By David McNeal, Contributor of My Compliance Blog
August 6, 2019. In a seemingly exhaustive path towards proper record keeping and disclosures, many advisory firms are falling short of communicating
its business practices to regulators.
Understandably, many of these disclosure types can be highly
subjective. In addition, compliant
disclosures will likely require further examination into an advisor’s business activities
through communication passed down from staff in management and compliance
working in tandem—not any easy feat. Oftentimes,
smaller firms will have principals that must wear both hats.
Time and time again – some of
the largest firms in the U.S. securities industry are rocked with disclosure
violations and hefty fines handed down from the SEC, FINRA, and on occasion,
even State Securities Regulators (see. “State Street Settles
SEC Charges for Adding Undisclosed Markups on Client Expenses”)
State Street, one of the
largest custodial firms in the U.S, agreed to pay $88 million to settle claims of
overcharging its mutual fund and investment advisory clients for undisclosed
expenses associated with its the firm's custodial services.
What is going on?
In
some cases, the rules on disclosure making can become so cumbersome or
subjective that 100% compliance
becomes an elusive feat for firms – even those with ample resources like state
street.
Over the last two years, the SEC engaged in a broad
sweeping crackdown on similar issues, including disclosures related to the
disciplinary history associated with many of its registrants.
In September 2017, the SEC Office of Compliance Inspections and Examinations
(“OCIE”) adopted a “Supervision Initiative”1, a series of
examinations to assess the oversight practices of SEC-investment advisers which
previously employed, and/or currently employ, any individual with a history of
disciplinary events.
This action focused on each advisors’ protocols in certain areas,
including compliance programs and supervisory oversight practices, disclosures,
and conflicts of interest. The initiative identified a variety of
observed deficiencies.
Many of these shortcomings related to disclosure issues, including
undisclosed conflicts of interest.
A Look into Disciplinary History
Advisers were identified for examination through a review of
information about disciplinary events and other legal actions involving
supervised employees under each firm.
The information analyzed included legal actions that are not required
to be reported on Form ADV (e.g., private civil actions).2
In aggregate, of the more than fifty audits performed on advisors, firms
managed approximately $50 billion in assets for nearly 220,000 clients, the
vast majority of whom are retail investors.
The examinations did not focus solely on supervisory practices of
individuals with prior disciplinary histories, but rather on the importance of
those practices in relation to the management and the firm’s overall compliance
culture.
Reviews included:
1 - 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, with a particular emphasis on practices
covering the activities of previously-disciplined individuals and their prior events.3(4)
2 - Additionally, staff focused on whether disclosures in public
statements or documents (e.g., marketing materials) and filings were complete
and fair, included all material facts, and were not misleading.5
3 - Finally, the staff assessed whether the adviser identified,
addressed, and completely disclosed all material conflicts of interest that
could affect the advisory relationship, particularly those conflicts dealing
with compensation arrangements and account management.6.
Findings – Disciplinary Events, Fees, and Conflicts of Interest
The OCIE staff observed that many advisers failed to adopt and implement compliance policies and procedures that addressed the risks associated with employing individuals with prior disciplinary histories.
Notably, several advisers had adopted policies and procedures that
were inconsistent with their actual business practices and disclosure
guidelines.
For example, advisers did not have processes reasonably designed to determine:
1- Whether supervised persons’ self-attestations
completely and accurately described disciplinary events.
2- Whether supervised persons’ self-attestations
truthfully disclosed reportable events or recent bankruptcies at all (see “CFP Board Snafu”).
And/or,
3 - Adequate annual compliance review processes. Annual reviews that were examined were
insufficient because the firms failed to adequately document supervised persons
reviews and appropriately assess the risk areas applicable to its own firms or
attempt to identify any risks at all.
Fee Disclosure Violations are commonplace
The study also revealed the categories which commonly showed the most
inconsistent compliance practices, involved areas 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).
Conflicts of Interest from undisclosed compensation:
Several advisers had undisclosed compensation
arrangements, which resulted in conflicts of interest that could have impacted
the impartiality of the advice the supervised persons gave to their clients.
For example, some of these advisers did not
disclose that:
1 - Forgivable loans were made to the advisers or
their supervised persons. Furthermore, the terms of which were contingent upon
certain client-based incentives that may have unduly influenced the investment
decision-making process, resulted in higher fees and expenses for the affected
clients, or both.
2 - Supervised persons 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.
Findings Specific to Disciplinary Histories:
The staff observed that nearly half of the
disclosure-related deficiencies of the entire panel of advisers examined were
due to the firms providing inadequate information regarding disciplinary
events.7
Some examples are:
1 - Omitted material disclosures regarding
disciplinary histories of certain supervised
persons or the adviser itself due to the firm’s
reliance on these supervised persons to self-report to the firms’ information
about their required disclosures (ref “CFP Board snafu”).
2 - Incomplete, confusing, or misleading
information regarding disciplinary
events. For
example, a firm did not include the total number of events,
the date for each event, the allegations, or
whether the supervised persons were found
to be at fault (i.e., whether fines, judgments or
awards, or other disciplinary sanctions
were imposed).8
3 – Firms did not timely update and deliver
disclosure documents to clients, such as updating Form ADV for new disciplinary
events of supervised persons reported on CRD (e.g. Form U5s).9
OCIE’s Best Practices for improvement of
compliance and disclosure policies and procedures:
Much of the compliance and supervisory deficiencies
observed with this panel of advisers may help other firms address the
weaknesses discussed above.
Advisers that may hire or employ supervised
persons with disciplinary histories in the future, or that have not already
adopted a successful compliance program, may want to consider additional considerations
not covered within this analysis. These
can include:
1 - Adopting written policies and procedures that
specifically address what must occur prior to hiring supervised persons that
have reported to the adviser disciplinary events.
2 - Enhancing due diligence practices associated
with hiring supervised persons to identify disciplinary events. Through this evaluation, it was confirmed that
firms with written hiring policies and procedures, more consistently included: (1)
conducting background checks (e.g., the firms confirmed employment histories,
disciplinary records, financial background and credit information), (2) performing
internet and social media searches, (3) fingerprinting personnel, (3) utilizing
third parties to research potential new hires, (4) contacting personal
references, and (4) verifying educational claims.
In addition, some advisers:
- Requested that potential new hires provide the
firm with copies of their Form U5s, where applicable.
- Reviewed new hires’ Form U5 filings 30 or more
days after they are hired (this type of procedure may identify termination
notices the new hire did not disclose that were filed after the hiring decision
was made), when applicable.
- Initially checked CRD/IARD for supervised
persons’ filings and re-checked the filing information after a designated
period of time, such as three months later.
3 - Establish heightened oversight practices for
supervised persons with certain disciplinary histories. The staff observed that many of the advisers had not adopted
supervision practices or compliance procedures that addressed the risks of
hiring people with previous disciplinary history (e.g., disciplinary history
relating to misappropriation, unauthorized trading, forgery, bribery, and
making unsuitable recommendations).
The examined advisers who had written, and
implemented policies and procedures specifically addressing the oversight of
supervised persons with disciplinary histories were far more likely to identify
misconduct by supervised persons than advisers without these written protocols.
4 - Adopt written policies and procedures addressing
client complaints related to supervised persons. The staff observed that advisers with written
policies and procedures addressing client complaints regarding their supervised
persons were more likely to have reported the receipt of at least one such
issue related to their supervised persons. In addition, these advisers were consistently
more likely to escalate matters of concern raised in these complaints than
advisers without written protocols.
5- Include oversight of persons operating out of
remote offices in compliance and supervisory programs,
particularly when supervised persons with disciplinary histories are located in
branch or remote offices.
Summary of thoughts from the SEC:
The examinations within the scope of this review
resulted in a range of actions. In response to the staff’s observations, some
advisers elected to amend disclosures, revise compliance policies and
procedures, or change other practices.
In light of the findings from this investigation,
there are far too many compliance issues
that are not being met. It is vital to the
integrity of our industry, and the clients we represent that advisors are doing
their due diligence to identify risks associated with hiring, and employing
persons with disciplinary history, and advising them of appropriate procedural
conduct specific to their history.
Furthermore, compliance policies and procedures should
be drafted and implemented that are unique to every firm. Full and truthful
disclosure of facts within a supervised persons disciplinary record, as well as
an advisors record, should be appropriately documented and reviewed at
necessary intervals to avoid mis-management and rogue activities.
Finally, advisors must commit to following
through with their implemented policies to maintain the standards set forth in
the Advisers Act, and to avoid the unacceptable problems that have been
identified through this initiative’s efforts.
In conclusion, the OCIE encourages advisers when
designing and implementing their compliance and supervision frameworks, to research
the regulations within the Advisers Act, to consider the risks presented by, as
well as the disclosure requirements triggered by, the hiring, and employing of
supervised persons with disciplinary histories, and adopt policies and
procedures to address those risks and disclosure requirements while improving
upon their supervisory practices and compliance programs.
Research:
1.
See NEP
Risk Alert: Examinations of Supervision Practices At Registered Investment
Advisers (Sept. 12,
2016). For
purposes
of the Supervision Initiative, and as referenced in this Risk Alert,
“supervised persons” include principals and officers of the adviser, and other
individuals performing services on behalf of the adviser (other than clerical),
regardless of whether these individuals are independent contractors or
employees of the adviser. See also Investment Advisers Act of 1940 (“Advisers
Act”) Section 202(a) (25) (defining “supervised person”).
2. See Form ADV, Part
2A, Item 9 and Part 2B, Item 3 (Disciplinary Information). All registered
advisers must promptly
disclose
any legal or disciplinary events that would be material to a client’s or a
prospective client’s evaluation of the adviser’s integrity or its ability to
meet its commitments to clients. See also Advisers Act Rules 204-3(b) (4) and
204(2)(a)(14)(iii).
3
Advisers Act Rule 206(4)-7. Section 203(e)(6) of the Advisers Act also
highlights that establishing supervisory procedures
reasonably designed to prevent and detect such
violations and following these procedures are important steps an adviser should
take in supervising persons subject to its supervision. The Commission has
brought enforcement actions against advisers that did not adopt or implement
any policies or procedures regarding their supervision of certain personnel.
See, e.g., In re James T
Budden and Alexander Budden, Advisers
Act Release No. 4225 (Oct. 13, 2015) (settled).
4 See, e.g., SEC v. Capital Gains Research Bureau,
Inc., 375 U.S. 180 (1963) and Amendments to Form ADV, Advisers Act Release No. 3060 (Jul. 28, 2010) (“as a
fiduciary, an adviser has an ongoing obligation to inform its clients of any
material information that could affect the advisory relationship”). See also General Instruction 3 to Form ADV, which states that “[u]under federal and state
law, [an adviser is] a fiduciary and must make full disclosure to [its] clients
of all material facts relating to the advisory relationship.”
5 An adviser’s obligation as a fiduciary is
enforceable through Advisers Act Section 206. As fiduciaries, advisers must
provide full and fair disclosure of all material
facts to their clients and prospective clients. Also, it is unlawful for
advisers to make untrue statements or omit any material facts in applications
or reports filed with the Commission (Advisers Act Section 207) or to have
advertising (as defined in Advisers Act Rule 206(4)-1) that is false or
misleading or that contains any untrue statement of a material fact.
6 Advisers Act Section 206. Also, General Instructions to Form ADV, such as General Instruction 3, state that an
adviser’s
disclosure obligation “...requires that [the
adviser] provide the client with sufficiently specific facts so that the client
is able to understand the conflicts of interest [the adviser has] and the
business practices in which [the adviser] engage[s], and can give informed
consent to such conflicts or practices or reject them.”
7 All registered advisers must promptly
disclose in Form ADV certain legal or disciplinary events that would be
material to a
client’s or a prospective client’s evaluation of
the adviser’s integrity or its ability to meet its commitments to clients. See Amendments to Form ADV, Advisers Act Release No. 3060 (Jul. 28, 2010).
See also generally, Commission
Interpretation Regarding Standard of Conduct for Investment Advisers, Advisers Act Release 5248 (June 5, 2019).
8 See Form ADV, Item 11 and Criminal Disclosure Reporting Page
(DRP), which requires advisers to report details regarding certain disciplinary events
9 See General Instructions to Form ADV, which specifies that an adviser must promptly
file an “other-than-annual
amendment” to its Form ADV when certain
information becomes inaccurate in any way, including reportable disciplinary
events. CRD (Central Registration Depository) is a database maintained by
FINRA. It is used to store and maintain information on registered broker-dealers
and their associated individuals. Many supervised persons of advisers are
representatives of both broker-dealers and advisers
10 Advisers Act Rule 206(4)-1
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