Compliance Program Rule, Rule 206(4)-7 | Compliance Programs | Examinations and Audits | Investment Advisers Act

Just in time for Halloween: Compliance Rule Horror Stories (Part 1 of a 3-part series)

Compliance Rule Horror Stories

October 18, 2014

Jaqueline M. Hummel, Managing Director, Hardin Compliance Consulting, LLC

In observance of the ten-year anniversary of the Compliance Program Rule (Rule 206(4)-7 of the Advisers Act) which became effective on October 5, 2004, I am presenting a three-part series to discuss the SEC’s use of this enforcement tool. The first part discusses the early settlement actions, where the Commission grabbed the low hanging fruit: firms with inadequate programs and compliance officers that were, at best, clueless, or, at worst, willfully ignorant. The second part follows the evolution of the enforcement of the Compliance Program Rule, where the Commission starts linking compliance program failures to fraudulent activity. The final part of the series discusses the increasingly scary settlements. In these cases, the SEC appears to be replacing the “reasonableness” standard set forth in the rule to one of strict liability.

The early cases follow a script similar to a horror film.  The SEC warns the industry about its new rule, meant to protect against the investing public from unscrupulous advisers. Unwitting advisers ignore the warning and later receive a personal visit from SEC staff, strongly advising them to clean up their act and comply. Like those poor victims in the horror films, however, the advisers ignore the advice and end up with a very unhappy ending. For the most part, however, the SEC has specifically sought to punish the guilty, not only fining advisory firms, but imposing sanctions on those individuals the SEC found to be responsible, including, in some cases, the Chief Compliance Officer.  Those sanctions included escalating fines and, in some cases, industry bans.

And as time goes on, the SEC has been championing its theory that an effective compliance program can prevent securities laws violations.  The SEC’s Compliance Program Initiative, stared in 2011, specifically targets firms previously warned by SEC examiners about compliance deficiencies but failed to act.  In cases settled as part of this initiative, the SEC asserted that if those problems had been addressed, the firms could have prevented their eventual securities law violations.

Effective compliance policies and procedures can certainly help protect investors by preventing and detecting securities laws violations. But making the compliance officer an adviser’s first and primary line of defense will not prevent investor harm. Individuals or companies motivated by greed will always find new and ingenious ways to circumvent compliance procedures. And if compliance efforts are not fully supported by firm management, the Chief Compliance Officer (“CCO”) is not going to make much headway.

The original purpose of the Compliance Program Rule was to require firms to adopt policies and procedures “reasonably designed to prevent violation of the federal securities laws.” Based on the SEC’s more recent actions, this reasonableness standard is being replaced by strict liability, making life much scarier for compliance officers.

You’ve been warned.

Many of the cases brought under the Compliance Program Rule follow a similar pattern. The basic facts include a visit from SEC staff, who tell the adviser to develop and maintain a compliance program as required by Rule 206(4)-7, and conduct the required annual review of the efficacy of the program.  The adviser thumbs its nose at the SEC by ignoring these directives.

The next time (or the time after that) the SEC comes back, the adviser has failed to make sufficient progress and, predictably, the SEC gets tough. And in those cases where investors are harmed, the adviser tries to mislead the SEC staff or there is fraud, the punishments get increasingly more severe. But in almost all of these cases, any compliance officer worth his or her salt could have seen SEC sanctions coming a mile away.

The first two settlement orders are good illustrations of the typical scenario, CapitalWorks Investment Partners and Consulting Services Group, LLC. The SEC told the adviser exactly what it expected, and then came back to see the adviser met the expectations. In both situations, the adviser not only failed, but actively misrepresented facts to the SEC and/or its clients. The SEC punished both firms with fines and required them to hire outside consultants to make things right. The SEC also imposed fines on the individuals it found responsible for the misrepresentations, which, in one case, was the CCO.[1]

In 2010, the SEC brought a case with a much better set facts for articulating its expectations under the Compliance Program Rule. The SEC alleged that Buckingham Capital Management, Inc. (BCM), a registered investment adviser, and its registered broker-dealer parent company, The Buckingham Research Group, Inc. (BRG), had inadequate compliance procedures, and had failed to follow its existing procedures. The SEC also charged the advisory firm with altering compliance records and failing to perform the required annual review of its compliance program.

As part of their settlement with the SEC, BCM and BRG were required to retain an independent compliance consultant and adopt the recommendations provided by the consultant to improve their compliance policies and procedures.  Penalties were also imposed:  $50,000 for BRG; $75,000 for BCG; and $35,000 for the CCO found responsible.

There are a number of cases that follow a similar pattern, where the SEC had previously noted deficiencies in the compliance program, and the adviser did little or nothing to fix them. These cases include: OMNI Investment Advisers Inc.[2]  i, Consultiva Internacional, Inc.[3], Equitas Capital Advisers LLC, and Equitas Partners LLC, Stephen Derby Gisclair [4]and Modern Portfolio Management Inc. (MPM), and IMC Asset Management, Inc.[5]

In the MPM case, however, the SEC added an additional sanction to the usual fines, client disclosure and retention of an independent compliance consultant: 30 hours of compliance training for the firm’s principals. The SEC seemed particularly annoyed that the firm selected someone with virtually no experience to act as CCO, and ignored the issues cited by the SEC staff not once, but twice.

In most of these cases, the lessons for investment advisers are obvious, but are summarized here.

  1. Adopt a compliance programs and a code of ethics and enforce
  2. Follow your written
  3. When advised of a violation, fix it
  4. Adopt policies and procedures that address your firm’s business practices and operations.
  5. Do not mislead the SEC during an
  6. Perform an annual review of your firm’s compliance program and put the results in writing.
  7. Ensure that the annual review is more than just an update of the compliance manual; include an analysis of the policies and procedures that addresses their adequacy and the effectiveness of their implementation.

Square Pegs in Round Holes

The next line of cases involves firms that started out as broker dealers and expanded into advisory services. In the majority of these cases, the firm’s compliance program did not keep up with the firm’s new business.[6] Typically the CCO had little or no background in the Investment Advisers Act of 1940 and very little thought went into the compliance manual. Consequently, the SEC found these firms in violation of the Compliance Program Rule and the Code of Ethics Rule (Rule 204A-1 of the Advisers Act). Harsher sanctions were doled out for firms whose ignorance of the Advisers Act led to harming clients.

Alpine Woods Capital Investors case is a good example. The SEC focused on the firm’s over- allocation of IPOs to its smaller funds, which violated the firm’s allocation procedures and contravened the disclosure in its Form ADV Part 2A. The firm further compounded these violations by failing to disclose the effect that IPO trading had on the funds’ performance or the risks associated with short-term IPO trading. Apparently the CCO was so overwhelmed with his responsibilities within the firm that it was physically impossible for him to devote sufficient time to oversee the firm’s compliance program. The CCO requested additional resources, which management failed to provide.

Ultimately, the firm settled with the SEC and was ordered to pay a civil penalty of $650,000. The firm’s CEO and portfolio manager, who appeared to be primarily responsible for most of the issues raised by the SEC, was individually ordered to pay a civil penalty of $65,000. The SEC seemed to take pity on the CCO, who was not held personally liable or fined for the firm’s compliance failures. Predictably, the firm was also required to hire an independent compliance consultant for two years to help improve its compliance policies and procedures.

There is not much to learn from these cases, since most knowledgeable compliance officers would have spotted these issues right away.  Here is a summary:

  1. Engage a CCO with sufficient knowledge of the Advisers Act to create and manage a compliance
  2. Provide the CCO with sufficient resources to carry out his/her duties
  3. Understand that the rules governing broker dealers are very different from investment advisers’ fiduciary

In Part 2 of this series:  Adding insult to injury, a day late and a dollar short, and Scarier Stories


[1] In Consulting Services, the firm was required to pay a $20,000 fine, and one of its principals, who acted as CCO, was fined $10,000 and barred from acting in a compliance capacity for a broker, dealer or investment adviser. In CapitalWorks Investment Partners, the firm was fined $40,000 and the individual responsible for the violations was fined $25,000.

[2] Adviser failed to correct deficiencies from prior exam, lost and did not replace its CCO, failed to perform annual review. SEC barred the firm’s owner and CCO from the industry and required him to pay a $50,000 penalty.

[3] Adviser failed to follow up on deficiencies noted during exam, including CCO with lack of knowledge and inadequate compliance manual. Settlement order required firm to hire an independent compliance consultant for two years, provide clients and potential clients with a copy of the settlement order for the next year, and pay a fine of $35,000.

[4] Adviser failed to correct ongoing compliance violations and failing to adopt and implement written compliance and policy procedures. Firm agreed to pay penalties of $100,000, and $35,000 for firm CEO, hire independent compliance consultants and notify clients of these issues. Stephen Gisclair acted as CCO for Equitas, personally fined $90,000.

[5] SEC alleged the firm’s compliance officers “performed virtually no compliance-related functions” and that the CCO had very little compliance experience or training. Adviser failed to perform an annual review of  its compliance program or to update its compliance policies and procedures. Firm was required to retain an outside compliance consultant and provide training for its CCO on the Adviser’s Act.

[6] Wunderlich Securities, Inc., Tracy L. Wiswall, and Gary K. Wunderlich, Jr., IA Release 3211, May 27, 2011.; (Adviser found to have overcharged advisory clients for commissions and other transactional fees, failed to disclose and get client consent for principal transactions, and violated the Compliance Program Rule and Code of Ethics Rule. Sanctions imposed included repaying clients $369,000, a fine of $125,000 to be paid by the firm, a fine of $50,000 to be paid by the CCO, and a fine of $45,000 to be paid by the CEO. OMNI Investment Advisers Inc. and Gary R. Beynon, IA Release 3323 (November 28, 2011) (Adviser failed to correct deficiencies from prior exam, lost and did not replace its CCO, failed to perform annual review. SEC barred the firm’s owner and CCO (same person) from the industry and required him to pay a $50,000 penalty.) Feltl & Company, Inc., IA Release No. 3325, November 28, 2011, (Dually registered broker-dealer and investment adviser failed to comply with Compliance Program Rule and Code of Ethics Rule. SEC found firm overcharged wrap fee clients by charging both wrap fees and commissions, and engaged in principal transactions without appropriate disclosure and consent. Firm agreed to repay clients $142,000, retain compliance consultant, and pay $50,000 fine). Asset Advisors LLC, IA Release No. 3324, November 28, 2011, (Advisor had no knowledge of Compliance Program Rule prior to SEC examination, and failed to address deficiencies in compliance program after SEC exam. Firm agreed to pay $20,000 fine, cease operations and de-register with SEC)