Advisers Act Release No. 3703, Securities Exchange Act Release No. 70742.
6 See Further Lane Asset Management, LLC, Investment Advisers Act Release No. 3707, Investment Company Act Release No. 30767, Securities Exchange Act Release No. 70759 (directing the adviser to designate a chief compliance officer other than the chief executive officer; Knelman Asset Management Group, LLC, Investment Advisers Act Release No. 3707, Investment Company Act Release No. 30766 (alleging that the chief compliance officer had “no relevant experience” and had not received compliance training and ordering designation of a new chief compliance officer and retention of a compliance consultant).
7 See Knelman Asset Management.
9 See Compliance Reporter, Vol. XX, No. 22, Nov. 4, 2013.
This article was originally published by Bingham McCutchen LLP.