CEO Accused of Lying to Compliance Department Faces SEC Action
The SEC counts on chief compliance officers and their staff to be the front lines in the fight against fraud. When it believes that an advisory firmís CEO outright lied to his compliance department, it does not take the matter lightly.
Edgar Lee Giovannetti
, co-founder and former CEO of Tennessee-based adviser Consulting Services Group, was chargedby the SEC on January 16 with failing to disclose a $50,000 personal loan provided in April 2009 by a third-party investment adviser that his firm recommended to clients. When asked specifically about the loan by his compliance department in August 2009, he replied that it had been paid off when, in fact, it had not, according to the agency.The allegations raise conflict of interest and disclosure issues. But they also raise the issue of an adviser, particularly its CEO, supporting the firmís compliance department, creating a culture of compliance, and presenting an appropriate Ďtone at the topí Ė let alone telling it the truth.
Giovannetti finally paid off his loan in July 2012, by which time it totaled, including interest, $63,044, according to the SEC administrative order initiating administrative and cease-and-desist proceedings. Both he and Consulting Services Group were charged with committing fraud and making untrue statements on their Forms ADV (see below).†Consulting Services Group settled
its case and paid a $150,000 civil money penalty, while Giovannettiís case is moving to an administrative proceeding.
"The problem likely could have been avoided altogether if the adviserís compliance policies simply had prohibited the adviser and its associated persons from borrowing money from any entities with whom the adviser conducts business," said
Stradley Ronon partner Lawrence Stadulis. "Advisers also should periodically review their policies to determine whether they adequately capture and address all potential conflicts of interest."
The SEC and CCOs
The SEC has long championed advisory firm compliance departments. This includes its adoption of Rule 206(4)-7, the Compliance Program Rule, now more than 10 years old. The Rule requires firms to hire a chief compliance officer, adopt comprehensive, written compliance policies and procedures, and review those policies and procedures annually to ensure they are operating efficiently and effectively. SEC officials have also extolled the importance of the role CCOs play.
"Many of you in the audience today stand on the front lines of upholding the compliance rule," Division of Investment Management director
Norm Champ told compliance professionals and others in a March 2014 speech. "You are key to the success of our mission to protect investors, and we value and respect the work that you do. We want you to have the tools, resources and support that you need to do it within your firms. I believe that the compliance rule has been a win for clients, the Commission and for the investment management industry as a whole in bringing attention and resources to this important function."
In that same speech, Champ referenced an enforcement action against a portfolio manager who was banned from the securities industry for five years after "misleading and obstructing a chief compliance officer. This case should send a clear message to the industry that professionals have an obligation to adhere to compliance policies, and that the Commission will not tolerate interference with CCOs who enforce those policies."
Small wonder then that the SEC reacted as it did when Giovannetti allegedly lied about the $50,000 loan. Not only was the loan a conflict of interest and the failure to disclose harmful to investors, but, it seemed to be saying, lying to the compliance department undermined the effectiveness of what the SEC counts on CCOs to do.
Not the first for Consulting Services Group
This current SEC action is not the first time that Consulting Services Group has gotten in trouble with the agency. The firm was censured by the SEC in an October 2007 settlement
and was ordered to pay a civil money penalty of $20,000 for, among other things, allegedly:
Failing to adopt a code of ethics compliant with applicable rules,
Failing to adopt written compliance policies and procedures, and
Back-dating written code of ethics acknowledgement forms by supervised persons.
The current allegations
Consulting Services Group, which stated in its Form ADV that it had certain assets under management that ranged from $21.7 million in one client account in 2009 to $22.5 billion in 74 client accounts in 2012, was, according to the SEC, registered with the Commission from July 1990 until October 2013, when it ceased advisory activities. Its clients included public and private pension and retirement plans, endowments and high net worth individuals. Firm CEO Giovannetti was also the CEO and chairman of the executive management committee of the firmís parent holding company, CSG Holdings, and held the second largest equity interest in the parent company.
But in or about April 2009, "Giovannetti was undergoing significant personal financial challenges," the SEC said.
Giovannetti turned to a New York-based third-party adviser for help, according to the agency. The third-party adviser, which is not named, was known to Giovannetti, as evidenced by the fact that both he and CSG had previously recommended the third-party adviser and its funds to CSG clients, the SEC said.
The third-party adviser loaned Giovannetti $50,000 on April 21, 2009, and Giovannetti signed a promissory note in connection with it, according to the administrative order. Principal and interest were required to be repaid within 90 days on the note, which carried a 3.1 percent interest rate. In the event that Giovannetti failed to pay the loan on time, the interest rate would shoot up to 8 percent.
But in violation of Consulting Services Groupís policies and procedures, Giovannetti did not disclose the existence of the loan to his firmís compliance department, the agency said.
Caught Ö and the response
But the compliance department found out just the same.
In an August 5, 2009 memo, the compliance department "advised Giovannetti that a review of emails by the compliance department had discovered the existence of the loan from the New York investment adviser," the SEC said. "The memo noted that the New York investment adviser from whom he had obtained the loan managed the assets of seven [Consulting Services Group] clients (including some of his own clients) and created a Ďpotential conflict of interest.í" It then asked whether the debt still existed and that, if it did, Consulting Services Group and/or he would need to disclose its existence to clients that invest with the third-party adviser.
On August 8, 2009, Giovannetti replied via email to his firmís CCO, "falsely stating, among other things," that he had paid off the loan," the SEC said, quoting from the email, "íI redeemed July 1 and paid the loan off.í"
"By Giovannettiís initial concealment of the loan, and his subsequent misstatement and omissions about its status, required disclosure about the loan, including information relating to the conflict, were not disclosed in the firmís Forms ADV Part II, dated August 6, 2009, and July 6, 2010, nor in the Form ADV Part 2A, dated March 31, 2011," the agency said.
"The compliance department appears to have had a good monitoring policy in place that actually discovered the loan early on," said
Montgomery McCracken of counsel Terrance Reilly. "Also, it provided notice that he [Giovannetti] was handling the loan situation poorly. Where the compliance department seems to have failed was in believing Giovannettiís statements and not independently verifying that they were true. You canít just accept the written statement of a party in this situation."
"The firmís compliance department deserves kudos here," said
Nixon Peabody counsel Bradley Mirkin. "The putative conflict was discovered in a review of the CEOís electronic communications and then documented, as was the appropriate follow-up. However, seeing a firm close its doors when a compliance officer does his job is always bittersweet."
Giovannetti finally admitted that the loan remained outstanding when the firm was examined by OCIE examiners in August 2011, the agency said. The firm then disclosed the loanís existence in its August 11, 2011 Form ADV Part 2A, the agency said, stating that the loan "presents a potential conflict of interest in that [Consulting Services Group] may recommend [the New York Investment Adviser] over other money managers as a result of the loan."
But even that was not enough disclosure, as the SEC said no mention was made of Giovannetti having allegedly:
already redeemed the monies in his fund but not paid off the loan from his redemption proceeds,
previously falsely stated to his compliance department that he had paid off the loan,
not paid off the loan on time, causing it to be in default, and
that the interest rate was then accruing at 8 percent, since it had not been paid off on time.
"Investment adviser compliance professionals must always be on the lookout for potential conflicts of interest," said Stadulis. "When they become aware of a conflict, they should establish an accurate and complete understanding of all the relevant facts, particularly those that may be material to potential investors. To accomplish this, CCOs should be proactive and take whatever steps they believe are reasonably necessary to gain a complete picture of the situation."
"It is not sufficient to simply point out the existence of potential conflicts without also providing all supporting facts necessary for clients to make informed investment decisions," he said. "In other words, the SEC does not award full credit for partial or incomplete answers."
Giovannetti was charged with willfully violating Sections 206(1) and (2) of the Advisers Act, both of which prohibit fraud; and Section 207 of the Advisers Act for making untrue statements on a registration application. He was also charged with willfully aiding, abetting and causing Consulting Services Groupís violation of Section 207. The case will now proceed to an administrative proceeding. Consulting Services Group, in its separate settlement with the SEC, was charged with violating Section 206(2) of the Advisers Act prohibiting fraud and Section 207 for making untrue statements on its registration application. It agreed to pay a civil money penalty of $150,000. An attorney representing Giovannetti and Consulting Services Group chose not to comment on the case, and an attorney representing Consulting Services Group could not be reached for comment.