SEC’s OCIE issues risk alert on investment advisers that employ individuals with a history of disciplinary events



August 01, 2019

Securities Law Alert

Author(s): Daniel McAvoy

The SEC’s OCIE issues risk alert on registered investment advisers that employ or have previously employed individuals with a history of disciplinary events.

On July 23, 2019, the Securities and Exchange Commission’s (SEC’s) Office of Compliance Inspections and Examinations (OCIE) released a summary of its findings from examinations evaluating the oversight practices of SEC-registered investment advisers that employ or have previously employed individuals with a history of disciplinary events. The examinations focused on (1) whether compliance policies and procedures covering the activities of previously disciplined individuals were reasonably designed to detect and prevent violations of the Investment Advisers Act of 1940 (the Advisers Act), including whether there was sufficient oversight over those individuals; (2) whether disclosures in marketing materials and other public disclosures were full and fair, included all material facts, and were not misleading; and (3) whether the advisers 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.

OCIE observed various deficiencies relating to compliance, disclosure, and oversight, among others, and offered recommendations to investment advisers for improving compliance. Unlike some of OCIE’s recent risk alerts, this alert is almost entirely applicable to managers in the private investment funds space and, for the most part, is equally applicable to registered advisers and exempt reporting advisers.

Disciplinary Histories

OCIE found that certain investment advisers’ oversight of supervised persons with disciplinary histories was lacking in the following ways:

Failure to Provide Full and Fair Disclosure: certain investment advisers provided inadequate information regarding disciplinary events on Form ADV, including:

  • Omission of Material Disclosures—Material disclosures regarding disciplinary histories of certain supervised persons were omitted, often due to reliance on self-reporting rather than proactively performing checks or seeking periodic certifications.
  • Presenting Incomplete, Confusing, or Misleading Information—Certain advisers did not present 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).
  • Failure to Update—Disclosure documents often were not updated and delivered to clients in a timely manner, including filing amendments to Form ADV, for new disciplinary events of supervised persons.

Failure to Adopt and Implement Effective Compliance Programs: Certain advisers were deficient in adopting and implementing compliance policies and procedures that address the risks associated with hiring and employing individuals with prior disciplinary histories. They lacked processes reasonably designed to identify whether the supervised persons’ self-attestations regarding disciplinary events accurately described those events and whether the supervised persons’ self-attestations that they were not the subject of reportable events or recent bankruptcies were, in fact, the case.

Compliance, Supervision, and Conflicts of Interest

OCIE also reviewed the firmwide practices of investment advisers and observed issues that were not necessarily attributed directly to the hiring and supervision of individuals with a history of disciplinary events, including the following:

Compliance and Supervision

  • Supervision: Many investment advisers did not adequately supervise or set appropriate standards of business conduct for their supervised persons, as their policies and procedures did not sufficiently document the responsibilities of supervised persons or did not clearly outline the expectations for these individuals. Examples include practices where an investment adviser did not adequately disclose fees and expenses, have adequate policies for the preparation of advertising materials and websites, or adequately monitor those who work from remote locations.
  • Oversight: Many investment advisers failed to confirm that supervised persons identified as responsible for performing certain compliance policies and procedures were executing their duties. Though they may have had policies and procedures that clearly assigned the individuals to particular duties, either there was no means of assuring that those duties were performed, or they did not adequately document performance of those responsibilities under their policies and procedures. In some instances, the duties included key regulatory and business responsibilities for managing investor assets, such as monitoring the appropriateness of client account types or complying with the Advisers Act recordkeeping rule.

Compliance Policies and Procedures: Several investment advisers adopted policies and procedures that were inconsistent with their actual business practices and disclosures, generally with respect to commissions, fees, and expenses.

Annual Compliance Reviews: Annual reviews were found to be insufficient when the firms did not adequately document the reviews and appropriately assess (or failed to identify) the risk areas applicable to the firms.

Conflicts of Interest

Compensation Arrangements: Certain investment advisers had undisclosed compensation arrangements, which resulted in conflicts of interests that could have impacted the impartiality of the advice the supervised persons gave to their clients. For example, some investment advisers did not disclose that forgivable loans were made to their supervised persons, 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, and 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.

Ways to Improve Compliance:

Based on some of the items described above, the OCIE offered the following recommendations for investment advisers that hire or employ supervised persons with disciplinary histories to consider:

  • Policies and Procedures: Adopting written policies and procedures that specifically address what must occur prior to hiring supervised persons that have reported to the adviser disciplinary events, including requiring investigations of the disciplinary events and ascertaining whether barred individuals were eligible to reapply for their licenses.
  • Enhanced Due Diligence: Enhancing due diligence practices associated with hiring supervised persons to identify disciplinary events, including conducting 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. In addition, OCIE recommended review of filings and Form U5s (where applicable), and periodically re-checking documentary evidence of disciplinary information.
  • Heightened Supervision: Establishing heightened supervision practices when overseeing supervised persons with disciplinary histories involving fraudulent practices or crimes of moral turpitude.
  • Client Complaints: Adopting more robust written policies and procedures addressing client complaints related to supervised persons.
  • Oversight of Remote Offices: Including 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.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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