(Article from Registered Funds Alert, September 2015)
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As mentioned earlier in this Alert, the Kornitzer enforcement action was brought against the adviser’s CCO as well as the adviser itself. In addition to Kornitzer, two other recent enforcement actions have involved allegations that an adviser’s violations were, at least in part, caused by its CCO, illustrating a trend that has sparked significant debate within the ranks of the SEC and seemingly drawn a target on the backs of CCOs.
The first case, settled in April 2015, involved a prominent investment manager (the “Firm”) and its CCO. The SEC alleged that a portfolio manager of certain private funds, registered funds and separately managed accounts advised by the Firm, had engaged in outside business activity, of which the Firm and its CCO were aware, that created a conflict of interest but was not disclosed to the funds’ boards or investors. The SEC alleged that the failure to disclose this conflict of interest violated Section 206(4) and Rule 206(4)-7 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) and Rule 38a-1 under the 1940 Act, and that the violations were caused by the CCO. We addressed some of the compliance lessons from this action in a separate client memorandum.
A second case, settled in June 2015, involved SFX Financial Advisory Management Enterprises, Inc. (“SFX”) and its CCO. An employee of SFX allegedly misappropriated funds from multiple client accounts, and the CCO allegedly failed to implement SFX’s compliance procedures, did not conduct an annual compliance review and caused a material misstatement in SFX’s Form ADV.
These cases have sparked strong reactions from several SEC commissioners and SEC Chair Mary Jo White. Commissioner Daniel Gallagher issued a statement shortly after the SFX settlement to explain his rationale for voting against both settlements. Commissioner Gallagher stated that “[b]oth settlements illustrate a Commission trend toward strict liability for CCOs” and expressed his belief that the responsibility for implementation of compliance policies and procedures rests with the advisory entity, not the CCO.
Commissioner Luis Aguilar responded by issuing his own statement, saying that he believes that CCOs must be supported and that the SEC is not targeting CCOs who “do their jobs competently, diligently, and in good faith to protect investors.” He also cited a subsequent SEC enforcement action involving Pekin Singer Strauss Asset Management, Inc. (“Pekin”), in which the SEC alleged violations of Pekin and its top executives for failing to provide adequate resources to Pekin’s CCO, who was not a party to the enforcement proceedings. Additionally, Commissioner Aguilar noted that CCOs are not usually targeted in enforcement actions against advisers and investment companies, but those actions that have included CCOs involved situations where a CCO held multiple positions within an adviser. He notes that those cases are usually either egregious or involve actions of CCOs unrelated to their compliance functions. Chair White echoed Commissioner Aguilar’s sentiments in a July speech before the SEC’s Compliance Outreach Program for Broker-Dealers. She emphasized that CCOs should not be worried about the SEC “second guessing [their] good faith judgments, but rather when their actions or inactions cross a clear line that deserve sanction.”
Chair White’s attempt to reassure CCOs, however, begs the question of where that “clear line” is drawn. For instance, what separates the Pekin case from the other two cases? Pekin includes allegations of compliance failures including (i) missing annual compliance reviews, (ii) undetected compliance violations, (iii) misleading Form ADV disclosures and (iv) not adequately disclosing conflicts of interest to clients. Similar allegations can be found in one or both of the other two cases (but notably, neither case includes all four alleged compliance violations). The main distinction between Pekin and the other two cases is that the SEC placed significant emphasis on the fact that Pekin’s CCO was wearing multiple hats and asked for additional resources to help him fulfill his compliance responsibilities. There is an acronym for the message these actions seem to prescribe for CCOs—CYA—that cannot be written out for the sake of propriety.