A Resolution for Advisers and CCOs: The (New Year’s) Annual Review

It’s a New Year!  And for advisers it’s again time for a new year’s resolution, only this kind of resolution is not voluntary.  Like holidays, it comes once a year, and while the responsibility for it falls on the adviser, the obligation to “administer” (or the commitment to follow our new year’s theme) falls on the Chief Compliance Officer – it’s called the Annual Compliance Review.  Further, consider it the type of resolution made mandatory by Rule 206-4(7) of the Investment Advisers Act of 1940 known as the “Compliance Rule.”

This new year’s “resolution” requires advisers and their CCOs not simply to resolve that they will do better with compliance than last year, but requires them actually to adopt and implement written policies and procedures reasonably designed to prevent a violation of the federal securities laws, and to evaluate their adequacy and effectiveness.

With this in mind, as CCO what have you resolved to do this year?  As the SEC’s Final Rule  clearly mandated, will your annual review of 2011, at a minimum,  address the adequacy of your policies and procedures in the following areas:

  • Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, disclosures by the adviser, and applicable regulatory restrictions;
  • Trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (“soft dollar arrangements”), and allocates aggregated trades among clients;
  • Proprietary trading of the adviser and personal trading activities of supervised persons;
  • The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
  • Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
  • The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • Marketing advisory services, including the use of solicitors;
  • Processes to value client holdings and assess fees based on those valuations;
  • Safeguards for the privacy protection of client records and information; and
  • Business continuity plans.

After considering those questions, among others, will advisers resolve in the new year to test 2011 to determine whether they have (i) met regulatory deadlines? (ii) conducted a risk assessment to determine any unique compliance risk exposure to its business?(iii) determined whether compliance procedures needed to be changed to better reflect the adviser’s business practices? (Obsolete procedures or programs that the firm cannot follow should be repealed) (iv) conducted adequate transactional, forensic or periodic tests of its procedures and programs in the areas mentioned in the Final Rule? (In both speeches and its own seminars, the SEC has made clear the importance of proper testing); and (v) adequately documented the annual review?  The SEC examination staff will ask advisers for documentation of their annual compliance review.  Further, Investment Advisers Act Rule 204-2(17)(ii) and Investment Company Act Rule 38a-1(d)(3) to preserve records documenting the annual review.

When looking back on your annual compliance review for 2011, what resolutions/changes or enhancements will you be making?

 

 

 

The SEC Citigroup Settlement Saga May Mean Longer Investigations

As a follow up to our post of December 15, where we asked whether settling enforcement actions might become harder after Judge Jed Rakoff rejected the recent settlement between the SEC and Citigroup, one thing is clear, it will certainly be harder for the SEC to settle cases before federal judges like Rakoff who may be troubled by settlements in which a defendant is allowed to neither admit nor deny liability when accused of securities fraud.

The Washingon Post story on Judge Rakoff’s order accusing the SEC of misleading him and the federal appeals court, by among other things, failing to give him notice of the SEC’s emergency request to the appeals court to stop the judge from rejecting the Citigroup settlement, may have gotten for the SEC the opposite kind of attention it wanted when it first announced what it thought was a great settlement.  If Rakoff turns out to be right, this new and unwanted attention may come from federal judges who may begin to question more thoroughly both the SEC’s motives and tactics in settling such cases.  For the SEC, this could mean having to conduct longer investigations with an eye toward expecting to have a long trial, or, alternatively, foregoing court actions and opting for administrative actions.  In the future, to avoid federal judges questioning such settlements, the SEC may decide its easier to take the latter route.

What FINRA’s Investor Protection Efforts Will Mean for Broker-Dealers and Reps in 2012

On December 16, Financial Industry Regulatory Authority (FINRA)  issued a Press Release highlighting its regulatory accomplishments during 2011.  FINRA makes clear its goal is two-fold:  protecting investors and bringing transparency to financial markets.  The release demonstrates for senior management, risk management and compliance managers the additional arsenal FINRA is employing to beef up its oversight of broker-dealers and their registered reps.  So far, for reps and their firms, this has meant a significant increase in the number of disciplinary actions this year.  The release identifies  some of the newer tools and sources FINRA has used and will continue to employ to protect investors.

What’s been different about 2011 and what will firms and reps experience more of in 2012?  The press release sheds light on some measures FINRA will be employing, including:

  • Using its Office of Fraud Detection and Market Intelligence (OFDMI) to refer matters involving potential fraudulent conduct to federal and state regulators and law enforcement agencies.  FINRA referred more than 600 matters this year.
  • Reconfiguring its exam program to be more risk-based and ensuring exam teams are more focused on those areas critical to investor safety; including identifying high-risk firms, branch offices, brokers, activities and products through broader data collection.
  • Developing, through its Market Regulation Department, cross-market surveillance patterns that monitors all FINRA, NYSE and NASDAQ markets (80 percent of equity markets) with plans to launch these patterns in 2012.  Earlier, FINRA expanded the Order Audit Trail System (OATS) to include all NMS securities to create a uniform order audit trail to serve as a foundation for the cross-market surveillance program.
  • Expanding the Trade Reporting and Compliance Engine (TRACE) to include securitized products.  The effect was to add more than 1.2 million asset- and mortgaged-backed securities to the current 70,000 TRACE-eligible securities; and introduced securitized products benchmark pricing and aggregated data reports on FINRA’s website.
  • Continuing to push rule proposals that include Back Office Registration, Suitability and Debt Research Conflicts of Interest.
  • Enhancing its examination program by taking a more risk-based approach to focus on areas posing greatest risk to investors.  With this, FINRA has increased the number of its staff in district offices responsible for having a deeper understanding of specific firms, including increased real-time monitoring of business and financial changes.
  • Placing greater emphasis on branch-level activity by increasing the number of branch exams that focus exams at the point-of-sale.
  • For 2012, developing comprehensive cross-market surveillance patterns that will examine trading activity across all markets, including FINRA, NYSE and NASDAQ equity markets, at one time (which account for 80 percent of equity volumee time), rather than having multiple patterns survey each market separately.  This is suppose to help FINRA identify problematic trading more quickly.
  • Finally, FINRA implemented a rule for firms and reps involved in FINRA arbitrations allowing investors to choose all-public panels in customer cases involving three arbitrators.

SEC Announces 2012 Compliance Program to Focus on Compliance for Senior Management

For next year, the SEC has announced it will be enhancing its CCO Outreach program to include both chief compliance officers and senior personnel of investment advisers and investment companies will.  The program will occur on Jan. 31, 2012, at the SEC’s Washington D.C. headquarters and will also be webcast.  By adding senior personnel, the SEC says the change is aimed at emphasizing the need for compliance awareness at all levels of an organization.  Program topics will include compliance and enterprise risk management, trading, custody, Dodd-Frank reform and enforcement issues.

Registration materials and other information about the national seminar are
available at: http://www.sec.gov/info/complianceoutreach/complianceoutreachns2012.htm.

THE RECURRING DUE DILIGENCE FAILURES WITH PRIVATE OFFERINGS

FINRA Sanctions Eight More Firms.  FINRA’S  recent announcement that it had sanctioned eight more firms and 10 individuals, and ordered restitution totaling more than $3.2 million, for selling interests in private placement offerings without having a reasonable basis for recommending the securities is yet another warning to firms that fail to conduct adequate due diligence on alternative investment products.

NASD Conduct Rule 2310 requires member firms, when making a recommendation to a customer to purchase or sell a security, to have reasonable grounds to believe that the recommendation is suitable for the customer.  What this means, under FINRA rules, is that member firms who sell alternative investments such as Regulation D offerings must be able to demonstrate that they have an understanding of the potential risks and rewards of the security.  That demonstration must go beyond simply reading prospectuses, private placement memoranda, and other scripts passed along from issuers or participants in the offering process.

The eight firms and their reps FINRA snctioned sold interests in several high-risk private placements, including those issued by Provident Royalties, LLC, Medical Capital Holdings, Inc. and DBSI, Inc., which ultimately failed, causing significant investor losses.  The oft-forgotten message FINRA makes with these cases is that firms have at least two continuing responsibilities with alternative securities offerings.  The first is that member firms need first to document for themselves, and convey to their clients, an understanding of the inherent risks of private offerings; and the second is, after doing so, ask themselves whether these products are suitable for their customers.  Failing to conduct adequate due diligence makes this impossible to do since a selling firm may have no reasonable grounds to believe that the Regulation D offfering is suitable for any customer.

As with these cases, FINRA has shown no reservation in imposing supervisory liability , under Rule 3010, on principals of these firms for failing to conduct meaningful due diligence prior to approving such offerings for sale to customers.

FINRA AND SEC GUIDANCE: EFFECTIVE RISK MANAGEMENT FOR BRANCH AUDITS

In its continual focus on the importance of effective risk management for broker-dealers (as well as investment advisers) the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations and FINRA have issued a National Exam Risk Alert aimed at providing broker-dealer firms with information on developing effective policies and procedures for branch office inspections.  In addition to reminding firms of their supervisory obligations under FINRA’s supervision rule, the alert notes some common deficiencies found during SEC and FINRA examination of branch office audit practices and emphasizes the need for firms to adopt a comprehensive risk approach to compliance practices. 

The Alert, including FINRA’s Regulator Notice 11-54 , contains a number of best practices that Chief Compliance Officers and other compliance professionals of broker-dealers should consider incorporating as part of their mandated supervisory oversight of branch offices.  The Alert warns that some practices FINRA and SEC examiners have observed, including

  • firms utilizing generic examination procedures for all branch offices, regardless of business mix
  •  leveraging  novice or unseasoned branch office examiners who lack the experience or understanding of the business to challenge assumptions, and
  •  devoting minimal time to each exam and little, if any, resources to reviewing the effectiveness of the branch office exam program

will not be tolerated.  In short, the alert is a reminder that the SEC and FINRA view branch office inspections as integral to determining whether a firm’s culture of compliance eliminates risks to the firm and its clients or contributes to violations of the securities laws.

Enhancing CCO Effectiveness: Seven Things CCO’s Should Remember

As we mentioned in our July 25, 2011 post, prior to delving into the actual work, skills and knowledge required of a Chief Compliance Officers to an investment adviser, the very first step a CCO should take is to make sure she understands the framework and principles that guide the work they do. Not surprisingly, given the demands of their position, even experienced CCOs ignore or forget some of these clearly written admonitions about the CCO function that routinely appear in canned written compliance policies and procedures that they pass out to registered adviser personnel. As a reminder, periodically, we’ll post rules CCOs should never forget. We follow now with a third rule.

Rule Number Three: Communicate your role to your Boss(es)

To avoid the appearance that you are doing more than administering the compliance program, take the time to carefully define, in writing, your job responsibilities and take steps to ensure that person(s) who supervise you know them and understand the roles and limitations of the job. Then, periodically, take the time to remind them again and again. Were I to give a quiz to all of the managers who supervise CCOs, asking about the CCO role and what a CCO does, I venture, most of them (who have not served in that capacity or have no prior legal or compliance background) would, unfortunately, fail. Even more unfortunate, is that they and other employees believe that you are somehow, by definition, responsible for the day-to-day oversight of others. When you’re perceived as the person responsible for “signing-off” on the actions of others, you open yourself up for assuming supervisory responsibility, and thus liability, for those employees.

Enhancing CCO Effectiveness: Seven Things CCO’s Should Remember

Prior to delving into the actual work, skills and knowledge required of a Chief Compliance Officers to an investment adviser, the very first step a CCO should take is to make sure she understands the framework and principles that guide the kind of work CCOs perform. Not surprisingly, given the demands of their position, even experienced CCOs ignore or forget some of these clearly written admonitions about the CCO functions, even though they routinely show up in canned written compliance policies and procedures that are passed out to adviser personnel.

As a reminder, periodically, we’ll post rules CCOs should never forget even as they comply with all the other rules that apply to investment advisers. We start with the first two below:

Rule Number One: Your Job is to “Administer” the Compliance Program: The CCO’s job function as mandated by Rule 206(4)-7 (the “rule”) is limited to “administering” the investment adviser’s compliance policies and procedures. While the rule contains no explicit definition for what the term administering means, the rule makes one thing clear, it is the adviser who is legally required to “adopt and implement written policies and procedures reasonably designed to prevent violation” of the Investment Advisers Act of 1940. What this means is that you are not the guarantor that your adviser will not experience a compliance failure. Nor is it necessarily true, from a supervisory perspective, that you are responsible for the compliance failures of others in the firm. To the contrary, the failure of a compliance program to find and remedy compliance problems can just as easily be viewed as evidence that the adviser’s compliance program, including its policies and procedures, are not effective.

This doesn’t mean that compliance personnel of an adviser can’t be sanctioned for not properly supervising employees. Of course, they can be and are sanctioned. However, the fact that you are a CCO does not, in and of itself, give you supervisory responsibility over your adviser’s personnel. In short, if you’re not supervising other advisory personnel, and you limit supervisory responsibility to persons who are part of the compliance staff, the Adopting Release to the rule makes clear that you aren’t necessarily liable for the supervisory lapses of your adviser. This leads to our second rule.

Rule Number Two: Consider avoiding taking on roles that give the appearance that you supervise personnel outside of administering the compliance function: Such advice may be particularly hard to follow with smaller advisers or in other instances where the adviser’s overall management structure is fairly narrow (e.g. the president and CCO are one and the same). However, for most others, taking on management responsibilities outside the compliance program can be a recipe for trouble. One such problem is that it places you in a supervisory role, when the very title of chief compliance officer does not carry with it supervisory responsibility. The SEC made this clear when it adopted the rule. In short, if you do supervise others outside the compliance staff, remember using, among other rules and Investment Advisers Act §203(f), the SEC has brought cases showing you can be sanctioned for not properly supervising investment adviser representatives and others.