During fiscal 2012, the Securities and Exchange Commission's enforcement division filed 734 enforcement actions, one short of its 2011 record. An SEC unit targeting investment advisers took a record 147 enforcement actions against advisers in fiscal 2012. This represented a 30% increase over 2010 and a 200% increase over 2002.
These actions have been generated by the SEC's Asset Management Unit, which was created by the SEC's Department of Enforcement in 2010.
For registered investment advisers, times have changed, indeed. Unfortunately, too many investment advisers are living in 2002 when it comes to awareness of and preparation for regulatory action.
The types of companies targeted have evolved. Now there is much more enforcement activity involving RIAs. Companies falling under that description often include wealth management firms with varying business models, including family offices, hedge funds and private-equity firms, as well as more-traditional advisory firms. In essence, any firm that includes as part of its business model offering investment advice for a fee may now operate as an RIA, subject to SEC regulations under the Investment Advisers Act of 1940.
The SEC recently has focused on custody, as well as the adequacy of a firm's compliance program, policies and procedures.
On March 4, the SEC's Office of Compliance Inspections and Examinations issued a Risk Alert and Investor Bulletin on the Investment Advisor Custody Rule. The risk alert followed a review of recent examinations where significant deficiencies were identified, and it noted custody-related issues in nearly one-third of the firms examined.
Advisers' deficiencies included:
• Failure to recognize that they have custody, such as situations where the financial adviser serves as trustee and is authorized to write or sign checks for clients, or is authorized to make withdrawals from a client's account as part of bill-paying services.
• Failure to meet the custody rule's surprise-examination requirements. Those requirements in-clude, among other stipulations, that RIAs deemed to have custody of client funds or securities must submit to an exam by an independent public ac-countant at least once a year at a time chosen by the accountant, without prior notice.
• Failure to satisfy the custody rule's qualified-custodian requirements, for instance, by commingling client, proprietary and employee assets in a single account or by lacking a reasonable basis to believe that a qualified custodian is sending quarterly account statements to the client.
For advisers to pooled investment vehicles, the exams found that certain RIAs had failed to meet the requirement that they engage an independent accountant and also failed to demonstrate that financial statements were distributed to all fund investors.
The OCIE director emphasized that deficiencies in the area of custody are taken very seriously and that custody “is a key component of our investment adviser examination program.”
RIA firms vary widely in their level of preparedness.
Although some companies devote substantial time and money to compliance, many don't.
Firms often have greater complexity or a wider range of activities than set forth on their ADV forms, resulting in compliance gaps. Some firms strictly adhere to the letter of the law. And some have a false sense of security, perhaps thinking that it is enough to have an individual devoting a modest amount of his or her time to compliance or because it occasionally consults with an outside compliance professional.
Inadequate preparation is inexcusable, particularly from the SEC's perspective. And it is less problematic and expensive to fix problems beforehand than it is once the SEC points them out.
Although it is uncomfortable to think about, RIAs — even smaller advisers trying to stay competitive — must consider how an enforcement action will affect their ability to compete if regulators discipline their firm through fines or other measures.
Scary but preventable
Indeed, suspensions aren't uncommon if the firm is deemed to have failed to supervise or have adequate policies and procedures reasonably designed to prevent problems found by regulators. This scary scenario is preventable if a firm devotes some time and resources before a situation arises and before the SEC shows up at their doorstep.
Firms should first analyze their risks and figure out if their compliance programs adequately address them. Focus on “hot button” areas such as custody, corporate governance and financial controls.
Executives should ask themselves these questions:
• Is ultimate control in the hands of one person?
• Is there inadvertent custody?
• Is the chief compliance officer able to adequately “control” the principals/officers?
• Is there sufficient separation of duties and other appropriate financial controls?
Second, shore up the basics. Firms should make sure they have strong compliance programs, and that their policies and procedures are tailored specifically to their business and cover all activities.
Other questions to ask include:
• Do the firm's policies and procedures have gaps that need to be filled? Have they been updated regularly?
• Does the ADV capture all activities?
• Is the firm's marketing/advertising SEC-compliant?
• Do employees comply in all respects with the written code of ethics?
• Has the firm addressed all deficiencies noted from any prior exams?
Third, in an SEC exam, a number of helpful practices should be considered.
It is important to designate the right person to serve as exam coordinator. That person, preferably with the assistance of counsel, should coordinate the flow of information to the regulator.
Other tips include:
• Anticipate the focus of the exam.
• Review the scope of requests. Consider the need to contact SEC staff to clarify or narrow the scope of requests.
• Establish a log to record all SEC staff requests, and the documents and information provided to the commission, including date of request and date provided.
• Prepare company personnel. Company representatives should ensure they are accompanied by the company's exam coordinator when talking to the SEC.
• Invite the firm's legal counsel to prepare key personnel for interviews by the SEC. The SEC is using more interviews than ever before.
• Correct what can be corrected. Remedial measures may help avoid enforcement action or at least reduce the severity of any penalties. If deficiencies are noted, implement corrective measures.
Fourth, as alluded to above, consider involving an attorney experienced in SEC matters. This is complicated stuff, particularly where the laws and regulations are constantly evolving or changing. An experienced CCO should know when to involve legal counsel.
Remember, times have changed. Taking a devil-may-care attitude may prove very costly. By being proactive, advisers will reduce the stress surrounding compliance exams, reduce deficiencies and lessen the likelihood of a referral to the SEC's enforcement division.
Matthew T. Boos (mboos@fredlaw.com) is an attorney with Fredrikson & Byron PA and co-chairman of Fredrikson's investment management practice group.
