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News March 6, 2006 Issue

Gohlke’s Material Compliance Matters

In identifying and addressing conflicts, risks, and compliance matters, an adviser must distinguish between immaterial and material situations.

At last weekís IAA/IA Week conference, SEC Division of Investment Management assistant director Jennifer Sawin noted that the Advisers Act and rules do not define materiality. However, she described the general legal standard, as developed in other contexts of the federal securities laws, as follows: "Whether a reasonable investor would consider the disclosure information important in determining whether to engage an adviser or continuing to retain an adviser that has been engaged."

To help put that into the context of the annual review requirement, hereís a list of examples that, to OCIE associate director Gene Gohlke, would be "material compliance matters":

  • An access person was found to have front-run clientsí trades, "not just once but sortíve over time."
  • An employee had been cherry-picking, by reallocating client block trades at the end of the day, once he or she knew how the market closed, to benefit certain other clients of the firm or his personal account.
  • On a regular basis, a portfolio manager or another employee had smoothed out the pricing of client or fund portfolios so that a decline of prices doesnít hit all in one day, but rather occurs over a period of weeks or months. "If thereís a pattern of doing that, I would say thatís a material compliance issue," said Gohlke.
  • Somebody within the firm had used client brokerage to obtain products and services that are "far outside" the Section 28(e) safe harbor, and had tried to conceal it from the firmís soft dollar committee.
  • Any recidivist activity, where "somebody has been told Ďthis is inappropriate, donít do it,í and they do it again."
  • Any issue where the firmís clients had been harmed in some material way.
  • A service provider had caused the firmís clients to be harmed.
  • A serious compliance issue that involved senior management of the firm, or some star performer. If there is someone in the firm that the compliance department has trouble controlling, and that person "goes off and does a bunch of bad stuff," thatís a material compliance issue.

Gohlke emphasized that the list reflected his opinion, not that of the Commissionís.