Jaqueline M. Hummel, Managing Director
Hardin Compliance Consulting
June 25, 2015
There have been three events in the last month to give compliance professionals hope. Ever since the passage of Advisers Act Rule 206(4)-7 (“the Compliance Program Rule”), the SEC has increasingly placed Chief Compliance Officers (“CCOs”) in their cross hairs. But in the last month, SEC Commissioner Daniel M. Gallaher came out with a well-reasoned statement telling the SEC to back off from imposing a strict liability standard for CCOs.1 In addition, SEC Administrative Law Judge (“ALJ”), James E. Grimes, found an investment adviser’s reasonable reliance on the advice of compliance professionals met industry standards of due care.2 This is the first time an SEC administrative judge was willing to provide guidance to investment advisers and give them credit for taking reasonable measures to comply with their disclosure obligations. Finally, in a move that should have compliance officers rejoicing nationwide, the SEC has at long last recognized what CCOs have known for years – that without management support and sufficient resources, it is not possible to run a successful compliance program.3
Kudos to Commissioner Daniel M. Gallagher for his willingness to publicly state what many compliance professionals have already concluded: that the SEC has been imposing a strict liability on CCOs under the Compliance Program Rule for failure to “implement” a firm’s compliance policies and procedures. This position ignores the role firm management plays in regulatory compliance. As most compliance officers will attest, the CCO cannot implement an effective compliance program without the support and assistance of the firm’s management.
In his statement, Commissioner Gallagher noted that the rule itself fails to provide any clarification as “to the distinction between the role of CCOs and management in carrying out the compliance function.” The rule merely states that the CCO is responsible for administering the compliance program, but the adviser itself is responsible for implementation of the firm’s policies and procedures. Notably, in the 11 years since the Compliance Program Rule was enacted, however, the SEC has provided no guidance to investment advisers to define the roles and responsibilities, aside from the many enforcement actions outlining their failures. He astutely acknowledges the “perverse incentives that will naturally flow from targeting compliance personnel who are willing to run into the fires that so often occur at regulated entities.”
The second event indicating that the regulatory tide may have turned for CCOs came from ALJ James E. Grimes. In this case, the SEC alleged that The Robare Group, Ltd. (“TRG”), a registered investment adviser, failed to provide adequate disclosure regarding a compensation arrangement TRG had with Fidelity, its custodian, and Triad Advisers, a registered broker dealer.4
The judge went to great lengths to describe the process for drafting the appropriate language for the Form ADV from 2005 through 2013, validating the contention that the adviser was exercising due care. The two principals did not have expertise with respect to including the appropriate disclosure in the Form ADV, so they relied on experts to help them describe the compensation arrangement, which all parties agreed could be a conflict of interest for TRG. In dismissing the case, ALJ Grimes acknowledged how difficult it is to appropriately disclose conflicts of interest, and gave credit to the firm’s principals for their efforts in a situation where none of the parties seemed to agree on the right language.
Perhaps most importantly, the judge at long last provided investment advisers with direction on the appropriate standard of care for disclosing conflicts of interest in Form ADV. In coming to his conclusion, the judge relied heavily on the testimony of a compliance expert, including her statement that “with respect to Form ADV disclosures, advisers operate in a difficult environment that presents challenges for even experienced compliance professionals.” As a result of this testimony, ALJ Grimes concluded that “employing a compliance professional and following his or her advice” met industry standards of due care. These comments indicate a willingness by at least one judge to require the SEC to demonstrate why an adviser’s compliance efforts were deficient, instead of simply stating that regulatory violations occurred and consequently the firm did not meet its standard of care.
A few other minor points that bear mentioning. First, the judge notes in his opinion that the principals of the firm were credible witnesses who were clearly trying to do the right thing. The firm had a 97% client retention rate, indicating that its clients had a high level of satisfaction with the services being provided. Second, the principals were able to convince the court that even though they were compensated under the Program Agreement, their investment decisions were not influenced by those payments. Third, ALJ Grimes specifically states that no clients were harmed in this situation. It is refreshing to see a government official focusing on what should be most important to the SEC: whether the adviser’s actions were reasonable under the circumstances, and whether clients were harmed.
The most recent cause for celebration among compliance professionals came in the form of an administrative proceeding, In Re Pekin Strauss Asset Management, Inc.5 In this case, the SEC placed the blame squarely on firm management for failure to devote adequate resources to compliance, instead of finding the CCO at fault. The Commission found that firm management failed to provide the CCO with sufficient guidance regarding his duties and responsibilities or adequate assistance to fulfill his compliance role.
Surprisingly, the SEC focused on the actions of the adviser’s president, who specifically instructed the CCO to prioritize his other firm responsibilities over compliance work, and failed to engage the assistance of a compliance consulting firm, despite repeated requests and warnings from the CCO. It wasn’t until the firm’s president received pressure from the board of a mutual fund that was managed by the firm that he finally agreed to hire a compliance consultant – but only on a limited basis.
Ultimately, the SEC found that the firm and its principals violated the Compliance Program Rule, and Rule 204A-1, relating to establishing, maintaining and enforcing a written code of ethics. The SEC imposed sanctions against the president, including a 12-month suspension from acting in a compliance and supervisory capacity in the financial services industry. The president and two other firm principals were also required to pay civil penalties of $45,000. Additionally, the firm was required to pay a fine of $150,000.6
Although it is probably too early to predict a sea change, it is at least heartening to see someone at the SEC recognize the chilling effect of finding CCOs guilty of compliance failures. Being a CCO is a tough job that often comes without much praise or financial remuneration. In many firms, the CCO does not wield the same power as other management positions. Compliance officers must become adept at persuading management of the efficiencies and cost savings of compliance efforts in order to obtain the resources they need. Many firms view compliance as a cost center as opposed to a revenue generator, making it an uphill battle to wrest the appropriate funds to support the compliance program from the firm-wide budget. At least now compliance officers have a few definitive statements from the SEC to show management that ignoring requests for additional resources could result in personal fines and sanctions.
2In re The Robare Group, et al, Admin. Proceeding File No. 3-16047, www.sec.gov/alj/aljdec/2015/id806jeg.pdf
3In re Pekin Singer Strauss Asset Management, Inc., IA Release No. 4126
6It should be noted that there was an additional issue related to the sale of mutual fund classes, but it appears that the firm self-reported that issue and fully reimbursed clients prior to the entry of the order.