The Securities and Exchange Commission's Office of Compliance Inspections and Examinations (OCIE) recently issued a crucial Risk Alert. This alert, of significant importance, highlights common compliance issues related to the Investment Advisers Act of 1940 (IAA) requirements.
The Compliance Rule, a key component of this act, mandates that a registered investment adviser cannot provide investment advice without having adopted and implemented written policies and procedures designed to prevent the adviser from violating the rules.
This rule requires investment advisers to designate a chief compliance officer to administer their compliance policies and procedures. This is a pivotal role, as an investment adviser's Chief Compliance Officer (CCO) should have adequate knowledge of the Advisers Act and should have the responsibility and authority to create and enforce appropriate procedures for the investment adviser.
The Risk Alert is a government initiative designed to utilize effective compliance programs to mitigate market and national security risks relevant to investment advisers and international commerce. It serves as a warning to investment advisers about potential compliance issues and the need to address them to avoid legal and regulatory consequences.
As a result, investment advisers with the identified deficiencies also risk violating anti-corruption, export, and sanctions regulations when engaging in international transactions or dealing with non-U.S. investors. The potential risks of non-compliance are significant and should not be underestimated.
What is the Investment Advisers Act?
The Investment Advisers Act of 1940 is the fundamental regulatory framework for investment advisers in the United States, administered by the Securities and Exchange Commission (SEC). The purpose of this law is to:
- Protect investors from fraudulent practices,
- Ensure transparency in the financial advisory industry, and
- Establish fiduciary standards by outlining guidelines and prohibitions for advisers to maintain ethical and lawful practices.
The IIA is a federal law that regulates investment advisors in the United States. Its primary goal is to protect investors by ensuring advisors adhere to ethical and professional standards. However, it's essential to note that violations of this act are not uncommon and can result in significant civil and, in some cases, criminal penalties.
These penalties can include fines, suspension or revocation of registration, and even imprisonment. This highlights the importance of compliance and the necessity for strict adherence to regulations, as the consequences of non-compliance can be severe.
The SEC closely monitors the behaviors and transactions conducted by financial advisors, and perceived breaches of the rules may result in legal scrutiny.
Violations include the absence of adequate written policies and procedures, improper handling of client assets, failure to supervise employees, misleading marketing materials, and inadequate regulatory filings. This regulatory oversight underscores the importance of maintaining compliance at all times.
What Does Federal Law Say?
15 U.S. Code § 80b-1 - Findings says -
"Upon the basis of facts disclosed by the record and report of the Securities and Exchange Commission made pursuant to section 79z-4 of this title, and facts otherwise disclosed and ascertained, it is found that investment advisers are of national concern, in that, among other things.
(1) Their advice, counsel, publications, writings, analyses, and reports are furnished and distributed, and their contracts, subscription agreements, and other arrangements with clients are negotiated and performed by the use of the mails and means and instrumentalities of interstate commerce.
(2) Their advice, counsel, publications, writings, analyses, and reports customarily relate to the purchase and sale of securities traded on national securities exchanges and in interstate over-the-counter markets, securities issued by companies engaged in business in interstate commerce, and securities issued by national banks and member banks of the Federal Reserve System; and
(3) The foregoing transactions occur in such volume as substantially to affect interstate commerce, national securities exchanges, and other securities markets, the national banking system, and the national economy."
What are the Compliance Violations?
The IAA prohibits advisers from employing fraudulent schemes, making untrue statements, or engaging in any practices that defraud or mislead clients. Common examples of fraud under this provision include:
- Inadequate Resources: Investment advisers failed to allocate adequate resources to their compliance programs. CCOs had other responsibilities and failed to devote sufficient time to their roles or to develop their knowledge of the Advisers Act. Compliance staff lacked sufficient resources to implement programs for preventing, detecting, and correcting violations.
- Cherry-picking trades: This practice involves allocating profitable trades to preferred accounts, such as those belonging to the adviser or their family members, while leaving less profitable or losing trades to other clients. This is a clear violation of the adviser's fiduciary duty to act in the best interest of all clients.
- Front-running: Placing personal or proprietary trades ahead of client orders to gain an unfair advantage.
- Inadequate Written Policies: Advisers are required to have written policies and procedures to prevent and detect violations of securities laws. Failure to establish and implement such procedures is a common violation.
- Custody Rule Violations: The Custody Rule under the Advisers Act addresses the handling of client funds and securities. Violations can occur when advisors have unauthorized access to client assets or fail to safeguard them properly.
- Failure to Supervise: Failing to supervise a subordinate who commits a violation reasonably can lead to sanctions for the adviser.
- Misleading Marketing Materials: Advisers must ensure their marketing materials are truthful. This includes advertisements that overstate potential returns, brochures that misrepresent the adviser's experience, and any other forms of communication used to solicit clients that contain false or misleading information. For instance, a brochure that claims an adviser has a long history of successful investments when they have only been in business for a short time would be considered misleading.
- Inadequate Regulatory Filings: Investment advisors are required to submit various regulatory filings with the Securities and Exchange Commission (SEC). Failure to file required reports or making inaccurate filings can lead to violations.
- Theft of Assets: Advisers are entrusted with managing client assets. Any fraudulent activity or theft of those assets constitutes a serious violation, including the misuse of client funds for personal benefit or the misrepresentation of investment performance to deceive clients.
- Insider Trading: Advisers who use non-public information to trade securities for their benefit can be subject to harsh penalties.
Key Takeaways
The Risk Alert warns that compliance practices among investment advisers may expose them to violations of the Advisers Act. The Risk Alert is the latest in a series of government notices and advisories, including the OFAC and U.S. Department of Justice compliance guidance documents, which recognize risks for investment advisers.
Investment advisers will likely face increased government enforcement of these compliance regimes and will work to address the deficiencies described above. Specifically, investment advisers must not only establish compliance policies and programs and engage a Chief Compliance Officer (CCO) to perform an annual review.
Still, they must also integrate their compliance departments into their regular business operations. In particular, investment advisers should ensure CCOs are empowered with sufficient seniority and authority to implement compliance programs tailored to an investment adviser's size and specialty. Doing so will also help reduce corruption and sanctions risks.
Related Federal Laws
15 U.S. Code Chapter 2D Subchapter II has several related federal statutes, including the following:
- 15 U.S.C. 80b-1: Findings.
- 15 U.S.C. 80b-2: Definitions.
- 15 U.S.C. 80b-3: Registration of investment advisers.
- 15 U.S.C. 80b-3a: State and Federal responsibilities.
- 15 U.S.C. 80b-4: Reports by investment advisers
- 15 U.S.C. 80b-4a: Prevention of misuse of nonpublic information.
- 15 U.S.C. 80b-5: Investment advisory contracts.
- 15 U.S.C. 80b-6: Prohibited transactions by investment advisers.
- 15 U.S.C. 80b-6a: Exemptions.
- 15 U.S.C. 80b-7: Material misstatements.
- 15 U.S.C. 80b-8: General prohibitions.
- 15 U.S.C. 80b-9: Enforcement of subchapter.
- 15 U.S.C. 80b-10: Disclosure of information by Commission.
- 15 U.S.C. 80b-10a: Consultation.
- 15 U.S.C. 80b-11: Rules, regulations, and orders of the Commission.
- 15 U.S.C. 80b-12: Hearings.
- 15 U.S.C. 80b-13: Court review of orders.
- 15 U.S.C. 80b-14: Jurisdiction of offenses and suits.
- 15 U.S.C. 80b-15: Validity of contracts.
- 15 U.S.C. 80b-16: Omitted.
- 15 U.S.C. 80b-17: Penalties.
- 15 U.S.C. 80b-18: Hiring and leasing authority of the Commission.
- 15 U.S.C. 80b-18a: State regulation of investment advisers.
- 15 U.S.C. 80b-18b: Custody of client accounts.
- 15 U.S.C. 80b-18c: Rule of construction relating to the Commodities Exchange Act.
- 15 U.S.C. 80b-19: Separability,
- 15 U.S.C. 80b-20: Short title.
- 15 U.S.C. 80b-21: Effective date.
Criminal Implications
While many violations of the Investment Advisers Act result in civil penalties, serious willful infractions can result in criminal liability. Any willful violation of the IAA may result in fines of up to $10,000 and imprisonment for up to five years (15 U.S.C. 80b-17).
Federal prosecutors have the option to file additional charges for IAA violations, such as the following:
- Mail Fraud (18 U.S.C. 1341)
- Wire Fraud (18 U.S.C. 1343)
- Conspiracy (18 U.S.C. 371)
A conviction may result in significant prison time and substantial fines. If you are suspected of violating one or more provisions of the IAA, hiring our experienced federal criminal defense attorneys is crucial for mitigating these threats and enhancing your chances of a favorable outcome. For more information, contact the Hedding Law Firm, located in Los Angeles, CA.
Related Content:
