The SEC Examined 50+ RIAs Who Are Employing or Have Employed Individuals with a History of Disciplinary Issues and This is What They Found…

Financial Institutions Law Alert

 

The U.S. Securities and Exchange Commission’s (SEC) Office of Compliance and Inspections (OCIE) performed over 50 examinations of registered investment advisers who employed or currently employ individuals with disciplinary events. The examinations were part of a “Supervision Initiative” for the purpose of assessing investment advisers’ oversight over individuals with past disciplinary events. On July 23, 2019, OCIE issued a Risk Alert identifying the “compliance issues” that it observed and ways in which firms can improve their compliance relating to those issues.1

OCIE’s “Supervision Initiative” examinations focused on compliance programs, disclosures and conflicts of interest. Although the focus of the “Supervision Initiative” was oversight over individuals with prior disciplinary events, OCIE reviewed the investment advisers’ supervisory practices overall. Almost all of the investment advisers who were examined as part of the “Supervision Initiative” received deficiency letters.

Supervision Issues Specific to Disciplinary Histories

Over half of the disclosure deficiencies related to investment advisers failing to provide adequate information about disciplinary events. Specifically, the investment advisers:

  • omitted material disciplinary disclosures for certain supervised persons;

  • included incomplete, confusing or misleading information about disciplinary events; and

  • failed to timely update and deliver disclosure documents to clients such as updated Form ADVs reflecting new disciplinary events.

The investment advisers also did not adopt and implement adequate compliance policies and procedures to address the risks associated with employing individuals with disciplinary histories. Many of the investment advisers did not have processes reasonably designed to identify whether supervised persons’ self-attestations completely and accurately described disciplinary events. Several investment advisers did not have adequate processes in place to verify the accuracy of supervised persons’ representations including when they represented that they had no disclosable disciplinary events or bankruptcies.

Firm-Wide Supervision Issues

Many of the deficiencies identified as part of OCIE’s “Supervision Initiative” were deficiencies that were previously the subject of Risk Alerts and fundamental to effective supervision. Investment advisers did not adequately supervise or set appropriate business conduct standards for supervised persons. Supervised persons’ responsibilities were not sufficiently documented nor were expectations clearly outlined. By way of example, investment advisers did not:

  • supervise whether fees charged by supervised persons were disclosed or whether clients received the services they paid for;

  • have adequate policies and procedures in place with specific guidance for supervised persons who prepared their own advertising materials and/or websites; and

  • did not review supervised persons who had past disciplinary events and who worked from remote locations.

Oversight deficiencies were common. Many of the investment advisers did not have procedures in place to confirm that supervised persons who were assigned compliance responsibilities were executing their duties as prescribed. In addition, in many instances there was no documentation evidencing that supervised persons performed their responsibilities consistent with the applicable policies and procedures.

Policy and procedure deficiencies were also common. Several investment advisers had policies and procedures in place relating to commissions, fees and expenses which were not consistent with their actual practices and disclosures. Annual compliance reviews including reviews of policies and procedures were also inadequate. Investment advisers also did not adequately document their reviews of and/or appropriately assess risks associated with their businesses. In several cases, the investment advisers did not identify certain applicable risks.

The “Supervision Initiative” examinations also identified common disclosure deficiencies. Some of the investment advisers had undisclosed compensation arrangements which could have impacted the impartiality of the advice their supervised persons gave to clients. There were undisclosed forgivable loans granted to supervised persons which included terms which could have unduly influenced the investment decision-making process and result in clients paying higher fees and expenses or both. Investment advisers also did not disclose that in some instances supervised persons paid all transaction-based fees which could incentivize them to trade less frequently on behalf of certain clients.

Best Practices to Improve Compliance

The Risk Alert included the following best practices about the weaknesses that OCIE identified during its “Supervision Initiative” examinations:

  • adopt written policies and procedures on what must be done prior to hiring persons with past disciplinary events;

  • enhance due diligence when hiring supervised persons to identify undisclosed disciplinary events including: (1) reviewing new hires’ Form U5s; (2) reviewing new employees’ Form U5s at least thirty days after they join the firm; and (3) rechecking CRDs/IARDs of supervised persons three months after onboarding;
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  • establish tailored heightened supervision practices for overseeing supervised persons with certain disciplinary histories;
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  • adopt written policies and procedures for addressing client complaints relating to supervised persons; and
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  • have written procedures for overseeing supervised persons working from remote locations particularly those with past disciplinary events.

The Risk Alert also generally emphasized that it is important for investment advisers to fully consider and have written policies and procedures in place about the risks associated with employing supervised persons with disciplinary histories and any required disclosures.

In 2018, the SEC examined approximately 15% of registered investment advisers and 72% had compliance deficiencies. OCIE Risk Alerts highlight what the SEC’s concerns are on particular topics and provide invaluable guidance on how to address those concerns. In an effort to mitigate examination risk, investment advisers of all sizes should closely review the issues that OCIE identifies in their Risk Alerts, compare them to their compliance programs and take action to correct any deficiencies and/or apply the SEC’s guidance on best practices to strengthen compliance controls. Failure to do so may result in increased regulatory risk including the risk of significant examination findings or possible referrals to enforcement.


This article was written with the assistance of summer associate Taylor Bandy.

1  https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Supervision%20Initiative.pdf