SEC's "ComplianceAlert" Provides Helpful Guidance to Investment Advisers and Their Attorneys

by James J. Eccleston, Esq.

s part of its compliance outreach program, the Securities and Exchange Commission (SEC) has decided to publicize some of the deficiencies and weaknesses that it has uncovered during its examinations of financial services firms. Unveiled for the first time in June, 2007, the SEC's "ComplianceAlert" is designed to alert financial professionals so that they can review their practices, procedures and programs, and make whatever improvements are necessary or desirable - before the SEC examines them!

The scope of this first ComplianceAlert is broad, because it relates to numerous deficiencies found among investment advisers, mutual funds and brokerage firms. Let's examine two deficiency areas that relate to investment advisers. They are deficiencies in performance advertising and in disaster recovery plans.

Regarding performance advertising, the SEC discloses that it "identified a number of deficiencies", and that the most common deficiency was that "many" advisers did not include certain disclosures in their advertisements to prevent the advertisements from being misleading. As examples, the SEC reveals that investment advisory firms failed to deduct advisory fees from performance results; failed to disclose whether results reflected dividends; and failed to disclose differences with the particular benchmark index that they had used to compare performance claims. Likewise, "many" investment advisers advertised their past specific recommendations but used only partial lists of recommendations.

Additionally, about one-third of investment advisers lacked compliance policies and procedures governing marketing and performance advertising. Others maintained ineffective procedures.

On a positive note, "firms with fewer deficiencies" maintained policies and procedures such as:

A multi-level review and approval process of materials prior to their use;

The creation of monthly "tolerance reports" to compare all composite accounts to their respective benchmarks, investigating all discrepancies;

A quarterly composite committee review of all accounts to ensure proper composite construction and maintenance; and

The use of a second, independent pricing service to periodically verify the accuracy of prices supplied by the primary pricing service, investigating all discrepancies.

Finally, a "very common deficiency" found to exist was advisers' claims that they were in compliance with the CFA Institute's performance presentation standards when, in fact, they were not. This deficiency was all the more notable because most of the advisers further were claiming that someone else had "verified" their calculations and methodology.

The second deficiency area relates to investment advisers' disaster recovery plans. The SEC examined advisers in Louisiana and Mississippi which were affected by Hurricane Katrina in August, 2005. The SEC reveals in its ComplianceAlert that "most" (though not all) of the investment advisers examined complied with the law in having a disaster recovery plan in place. Of those who had a plan, most, but not all, addressed hurricanes and flooding.

Hurricane Katrina forced all of the investment advisory firms to relocate, and they did so on average 330 miles away from their original office locations. Despite that fact, all of the firms were able to "conduct general business operations." Specifically, firms were able to resume trading and manage accounts within 32 hours of the hurricane and to resume general operations within 5 days of the hurricane.

Most, but not all, firms were able to access their electronically-stored business records and client data from their remote locations because they maintained remote servers, laptop computers, back-up data tapes, Internet access and online trading platforms. That said, some firms were required to return to the hurricane site in the days and weeks thereafter to physically retrieve their servers from their original offices!

None of the investment advisory firms reported that clients had difficulty accessing their funds or initiating transactions. Communications occurred at most firms through email and the firms' websites, as well as through cell phones that could send and receive text messages. Clients also were able to contact the custodian firm of the investment adviser. Not a single firm reported receiving any client complaints concerning operations or service.

The SEC reveals particular provisions of disaster recovery plans which appear to have been effective:

Pre-arranged remote location for possible long-term use;

Alternative communication protocols to contact staff and clients;

Remote access to business records and client data (appropriately secured in compliance with Regulation S-P and other confidentiality requirements);

Temporary lodging for key staff;

Maintaining accurate contact information for all third-party service providers, such as custodians;

Familiarity with the business continuity plans for such third-party service providers;

Contingency plans for the loss of key personnel;

Effective training of staff on how to fulfill essential duties;

Periodic testing, evaluation and revision of the plan; and

Maintaining sufficient insurance and financial liquidity to prevent the interruption of services.

As one can see, the SEC's ComplianceAlert is a worthwhile compliance guide for investment advisers!

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James Eccleston, an attorney specializing in adviser and broker-dealer issues, is a partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston in Chicago.