On November 4, 2015, Andrew Ceresney, director of the Securities and Exchange Commission’s (SEC’s) Division of Enforcement (Enforcement Division),
delivered the keynote address at the 2015 National Conference of the National Society of Compliance Professionals (NSCP). His comments focused on the
approach of the Enforcement Division in cases involving chief compliance officers (CCOs) of private fund managers that are registered with the SEC as
investment advisers under the Investment Advisers Act of 1940, as amended (Advisers Act).
The speech includes a description of the circumstances in which the Enforcement Division will bring cases against CCOs as well as considerations relating
to the compliance function generally. Accordingly, the content of this speech is important for CCOs of private investment vehicles.
here for access to Mr. Ceresney’s
November 4, 2015, speech.
Consistent with prior statements by the SEC staff, Mr. Ceresney outlined the three areas where the Enforcement Division generally brings cases against
CCOs. According to Mr. Ceresney, the SEC will bring cases against CCOs where they have:
- directly engaged in misconduct unrelated to the compliance function,
- attempted to obstruct or mislead the SEC staff, or
- exhibited a wholesale failure to carry out their responsibilities as CCOs.
The foregoing categories were previously identified by Mr. Ceresney as sufficient for CCO liability in a speech on May 20, 2014. Click
here for access to Mr. Ceresney’s May 20, 2014, speech.
We briefly discuss each of these categories below.
To begin with, it is important to understand this recent speech by Mr. Ceresney in the context of public statements by other SEC members and staff
concerning the SEC’s approach to CCO liability.
On June 18, 2015, then-SEC Commissioner Daniel Gallagher issued a public statement expressing his dissent with respect to two enforcement actions involving
CCOs that asserted violations of Rule 206(4)-7 under the Advisers Act. Rule 206(4)-7, commonly referred to as the “compliance rule,” requires that each
federally registered investment adviser:
- adopt written compliance policies and procedures,
- designate a CCO to administer these policies and procedures, and
- review, at least annually, the adequacy of the these policies and procedures.
Among other things, Commissioner Gallagher recommended that amendments to, or staff- or SEC-level guidance concerning, the compliance rule should be
seriously considered to clarify the roles and responsibilities of compliance personnel so that “these individuals are not improperly held accountable for
the misconduct of others.”
here for access to Commissioner Gallagher’s statement.
On June 29, 2015, SEC Commissioner Luis Aguilar responded by stating that CCOs who put investors first and do their jobs competently and in good faith do
not have to worry about being targeted in an SEC enforcement action. This statement by Commissioner Aguilar, in many respects, is remarkably similar to the
speech by Mr. Ceresney. Click
here for access to this
statement by Commissioner Aguilar.
It is also important to note that the NSCP, a significant industry player, has expressed concerns similar to those of Commissioner Gallagher.
On August 18, 2015, the NSCP released a letter (NSCP Letter) to Mr. Ceresney
expressing concern over the Enforcement Division’s approach in cases involving
potential CCO liability. The NCSP makes the point that the SEC should decline,
as a matter of policy, to bring an enforcement action against a CCO based
on simple negligence. The NSCP emphasized that CCOs do not operate the business; they advise and support the business. The NSCP also emphasized that
because of the practical reality of the function of a CCO, the SEC’s approach presents a risk of “liability by hindsight” that may to some extent be
unavoidable. The NSCP Letter stated:
On this point, we respectfully suggest that charging a compliance officer for designing what, with the benefit of hindsight, turns out to be a less than
perfect policy and procedure, fails to acknowledge that policies or procedures are rarely “perfect.” They are routinely reexamined and improved based upon
lessons learned at the firm. This dynamic does not suggest a control weakness. Indeed, the American Institute of Certified Public Accountants recognizes
that controls are limited in nature and may “not prevent or detect and correct all errors or omissions.”
The NSCP Letter recommends that the Enforcement Division adopt internal guidelines based upon the standard for aiding and abetting in dealing with the role
of the CCO under the compliance rule.
here for access to the NSCP Letter.
Mr. Ceresney’s November 4, 2015, speech was delivered at a major NSCP function, and provided an opportunity for Mr. Ceresney to deal with the issues raised
in the NSCP Letter.
Mr. Ceresney’s speech appeared to be an attempt to reassure competent, committed and conscientious CCOs that they need not fear an SEC enforcement action
against them personally in their capacity as CCOs.
He cites statistics to demonstrate that enforcement cases against CCOs who have only the CCO title are infrequent. (Commissioner Aguilar cited
substantially similar statistics in his June 29, 2015, statement.)
However, Mr. Ceresney did not directly address the specific recommendation contained in the NSCP Letter.
Mr. Ceresney emphasized that cases against CCOs largely involve misconduct outside of the CCO role or are otherwise limited to “wholesale” failures to
carry out their compliance duties as CCOs. The practical implications of this concept are discussed below.
Misconduct Unrelated to the Compliance Function
Mr. Ceresney noted that the Enforcement Division will bring cases against a CCO who is directly involved in fraudulent activity or other conduct that harms
investors. These situations can involve CCOs who wear “multiple hats” or, in other words, serve in several capacities, such as a CCO who is also the CEO or
CFO of the investment adviser. Misconduct in such other roles has led to SEC enforcement actions.
For example, Mr. Ceresney pointed to the recent enforcement action against AlphaBridge Capital Management’s CCO, in which the SEC charged a CCO who was
also a portfolio manager and who, according to the SEC, affirmatively misled the fund administrator and auditor about asset values.
Efforts to Obstruct or Mislead SEC Staff
Mr. Ceresney also emphasized that the Enforcement Division will charge CCOs who engage in efforts to obstruct or mislead SEC staff.
As one of the examples here, Mr. Ceresney cited the Parallax case, in which the SEC charged a CCO for compliance-related violations where, according to the SEC, the CCO
altered documents during a regulatory compliance examination in order to deceive SEC staff about whether the CCO had conducted the annual compliance
reviews required by Rule 206(4)-7.
Wholesale Failure to Carry Out CCO Duties
In this category, Mr. Ceresney stated that enforcement action is appropriate when CCOs “completely fail” in their responsibilities, particularly where
significant investor harm results. Mr. Ceresney discussed two recent enforcement actions,
SFX and a case including a major fund sponsor, as illustrating this point.
In SFX, an employee of an investment adviser with signatory power over client bank accounts withdrew money directly from those accounts for more
than five years. The CCO was not involved in and was not charged with this misappropriation, but was charged with causing the firm’s violation of the
compliance rule. The SEC alleged that the firm’s policies and procedures specifically assigned the CCO with responsibility to implement the firm’s policy
requiring review of “cash flows in client accounts,” but the CCO failed to ensure that a review took place.
Mr. Ceresney stated that if the CCO had implemented cash-flow review policies, the firm likely would have uncovered the misappropriation earlier.
In the second case, according to the SEC, the company did not have any written policies and procedures regarding the outside business activities of its employees, even though the CCO knew of and approved many outside activities engaged in by
its employees. The SEC alleged that the CCO was involved in extended
discussions about a significant outside family business of a new portfolio manager that posed a conflict with the investments his fund held, and despite
these red flags, the CCO failed to develop and implement written policies and procedures to assess and monitor the outside activities of
employees and to disclose related conflicts of interest to the funds’ boards and
to advise any clients.
These two cases are the same enforcement actions that sparked the public dissent from then-Commissioner Gallagher,
mentioned above. Among other things, Commissioner Gallagher stated:
Both settlements illustrate a Commission trend toward strict liability for CCOs under Rule 206(4)-7. Actions like these are undoubtedly sending a troubling
message that CCOs should not take ownership of their firm’s compliance policies and procedures, lest they be held accountable for conduct that, under Rule
206(4)-7, is the responsibility of the adviser itself.
The use of the concept of “strict liability” as outlined by Commissioner Gallagher and the concerns identified in the NSCP Letter are both worth noting. In
regulatory compliance exams, a matter that is perceived by examination staff to be a deficiency may also be cited as a failure to have adequate compliance
procedures. In other words, if the CCO had designed effective compliance procedures, the deficiency would not have taken place. From the standpoint of the
SEC staff, this type of failure can be perceived to be a “wholesale failure,” potentially resulting in an enforcement action.
In others words, “wholesale failure” does not just refer to a situation where a CCO did not carry out his or her compliance responsibilities generally.
Instead, it can also refer to a situation where isolated or specific compliance deficiencies result in a finding that the compliance procedures were
inadequate with respect to those specific deficiencies.
SEC Efforts to Support the Compliance Function
Mr. Ceresney also discussed actions by the Enforcement Division that he believes support the compliance function. The thrust of this part of his speech was
that the SEC has taken actions that support CCOs in their compliance function. Mr. Ceresney discussed the
Pekin Singer and Carl Johns cases to illustrate
In Pekin Singer, the SEC charged an investment adviser with numerous compliance failures, and also charged the adviser’s president with causing
those violations. Among other things, the SEC alleged that the adviser failed to conduct timely annual compliance program reviews and failed to implement
and enforce provisions of its policies and procedures and its code of ethics. Of particular importance, the SEC’s order alleged that the firm did not
dedicate sufficient resources to its compliance program. The CCO, who was not charged, was tasked with numerous responsibilities unrelated to compliance,
which severely limited his ability to focus on the compliance function. The SEC alleged that the CCO repeatedly told the firm’s president that he needed
help to fulfill his compliance responsibilities, including the annual compliance program review. The SEC also alleged that the CCO had expressed concern
about not completing compliance testing, and warned that the firm would not be ready for an SEC examination. This warning proved to be accurate.
The SEC did not charge the CCO in Pekin Singer. However, the SEC did charge the president for causing the violations, largely because he had ignored
the CCO’s repeated requests for more resources and support. The message from this case, according to Mr. Ceresney, is that the business side of private
fund management needs to make sure that compliance personnel get the resources they need.
Mr. Ceresney also pointed to the 2013 enforcement action in Carl Johns. In this case the SEC filed its first-ever charge against an individual for
misleading and obstructing a CCO. In that case, it was alleged that an assistant portfolio manager at an SEC-registered investment adviser failed to
pre-clear or report his personal securities transactions. The SEC alleged that he also submitted false quarterly and annual reports related to his
securities trading, altered trade confirmations, and manually deleted securities holdings on his brokerage statements. When the CCO detected irregularities
in the altered documents and confronted the portfolio manager, the portfolio manager was alleged to have misled the CCO about the transactions and to have
accessed the hard-copy file of his previously submitted brokerage statements and changed them.
According to Mr. Ceresney, the message of Pekin Singer and Carl Johns, as well as similar cases, is that the Enforcement Division will
aggressively pursue business line personnel and firms who mislead or deceive CCOs, or obstruct the compliance function, or who fail to support CCOs, in a
manner that causes compliance violations.
The Compliance Function Generally
Mr. Ceresney emphasized the importance of the compliance function by recommending that firms ask the following questions about the role of the compliance
- Are compliance personnel included in critical meetings?
- Are their views typically sought and followed?
- Do compliance officers report to the CEO and have significant visibility with the board?
- Is the compliance department viewed as an important partner in the business and not simply as a support function or a cost center?
- Is compliance given the personnel and resources necessary to fully cover the entity’s needs?
Mr. Ceresney stated that when the answer to these questions is no, the absence of real compliance involvement in company deliberations can lead to
compliance lapses, which, in turn, can result in enforcement issues.
Several aspects of the SEC’s current approach to the compliance rule should be noted by CCOs.
First, to some extent, the SEC’s current regulatory approach is taking shape in enforcement actions, as opposed to staff guidance or rulemaking. For this
reason, it is particularly important to keep an eye on SEC enforcement actions and relevant public statements by SEC staff. The SEC’s approach on this
issue is not likely to change any time soon.
Second, it is important that compliance procedures be tailored to the operations of the fund manager and address the real-world risks inherent in those
operations. The compliance procedures should address the areas specifically identified by the rule itself, the areas that are highlighted in SEC
enforcement actions as well as SEC guidance and public statements by SEC officials. CCOs should be mindful of the fact that a perceived absence of adequate
policies dealing with a specific function or risk might be characterized as a “wholesale failure” in terms of the analytical framework outlined above.
Third, CCOs need to be proactive in carrying out their duties and responsibilities under applicable securities laws and regulations as well as their
functions under their firm’s compliance practices and procedures.
Fourth, fund managers need to make sure that the compliance function receives the resources needed for an effective program, including personnel, time and
expertise. It is particularly important that CCOs who wear “multiple hats” (such as CEO or CFO) have sufficient time and resources to do all their jobs.
Fifth, fund managers need to be prepared for regulatory examinations, well in advance. Fund managers should seriously consider performing “mock” regulatory
examinations in this regard. This kind of effort can be very helpful in making sure that the policies and procedures function effectively and that
compliance staff is in a position to respond in an appropriate and timely manner in the event of regulatory examination.
McGuireWoods Private Equity
The private equity team at McGuireWoods is
dedicated to keeping clients advised of new legal and business developments as they occur. If you have any questions regarding these issues, please feel
free to contact any of the authors or your primary attorney at McGuireWoods.
The NSCP Letter cites to Statement on Standards for Attestation Engagements [SSAE-16], Reporting on Controls at a Service Organization
[AICPA, Professional Standards, AT sec. 801.A68]
The NSCP Letter states that these elements “capture the spirit” of the principles Mr. Ceresney has articulated concerning cases involving CCOs: (i)
a primary securities law violation, (ii) knowing or extremely reckless conduct, and (iii) substantial assistance to the primary violator.
5. In the Matter of Parallax Investments, LLC, John P. Bott, II, and F. Robert Falkenberg,
Advisers Act Release No. 4159
(Aug. 6, 2015).
In the Matter of SFX Financial Advisory Management Enterprises, Inc. and Eugene S. Mason
Advisers Act Release No. 4116 (June 15, 2015).
Pekin Singer Strauss Asset Management Inc.,
Advisers Act Release No. 4126
(Jun. 23, 2015).