SEC Stresses Compliance Program Failures in Case Against Adviser
The SEC did something a bit unusual in a recent administrative order instituting a settlement with an adviser: It gave at least equal weight to charges of compliance program failure and best execution failure. In fact, it listed the allegations of compliance program failure first.
What’s unusual about this is that, in most administrative orders where compliance program failures are alleged along with other allegations, the SEC tends to place its compliance program charges at the end of the document, sometimes in just one or two paragraphs. In its June 23 settlement with Pekin Singer Strauss Asset Management, however, the compliance program charges are described first and take up more than three pages in the 13-page document. The best execution charges, listed afterward, take up just under four pages.
Sidley Austin partner Mark Borrelli said that while it is unusual for the SEC to list the compliance program failures over other alleged violations, in this case, "it may be due to the fact that the case appears to have come out of an examination and so many alleged compliance program violations were found." These included conducting inadequate annual reviews, having a chief compliance officer who was not properly trained and who did not devote sufficient time to compliance matters, and a list of undetected violations in the advisory firm.
"They are highlighting the compliance failures because they are pretty significant and laying down the gauntlet for other firms," said Eaton & Van Winkle partner Paul Lieberman. "It’s a cautionary note for chief compliance officers and other investment managers."
"The SEC was focused first on the compliance failures and was already investigating those failures when the best execution problem came to light," said Mayer Brown partner Matthew Rossi. "The SEC has brought freestanding compliance cases before and will do so again. In those cases, the SEC charged only violations of the compliance rule without any other violation. The compliance failures in the Pekin case seem so serious, that I suspect the SEC would have brought this case even if there was no best execution violation."
"Pekin Singer Strauss takes its compliance obligations very seriously, and we cooperated fully with the SEC to reach this settlement," said firm co-chief executive officer Adam Strauss in a statement. "Our clients were not adversely affected financially by these compliance deficiencies. Furthermore, since 2011, the firm has significantly enhanced its compliance function and completed timely annual compliance reviews."
CCO not charged
With so many allegations of poor compliance, one might expect that the CCO – who was not named in the administrative order – would also be charged. The SEC has, in other cases, brought charges against CCOs for either taking part in improper activities or for not stopping them. In this case, however, neither the unnamed CCO, nor a successor CCO mentioned in the order, were charged.
If in fact no charges are later filed against the CCO, "I would take some comfort from that if I were a compliance officer," said Borrelli, particularly given a belief expressed by some, including SEC commissioner Daniel Gallagher (ACA Insight, 6/29/15), that the agency is currently being too aggressive in taking enforcement actions against CCOs. Borrelli said that there will still be actions brought against CCOs, but that, in this case, the CCO’s case appears to have been helped by the firm’s denial of his repeated requests for assistance and
The administrative order does indeed place much of the blame for any compliance program failures on the firm president, Ronald Lee Strauss. The agency alleges numerous ways in which he did not provide the CCO with the resources and support he needed.
The SEC took what some might call a light hand with the firm in other ways, as well. The adviser was not required to retain a compliance consultant to review compliance policies and make recommendations, as is often the case with such SEC settlements, Lieberman noted. The civil money penalties assessed against the adviser and three of its executives amount to less than $300,000, which is relatively small for an adviser with assets
under management of more than $1 billion, he said.
Pekin Singer’s remedial efforts, which are given their own section in the administrative order, may at least partially explain why the SEC did not come down harder. The adviser, for instance, voluntarily self-reported the best execution matter to the agency staff during the SEC staff’s investigation into other compliance program issues at the firm. The adviser also voluntarily reimbursed client accounts by $360,680, hired outside counsel to advise it on regulatory matters, expanded an existing relationship with an outside compliance consultant, and hired an additional compliance director to support the CCO, the SEC said.
The firm was charged with willfully violating Section 204A of the Advisers Act and its Rule 204A-1, which require registered advisers to adopt and enforce a written code of ethics; Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for not conducting an annual compliance review and other alleged compliance program violations; Section 207, for making untrue statements on its Form ADV; and Section 206(2), which prohibits fraud. Ronald Lee Strauss was charged with willfully violating Section 207, and Section 206(2).
The CCO and his requirements
Pekin Singer works primarily with high-net-worth individuals and separately managed accounts. It launched an open-end mutual fund called Appleseed in December 2006, according to the SEC’s administrative order. From 2005 to June 2007, the firm employed a CCO who also served as its chief financial officer. His work was overseen by Ronald Lee Strauss. By 2007, the CCO/CFO, planning to retire, had become a part-time employee.
Ronald Lee Strauss hired another CCO in November 2006. Prior to starting work as the new CCO in June 2007, this unnamed individual held a variety of other roles at the firm, including back-up trader, back-up trade reconciliation, research analyst and portfolio manager for a handful of accounts, the agency said.
"R. Strauss knew the chief compliance officer had limited prior experience and training in compliance prior to becoming CCO," the SEC said, adding that the individual "retained his other responsibilities in addition to his new CCO role." In addition, according to the agency, Ronald Lee Strauss:
Did not provide the new CCO with sufficient guidance regarding his duties and responsibilities as the new CCO and instead left it for the individual and the prior CCO to manage the transition;
Did not provide the CCO with staff to assist him with compliance, other than the departing and part-time prior CCO, who was then serving in an advisory
Directed the CCO to prioritize his investment research responsibilities over compliance in 2009 and 2010. "R. Strauss also gave the chief compliance officer other responsibilities at the firm that impacted his ability to focus on compliance, including naming him CFO in 2009," the SEC said. "Between his research and other responsibilities, the chief compliance officer was only able to devote between 10 percent and 20 percent of his time on compliance matters."
Annual compliance program reviews
As a result of this lack of support and where he was directed to focus, "the chief compliance officer was unable to complete timely annual compliance program reviews for 2009 and 2010," the agency said. Almost three years passed between Pekin Singer’s completion of what the SEC described as a limited annual compliance program review in early 2009 and the completion of the next annual review in late 2011, according to the administrative order.
The CCO went to Ronald Lee Strauss more than once in 2009 and 2010, saying that he needed help to fulfill his compliance responsibilities, including the annual review, the agency said. "However, when the chief compliance officer expressed concern about not completing compliance testing and warned that Pekin Singer would not be ready for an SEC examination, R. Strauss told him that the firm’s primary responsibility was serving clients, and that they could address any problems that came up in an examination at that time." The CCO again spoke to Ronald Lee Strauss by mid-2010 about the need to complete annual compliance reviews, yet, according to the agency, Strauss did not engage a consultant to assist him.
A compliance consultant was finally retained in January 2011 to work with the CCO, but the engagement was on a narrow basis to reduce costs. The consultant nonetheless issued a report in June 2011, listing several compliance deficiencies at the advisory firm, the SEC said. "It took the firm an additional six months after receiving the compliance consultant’s report to complete its compliance program review covering 2009 and 2010," the agency said. "The lack of assistance and support for the chief compliance officer contributed substantially to the delay in completing the annual reviews."
The alleged violations found by the consultant or by examiners, previously undetected, included:
A Pekin Singer research analyst failed to pre-clear and report certain securities transactions and holdings, some of which were owned by advisory firm clients and Appleseed, and the adviser lacked documentation supporting preclearance of trades for other Pekin Singer employees;
The advisory firm did not receive all required documentation of employee trading and employee personal account statements;
Documentation of the firm’s best execution reviews was not maintained;
Pekin Singer failed to obtain annual securities holdings reports and annual code of ethics compliance certifications from certain employees, as required by the firm’s code of ethics; and
The adviser did not conduct regular reviews of its code of ethics and failed to conduct annual compliance meetings for firm personnel, as required by Pekin Singer’s policies and procedures manual.
Not best execution
The SEC’s best execution allegations against the firm cover 2011 to early 2014. According to the agency, during that period, Pekin Singer, Ronald Lee Strauss and two other executives "kept or placed a substantial number of their clients in the investor share class of Appleseed … when those clients were eligible for the less-expensive institutional share class."
"Pekin Singer clients paid an additional 25 basis points in fees on their Appleseed shares beyond what the clients would have paid had they been invested in the less-expensive share class," the SEC said. "Pekin Singer received the additional 25 basis points in Appleseed fees generated by having Pekin Singer clients in the more expensive share class. By selecting the less economical share class for its clients, Pekin Singer failed to seek best execution for its clients and failed to adequately disclose its conflict of interest in selecting a share class for clients that would generate more fees for the firm."
In his statement, Adam Strauss noted that "we fully and voluntarily remediated the investor share class matter. We converted all separately managed client shareholdings to the institutional class shares; notified affected clients; self-reported the matter to the SEC; and voluntarily and proactively reimbursed clients for the expense ratio difference. … The difference in expense ratios represented an average of less than $91 per client portfolio per year. Our compliance team identified the issue and the firm proactively corrected it."