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News April 20, 2015 Issue

Outsourced CCO and Advisers Face Form ADV, Books and Records Charges

Outsourcing a chief compliance officer may leave both an adviser and the third-party CCO it hired in trouble.

That, at least, is one message to take away from an administrative action the SEC took on March 30 against two advisory firms, their chief operating officer, an outsourced CCO and his consultant employer in regard to keeping improper books and records, and overstating assets under management and number of clients on their Forms ADV.

The SEC did not say the responsibility rested solely with the outsourced CCO, David Osunkwo, a principal of also-charged Illinois-based Strategic Consulting Advisors. It also charged the advisory firms, North Carolina-based Aegis Capital and Florida-based Circle Wealth Management and their chief operating officer, Diane Lamm.

"As a direct consequence of Osunkwo’s and Lamm’s failures, registrants failed to file accurate and timely reports with the Commission and failed to make and keep required books and records," the agency said in its administrative order instituting proceedings.

The SEC’s message

"The SEC seems to take quite a slap at outsourcing, almost gratuitously, because compliance is ultimately the responsibility of the adviser, not the CCO," said Stroock partner and former SEC Division of Investment Management deputy director Robert Plaze.

It is not unusual for an outsourced CCO to ask an advisory firm how many clients it has, said Mayer Brown attorney Adam Kanter. If an advisory firm says it has 10 clients, that figure will typically be accepted. "An outsourced CCO doesn’t necessary have access to the kind of information needed to independently verify information," he said, in that in some cases they can’t simply walk down the hall and ask to see the records.

"The outsourced CCO was told by the adviser the numbers to put down, he put the numbers down, and he and his consulting firm are charged with willfully abetting a violation," he said.

There are, in fact, many situations in which outsourcing a CCO makes sense. Such situations might include if the advisory firm is too small to hire its own CCO, or if the main business of the firm is as something other than an advisory firm, so it needs to tap outside expertise. Mutual funds, which are required to have their own CCO, typically outsource the CCO to the adviser or administrator.

In the case of Aegis Capital and Circle Wealth Management, the use of an outside CCO may not have worked well, Plaze said, adding that he wonders how much the industry should read into the case. "Would the SEC have brought the same case against an
in-house CCO who made the same mistakes?"

Should outsourced CCOs and attorneys who help their clients complete Forms ADV and other filings be concerned about their own liability as a result of this case? Not just yet, said Kanter, noting that the case is not yet settled or otherwise decided. "These allegations are just the opening salvo," he said. "The SEC is sending a message that you have to be careful with outsourced CCO relationships."

A public hearing on the charges is expected to be held by at the end of May, with an administrative law judge expected to make an initial ruling by the end of January 2016. It is also possible, of course, that a settlement between the SEC and the parties will be reached before then.

Violations

The SEC charged Aegis Capital with willfully violating, and Strategic Consulting Advisors and Osunkwo with causing, violations of Section 204 of the Advisers Act and its Rule 204-1(a)(1), which requires advisers to amend their Form ADV at least annually. It also charged Aegis Capital and Circle One with willfully violating, and Lamm with willfully aiding and abetting or causing violations of, Section 204 and its Rule 204-2(a), which requires advisers to create and keep accurate and current books and records.

Aegis Capital, Circle One, Lamm, Strategic Consulting Advisors and Osunkwo were charged with willfully violating Section 207 of the Advisers Act for making untrue statements of material fact in a registration application or report. Attorneys representing Aegis Capital, Circle One, Lamm, Strategic Consulting Advisors and Osunkwo could not be reached for
comment.

What happened

Strategic Consulting Advisors contracted to provide compliance services to both Aegis Capital and Circle Wealth Management between January 2010 and December 2011, according to the administrative order. Among the services the compliance consultant provided to the two firms, which were under common control, were designating a principal of the consultant as their CCO, Osunkwo, and preparing, reviewing and filing Forms ADV.

During this period, "Aegis Capital and Circle One failed to file timely and accurate reports with the Commission and to maintain required books and records," the SEC charged. The specific allegations are that:

In March 2010 and March 2011, the two firms collectively overstated their AUM and total number of client accounts. "Indeed, in March 2011, [the firms] overstated their AUM by over $119 million, or 190 percent, and total number of client accounts by at least 1,000 accounts, or over 340 percent," the agency said.

The firms’ books and records were unsegregated and mixed together with affiliated entities at the level of the parent holding company from 2009 to 2011. "[The firms] were unable to provide adviser-specific books and records in response to examination staff’s
queries in a timely manner, if at all," according to the SEC.

Aegis Capital did not file an annual update to its Form ADV for the 2010 calendar year, the SEC said. Both firms terminated their registration with the SEC in the first half of 2012, according to the administrative order.

Form ADV and the CCO

The SEC took the outsourced CCO to task for allegedly improper Forms ADV. For instance, in regard to Form ADV and Circle One:

"When preparing and filing the 2010 Form ADV for Circle One, Osunkwo did not personally review Circle One’s records to determine Circle One’s AUM and number of advisory accounts," the agency said. "Instead, Osunkwo relied exclusively on information provided to him by Circle One’s chief investment officer, whom Osunkwo knew had little to no involvement with [the firms’] investment advisory client accounts. Osunkwo collected the information from the CIO only hours before the filing deadline, and knew from the CIO’s message that the information was only intended to be an estimate."

Further, the agency charged, when Osunkwo filed the 2010 Form ADV, "he misrepresented that the CIO certified the contents of Circle One’s Form ADV to be true and correct, and forged the CIO’s electronic signature on the filing."

Saying that the CCO "forged" the signature is an interesting word choice, Kanter said, since no actual script signature is entered with the electronic filing. Rather, the name of the responsible party is simply typed into the electronic form.

What should be considered before filing, he suggested, is to "break out the parts of the Form for review and comments" by the various responsible parties at the advisory firm, such as the human resources, client/investor relations or accounting departments. Responses from the department heads, whether by email or a signature on a sign-off sheet, should be kept by both the advisory firm and the CCO, providing documentation that the various parts of Form ADV were reviewed and approved prior to filing. Finally, both the adviser and the consultant should keep a hard copy of the final version of Form ADV that the filing’s signatory reviewed, together with the original, hand-signed signature page – particularly if the signatory is not the same person that serves as the firm’s IARD account administrator, said Kanter. These practices should not be limited to outsourced CCOs, but should also be used by internal CCOs, he said.

Books and records

Unlike the Form ADV allegations, the SEC leveled its books and records charges primarily against the advisory firms and Lamm.

Aegis Capital, between 2009 and 2011, "failed to make and keep advisory-specific trial balances, financial statements and internal working papers; journals, including cash receipts and disbursements, and other records of original entry forming the basis of entries into ledgers; general ledgers reflecting asset, liability reserve, capital, income and expense accounts; checkbooks, bank statements, cancelled checks and cash  reconciliations; and bills or statements, paid or unpaid," the agency said.

Circle One, also between 2009 and 2011, not only allegedly failed to keep similar books and records segregated, it "instead created and maintained such records in the name of Capital L," the parent holding company of the two advisers.