The Securities and Exchange Commission has brought a wave of enforcement actions against investment advisory firms lately for compliance failures, and all indications are that the agency is just getting started on the crackdown.
Some firms the SEC is targeting haven't even experienced fraudulent behavior, but the SEC is charging the investment advisers with not having a workable compliance program in place.
The enforcement push comes as the SEC's Enforcement Division begins to flex the muscle of its newly created Asset Management Unit, which essentially provides the SEC with a “more sophisticated cop on the beat,” says Jordan Thomas, chair of the whistleblower representation practice at law firm Labaton Sucharow and former assistant director in the SEC's asset management unit.
The Asset Management Unit is investigating firms to ensure they have a viable compliance program in place. “Not all compliance failures result in fraud, but many frauds take root in compliance deficiencies,” SEC Enforcement Director Robert Khuzami said in a statement last month. “That simple truth underlies our renewed focus on identifying and charging firms and individuals that fail their legal obligations to maintain adequate compliance programs.”
Investment advisers have long been one of the weak points in the financial services food chain, overseen to some extent by many regulators by overseen closely by none. Such cracks in the system helped to allow Bernard Madoff to run his giant Ponzi scheme until it unraveled in 2008, and that prompted Congress to re-write the rules for investment advisers as part of the Dodd-Frank Act. While smaller investment advisers (with less than $100 million in assets) will now be overseen by state authorities, larger players will be under the eye of the SEC—which is also eager to demonstrate that another Madoff-style lapse won't happen again.
As part of that effort, the SEC brought enforcement actions against OMNI Investment Advisors, Feltl & Co., and Asset Advisors in November. All three advisory firms have been charged with failing to put in place compliance procedures in violation of Rule 206 of the Investment Advisers Act. Specifically, Rule 206 requires registered investment advisers to:
- Adopt and implement written policies and procedures reasonably designed to prevent, detect, and correct violations;
- Annually review the adequacy and effectiveness of the compliance policies and procedures; and
- Designate a chief compliance officer, responsible for administering the policies and procedures.
OMNI and Asset Advisors were warned of their compliance deficiencies, but failed to correct them.
“When SEC examiners identify compliance deficiencies, firms are expected to remediate them,” said Carlo di Florio, Director of SEC's Office of Compliance Inspections and Examinations. Investment advisers who ignore SEC examination warnings risk further enforcement actions, he said.
“The bottom line is that [the SEC] wants to see lots of paperwork. I had a far away compliance service giving us recommendations, but it was not good enough. We should have had a compliance officer here on staff.”
President & CEO,
In OMNI's case, the firm had neither a compliance program nor a compliance officer from September 2008 to November 2010, and the firm's advisory representatives were completely unsupervised during that period, the SEC said. Additionally, OMNI never conducted an annual review of its written compliance policies and procedures, even after SEC examiners informed OMNI of such deficiencies in 2007.
The SEC also charged OMNI Chief Executive Officer Gary Beynon, who assumed the firm's chief compliance officer post in November 2010 while living in Brazil. In this capacity, Beynon “generally did not perform any supervisory or compliance functions,” the SEC's administrative order said.
Under the settlement agreement, Beynon was permanently barred from working in the securities industry and from associating with any investment company. He also will pay a $50,000 penalty.
Asset Advisors also faced charges of failing to fully implement a compliance program. In May 2007, Asset Advisors adopted written compliance policies and procedures only after SEC examiners alerted the firm to its compliance failures, according to the SEC's administrative order.
In addition, from January 2005 through April 2007, the firm failed to adopt a written code of ethics. In May 2007, after the SEC alerted the firm of its obligations, Asset Advisors adopted a code of ethics. Nevertheless, the firm failed to maintain and enforce the code by failing to collect written acknowledgements of the code from employees.
Carl Gill, president and CEO of Asset Advisors, says the SEC is unfairly targeting smaller firms because they're sitting ducks. Small firms “don't have half-million dollars and 12 attorneys to stonewall the SEC like most of the other big firms, so they come and pick on us,” Gill said in a phone interview. The big firms can fight off the SEC “much better than us little piss-ants.”
The following excerpt is from the SEC's press release regarding the Commission's action taken against three investment advisers:
OMNI Investment Advisors and Gary R. Beynon
According to the SEC's order in the case against OMNI and Beynon, the firm failed to adopt and implement written compliance policies and procedures after SEC examiners informed OMNI of its deficiencies. Between September 2008 and August 2011, OMNI had no compliance program and its advisory representatives were completely unsupervised. Beynon assumed the chief compliance officer responsibilities in November 2010 while living abroad.
OMNI failed to establish, maintain, and enforce a written code of ethics, and failed to maintain and preserve certain books and records. In response to a subpoena, OMNI produced client advisory agreements with Beynon's signature evidencing his supervisory approval when, in fact, Beynon had never reviewed the agreements. Beynon backdated his signature on those agreements one day before the documents were produced to the Commission.
Under the settlement, Beynon agreed to pay a $50,000 penalty. He also agreed to be permanently barred from acting within the securities industry in any compliance or supervisory capacity and from associating with any investment company. Additionally, as part of the settlement, OMNI agreed to provide a copy of the proceeding to all of its former clients between September 2008 and August 2011.
Feltl & Company, Inc.
According to the SEC's order against Feltl & Company, the firm failed to adopt and implement written compliance policies and procedures for its growing advisory business. It further neglected to adopt a code of ethics and collect the required securities disclosure reports from its staff. As a result of its compliance failures, Feltl engaged in hundreds of principal transactions with its advisory clients' accounts without informing them or obtaining their consent as required by law. Feltl also improperly charged undisclosed commissions on certain transactions in clients' wrap fee accounts.
Under the settlement, Feltl & Company agreed to pay a penalty of $50,000 and return more than $142,000 to certain advisory clients. Additionally, the firm will hire an independent consultant to review its compliance operations annually for two years, provide a copy of the SEC's order to past, present and future clients, and prominently post a summary of the order on its Website.
Asset Advisors LLC
According to the SEC's order against Asset Advisors, SEC examiners found that the firm had failed to adopt and implement a compliance program. After SEC examiners brought it to the firm's attention, Asset Advisors adopted policies and procedures but never fully implemented them. Similarly, Asset Advisors only adopted a code of ethics at the behest of the SEC exam staff and then failed to adequately abide by the code.
Under the settlement, Asset Advisors agreed to pay a $20,000 penalty, cease operations, de-register with the Commission, and—with clients' consent—move advisory accounts to a firm with an established compliance program.
Feltl & Company, Asset Advisors, OMNI Investment Advisors and Beynon did not admit or deny the allegations. In addition to the penalties, they all consented to cease-and-desist orders and agreed to be censured.
“The bottom line is that they want to see lots of paperwork,” Gill adds, which presents unique challenges for a one-man shop. “I had a far-away compliance service giving us recommendations, but it was not good enough. We should have had a compliance officer here on staff.”
The chief compliance officer at small advisory firms often does wear more than one hat, “so sometimes the compliance function is viewed as sort of an afterthought,” says Jay Gould, a partner of Pillsbury Winthrop Shaw Pittman. That's a “huge mistake” and “something the Commission takes very seriously,” he adds.
The lesson for other advisory firms: “There is no substitute like having a full-time compliance officer,” Gill says. “That's really all it comes down to.”
The SEC enforcement action was a death sentence for Asset Advisors. Under the settlement, the firm agreed to cease operations and transfer its advisory accounts to another SEC-registered investment adviser with a compliance program. The firm must additionally pay a $20,000 fine.
In the third enforcement action, the SEC charged Feltl & Co. with failing to adopt and implement written compliance policies and procedures for its growing advisory business. The firm also neglected to adopt a code of ethics and collect the required reports from its staff.
Chet Taylor, general counsel for Feltl, explains that Feltl is “primarily a commission-based securities broker-dealer,” and that the firm created a Registered Investment Advisory to accommodate a small percentage of its customers who prefer to pay asset-based fees, rather than transactional-based commissions. “The advisory-fee business conducted through the RIA represents only about 5 percent of the firm's revenue,” he says.
“The mistake we made was using the same compliance systems and procedures to supervise our advisory accounts that we used to supervise our brokerage accounts,” Taylor says. The firm did so, he says, because the only difference between the firm's advisory customers and brokerage customers is that the former pays a percentage of their assets, and the latter pays a commission on each transaction.
“It makes no sense that our duties to our customers change depending on how we are compensated,” Taylor adds. “Nevertheless, that clearly is the current state of the law, and until that changes, we will employ separate systems and procedures to supervise our advisory accounts.”
Under the settlement, Feltl & Co. agreed to pay $50,000 and return more than $142,000 to advisory clients. Additionally, the firm will hire an independent consultant to review its compliance operations annually for two years, provide a copy of the SEC's order to clients, and post a summary of the order on its Website.
More to Come
The SEC warned that investigations related to the Asset Management Unit's compliance program initiative are continuing. “Any organization that fails to establish an effective compliance program is vulnerable to enforcement actions by the SEC,” Thomas says.
Compliance officers at investment firms shouldn't take comfort in the mere fact that they already have a compliance program in place. “The bar is going to rise for all organizations to implement stronger investor protection policies and procedures,” Thomas says.
In fact, the SEC filed a record 146 enforcement actions against investment advisers in fiscal 2011, a 30 percent increase over the previous year, and a nearly 200 percent increase since 2002, when the SEC filed 52 cases. The SEC filed another 112 enforcement actions against broker-dealers, a 60 percent boost from fiscal year 2010.
And many expect those numbers to continue to climb. “I would expect the number of enforcement actions involving investment advisers to increase in the coming years,” Thomas says. He reasons that the Asset Management Unit was established less than two years ago and that SEC investigations often take two to four years to complete—as evidenced by the SEC's last annual report which indicated that only 61 percent were resolved within two years. “That wave is coming in the next year or two,” he says.
On top of more enforcement actions, the significance of the cases are also likely to grow because more and more whistleblowers at investment advisers are expected to come forward now that the whistleblower provisions of the Dodd-Frank Act are in place. “More individuals have been willing to come forward because the incentives and protections are far stronger than they ever were,” Thomas adds. “So the full impact of the asset management unit hasn't been fully felt yet.”