OCIE Turns the Spotlight on Municipal Adviser Compliance Failures
The SEC’s Office of Compliance Inspections and Examinations on November 7 issued a Risk Alert based on its observations from examinations of municipal advisers. The observations make clear that OCIE finds compliance lacking in at least three key areas: registration, recordkeeping and supervision.
"Municipal advisers should take steps to educate themselves regarding their compliance obligations," the OCIE staff said in the six-page Risk Alert. "In sum, the staff observed that municipal advisers were generally unfamiliar with many of their regulatory obligations."
"What OCIE is saying is, ‘Here is a new regulatory regime. It imposes compliance conditions and we are seeing that the industry is not complying the way that they should.’ It’s a reminder and it’s a warning," said Morrison & Foerster of counsel Kelley Howes.
While OCIE said it issued the Risk Alert to share its observations, it is unclear why it waited so long to do so. The examinations, 110 in all, were conducted in 2014 and 2015. "OCIE hopes to encourage municipal advisers to reflect upon their practices, policies and procedures in these areas and to make any necessary improvements," the agency said.
One can only speculate as to the reason for the time lag between the completion of the exams and the issuance of the risk alert, said Goodwin Procter partner Peter LaVigne. OCIE "may have wanted to wait until all of the correspondence relating to the examinations and also enforcement referrals were finished, which could have been well into 2016. After that, there may have been a pause after the election during which the staff waited to find out who the new chair would be and whether this effort would still be supported."
Advisory firms and registration
Municipal advisers were not required to register with the SEC or any other federal, state or self-regulatory entities until the passage of the Dodd-Frank Act, which required them to register by October 1, 2010. The agency created an interim procedure for temporary registration and then adopted a final Registration of Municipal Advisers Rule September 2013, which became effective the following year. Dodd-Frank also granted the Municipal Securities Rulemaking Board (MSRB) regulatory authority over municipal advisers and, significantly, imposed a fiduciary duty on them when advising municipalities.
Many SEC-registered investment advisers do not need to be concerned about this Risk Alert, since they are often excluded from the definition of municipal adviser unless they engage in soliciting municipal entities to become clients of a third party adviser.
That said, the Rule’s adopting release leaves some wiggle room on the question, said Howes. "It’s true that SEC-registered advisers are generally not required to register as municipal advisers, but it’s not quite that simple," she said, noting that in certain situations, they may have to register as both investment advisers and municipal advisers.
The adopting release, she pointed out, states that "the Commission interprets the statutory language, which provides an exclusion for registered investment advisers and associated persons ‘who are providing investment advice,’ as evidence that Congress did not intend to grant a blanket exemption from municipal adviser registration for all registered investment advisers and their associated persons regardless of the activities in which they are engaged."
"The Commission believes the phrase ‘who are providing investment advice,’ limits the exclusion," the adopting release continues. "Under this interpretation, if an associated person or a registered investment adviser engages in municipal advisory activities that do not constitute ‘investment advice’ for purposes of Rule 15Ba1-1(d)(2)(ii), both the registered investment adviser and the associated person of such adviser engaging in the municipal advisory activities would be ‘municipal advisers’ unless eligible for another exclusion or exemption."
What activities do not constitute investment advice? The adopting release notes that, solely for purposes of the Municipal Adviser Registration Rule, investment advice "does not include advice concerning whether and how to issue municipal securities, advice concerning the structure, timing and terms of an issuance of municipal securities and other similar matters, advice concerning municipal derivatives, or a solicitation of a municipal entity or obligated person."
"The definition of who is a municipal adviser and the exclusions, as interpreted by the SEC, are unnecessarily complex," said LaVigne. "The exceptions to the investment adviser exclusion are a good example; a blanket exclusion for all investment advisers, federal and state, would have been much simpler to apply."
"Compounding the problem," he said, "is the fact that, while there are many lawyers who can advise on the registration requirements of investment advisers and brokers, and many more who can at least spot potential registration issues, there are far fewer who are familiar with the municipal advisor rules and registration requirements. As a result, there are likely to be continuing failures to register as municipal advisers."
State-registered advisers have to register with the SEC as municipal advisers, LaVigne said. "State-registered investment advisers do not have that exception from being municipal advisers," he said, and must register with the SEC as municipal advisers if they are in the business of providing municipal clients with investment advice. One of the reasons given by the SEC in the adopting release for not excluding state-registered advisers from registration is that state regulation is not always similar to the requirements of the Advisers Act, such as the SEC’s pay-to-play rule, LaVigne noted.
The SEC’s registration requirements for municipal advisers involve four forms:
Form MA. This is the application for municipal adviser registration. "An entity that seeks to engage in municipal adviser activities must register with the Commission using Form MA," OCIE staff said. Annual updates must be filed within 90 days after the end of the adviser’s fiscal year.
Form MA-I. Municipal advisers must complete and file this form for each natural person associated with the adviser that is engaged in municipal adviser activities.
Form MA-NR. This is for non-resident municipal advisers, non-resident general partner or non-resident managing agent of a municipal adviser, and non-resident persons associated with a mutual adviser. Such persons must execute an irrevocable consent and power of attorney on this form.
Form MA-W. This is the form that must be used when a municipal adviser no longer engages in municipal adviser activities.
In addition, the MSRB requires that its Form A-12 be completed.
Following is the list of the compliance failures that OCIE staff found during their examinations of municipal advisers. The examiners observed failure to:
Register with the Commission or the MSRB prior to engaging in municipal adviser activities;
File annual updates to Form MA;
File amendments to several of the forms when required;
Complete Form MA "with accurate and complete information, particularly with respect to compensation arrangements and outside business activities;"
Pay MSRB registration fees and late fees; and
File a Form MA-W and withdraw MSRB Form A-12 when withdrawing from MA registration.
Books and records
Municipal advisers are required to make and keep certain books and records under Exchange Act Rule 15Ba1-8. These include:
Originals or copies of all written communications received or sent by the municipal adviser, regardless of format; and
All checkbooks, bank statements, general ledgers, cancelled checks and cash reconciliations.
In this area, according to the Risk Alert, examiners observed failure to:
Maintain copies of written communications sent or received by the firm in relation to its municipal adviser activities, "including those sent electronically;"
Make and keep documents material to a recommendation made to a client;
Prepare and maintain accurate general ledgers; and
Maintain accurate records of cash receipts and disbursements.
The OCIE staff said that a supervisory system must provide for:
The establishment, implementation, maintenance and enforcement of written supervisory procedures that are reasonably designed to achieve compliance with all applicable rules; and
The designation of one or more municipal advisory principals to be responsible for supervision. The MSRB also requires each municipal adviser to designate an individual as its chief compliance officer.
The Risk Alert said that OCIE examiners, in their visits to municipal advisers, found failures to:
Have a system to supervise the municipal adviser’s activities of employees that was reasonably designed to achieve compliance with all applicable rules, specifically naming failure to monitor gifts, travel and entertainment expenses; and failure to oversee the firm’s responses to requests for proposals;
Have written supervisory procedures reasonably designed to ensure compliance with applicable rules, specifically mentioning a failure to tailor such written supervisory procedures to the firm’s business activities and conflicts of interest; and
Designate one or more principals to be responsible for supervisory activities.