Risk Alert – Observations from Examinations of Investment Advisers: Compliance, Supervision, and Disclosure of Conflicts of Interest

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On July 23, 2019, the U.S. Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert to share its findings related to a series of examinations conducted to assess the oversight practices of registered investment advisers that previously employed, or currently employ, any individual with a history of disciplinary events.  These examinations, collectively referred to as the “Supervision Initiative” entailed examinations of over 50 registrants over the course of 2017.  Registrants collectively managed approximately $50 billion in assets for nearly 220,000 clients, the vast majority of whom were retail investors.  Advisers were identified for examination through a review of information about disciplinary events and other legal actions involving supervised persons, including legal actions that are not required to be reported on Form ADV (e.g., private civil actions).

The Supervision Initiative focused on advisers’ practices in certain areas, including:

  • Compliance programs and supervisory oversight practices:  The staff reviewed whether compliance policies and procedures were reasonably designed to detect and prevent violations of the Advisers Act by the firm and its supervised persons, particularly policies and procedures attendant to the activities of previously disciplined employees.
  • Disclosures:  The staff focused on whether disclosures in public statements, marketing materials, and filings were complete and fair, included all material facts, and were not misleading.  Particular emphasis was placed on disclosures related to previously disciplined individuals and their prior disciplinary events.
  • Conflicts of interest:  The staff assessed whether the adviser identified, addressed, and fully and fairly disclosed all material conflicts of interest that could affect the advisory relationship, particularly those conflicts dealing with compensation arrangements and account management.

General Observations

The Initiative, while reflecting interest in supervision practices attendant to previously disciplined individuals, did not focus exclusively on that topic. Due to the importance that the Commission places on setting the “tone at the top” relative to supervisory practices and to the compliance culture itself, the initiative also focused upon general supervisory practices of the adviser.

In this respect, the Risk Alert contains two classifications of OCIE observations: (1) those which pertain directly to the supervision of previously disciplined employees, and (2) those which pertain to firm-wide practices and issues identified during the Supervision Initiative examinations. The findings flagged below were reflected in examination deficiency letters.

Supervision of Previously Disciplined Employees

Full and fair disclosure: OCIE observed that nearly half of the disclosure-related deficiencies of the advisers examined were due to the firms providing inadequate information regarding disciplinary events as follows:

  • Omitted material disclosures regarding disciplinary histories of supervised persons or the adviser itself.  Disclosure omissions occurred due to adviser reliance on self-reporting procedures pertaining to employee disciplinary history.
  • Disciplinary disclosures were incomplete and/or misleading, e.g., failure to include the total number of events, the date for each event, the allegations, and/or whether the employee was subjected to fines, judgments or awards, or other disciplinary sanctions.
  • Did not provide timely updates and subsequently deliver disclosure documents to clients, such as updating Form ADV for new disciplinary events of supervised persons reported on Form U5s.

Compliance programs: Advisers did not implement compliance policies and procedures to address the risks related to employing individuals with prior disciplinary histories to establish:

  • Whether employee self-attestations regarding disciplinary events were complete and accurate.
  • Whether employee self-attestations reflecting an absence of reportable events or recent bankruptcies were in fact accurate.

General Compliance and Supervision 

Supervision: OCIE observed that advisers did not adequately supervise or establish appropriate standards of business conduct for employees in their supervision policy, i.e., policies and procedures did not sufficiently document the responsibilities of supervised persons or did not clearly reference the expectations for certain employees as follows:

  • Fees charged by employees were not adequately disclosed and/or the services related to those fees were not reconciled to the assessed fee itself. Examinations determined that several adviser clients paid for certain services they did not receive or were charged undisclosed fees.
  • Employees that prepared their own advertising material and/or website content either did not comply with implemented advertising policies and procedures or in fact there were no policies and procedures in place to supervise this activity. Examinations identified several events whereby dissemination of advertising content did not comply with Rule 206(4)-1.
  • There were no policy provisions or advisers did not comply with policies and procedures pertaining to the supervision of employees working from remote locations.  OCIE observed that geographically dispersed employees were operating in a self-directed manner that was not consistent with firm policy. These conditions evidenced a lack of compliance risk management whereby registrants are required to effectively monitor employee activities.

Oversight: OCIE observed that many advisers did not confirm that employees who were identified as responsible for executing certain compliance action items were doing so in a compliant manner pursuant to policy and/or did not document the execution of their duties. In some instances, the action items included key regulatory and business responsibilities for advisers managing investor assets, such as:

  • Monitoring the appropriateness of client account types, e.g., firms did not review whether at account opening the type of account selected was appropriate (e.g., wrap fee versus separately managed account), document that an assessment of the type of account took place, or document the factors considered in making these assessments.
  • Maintaining true, accurate, and current books and records, including those necessary to provide investment supervisory or management services to clients (e.g., maintaining a list of all accounts in which the adviser is vested with discretionary authority or to identify individuals with access to sensitive information).

Compliance policies and procedures:  OCIE observed that advisers had adopted policies and procedures that were inconsistent with their actual business practices and disclosures.  Most frequently cited areas of non-compliance were those addressing commissions, fees, and expenses (e.g., solicitation fees, management fees, compensation related to hiring personnel, and oversight of firm compensation practices, including such practices within branch offices).

Annual compliance reviews: OCIE observed that in many cases, firms were non-compliant with the annual review requirement due to a lack of documentation and/or insufficient or non-existent identification of compliance risk sets required to be referenced in the review, e.g., failure to identify and disclose and manage new or emergent conflicts of interest.

Disclosure of Conflicts of Interest

Conflicts of interest originate at both the business level and employee level.  The fiduciary standard requires advisers to identify, mitigate, and in some cases disclose material conflicts of interest. OCIE observed that several advisers had undisclosed compensation arrangements, which resulted in conflicts of interests that may jeopardize the impartiality standard which advisers must adhere to relative to the provision of investment advice to clients as follows:

  • Forgivable loans were made to the advisers or their employees whereby the terms were contingent upon certain relationship incentives that have the potential to unduly influence the development or execution of investment advice.
  • Employees were required to incur all transaction-based charges associated with executing client transactions, which created incentives for the supervised persons to trade less frequently on behalf of their clients.

            Recommended Policy Mitigation

  • Adopt policies and procedures that specifically address what must occur prior to hiring professionals that have disclosed prior disciplinary events. Adopt written policies and procedures specifically addressing what to do before hiring such individuals.  Best practices include investigation of the disciplinary event(s) and ascertaining whether barred individuals were eligible to reapply for their licenses.  
  • Enhance due diligence practices associated with hiring new employees, especially those who will be access persons. In addition to specific event due diligence, best practices include written procedures requiring background checks (e.g., confirming employment histories, disciplinary records, financial background, and credit information), conducting internet and social media searches, fingerprinting personnel, utilizing third parties to research potential new hires, contacting personal references, and verifying educational claims. 
  • Cross reference due diligence and self-reporting with regulatory filings:
    • Require potential new hires to provide copies of their Form U5s.
    • Check CRD/IARD for employee-related filings and re-check the filing information 30 – 60 days post hiring to flag new filings submitted by prior employers.
  • Establish heightened supervision practices attendant to employees with disciplinary histories.  OCIE observed that many advisers had not adopted supervision practices or compliance procedures that addressed the risks associated with employees having prior disciplinary histories (e.g., disciplinary histories relating to misappropriation, unauthorized trading, forgery, bribery, and making unsuitable recommendations). Advisers with explicit policy in this regard are more likely to identify misconduct by supervised persons.
  • Adopt written policies and procedures which address client complaints. Advisers with effective client complaint policies are more likely to identify complaints and concerns earlier than those firms without effective policies. 

Final Takeaway

The most important takeaway from this Risk Alert is the reminder that advisers must adopt and implement a risk-based compliance program. Hiring employees with disciplinary records ratchets up the adviser’s risk rating in the eyes of the SEC. If the regulator ascribes more risk to this condition, so should the firm. And by all means, document the steps taken throughout the hiring and supervisory process. Implementing a thoughtful and careful hiring and supervisory system can help protect the adviser’s revenue stream and reputation.

For More Information

Follow this link for the Risk Alert: Observations from Examinations of Investment Advisers: Compliance, Supervision, and Disclosure Conflicts of Interest (PDF)

Rules and Interpretations to Enhance Protections and Preserve Choice for Retail Investors in their Relationships with Financial Professionals

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SEC rules package published June 5, 2019
___________________
This past June, the U.S. Securities and Exchange Commission (“SEC” or the “Commission”) adopted two rules and issued two interpretations, each of which pertain to standard of conduct requirements for broker-dealers and investment advisers. The rules package addresses the following aspects of broker/dealer and investment adviser client disclosures and registrant comportment to the fiduciary standard of care:

Regulation Best Interest (Regulation BI), a new rule imposing a “best interest” standard of conduct on broker-dealers making recommendations to retail clients (compliance date: June 30, 2020)

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SEC Risk Alert: Safeguarding Customer Records and Information in Network Storage – Use of Third-Party Security Features

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issued May 23, 2019

The U.S. Securities and Exchange Commission (“SEC” or the “Commission”) has again commenced a series of cybersecurity examinations of registered investment advisers. The SEC distributed numerous request letters in May to gather registrant information pertaining to vendor diligence and oversight of cloud providers. The Commission is scrutinizing adviser policies and procedures which relate to the identification and monitoring of risks attendant to client information stored on third party vendor platforms. In general, advisers have a fiduciary duty and regulatory obligation pursuant to privacy regulations and cybersecurity guidance to ensure that non-public client information residing on third-party platforms remains secure and protected from misappropriation.

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SEC Risk Alert: Compliance Issues with Privacy Notices and Safeguard Policies

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issued April 16, 2019

On April 16, 2019 the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert related to Privacy Notice and safeguard policy compliance issues. This regulatory communication is applicable to investment advisers and broker-dealers (“registrants”) alike.  OCIE cited issues identified in deficiency letters from broker-dealer and adviser exams completed by the Staff during the past two years. It should be noted by SEC registrants that the Commission has issued deficiency notices and pursued enforcement actions on the basis of registrant non-compliance with Risk Alerts, including on the basis of guidance in the absence of a rule.

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SEC Risk Alert – Electronic Messaging and 2019 Exam Priorities

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Introduction

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) just delivered a holiday and new year greeting to registered investment advisers … just in case the volatile markets were not enough to keep you on your toes!  On December 14th, OCIE issued a Risk Alert related to electronic messaging and on December 20th released its 2019 examination priorities. It may be the busiest time of the year, but when OCIE talks, it is worth listening!

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SEC Risk Alert: Investment Adviser Compliance Issues Related to the Cash Solicitation Rule

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Risk Alert 

While we were busy handing out candy, the SEC was busy handing out advice! The Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert on October 31, 2018 to provide investment advisers, investors and other market participants with information concerning the most common deficiencies the staff has cited relating to Rule 206(4)-3 (the “Cash Solicitation Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The Risk Alert is intended to assist investment advisers in identifying potential issues and adopting and implementing effective compliance programs, and generally pertains to an adviser’s use of third-party solicitors that are subject to the broader requirements of the Cash Solicitation Rule.

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IM Information Update 2018-02   Statement Regarding Staff Proxy Advisory Letters

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Information Update 

On September 13, 2018, the SEC’s Division of Investment Management issued IM Information Update 2018-02 entitled “Statement Regarding Staff Proxy Advisory Letters.” The purpose of this Update is to notify advisers of its withdrawal of two 2004 no-action letters related to proxy voting. This Update follows the Commission’s July 2018 announcement of its plans to host a Roundtable with market participants (now scheduled for November 2018) to address proxy voting topics including the voting process, retail shareholder participation and the role of proxy advisory firms.

Over the past decade the SEC has consistently conveyed concern in public discourse and in adviser examinations regarding the growing reliance by advisers on proxy consultants. In 2010 the Commission sought public comment on the issue due to concern that the SEC’s own guidance permitted advisers to fulsomely rely upon the recommendations of proxy consultants. After reviewing this condition, the SEC has determined that over-reliance by advisers on proxy consultants may introduce a conflict of interest wherein the investment adviser fiduciary duty to provide objective investment advice is jeopardized.

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OCIE Risk Alert – Compliance Issues Related to Best Execution by Investment Advisers

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Introduction
On July 11, 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert addressing deficiencies observed in their recent examinations of investment advisers’ best execution practices. For years, advisers have been required to obtain and document best execution on behalf of client account, yet firms continue to struggle with sustainable and effective best execution policy and procedure, according to SEC staff.

The Investment Advisers Act of 1940 (“Advisers Act”) establishes a federal fiduciary standard for investment advisers. As a fiduciary with responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek “best execution” of client transactions, taking into consideration the circumstances of each particular transaction. An adviser must execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances. Read More

SEC Risk Alert – Frequent Fee and Expense Deficiencies in Adviser Exams

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April 12, 2018:  The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert to highlight recurrent deficiencies observed in their recent examinations of investment advisers’ policies and procedures governing client fee and expense assessments. The deficiencies were identified by OCIE while conducting more than 1,500 investment adviser examinations over the past two years.  This Risk Alert emphasizes the importance of advisers’ provision of clear and thorough disclosures in Form ADV and client investment advisory agreements.  The Risk Alert further underscores prior Commission guidance relating to adviser obligations to develop, implement, and test effective risk-based compliance policies to minimize the risk of misrepresentation in client communications and the risk of misappropriation in the management of client assets.

Most Frequent Compliance Issues – Advisory Fees and Expenses 

The following issues were deemed to be significant and prevalent in nature, although they do not constitute all fee and expense-related findings detected by OCIE.

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SEC Announces Share Class Selection Disclosure Initiative

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February 12, 2018: Investment advisers recommending mutual fund shares to advisory clients may have a disclosure problem. And yes, the U.S. Securities and Exchange Commission (“SEC”) is here to help address the problem. Yesterday the Commission announced its new self-reporting initiative, the Share Class Selection Disclosure Initiative (“SCSD Initiative”), to provide relief to advisers that have engaged in improper mutual fund recommendations on behalf of their clients. This initiative, forgiveness if you will, relates to certain mutual fund share class selections made by advisers relative to the formulation and execution of investment advice. If the offending firm promptly fesses up to the Division of Enforcement and promptly returns any non-compliant fees to harmed clients, the Division will agree not to recommend financial penalties against such advisers for violating federal securities laws. Read More