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News March 7, 2011 Issue

Do You Know Where Your Books And Records Are? Advice From The Experts

Take this test. How did you calculate the performance youíre currently using in marketing materials or on your web site? Could you recreate it Ė accurately, based on real records Ė if the SEC showed up at your door? Does the thought of that exercise send chills down your spine?

Just bringing up the subject of books and records sends folks running for the exits. Resist the urge though. At the recent ACA Compliance Group and ACA Insight 2011 Spring Compliance Conference, a panel of experts offered up practical and, yes, interesting tips on ensuring that your books and records are where you want them to be.

It can be surprising how little an adviser knows about where certain of its books and records are, said ACA Compliance Group senior principal consultant Bert Sanchez. It is a great exercise to go back, find the correct records and recalculate performance information, he said. It is a quick test that will give you confidence in your records or give you an idea of what you have to do to get those records in order.

Without proper recordkeeping, youíre an easy mark for regulators.

"If theyíre going to hang you, youíre going to build the noose," said Andrews Kurth partner Roscoe Howard. To avoid that, the more documentation you have, the better. The goal is to use your documents to paint the fully compliant picture that you want the SEC to see. ĎStealí best practices, he said, thereís no copyright on them. Take the best from others and make them your own Ė codes of ethics, policies and procedures, and more Ė adapt them to your firmís business and get rid of what doesnít apply.

"Youíre ethical, youíre compliant, and youíre diligent, thatís what you want your program to say," said Howard.

Record retention is critical to documenting your business.

For example, said Sanchez, the firm must preserve employee records for five years. After an employee leaves, their records must remain with the firm. Firms must also not only keep a full set of all policies and procedures, but also all different versions, and the dates they were adopted, he said.

Do you keep every record forever? Maybe not. Destroy what you want, within the regulatory requirements, but have your document destruction parameters in a policy and keep the policy somewhere, said Howard. For example, in the Arthur Andersen case, firm employees destroyed records after they received a subpoena. You canít do that. "You need records that reflect exactly what you do," he said.

That mantra applies to all aspects of the business. Firms must keep all annual acknowledgements from employees that theyíre aware of code of ethics requirements, and the firm must maintain all versions of its Form ADV, said Blue Edge Capital CCO and COO Margaret Fretz. She noted that the SEC asks for those materials in exams.

Advances in technology must also be monitored.

"You need to be ahead of it, and know what the next wave is," said Howard. Texting is taking over emails, for example. What do you do when a client texts in an order? You must be able to capture that record if you want to act on the instruction.

ACA Compliance inventories all the ways a firm communicates with clients, said Sanchez. Means of communication that are not captured in the firmís books and records should be prohibited. Blue Edge Capital does not permit texting for that reason, said Fretz. Bloomberg Instant Messaging, however, is a popular tool that is permitted because those communications can be captured and archived. Global Relay, for example, is a service that does this in a searchable format, she said.

So what books and records must you show regulators from your pre-registration period?

Section 206 of the Advisers Act, the antifraud provision, applies to all advisers all the time, whether theyíre registered or not, noted Sanchez. Thereís no recordkeeping requirement that goes with that, however. Any records under your roof when you submit your application for registration must be preserved, said Fretz. Once a firm is registered, the SEC can reach back to pre-registration periods in their requests, but you can only give them what you have. One exception is performance advertising, she noted. If you are advertising performance back to year "x," you must have the records supporting that performance back to year "x" or you canít use it, pre-registration or not.

Thereís a general assumption that records are to be made "contemporaneously" with an event, said Howard. A 2004 Rhode Island federal district court case, SEC v. Slocum, Gordon & Co., established that records made within 24 hours of an event will be considered to be current for purposes of the recordkeeping rule (Rule 204-2(a)(3)). The SEC interprets that reading as restrictively as possible, said Howard.

Firms should preserve records in a way that is admissible. Electronic records should be accessible, but not able to be manipulated after the fact. Regulators want to take it, listen to it and know that it is what it purports to be, he said.

What is the current industry standard if you donít have a document management system?

PDF it, said Howard. A pdf is simply a picture of the document or record. "I know itís easy because I can do it," he said. For recordings, segregate them and limit access. It is the principle of "chain of custody," he said. You want to show the integrity of the contents.

The Advisers Act requires no specific record-keeping format, said Sanchez. Broker-dealers have the WORM system, which stands for "write once, read many." Whatever system an adviser chooses, it must be reliable and consistent. "To the extent that thereís no integrity in the documents, youíre word has no weight because the document has no weight," he said.

"This is not rocket science," said Howard, "itís about walking into some other venue at some other time and convincing them that this is how it was at the time of the order." The question really is, how can the document be trusted? If it is a sensitive document proving that youíre doing something correctly, it is worth protecting, said Sanchez.

You canít use the Fifth Amendment to withold firm records.

Howard, a white-collar criminal defense lawyer, made a few points about the lines between criminal and civil liability. As long as youíve agreed to operate pursuant to government regulation Ė and all registered advisers have Ė the firmís records essentially belong to the government, said Howard. The government can request them and they must be produced. In SEC v. Olsen, a 1965 case, an individual argued that producing the records of his registered advisory business to the SEC would violate his Fifth Amendment right against self-incrimination. The court noted that Olsenís mistake was in thinking the firmís records were his private documents. "On the contrary, they are quasi-public records and thus must be produced," said the court, "even though it is possible that [Olsen] might be prosecuted later on the basis, in part at least, of what these records disclose."

Also, the SEC deems a failure to file any required documents as a willful act, which is subject to a fine and up to five years imprisonment, said Howard. If you prove you didnít know you had the filing obligation, it is a defense to a criminal action. However, it sets you up for a civil action, he said.

Electronic recordkeeping.

The SEC typically requests electronic records in certain formats, said Sanchez. If your records are only available in an alternative format, you must provide the SEC with the ability to access it. Fretz noted that "prompt" production in response to a request is normally within 24 hours. Sanchez, a former SEC examiner, said he would use a 48 hour rule for smooth running exams. "Some things I know are on the shelf," he said. When the exam team arrived, they would ask for copies of the firmís Form ADV, policies and procedures, etc. "If I canít get that within a few hours, I know something is wrong." At that point 48 hours is out the window. If you canít get documents to examiners quickly it changes their whole attitude immediately, he said.

Do a Ďfire drill,í suggested Howard. See how long it takes to produce your core documents. Then test yourself on other specific records as well.

Also to note, advisers have no formal requirement to review emails, said Sanchez. They do have Section 203 liability if they fail to properly supervise employees, however. The level of review an adviser conducts depends on how the firm operates and the risks presented, he said. The standard is what a reasonable person would review. Do focus reviews targeting recent changes, hot offerings, or inside information. Instead of a generic word search with 50,000 hits, narrow the field to key employees, dates, or other appropriate limiters. Keep the results as a record of your review.

If you keep it, itís a record.

The rule requires that you retain written communications only, said Sanchez. Firms are not required to retain videos, for example. However, if you have it in your office and the SEC comes in and asks for it, it is fair game.

One key evaluation is, how do you do business? Say you receive a communication outside the firmís ordinary business practices, said Sanchez. You follow up with an email or a phone call and a transaction results from the phone call. The firm maintains the email or phone records, but deletes the original incoming communication. If the original communication is outside the firmís normal course of business and the firm has a deletion policy in those circumstances, the firm should be okay, said Sanchez. Make sure your policy reflects what you do, and that youíre following it.

One last note about copies.

Keeping multiple copies of business records is generally unnecessary, but what about voicemail to email retention and efaxes, for example?

A copy is a completely identical document, said Sanchez. If an efax is identical to the original electronic copy, you can discard the efax. However, if the fax embeds new information, such as time and date information, it is a separate record and should be kept. Any changes to an original Ė handwritten notes, evidence of forwarding to various readers, etc. Ė transforms a mere copy into a new record.