Section 31(a) of the Investment Company Act of 1940 (“ Investment Company Act”) requires that each registered investment adviser “maintain and preserve” records of accounts, correspondence, memorandums, tapes, discs, papers, books, and other documents or transcribed information. These books and records are to be maintained for a period of five years and are subject to random periodic inspection by the U.S. Securities and Exchange Commission (“SEC”). Likewise, under Rule 204-2 of the Investment Advisers Act of 1940 (“Investment Advisers Act”), the SEC requires certain books and records to be maintained by a registered investment adviser regardless of whether of the investment adviser is associated with a registered investment company.
A recent example where the SEC has initiated a disciplinary action as a result of a periodic record inspection is In the Matter of Diane M. Keefe. In this regulatory enforcement action, the SEC brought an action against Diane Keefe, an employee of a registered investment adviser, when the SEC, while conducting a period examination, discovered that Keefe did not maintain accurate records.
Diane Keefe, a former employee of Pax World Management Corp., a registered investment adviser, was found to have willfully violated Section 34(b) of the Investment Company Act for failure to maintain accurate books and records. Section 34(b) of the Investment Company Act prohibits investment advisors from making any untrue statement of material fact in a document that is required for record keeping pursuant to Section 31(a) of the Investment Company Act.
Keefe served as the portfolio manager of the Pax World High Yield Fund (“Fund”). The Fund’s filed registration statements state that an Investment Committee was responsible for overseeing the Fund’s investments. Keefe created handwritten notes that falsely represented that the Investment Committee was overseeing the investments of the Fund. However, the Fund’s board had never even assembled the Investment Committee.
The administrative law judge suspended Keefe for twelve months from association with a registered investment adviser or broker-dealer. Keefe has appealed her suspension and the case has been remanded for further fact-finding determinations.
On July 28, 2010 RIA Compliance Consultants will be conducting a webinar on the topic of maintaining investment adviser required books and records pursuant to SEC Rule 204-2 issued under the Investment Advisers Act. Individuals can register for this webinar, or any of our other upcoming webinars, by clicking here.
In 2009, the State of Michigan adopted several amendments to the Michigan Uniform Securities Act. One of the major amendments to the Michigan Securities Laws requires all investment adviser representatives to be licensed.
Under Michigan’s revised definition of “investment adviser representative,” all individuals who make recommendations or give advice, manage accounts, determine recommendations or advice, provide investment advice, solicit for the sale of investment advice or supervise any individual conducting such activities are considered investment adviser representatives and must be licensed.
To register as an investment adviser representative, an individual must make a Form U4 filing with FINRA’s CRD/IARD System. As part of this filing, an individual must submit proof that within the previous two years, the individual has passed either the Series 65 or both the Series 7 and the Series 66 examinations. Individuals may apply for a waiver of the exam requirements, which waiver request must be submitted by August 2, 2010.
The final date to comply with Michigan’s new investment adviser representative registration requirements is November 1, 2010. However, due to an anticipated high number of filings, the State of Michigan has stated that licensing may take 60 days from the time a filing is submitted. Therefore, it is recommended that individuals submit their investment adviser representative application prior to September 1, 2010 to prevent any lapse in registration. If you need advice or assistance regarding the filing of an investment adviser registration application, any of our compliance consultants are willing to assist you.
On June 21, 2010, the U.S. Securities and Exchange Commission (“SEC”) charged a New York based registered investment adviser and three affiliated firms with the fraudulent management of collateralized debt obligations (“CDOs”) tied to mortgage backed securities. The SEC alleges that ICP Asset Management LLC, and its owner/president Thomas Priore, made fraudulent misrepresentations that earned the firm several million dollars in advisory fees and also caused four CDOs to lose tens of millions of dollars.
According to the SEC’s complaint, the defendants caused the CDOs to enter into several prohibited transactions at inflated prices so the firm could collect larger advisory fees. In some instances, the defendants caused the CDOs to purchase assets from other firm clients at prices well above the market price. The SEC further alleges that the defendants made misrepresentations about these transactions to both investors and the trustees of the CDOs.
The defendants are charged with violating their fiduciary duty as investment adviser, which requires all investment advisers to conduct their business in a manner that is in their clients’ best interest. Robert Khuzami, the Director of the SEC’s Enforcement Division, characterized the firm’s actions as violating their fiduciary duty by putting their own interests ahead of their clients and taking “advantage of a distressed market to line their own pockets.”
Seeking a permanent injunction, disgorgement of profits, and other monetary penalties, the SEC’s complaint also charges the defendants with participation in prohibited transactions, failure to maintain required books and records, and other charges in violation of Sections 204 and 206(1)-(4) of the Investment Advisers Act of 1940; SEC Rules 204-2, 206(4)-7, and 206(4)-8; the Securities Act of 1933; and the Securities Exchange Act of 1934.
The Division of Investment Management of U.S. Securities and Exchange Commission (“SEC”) recently updated ”Staff Responses to Questions About the Custody Rule.” (For a link to Staff Responses click here). In the updated responses, the Division provided new guidance concerning a variety of issues related to the custody rule. Two important issues discussed by the SEC clarify an investment adviser’s ability to request checks from a client account and situations where an investment adviser has online access to client pension accounts through the client’s ID number and password.
Question II.5
Q: Does an adviser have custody if it has authority to instruct the qualified custodian that maintains a client’s account to remit the funds or securities from the account to the same client at his or her address of records?
A: We do not interpret the authority to instruct the qualified custodian maintaining a client’s account to remit the funds or securities from the account to the same client at his or her address of record as having custody if (1) the client has granted such authority to the adviser in writing and a copy of that authorization is provided to the qualified custodian, and (2) the adviser has neither the authority to open an account on behalf of the client nor the authority to designate or change the client’s address of record with the qualified custodian. (Posted May 20, 2010).
Question II.6
Q: If an adviser has the ID number and password to a client’s pension fund account to rebalance and adjust investments in the account, does the adviser have custody?
A: The adviser has custody if password access provides the adviser with the ability to withdraw funds or securities or transfer them to an account not in the client’s name at a qualified custodian. (Posted May 20, 2010).
Kenneth Starr, an investment adviser representative, to several celebrities and other wealthy clients, was arrested on May 27th for allegedly using client funds for his own personal use. Starr has been charged in a New York District Court with fraud by an investment advisor, a wire fraud scheme to obtain property, money laundering, false statements in an IRS Filing, and false statements to a federal officer, for fraudulently misappropriating over $30 million of client funds. The Complaint also charges Andrew Stein, an associate of Starr’s, with various tax fraud violations. (Click here for the full Complaint).
Starr, who is not the Kenneth Starr who served as the prosecutor in the Whitewater investigation, allegedly used his registered investment advisor firm, Starr & Company, LLC, to conduct the fraud. Through the investment advisor firm, Starr presented himself as an accountant and investment adviser representative to obtain management and control of over millions of dollars of client finds. In some instances, Starr assumed total control over his clients’ funds by collecting their earnings, paying their bills, and then investing their savings.
Starr allegedly transferred client funds to a trust account to make it appear as if the funds were being directed to investments. However, those funds were actually diverted to risky investments in which Starr had a financial interest or Starr would use the funds for his personal expenses, including the purchase of a condo on Upper East Side of New York City, for $7.5 million. When Starr’s clients made demands for payments, he would transfer funds from one client to another client. This behavior caused the Government to label Starr’s activity as “characteristic of a ‘Ponzi’ scheme.” If convicted, Starr faces up to 45 years in a federal prison.
This alleged Ponzi scheme involving a high profile registered investment advisor will undoubtedly increase regulatory scrutiny of other registered investment advisor’s custody practices and should serve as reminder to registered investment advisers of the need to address fully the requirements of the SEC’s new custody rule.
Wisconsin has enacted a law which enhances the penalties for violations of the Wisconsin Securities Act if the violations occur against an individual who is 65 years of age or older. The Wisconsin Securities Act prohibits various forms of fraud in connection with the sale or offering of securities or any other securities transactions. Specifically, registered investment advisors, as well as broker dealers, are prohibited form engaging in fraud or employing manipulative, deceptive, or fraudulent devices.
Under the prior Wisconsin law, a violation of the Securities Act could subject an individual to both criminal and civil liability. A violation could lead to a Class H felony conviction which was punishable by a maximum fine of $10,000 and a maximum prison sentence of six years. In a civil proceeding, a violator could face a civil penalty of a fine up to $5000 for a single violation and up to $250,000 for multiple violations. Along with this fine, a civil judgment could include payments for restitution, the disgorgement of profits, and the payment of interest.
The new Wisconsin law, which became effective May 6, 2010, nearly doubles the penalty for the violations of the state’s securities laws if the crime is committed against an individual who is 65 years of age or older. For criminal offenses, the fine will be increased from a maximum of $10,000 to a maximum of $15,000 and the prison sentence may be increased from up to 5 years to a maximum sentence of 10 years. In a civil proceeding, the court may impose a $10,000 fine for a single violation and a fine up to $500,000 for multiple violations. In both criminal and civil actions, the fact the defendant was unaware of the age of the victim is not a defense against the enhanced penalties. By enacting the penalty enhancer, Wisconsin joins a group of over a dozen states who have enacted similar penalties for securities crimes against senior citizens.
SEC Rule 206(4)-7 under the Investment Advisers Act of 1940 (Investment Advisers Act) requires an investment adviser registered with U.S. Securities and Exchange Commission (“SEC”) to appoint an individual to serve as the Chief Compliance Officer (CCO). The CCO must be an individual who is competent and knowledgeable regarding the Investment Advisers Act, should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the investment adviser, and should have a sufficient position of seniority and authority within the organization to compel others to adhere to the investment adviser’s policies and procedures. It is important to note that if the firm is a state registered investment adviser, the primary compliance principal may not necessarily have the exact title of CCO as it may not be required by the applicable state securities regulations; however, if an individual is required to be appointed as the person responsible for supervision and compliance in Form ADV, Part 1B, Item 2A, this individual is acting in a capacity similar or equal to that of the CCO.
Once an individual has been given the title as CCO (or other similar supervisory role for state registered firms), the first question is what now? Does the new CCO have a clear understanding of the regulatory expectations of this role and the related responsibilities within the investment adviser? Understanding this role as the investment adviser’s CCO is a crucial element of implementing and enforcing the investment adviser’s written compliance program. Having the title of CCO does not, in and of itself, carry supervisory responsibilities. It should not be assumed that the burden of compliance is all carried on the shoulders of the CCO. It is important that an investment adviser implement and enforce a culture of compliance throughout the firm and the CCO will be the primary leader and enforcer of this culture. However, the CCO can alleviate himself/herself from some of the compliance burden, but to do so: (1) the investment adviser must have adopted procedures reasonably designed to prevent and detect violations; (2) the investment adviser must have a system in place for applying the procedures; and (3) the supervisory responsibilities must have been discharged in accordance with the investment advisor’s written procedures and the CCO must have no reason to believe that the person(s) to whom the responsibilities have been discharged are not complying with the procedures. Therefore, it is extremely important that a CCO know the regulatory requirements as they relate to the investment advisor, assign responsibilities for those requirements, develop strong written procedures clearly defining the responsibilities and the individual responsible, and develop procedures for implementing, testing, and monitoring the procedures.
If you are interested in learning more about the role of the CCO and the related responsibilities, we would encourage you to purchase for $59.95 our previously recorded webinar, “Basic Training for a CCO of an Investment Adviser” by clicking here.
During the keynote address at the Compliance and Legal Society of the Securities Industry and Financial Markets Association 2010 Annual Seminar on May 6, 2010 (click here to read the entire speech), Mary Shapiro, the Chairman of the U.S. Securities and Exchange Commission (“SEC”), stated that her staff is preparing to present to the full Commission a proposal regarding adoption of Form ADV Part 2.
Although a registered investment adviser is held to a fiduciary standard, and consequently has an obligation to disclose or avoid conflicts of interest and to advise a client in a manner that is in the client’s best interest, a broker-dealer is subject to a different regulatory regime and does not have to meet the same fiduciary standard as an investment adviser. Chairman Shapiro commented that she believes that broker-dealers and investment advisers who provide the same services should “meet the same high fiduciary standard” and indicated that she hopes that any regulatory reform will address this issue.
Under SEC regulations, the Form ADV Part II, along with Schedule F, serves as the required disclosure statements that must be given to a client initially and only offered annually thereafter. Chairman Shapiro described the current Form ADV Part II as a “1960s check-the-box, paper-based approach,” where as, the proposed amendments would require more of a “plain English narrative discussion of an adviser’s conflicts, compensation, business activities, and disciplinary history.” Finally, the proposed amendment would require this same information to be provided through the SEC’s website, so that investors, as well as the general public, would have access to this information.
In a speech at the Investment Adviser Association Annual Conference on April 29, 2010 (click here to read the entire speech), Luis Aguilar, Commissioner at the United States Securities and Exchange Commission (SEC), stated the SEC is expected to soon revisit proposed changes to Form ADV Part II. According to Commissioner Aguilar, “the need to update Part II has been clear for over a decade.” In April 2000, the SEC originally proposed comprehensive amendments to Part I and II of Form ADV. However, at that time only changes to Part I were passed and the proposed changes to Part II were allowed to lapse without implementation. Then, in March of 2008, the SEC re-proposed various amendments to Part II.
In its March 2008 release, the SEC proposed exhaustive changes to Form ADV Part II including the use of a table of contents, the use of a plain-English brochure, the specific requirement to disclose all material arrangements and potential/real conflicts of interest. Investment adviser firms would also be required to deliver a complete copy of the brochure to all clients at least annually. Currently, investment adviser firms are required to only offer Form ADV Part II. The proposal also requires a supplement intended to provide information about the qualifications and background of personnel be providing the investor with personalized investment advice. The proposed rule overhauls the Schedule H brochure as well. A Schedule H must be prepared by wrap-fee program sponsors.
Form ADV is used as the official application document to register as an investment adviser firm. Both the SEC and the state securities regulators require use of the Form ADV as an investment advisor registration document. Once investment advisor registration is granted, the Form ADV must be amended at least annually and whenever material changes occur. More importantly, the Form ADV Part II and Schedule F serve as the required disclosure statement that an investment adviser must provide to its clients. Investment advisers that use a disclosure statement other than the Form ADV Part II and Schedule F must ensure that the disclosure statement contains the same information as the Form ADV Part II and Schedule F.
Stay tuned to RIA Compliance Consultants as we continue to follow this story.
When holding itself out to the public, an investment adviser should not imply that the U.S. Securities and Exchange Commission (SEC), a state securities regulator or another governmental agency has sponsored, recommended or approved the firm, based upon its registration. For example, an investment advisor should not use the term “Registered Investment Adviser” to imply that as an investment advisor, it has a level of professional competence, education or special training. The term should not be used after an individual’s name unless the individual is registered as an investment advisor (i.e. the registered entity is a sole proprietor). The same is true for the acronym “RIA” which should not be used after a person’s name because using initials after a name usually indicates a degree or a licensed professional designation for which there are certain qualifications; however, there are no federal qualifications for becoming an SEC-registered investment adviser.
On Thursday, May 13, 2010 from 12:00 – 1:00 p.m. Central, RIA Compliance Consultants will host a webinar focused on compliance policies and procedures related to advertising. The webinar, “Approving Marketing Materials”, will focus on SEC no-action letters and enforcement actions related to marketing materials used by investment advisors. Our consultants will also discuss best practices and sample disclosures.
If you would like to attend our webinar, Approving Marketing Materials, you can purchase your seat for $59.95 by clicking here
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