Recent SEC enforcement actions make annual policies and procedures exams even more important

Time is getting short for a registered investment advisers to conduct its annual audit of the firm’s policies and procedures. Rule 206(4)-7 under the Investment Advisers Act requires SEC-registered firms to conduct a yearly review of their policies and procedures. State-registered advisers will also benefit by reviewing the effectiveness of their policies and procedures.

Annual audits of the firm’s policies and procedures can make the New Year better for both advisers and their clients. The SEC strongly believes that one of the best ways to protect an RIA’s clients is for the firm to adopt robust and meaningful policies and procedures.

Have you looked at your policies and procedures lately?

While Rule 206(4)-7 only requires RIAs to conduct an annual review, advisory firms may benefit by conducting interim reviews in response to regulatory developments or a complaint by a client. State-registered advisers will also benefit by reviewing the effectiveness of their policies and procedures. If policies and procedures are weak, compliance problems are more likely to occur.

Policies and procedures should be reasonably designed to prevent, detect and correct securities law violations. They help RIAs to avoid potential compliance risks arising from the firm’s business model and should address the specific risks identified by the RIA. Investment advisers won’t score points with examiners by having superfluous or irrelevant policies and procedures. For example, having a policy and procedure relating to the oversight of solicitors is meaningless if the RIA does not use them to market the firm’s services.

Policies and procedures are on regulators’ hit list

On Nov. 28, the SEC brought three separate actions against advisory firms that failed to implement effective policies and procedures designed to protect investors and prevent securities laws violations. According to the SEC’s press release:

“The cases stem from an initiative within the SEC Enforcement Division’s Asset Management Unit to proactively prevent investor harm by working closely with agency examiners to ensure that viable compliance programs are in place at firms.”

In the press release, Robert Kaplan, co-chief of the Asset Management Unit, stated that an RIA’s failure to adopt and maintain adequate compliance policies and procedures is a significant violation of the federal securities laws.

An RIA’s failure to implement policies and procedures can lead to other compliance problems and rule violations. One of the firms charged by the SEC, a Minnesota RIA/broker-dealer, engaged in hundreds of principal transactions with the accounts of advisory clients without making the necessary disclosures and receiving the consent required by Section 206(3) of the Investment Advisers Act. The firm violated other SEC rules by charging undisclosed commissions on certain transactions in wrap fee accounts and failing to adopt a code of ethics. It also failed to conduct an annual review of the firm’s policies and procedures to measure their effectiveness.

In an order announced on the same day, the SEC charged an RIA in Utah with failing to adopt and implement written compliance policies and procedures. The RIA had no compliance program in place from September 2008 to November 2010, and had no chief compliance officer during that time frame. When the RIA’s sole owner and CEO assumed the CCO’s duties in November 2010, he was living in Brazil. In addition to violating the Code of Ethics Rule, the RIA willfully violated Rule 206(4)-7 and failed to conduct an annual audit of the firm’s policies and procedures.

The third RIA, located in Troy, Mich., had no written compliance policies and procedures from October 2004 through April 2007. The RIA finally adopted policies and procedures in May 2007, after receiving a warning from SEC examiners about its compliance errors. The RIA never fully implemented its compliance program and did not review its policies and procedures each year, even though the firm had been warned about the requirement.

Serious infractions

In a Nov. 30 article on RIABIZ.com, experts debated whether the SEC punished these advisers too severely or let them off easy. See: How much should RIAs shake in their boots after the SEC punished three firms then put out a detailed press release?.

From my perspective, these were very serious infractions. At a minimum, RIAs are expected to appreciate the importance of implementing effective compliance policies and procedures and should know that they must adopt and comply with a code of ethics. In bringing these actions, the SEC used fines to reinforce that message and show advisers there are consequences for ignoring prior warnings. The Commission also imposed ongoing sanctions that will hamper the RIAs’ ability to market themselves.

The RIA from Minnesota agreed to pay a $50,000 penalty and refund more than $142,000 to specified advisory clients. The firm also agreed to engage an independent consultant to review its compliance operation for two years. Aside from providing a copy of the SEC’s order to past and present clients, the RIA must show it to prospective clients for twelve months. The RIA must also place a summary of the order and a hyperlink to it on the firm’s principal website for twelve months.

The Michigan adviser was ordered to pay a civil money penalty in the amount of $20,000. The RIA also agreed to withdraw its registration with the Commission and transfer the firm’s existing advisory accounts to a new RIA with a fully-developed compliance program.

The CCO for the RIA in Utah was fined $50,000 and was permanently barred from acting in any compliance or supervisory capacity within the securities industry. The RIA agreed to provide a copy of the proceeding to all of its former clients from September, 2008 to August 2011.

To avoid similar problems, RIAs should make certain that they have conducted reviews of their policies and procedures. Policies and procedures help RIAs to stay compliant, which is a gift that keeps on giving.

Les Abromovitz is a senior consultant with National Compliance Services, Inc. Les, an attorney, is the author of Growing Within the Lines: The Investment Adviser’s Advertising and Marketing Compliance Guide. His new book, The Investment Advisor’s Compliance Guide, will be published in 2012. Les can be reached at 561-330-7645, Ext. 213, or at LAbromovitz@ncsonline.com.