Investment Advisers Put On Notice Of Current SEC Compliance Concerns

By James Eccleston

ecently, Lori Richards of the Securities Exchange Commission notified investment advisers of the SEC's current compliance concerns. In a speech entitled, "Compliance in Today's Environment: Step Up to the Challenge", the director of the SEC's Office of Compliance Inspections and Examinations urged investment advisers to "take a fresh look" at four compliance risks. Let's examine those four compliance risks.

Preliminarily, Ms. Richards reminded the audience that the overarching goal of any compliance program is to "assure that the conduct of the firm and its employees meets fiduciary standards owed to advisory clients, and that the firm is truly preventing problems, misdeeds and misconduct in the first place." Along those lines, Ms. Richards cautioned firms that they must have "fully-operational, effective, compliant compliance programs." Indeed, the compliance program must be "evergreen", which Ms. Richards defined as a continuing, "thorough and careful review of new compliance risks due to changes in the firm's business, its structure, its products, its service providers or other changes…."

To that end, Ms. Richards highlighted four current compliance risks. They are: 1) disclosure; 2) custody; 3) performance claims; and 4) the resources supporting the firm's compliance program. First, Ms. Richards posed the question, "Is the firm disclosing its activities and conflicts of interest in a way that is fully consistent with its obligations as a fiduciary?" Investment advisers, as fiduciaries, must make accurate and complete disclosure, and must obtain the client's informed consent. Ms Richards points out that inadequate disclosure over the years has been a frequent deficiency and in 2008 was among the top five most common deficiencies that SEC examiners found. As a result, Ms. Richards urged firms to revisit the adequacy and timeliness of their disclosure practices, especially in the following areas:

• Conflicts of interest created by business arrangements and affiliations;
• Compensation arrangements with solicitors, finders or other service providers;
• Fees paid by clients to the firm or affiliates and the services provided for such fees; and
• Use of client commissions to pay for products and services.

Second, regarding the custody risk, Ms. Richards posed the question, "Have you confirmed that advisory clients' assets are safe?" This inquiry is a priority given the recent news regarding Ponzi Schemes and other types of frauds. Most advisers custody their clients' assets at a "qualified custodian" (typically a large firm that provides account statements to clients at least quarterly). For those advisers who do not do so, the "Custody Rule" requires them to retain an independent auditor to conduct a surprise verification, which includes verifying client holdings. The goal of the effort, Ms. Richards told the audience, was for advisers to "attain a high level of confidence that the transactions and portfolio positions reported to clients by the adviser fully and fairly reflect actual investments and transactions made by the adviser." Ms. Richards suggested, among other things, that advisers also:

• Obtain custodian statements from the custodian;
• Compare custodian statements with advisory records;
• Review the adviser's reconciliation process;
• Take steps to confirm that the client assets are with the adviser or affiliate; and
• Review client account statements sent by the adviser.

Third, regarding performance claims, Ms. Richards asked, "Are you certain that they are accurate?" Ms. Richards observed that SEC examiners "often find problems" and they "range from errors in performance calculations due to carelessness to intentional deception." In addition to retaining an outside firm to verify their performance claims, Ms. Richards recommended the following other "strong practices":

• Use greater care when crafting performance composites for marketing materials;
• Conduct special tests to ensure that complete records with respect to marketing and performance advertisements are maintained;
• Establish procedures to periodically review marketing materials to ensure that the information is truthful and not misleading.

Fourth, regarding resources, Ms. Richards posed the question, "Does your compliance program have adequate resources to do the job?" This inquiry relates to recent warnings to firms that they should not trim costs associated with their compliance and legal functions if doing so will undercut their effectiveness. Ms. Richards states that "compliance policies and procedures should be designed to prevent violations from occurring, to detect violations that have occurred, and to correct promptly any violations that have occurred - and they must be adequate to this task." Should a firm's Chief Compliance Officer detect a lack of resources, he or she should document that fact in the annual report or review. Likewise, firms should consider "alternative ways to better target resources towards monitoring firm activities that pose the greatest risk for harm to investors." One approach is for firms to consider leveraging the work of other departments (such as internal audit and risk management).

In summary, Ms. Richards reminded firms that, though they face "historic" challenges, firms must continue to reinforce and strengthen their "Culture of Compliance" in order to better protect their clients.

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.