On November 4, 2015, Andrew Ceresney, director of the Securities and Exchange Commission’s (SEC’s) Division of Enforcement (Enforcement Division), delivered the keynote address at the 2015 National Conference of the National Society of Compliance Professionals (NSCP). His comments focused on the approach of the Enforcement Division in cases involving chief compliance officers (CCOs) of private fund managers that are registered with the SEC as investment advisers under the Investment Advisers Act of 1940, as amended (Advisers Act).

The speech includes a description of the circumstances in which the Enforcement Division will bring cases against CCOs as well as considerations relating to the compliance function generally. Accordingly, the content of this speech is important for CCOs of private investment vehicles.

Click here for access to Mr. Ceresney’s November 4, 2015, speech.

CCO Liability

Consistent with prior statements by the SEC staff, Mr. Ceresney outlined the three areas where the Enforcement Division generally brings cases against CCOs. According to Mr. Ceresney, the SEC will bring cases against CCOs where they have:

• directly engaged in misconduct unrelated to the compliance function,
• attempted to obstruct or mislead the SEC staff, or
• exhibited a wholesale failure to carry out their responsibilities as CCOs.

The foregoing categories were previously identified by Mr. Ceresney as sufficient for CCO liability in a speech on May 20, 2014. Click here for access to Mr. Ceresney’s May 20, 2014, speech.

We briefly discuss each of these categories below.

To begin with, it is important to understand this recent speech by Mr. Ceresney in the context of public statements by other SEC members and staff concerning the SEC’s approach to CCO liability.

On June 18, 2015, then-SEC Commissioner Daniel Gallagher issued a public statement expressing his dissent with respect to two enforcement actions involving CCOs that asserted violations of Rule 206(4)-7 under the Advisers Act. Rule 206(4)-7, commonly referred to as the “compliance rule,” requires that each federally registered investment adviser:

• adopt written compliance policies and procedures,
• designate a CCO to administer these policies and procedures, and
• review, at least annually, the adequacy of the these policies and procedures.

Among other things, Commissioner Gallagher recommended that amendments to, or staff- or SEC-level guidance concerning, the compliance rule should be seriously considered to clarify the roles and responsibilities of compliance personnel so that “these individuals are not improperly held accountable for the misconduct of others.”

Click here for access to Commissioner Gallagher’s statement.

On June 29, 2015, SEC Commissioner Luis Aguilar responded by stating that CCOs who put investors first and do their jobs competently and in good faith do not have to worry about being targeted in an SEC enforcement action. This statement by Commissioner Aguilar, in many respects, is remarkably similar to the speech by Mr. Ceresney. Click here for access to this statement by Commissioner Aguilar.

It is also important to note that the NSCP, a significant industry player, has expressed concerns similar to those of Commissioner Gallagher.

On August 18, 2015, the NSCP released a letter (NSCP Letter) to Mr. Ceresney expressing concern over the Enforcement Division’s approach in cases involving potential CCO liability. The NCSP makes the point that the SEC should decline, as a matter of policy, to bringing an enforcement action against a CCO based on simple negligence. The NSCP emphasized that CCOs do not operate the business; they advise and support the business. The NSCP also emphasized that because of the practical reality of the function of a CCO, the SEC’s approach presents a risk of “liability by hindsight” that may to some extent be unavoidable. The NSCP Letter stated:

On this point, we respectfully suggest that charging a compliance officer for designing what, with the benefit of hindsight, turns out to be a less than perfect policy and procedure, fails to acknowledge that policies or procedures are rarely “perfect.” They are routinely reexamined and improved based upon lessons learned at the firm. This dynamic does not suggest a control weakness. Indeed, the American Institute of Certified Public Accountants recognizes that controls are limited in nature and may “not prevent or detect and correct all errors or omissions.” [1]

The NSCP Letter recommends that the Enforcement Division adopt internal guidelines based upon the standard for aiding and abetting in dealing with the role of the CCO under the compliance rule. [2] Click here for access to the NSCP Letter.

Mr. Ceresney’s November 4, 2015, speech was delivered at a major NSCP function, and provided an opportunity for Mr. Ceresney to deal with the issues raised in the NSCP Letter.

Mr. Ceresney’s speech appeared to be an attempt to reassure competent, committed and conscientious CCOs that they need not fear an SEC enforcement action against them personally in their capacity as CCOs. [3] He cites statistics to demonstrate that enforcement cases against CCOs who have only the CCO title are infrequent. (Commissioner Aguilar cited substantially similar statistics in his June 29, 2015, statement.)

However, Mr. Ceresney did not directly address the specific recommendation contained in the NSCP Letter.

Mr. Ceresney emphasized that cases against CCOs largely involve misconduct outside of the CCO role or are otherwise limited to “wholesale” failures to carry out their compliance duties as CCOs. The practical implications of this concept are discussed below.

Misconduct Unrelated to the Compliance Function

Mr. Ceresney noted that the Enforcement Division will bring cases against a CCO who is directly involved in fraudulent activity or other conduct that harms investors. These situations can involve CCOs who wear “multiple hats” or, in other words, serve in several capacities, such as a CCO who is also the CEO or CFO of the investment adviser. Misconduct in such other roles has led to SEC enforcement actions.

For example, Mr. Ceresney pointed to the recent enforcement action against AlphaBridge Capital Management’s CCO, in which the SEC charged a CCO who was also a portfolio manager and who, according to the SEC, affirmatively misled the fund administrator and auditor about asset values. [4]

Efforts to Obstruct or Mislead SEC Staff

Mr. Ceresney also emphasized that the Enforcement Division will charge CCOs who engage in efforts to obstruct or mislead SEC staff.

As an example, Mr. Ceresney cited the Parallax case, in which the SEC charged a CCO for compliance-related violations where, according to the SEC, the CCO altered documents during a regulatory compliance examination in order to deceive SEC staff about whether the CCO had conducted the annual compliance reviews required by Rule 206(4)-7. [5]

Mr. Ceresney also noted that the Enforcement Division had charged a former Wells Fargo Advisors compliance officer with altering a document before it was provided to the SEC during an insider trading investigation. The compliance officer in question was responsible for identifying and reviewing potentially suspicious trading by Wells Fargo personnel or Wells Fargo customers or clients. This compliance officer had conducted a review of the trading of a Wells Fargo broker and closed the investigation without any findings. The SEC alleged that after the SEC charged the broker with insider trading, the compliance officer changed her review documentation to make it appear as if she had performed a more extensive investigation and provided that documentation to SEC staff. [6]

Wholesale Failure to Carry Out CCO Duties

In this category, Mr. Ceresney stated that enforcement action is appropriate when CCOs “completely fail” in their responsibilities, particularly where significant investor harm results. Mr. Ceresney discussed two recent enforcement actions, BlackRock and SFX, as illustrating this point.

BlackRock , according to the SEC, did not have any written policies and procedures regarding the outside business activities of its employees, even though the BlackRock CCO knew of and approved many outside activities engaged in by BlackRock employees. The SEC alleged that BlackRock’s CCO was involved in extended discussions about a significant outside family business of a new portfolio manager that posed a conflict with the investments his fund held, and “despite these red flags, the CCO failed to develop and implement written policies and procedures to assess and monitor the outside activities of BlackRock employees and to disclose related conflicts of interest to the BlackRock funds’ boards and to advise any clients.” [7]

In SFX, an employee of an investment adviser with signatory power over client bank accounts withdrew money directly from those accounts for more than five years. The CCO was not involved in and was not charged with this misappropriation, but was charged with causing the firm’s violation of the compliance rule. The SEC alleged that the firm’s policies and procedures specifically assigned the CCO with responsibility to implement the firm’s policy requiring review of “cash flows in client accounts,” but the CCO failed to ensure that a review took place. [8]

Mr. Ceresney stated that if the CCO had implemented cash-flow review policies, the firm likely would have uncovered the misappropriation earlier.

These two cases, BlackRock and SFX, are the same enforcement actions that sparked the public dissent from then-Commissioner Gallagher, mentioned above. Among other things, Commissioner Gallagher stated:

Both settlements illustrate a Commission trend toward strict liability for CCOs under Rule 206(4)-7. Actions like these are undoubtedly sending a troubling message that CCOs should not take ownership of their firm’s compliance policy and procedures, lest they be held accountable for conduct that, under Rule 206(4)-7, is the responsibility of the adviser itself.

The use of the concept of “strict liability” as outlined by Commissioner Gallagher and the concerns identified in the NSCP Letter are both worth noting. In regulatory compliance exams, a matter that is perceived by examination staff to be a deficiency may also be cited as a failure to have adequate compliance procedures. In other words, if the CCO had designed effective compliance procedures, the deficiency would not have taken place. From the standpoint of the SEC staff, this type of failure can be perceived to be a “wholesale failure,” potentially resulting in an enforcement action.

In others words, “wholesale failure” does not just refer to a situation where a CCO did not carry out his or her compliance responsibilities generally. Instead, it can also refer to a situation where isolated or specific compliance deficiencies result in a finding that the compliance procedures were inadequate with respect to those specific deficiencies.

SEC Efforts to Support the Compliance Function

Mr. Ceresney also discussed actions by the Enforcement Division that he believes support the compliance function. The thrust of this part of his speech was that the SEC has taken actions that support CCOs in their compliance function. Mr. Ceresney discussed the Pekin Singer and Carl Johns cases to illustrate this point.

In Pekin Singer, the SEC charged an investment adviser with numerous compliance failures, and also charged the adviser’s president with causing those violations. Among other things, the SEC alleged that the adviser failed to conduct timely annual compliance program reviews and failed to implement and enforce provisions of its policies and procedures and its code of ethics. Of particular importance, the SEC’s order alleged that the firm did not dedicate sufficient resources to its compliance program. The CCO, who was not charged, was tasked with numerous responsibilities unrelated to compliance, which severely limited his ability to focus on the compliance function. The SEC alleged that the CCO repeatedly told the firm’s president that he needed help to fulfill his compliance responsibilities, including the annual compliance program review. The SEC also alleged that the CCO had expressed concern about not completing compliance testing, and warned that the firm would not be ready for an SEC examination. This warning proved to be accurate. [9]

The SEC did not charge the CCO in Pekin Singer. However, the SEC did charge the president for causing the violations, largely because he had ignored the CCO’s repeated requests for more resources and support. The message from this case, according to Mr. Ceresney, is that the business side of private fund management needs to make sure that compliance personnel get the resources they need.

Mr. Ceresney also pointed to the 2013 enforcement action in Carl Johns. In this case the SEC filed its first-ever charge against an individual for misleading and obstructing a CCO. In that case, it was alleged that an assistant portfolio manager at an SEC-registered investment adviser failed to pre-clear or report his personal securities transactions. The SEC alleged that he also submitted false quarterly and annual reports related to his securities trading, altered trade confirmations, and manually deleted securities holdings on his brokerage statements. When the CCO detected irregularities in the altered documents and confronted the portfolio manager, the portfolio manager was alleged to have misled the CCO about the transactions and to have accessed the hard-copy file of his previously submitted brokerage statements and changed them. [10]

According to Mr. Ceresney, the message of Pekin Singer and Carl Johns, as well as similar cases, is that the Enforcement Division will aggressively pursue business line personnel and firms who mislead or deceive CCOs, or obstruct the compliance function, or who fail to support CCOs, in a manner that causes compliance violations.

The Compliance Function Generally

Mr. Ceresney emphasized the importance of the compliance function by recommending that firms ask the following questions about the role of the compliance department:

• Are compliance personnel included in critical meetings?
• Are their views typically sought and followed?
• Do compliance officers report to the CEO and have significant visibility with the board?
• Is the compliance department viewed as an important partner in the business and not simply as a support function or a cost center?
• Is compliance given the personnel and resources necessary to fully cover the entity’s needs?

Mr. Ceresney stated that when the answer to these questions is no, the absence of real compliance involvement in company deliberations can lead to compliance lapses, which, in turn, can result in enforcement issues.

Takeaways

Several aspects of the SEC’s current approach to the compliance rule should be noted by CCOs.

First, to some extent, the SEC’s current regulatory approach is taking shape in enforcement actions, as opposed to staff guidance or rulemaking. For this reason, it is particularly important to keep an eye on SEC enforcement actions and relevant public statements by SEC staff. The SEC’s approach on this issue is not likely to change any time soon.

Second, it is important that compliance procedures be tailored to the operations of the fund manager and address the real-world risks inherent in those operations. The compliance procedures should address the areas specifically identified by the rule itself, the areas that are highlighted in SEC enforcement actions as well as SEC guidance and public statements by SEC officials. CCOs should be mindful of the fact that a perceived absence of adequate policies dealing with a specific function or risk might be characterized as a “wholesale failure” in terms of the analytical framework outlined above.

Third, CCOs need to be proactive in carrying out their duties and responsibilities under applicable securities laws and regulations as well as their functions under their firm’s compliance practices and procedures.

Fourth, fund managers need to make sure that the compliance function receives the resources needed for an effective program, including personnel, time and expertise. It is particularly important that CCOs who wear “multiple hats” (such as CEO or CFO) have sufficient time and resources to do all their jobs.

Fifth, fund managers need to be prepared for regulatory examinations, well in advance. Fund managers should seriously consider performing “mock” regulatory examinations in this regard. This kind of effort can be very helpful in making sure that the policies and procedures function effectively and that compliance staff is in a position to respond in an appropriate and timely manner in the event of regulatory examination.

1. The NSCP Letter cites to Statement on Standards for Attestation Engagements [SSAE-16], Reporting on Controls at a Service Organization [AICPA, Professional Standards, AT sec. 801.A68]

2. The NSCP Letter states that these elements “capture the spirit” of the principles Mr. Ceresney has articulated concerning cases involving CCOs: (i) a primary securities law violation, (ii) knowing or extremely reckless conduct, and (iii) substantial assistance to the primary violator.

3. Somewhat similar statements are contained in an October 14, 2015, speech by Andrew J. Donohue, SEC chief of staff, titled “Remarks at NRS 30 ^th Annual Fall Investment Advisers and Broker-Dealer Compliance Conference,” and in an October 2013 speech by Chair White at the National Society of Compliance Professionals’ National Membership meeting.

4. Press Release, Secs. & Exch. Comm’n, SEC Charges Hedge Fund Advisory Firm With Conducting Fraudulent Fund Valuation Scheme (July 1, 2015), available at http://www.sec.gov/news/pressrelease/2015-134.html.

5. In the Matter of Parallax Investments, LLC, John P. Bott, II, and F. Robert Falkenberg, Advisers Act Release No. 4159 (Aug. 6, 2015).

6. Press Release, Secs. & Exch. Comm’n, SEC Announces Enforcement Action Against Former Wells Fargo Advisors Compliance Officer for Altering Document (Oct. 15, 2014), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370543175814. Judy K. Wolf, Initial Decision Release No. 851 (Aug. 5, 2015), available at https://www.sec.gov/ali/alidec/2015/ld851ce.pdf; see also Judy K. Wolf,Exchange Act Release No. 75969 (Sept. 23, 2015) (finality order), available at https://www.sec.gov/aali/alidec2015/34-75969.pdf. The administrative law judge found the compliance officer liable for violating the federal securities laws but did not impose remedies.

7. Press Release, Secs. & Exch. Comm’n, SEC Charges BlackRock Advisors With Failing to Disclose Conflict of Interest to Clients and Fund Boards (Apr. 20, 2015), available at http://www.sec.gov/news/pressrelease/2015-71.html.

8. In the Matter of SFX Financial Advisory Management Enterprises, Inc. and Eugene S. Mason . Advisers Act Release No. 4116 (June 15, 2015).

9. Pekin Singer Strauss Asset Management Inc., Advisers Act Release No. 4126 (Jun. 23, 2015), available at http://www.sec.gov/litigation/admin/2015ia-4126.pdf.

10. Press Release, Secs. & Exch. Comm’n, SEC Sanctions Colorado-Based Portfolio Manager for Forging Documents and Misleading Chief Compliance Officer (Aug. 27, 2013), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539791420.