Category Archives: code of ethics

Investment Advisors Beware: Ten Things OCIE Is Looking At

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The SEC is increasing the number RIA inspections by the Office of Compliance Inspections and Examinations (OCIE) and has signaled an aggressive agenda for such exams. Here is a non-exhaustive list of items a Chief Compliance Officer and his or her staff may want to consider well in advance of getting a call from OCIE:

  1. Cybersecurity Policies and Procedures: Make sure the firm’s policies are periodically reviewed and cover key issues (e.g., electronic security (passwords, encryption, “need to know” segmentation), physical security, employee training, incident response planning, and vendor due diligence).
  2. Product Selection: For both RIAs and BDs, the SEC is taking a close look at certain products (e.g., variable annuities) sold to retail investors. Ensure proper monitoring of client recommendations and allocations.
  3. Performance Advertising: Pay particular attention to the distinctions between true actual performance, model performance, and back-tested performance.
  4. Third-Party Affiliations: Disclose any business relationships with 3d parties (e.g., solicitor and sub-advisory relationships) and the potential conflicts they pose.
  5. Fee Structure/Reverse Churning: OCIE is looking at disclosures re: fee structure and the appropriateness of fee-based compensation (e.g., is a firm actively managing an account or just collecting fees).
  6. Custody: “Custody” is broadly defined in Rule 206(4)-2. Firms that have custody need to comply with the Rule’s requirements (e.g., hire an independent CPA to conduct an annual surprise audit).
  7. Code of Ethics/Insider Trading: Make sure the Code is up to date and has adequate personal trading and disclosure restrictions.
  8. Best Execution: If firm has authority to pick BDs, make sure to disclose how firm selects BDs and any “soft dollar” arrangements.
  9. Principal Trading: Disclose it; make sure Rule 3T being followed.
  10. Anti-Money Laundering Policies: For firms that are also BDs, make sure to have AML policies and procedures designed to pick up on suspicious activity (e.g., lots of relatively small transactions).

SEC Sanctions $1B AUM Investment Adviser for Weak Compliance Culture

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On June 23, 2015, the SEC censured an investment advisor and its two principals for rickety compliance policies and procedures.[1] Among other things, the SEC found that, due to systemic compliance failures, the advisor overcharged its high net worth clients for their investments in a mutual fund called the Appleseed Fund. The firm, Pekin Singer, offered shares in the Appleseed Fund under a sliding fee structure where clients who met a higher minimum investment paid a lower fee. Pekin Singer failed to timely advise its clients, most of whom met the higher minimum investment threshold, that they could convert to the lower costs shares, thereby improperly increasing the firm’s bottom line at the expense of customers.

Pekin Singer’s internal compliance issues ran deep. In 2009 and 2010, it failed to conduct required annual compliance program reviews and it chronically underfunded and underemphasized its compliance function. For example, the firm’s former CCO had limited compliance experience and was required to simultaneously serve as the CFO of the firm. Because of the multiple hats the he wore, the CCO was only able to devote 10% to 20% of his time to compliance issues.

Further, the CCO, aware of his limitations in the compliance area, sought to hire outside compliance help. After two years of lobbying, the firm hired an outside compliance consultant. The consultant’s review coincided with an OCIE examination by the SEC’s Chicago office. The examination and consultant’s review uncovered a number of compliance failures, including improper trading by an employee, which could have been prevented if the firm had enforced its code of ethics.

To its credit, Pekin Singer fully cooperated with the SEC and returned the excessive fees to its clients. It also hired a new CCO whose only job is compliance and hired an outside attorney to advise on securities law issues relating to mutual funds. Finally, the firm has continued and expanded its relationship with an outside compliance consultant who is charged with monitoring and advising on the firm’s annual compliance program reviews.

Bottom line: Advisory firms and their principals should not skimp on or de-prioritize compliance issues. While having robust compliance policies and controls in place can seem costly up front, the costs to the firm, both in terms of reputation and money, can be much more if OCIE finds deficiencies.

[1] http://www.sec.gov/litigation/admin/2015/ia-4126.pdf