Startup Spotlight: Compliance Primer for Investment Advisers

It is a common misconception that compliance is for larger, established SEC-registered investment advisers.  While SEC registrants have more robust compliance obligations than others, including the affirmative requirements to appoint a Chief Compliance Officer and implement a compliance program, many states have “post-effective requirements” for their registrants.  These can include an obligation to conduct business in an ethical manner and maintain certain books and records.  Moreover, the Form ADV itself includes policy-related questions about a firm’s Code of Ethics, proxy voting and brokerage practices, all of which should be considered at or before registration with a particular state.   Finally, various federal securities laws apply to many types of participants in the financial markets, requiring filings or compliance with other general regulations, irrespective of adviser registration.

This article will focus on compliance requirements and best practices for advisers registering in California.  Firms considering registration in other states are welcome to contact us.

  1. Code of Ethics, Proxy Voting, Brokerage and Soft Dollars

ADV Part 2A requires narrative responses describing a firm’s Code of Ethics, proxy voting and brokerage/soft dollar practices, among other things.  The ADV Part 2A (and 2B for state registrants) are filed online and available to the public.  As matters of best practices and client relations, an adviser’s initial state registration process should consider these issues and adoption of relevant policies,[1] each of which are discussed briefly below:

a. Code of Ethics

An adviser’s Code of Ethics (the “Code”) contains policies and procedures designed to prevent insider trading, manage conflicts of interest and avoid other improprieties, or the appearance of these.   Specifically, this includes personal trading by employees, business-related gifts and entertainment, political contributions and lobbying, dealing with regulators, outside business activities, involvement in litigation or other proceedings, use of electronic communication and safeguarding client information.

b.  Proxy Voting

Fund managers will typically vote proxies on behalf of the funds they sponsor.  Traditional advisers (i.e., to individuals and other separate accounts) vary somewhat, either voting or assisting clients in voting, or arranging for custodians to send proxy materials directly to clients, for them to vote (or not) as they wish.  Regardless of the client base or procedures, a firm should maintain a written policy and include corresponding descriptions in its ADV Part 2A.  For advisers that do vote proxies, the policy should detail the guidelines it uses when voting, circumstances in which it abstains from voting, recordkeeping and how clients can obtain disclosure on votes.

c. Brokerage and Soft Dollars

Advisers should have a process in place to select and evaluate the brokers it uses, and be aware of its obligations to achieve best execution of client transactions.  For advisers that use soft dollars, it is especially important to document the benefits they receive, and ensure that they are still fulfilling their client obligations.  The disclosure required in this item is a good outline of how a policy should look and the items to be covered, including: factors used in selecting brokers and determining reasonableness of compensation, soft dollars (associated conflicts of interest, types of services used, whether they are within or outside the Section 28(e) safe harbor, procedures used to allocate business to a broker in return for soft dollar benefits), whether the firm selects brokers based on client referrals, and whether clients can direct brokerage to a particular broker.

  1. Advertising

California-registered advisers are permitted to advertise their services; similar to SEC regulations, advertisements must be true, accurate and not contain any material misstatements.   Advertisement of performance, in particular, requires additional disclosures.  See California Code of Regulations (“CCR”) § 260.235.[2]  Advisers should be aware of these requirements and establish written guidelines that ensure that content in its marketing material meets these requirements.  In addition, an adviser’s internal process should ensure that factual statements are documented, opinions are clearly indicated as such, and that all marketing materials are approved by management (the Chief Compliance Officer if the adviser has one) before they are distributed.

  1. Recordkeeping

California requires its registered advisers to keep certain books and records.  The full list is available at CCR § 260.241.3.  This encompasses primarily financial records (financial statements and underlying worksheets, bank statements, ledgers, records of receipts, disbursements, assets, liabilities, bills and the like), as well as trading records, advisory agreements,  powers of attorney, advertisements, records of personal trading by employees, among other things.  Books and records must be maintained in an easily accessible place for five years (the first two years in the adviser’s office).

In reviewing the list, advisers should consider what other policies and procedures should be implemented to ensure that the appropriate records are kept.  For example, maintaining records of employee personal trading implies a certain degree of infrastructure around gathering duplicate statements and trade confirmations.  As part of this process, state registrants should consider the need for any controls to ensure that personal trading does not conflict with client trading (blackout periods, pre-approvals or others depending on the activity).

Finally, while many of these records would be kept in the normal course (such as the financial records listed above), additional recordkeeping may be prudent for other business reasons.   Archived emails and other electronic communications, for example, are useful sources of data in client or investor disputes, or to locate emails that may have been inadvertently deleted from an employee’s desktop.  Advisers that wish to access employees’ emails for HR, trade secret or other business conduct issues would find such a record invaluable, even beyond duties imposed on them by law, or recommended according to industry best practices.

  1. Fiduciary Duties

Like SEC registrants, California law imposes a fiduciary duty on its registrants, i.e. to act primarily for the benefit of clients, in good faith and exercise the highest standard of care.  Further, state registrants must engage only in activities that promote fair, equitable and ethical principles.    These issues are typically covered in the Code.  For specific examples of activities that are not in keeping with these duties, see CCR § 260.238.

  1. Custody and Financial Requirements

California’s custody rule differs somewhat from the SEC’s.  Under the SEC rule, the ability to deduct fees, by itself, does not create custody.  In California, however, this is considered custody and many advisers will be considered to have custody of their clients’ funds and securities.  Advisers with custody have safekeeping requirements, which may vary depending on the types of clients (private funds, versus separate accounts); in some circumstances, advisers with custody must also maintain a minimum net worth.  The full custody and net worth rules are available at CCR § 260.241.2 and CCR § 260.237.2.  See also our article on additional procedures required for fund managers.

  1. Regulatory Filings/General Securities Laws

Depending on their client base, strategy, business structure or other matters, advisers, regardless of registration status, may be required to file the following:

a. SEC Form D for private funds;

b. State blue sky filings for private funds;

c. Section 16 (Forms 3, 4, 5) for insiders or holders of 10% or more of an issuer’s securities (whether the adviser in the aggregate, or clients they manage);

d. 13G or D for ownership of 5% or more of an issuer’s securities; and

e. 13F for managers with discretionary authority over $100 million or more in issuer’s on the SEC’s 13F List.  Though as a practical matter it is likely that these advisers would be registered with the SEC.

f. 13H for “Large Traders,” whose daily or monthly trading volumes meet certain thresholds.

A firm’s compliance manual typically describes these filings, any applicable thresholds and authorizes the Chief Compliance Officer or other management person to monitor these and make any required filings.

Similarly, following are some general principles and laws that apply to virtually every market participant:

a. Anti-Fraud and Insider Trading

The Securities Exchange Act of 1940 prohibits fraudulent activities of any kind in connection with the offer, purchase, or sale of securities.   This prohibition is broadly construed and forms the basis for a variety of disciplinary and enforcement proceedings.  Insider trading is considered securities fraud and is vigorously prosecuted by the SEC.  All advisers regardless their registration status should implement a Code that is designed to detect, prevent and manage issues relating to securities fraud and insider trading.

b. Trading

Some of the techniques employed by hedge funds, in particular, are heavily regulated, such as short sales. For example,  SEC Rule 105 places significant limits around the timing of short sales in secondary or follow on offerings.  In addition, any adviser that invests in IPOs on behalf of its clients should take extra care to ensure it collects eligibility representations from its clients (or investors in private funds).  New registrants should consult their outside counsel and/or compliance consultant to determine whether any other aspects of their business or strategy create risk areas that should be addressed in their compliance program.

c. Private Offerings

Completely separate from adviser registration, firms that manage private funds must be cognizant of the rules that govern those offerings, including determinations of accredited investor, qualified client and qualified purchaser status, limitations on general solicitation and the number and types of investors permitted in a particular fund.  Many startups take advantage of the exemption from registration found in the Investment Company Act of 1940 Section 3(c)(1), which limits the number of accredited investors to 99.

For startup funds that “soft launch” with a round of friends and family investors that include non-accredited investors, it is important to note that these non-accredited investors should be admitted before the official launch date AND are limited to 35 in number over the life of the fund.  Given these limitations, investor inflows must be carefully monitored to ensure that these are not exceeded, or the fund will lose this exemption.   On a related note, firms taking advantage of California’s Exempt Reporting Adviser regime may not take any non-accredited investors.


For those advisers that eventually transition to SEC registration, having the above policies and procedures in place is a good start toward developing a SEC-level compliance program.  For firms that are completely exempt from registration as an investment adviser, there may still be filings, such as the short form of ADV for Exempt Reporting Advisers and the general filings and requirements discussed in Section 5.    For firms that trade in futures, CFTC registration and NFA membership may be required unless certain quite narrow exemptions are met. This will be discussed more fully in an upcoming article.

This article is a summary of selected laws, regulations and practices that typically apply to fund managers and other investment advisers.  Due to space limitations, we cannot provide an exhaustive discussion of all such issues.  In particular, Section 5 does not cover all laws and regulations that may apply to a particular business, financial services or securities industries generally.  We encourage all startups to discuss their business structure and investment strategies with outside counsel and/or a compliance consulting firm to make sure any specific questions are addressed.


[1] SEC Registrants are required to adopt a Code of Ethics and compliance program, typically including the policies and procedures discussed here.

[2] The online version of the California Code of Regulations does not permit direct linking to specific sections.  The online version is accessible via the Office of Administrative Law’s website:  (click the “online” link at the first bullet point; you will be taken to Westlaw’s home page for the Code, where you click the first link to “Search for a Specific Regulatory Section.”  For all of the CCR references in this article, enter 10 in the “Title” field and copy the code section into the “Section Field” (all of the digits and punctuation after the § symbol).

SEC Case Digest

  1. Investment Management Issues

As the following cases demonstrate, the SEC is actively policing investment managers’ collection of advisory and other fees, advertising and the charging of expenses to funds.

In the Matter of Total Wealth Management, Inc., et al.

In an unusual move, a Chief Compliance Officer was charged, along with the investment advisory firm, its Chief Executive Officer and an investment adviser representative in this case involving undisclosed revenue sharing arrangements.    The defendants recommended the Altus funds, managed by an unrelated firm, to their clients without disclosing that Altus paid them kickbacks for these referrals.  Charges included failure to disclose this arrangement and the resulting conflicts of interest, breach of fiduciary duty, fraud, as well as unrelated violations of the custody rule.

In the Matter of Transamerica Financial Advisors, Inc.

The SEC charged a Florida-based financial services firm with improperly calculating advisory fees and overcharging clients.  Transamerica Financial Advisors offered breakpoint discounts designed to reduce the fees that clients owed to the firm when they increased their assets in certain investment programs.  The firm permitted clients to aggregate the values of related accounts in order to get the discounts.  SEC examinations and a subsequent investigation found that, as a result of failing to process every aggregation request, the firm overcharged certain clients.  Transamerica agreed to settle the SEC’s charges.  The firm reimbursed client accounts (totaling $553,624 including interest) and agreed to pay a $553,624 penalty.

In addition to the reimbursements and sanctions, Transamerica agreed to retain an independent consultant to review its policies and procedures pertaining to its account opening forms, fee schedules, and fee computation methodologies as well as the firm’s account aggregation process for breakpoints.

In the Matter of Clean Energy Capital, LLC et al.

The SEC charged an Arizona-based private equity fund manager and his investment advisory firm for allegedly paying more than $3MM of the firm’s expenses with assets from private equity funds they manage.  When the funds ran out of cash to pay the firm’s expenses, Clean Energy Capital and Brittenham allegedly continued to benefit themselves by loaning money to the funds at unfavorable interest rates and unilaterally changing how they calculated investor returns.  The SEC’s press release emphasized that private equity advisers can only charge expenses to their funds when such charges are clearly described in fund offering documents.

SEC vs. Penn et al.

The SEC alleged that Penn used $9MM of fund assets to pay fees to a company to conduct diligence on potential fund investments.  The company, however, was a front; instead of conducting diligence, it returned the money to entities and accounts controlled by Penn.  The complaint seeks final judgments that would require Penn, his fund, the front company and another accomplice to disgorge ill-gotten gains with interest, pay financial penalties, and be barred from future violations of the antifraud provisions of the securities laws.

In the Matter of Navigator Money Management, Inc.

The SEC charged a New York-based money manager and his firm with making false claims through Twitter, newsletters, and other communications about the success of their investment advice and a mutual fund they manage.  In one instance, it was misleadingly claimed in a newsletter that the firm was “ranked number 1 out of 375 World Allocation funds tracked by Morningstar;” this claim was false on its face because Morningstar ranks funds, not managers.  Moreover, the investigation determined that this broad claim was based on cherry-picked ratings for the fund from October 2010-October 2011 and the it had a poorer relative performance during other time periods.

The money manager agreed to pay a penalty of $100K and he and the firm agreed to be censured and, among other things, retain an independent compliance consultant for a three-year period.

  1. Insider Trading

All of the press surrounding the SAC and related cases (and Galleon before that) might lead observers to believe that only high profile or glamorous people engage in insider trading.  As the following cases illustrate, however, otherwise ordinary people can and will engage in it as well.  Some of these cases are also noteworthy in that they show how the SEC uses trading data and works with agencies, SROs and others to connect the dots in tracking down illegal trades.

SEC vs. Wagner, et al.

The SEC charged two longtime friends with insider trading in connection with a 2012 acquisition of The Shaw Group by Chicago Bridge & Iron Company.  Walter Wagner and Alexander Osborne traded ahead of the public announcement of the acquisition based on information they obtained from John Femenia, who was previously charged in 2012, along with nine others that comprised an insider trading ring that specialized in pending mergers.  Wagner consented to entry of judgment including disgorgement of $528,175, prejudgment interest and an order permanently enjoining him from violations of Section 10(b) of the Exchange Act and Rule 10b-5.   The litigation is continuing against Osborne.

SEC vs. Hawk/SEC vs. Chen

In two unrelated cases the SEC charged two men with trading on material, nonpublic information misappropriated from their wives.  Tyrone Hawk of Los Gatos, CA, allegedly overheard his wife, an employee of Oracle Corp., discussing over the phone the potential acquisition of another company; he then purchased the target company’s stock.  Ching Hwa Chen of San Jose, CA allegedly overheard his wife discussing her employer’s earnings report, then shorted the employer’s stock.  Without admitting or denying the charges, both men agreed to pay fines equal to twice their illegal profits and to settle the cases against them.

SEC vs. Eydelman et al.

The SEC charged a stockbroker and a clerk at a law firm with insider trading that produced illicit profits of $5.6MM over a four-year period.  Steven Metro accessed confidential documents in his law firm’s computer system, then used a middle man to pass the material, nonpublic information to Vladimir Eydelman, a registered representative at Oppenheimer.  Eydelman effected the illegal trades on behalf of a range of individuals, including the middleman.  The middleman then made payment to Metro.  In a parallel action, the U.S. Attorney’s office announced criminal charges against Metro and Eydelman.  The SEC’s press release emphasized the futility of using middlemen, destroying evidence, and forging documents in an attempt to circumvent insider trading laws.

SEC vs. Hixon et al.

In another case involving family members, Frank Hixon Jr. used the brokerage accounts of his father and girlfriend in order to execute trades based on confidential information he obtained on the job, generating illegal insider trading profits of at least $950K.  In addition to an asset freeze, the SEC complaint seeks permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest, and financial penalties.   During the investigation, Mr. Hixon denied knowledge of these accounts, despite the fact that his father is also called Frank Hixon.  Hixon Jr. allegedly conducted the trades in his girlfriend’s account in lieu of the child support payments he was obliged to make for the benefit of their daughter.

Nexen Acquisition

The most recent developments in this major insider trading case involve two Hong Kong-based asset management firms (CITIC Securities International Investment Management (HK) Limited and China Shenghai Investment Management Limited) agreeing to pay nearly $11MM to settle the charges against them.  The case began in 2012 when China-based CNOOC Ltd. announced that it had agreed to acquire Canadian energy company Nexen Inc.  Shortly thereafter the SEC obtained an emergency asset freeze against unknown traders after discovering that traders using brokerage accounts in Hong Kong and Singapore stood to make more than $13MM in potentially illegal profits in connection with the misuse of confidential information.  SEC investigators worked with foreign regulators to identify the illegal trades, setting the stage for a trio of settlements:

SEC vs. Dombrowski et al.

In January of this year, Steven Dombrowski kicked off the trend of embroiling family members in insider trading by using his wife’s account to trade in the stock of his employer despite a company-imposed blackout period.  The SEC is seeking a judgment that permanently enjoins Dombrowski from future violations of various provisions of federal securities laws, orders him to disgorge all of his ill-gotten gains of approximately $286K, plus prejudgment interest, and orders him to pay a civil penalty.  In a parallel action, the U.S. Attorney’s Office announced criminal charges against Dombrowski.

  1. Market Manipulation

These cases illustrate how the SEC continues to work with other market participants and follow the money trail to identify traders whose practices are considered manipulative under the securities laws.

SEC vs. Babikian

The SEC alleged that John Babikian used a pair of penny-stock websites to commit a type of securities fraud commonly known as “scalping.”  The websites sent e-mails to approximately 700K people and recommended the penny stock America West Resources Inc.; meanwhile, Babikian owned and was positioned to sell) 1.4MM shares of America West through a foreign bank.  The emails triggered increases in America West’s share price and Babikian sold shares of America West’s stock for illegal profits of more than $1.9MM.  The court order freezes Babikian’s assets, temporarily restrains him from further similar misconduct, requires an accounting, prohibits document alteration or destruction, and expedites discovery.

In the Matter of Worldwide Capital, Inc. et al.

In the largest-ever monetary sanction for Rule 105 short selling violations, a Long Island-based trading firm and its owner, Jeffrey Lynn, agreed to pay $7.2MM to settle charges.  Lynn allegedly engaged traders to seek soon-to-be-publicly-offered shares, usually at a discount to the market price of the company’s already publicly trading shares.  Lynn and his traders then sold those shares short in advance of the offerings, improperly profiting from the difference between the price paid to acquire the offered shares and the market price on the date of the offering.

To settle the charges, the trading firm and Lynn agreed to jointly pay disgorgement, prejudgment interest, and a penalty, as well as agreeing to cease and desist from violating Rule 105.  Neither the trading firm nor Lynn admitted or denied the findings in the SEC’s order.

In the Matter of Thomas C. Gonnella/In the Matter of Ryan C. King

In separate cases, the SEC charged two traders involved in a fraudulent “parking” scheme.  Gonnella allegedly arranged for King, who worked at a different firm, to purchase several securities with the understanding that Gonnella would repurchase them at a profit for King’s firm.  By “parking” the securities in King’s trading book in order to reset the holding period when he repurchased them, Gonnella was attempting to avoid charges to his trading profits (and ultimately his bonus) for having aged inventory.  King agreed to settle the charges by disgorging his profits and being barred from the securities industry.  Litigation against Gonnella continues.

In the Matter of Gonul Colak and Milen K. Kostov

The SEC charged a pair of college professors in Tallahassee, Fla., with conducting a naked short selling scheme that generated more than $400K in illicit profits.  Colak and Kostov allegedly sold more than $800MM worth of call options in more than 20 companies.  Their trading strategy involved purchasing and writing two pairs of options for the same underlying stock, and targeting options in hard-to-borrow securities in which the price of the put options was higher than the price of the call options.  The two men profited by avoiding the cost of instituting and maintaining the short positions caused by their paired options trading.  Colak and Kostov agreed to settle the SEC’s charges by paying more than $670K.

California’s Amended Custody Rule: Additional Requirements for Fund Managers

Effective April 1, 2014, all investment advisers licensed (or required to be licensed) in California must comply with California’s amended custody rule.  In many respects, the amended rule parallels the federal rule, applicable to SEC registrants.  However, in several key areas California has imposed additional requirements on its registrants that will particularly impact fund managers.    We summarize some key changes below.

It should be noted that California’s Exempt Reporting Advisers are not affected by the rule changes.


The baseline definition of custody in California is unchanged.   Custody includes, without limitation:

  • Holding, directly or indirectly, client funds or securities; or
  • Having any authority to obtain possession of them, or having the ability to appropriate them, e.g.,
    • Pursuant to a power of attorney or other arrangement (such as a clause in an investment advisory agreement or equivalent);
    • As general partner, managing member or equivalent of a pooled vehicle. 

Many California registrants are deemed to have custody under this broad definition.   Advisers having custody must, among other things: arrange for client assets to be held by a qualified custodian such as a broker or bank; and make certain disclosures on Form ADV with respect to their custodial arrangements.

New Procedures for Fund Managers:

The amended rule clarifies that there are two routes for fund managers to comply with custody requirements: arrange for an annual audit of the fund, or retain a “gatekeeper” to evaluate and approve fund expenses.   Some confusion prevailed under the old rule on whether a fund manager had to do both, but the new rule clearly establishes that these are distinct alternatives to comply with the state’s custody rule.

The amended rule also establishes additional procedures, regardless of the route that is taken:

The adviser must send to all investors a quarterly statement that includes the following:

  • The total amount of all additions to and withdrawals from the fund as a whole;
  • The opening and closing value of the fund at the end of the quarter based on the custodian’s records;
  • A listing of securities positions on the closing date of the statement required to be disclosed under GAAP for non-registered investment partnerships (generally, any positions that represent 5% or more of the fund’s holding on the last day of the reporting period); and
  • A listing of all additions to and withdrawals from the fund by the investor and the total value of the investor’s interest in the fund at the end of the quarter. 

1. The Audit Route. This is similar to the practice under the prior rule.  The amendment makes clear, however, that the CPA firm must meet certain qualifications and explicitly requires an audit upon liquidation of a fund.

  • The fund manager retains an independent CPA that is registered with, and subject to regular inspection by the PCAOB to conduct an annual audit of the fund;
  • Audited financial statements must be prepared in accordance with GAAP and distributed to all investors and the California Commissioner of Corporations (the “Commissioner”) within 120 days of the fund’s fiscal year end;
  • A final audit is required upon liquidation of the fund, including distribution of the financial statements to the fund’s investors and the Commissioner;
  • If the engagement with the CPA is terminated, the CPA must notify the Commissioner within four business days by filing Form ADV-E; the agreement between the fund/adviser and the CPA must include a requirement to this effect.

2. The Gatekeeper Route. The gatekeeper route is substantively similar to the prior “independent representative” procedure, except that it now requires a formal written agreement between the adviser and the “gatekeeper,” among other things.   Under the amended rule, the gatekeeper is an independent attorney or accountant that is contractually obligated to act in investors’ best interests.

  • The adviser must send the gatekeeper all invoices or receipts with details regarding calculations, such that he or she can:
    • Review all fees, expenses and withdrawals from the fund;
    • Determine that payments conform to the fund’s limited partnership or equivalent agreement; and
    • Forward to the custodian approval for payments of the invoices, with a copy to the adviser.
    • Client assets are subject to an annual “surprise exam” by an independent CPA (meeting the same qualifications as for the Audit Route discussed above). 


The state’s amended custody rule is a step forward in that it largely harmonizes with rules applicable to SEC registrants, which helps to unify our understanding of what custody means and the implications for advisers, investors and service providers.   However, the amended rule also imposes additional compliance requirements that may be challenging to meet.  We recommend discussing any specific concerns with your service providers (including legal/compliance, audit and fund administration).

Throwback Thursday: 2013 Case Illustrates Expansive View of Misappropriation Theory

In April 2013, the SEC settled charges against Richard Bruce Moore (“Moore”) for insider trading with respect to a going private transaction of Tomkins plc, a British engineering and manufacturing firm.   Though no hard information as such was apparently transmitted to Moore, the SEC found sufficient facts to charge him with insider trading on a misappropriation theory.  Moore did not contest the charges; he disgorged his profits of $163,000, paid a penalty in the same amount and is permanently barred from the U.S. securities industry.

The pertinent facts are that Moore worked for Canadian Imperial Bank of Commerce (“CIBC”) and in that role pitched investment opportunities to CIBC clients, including the Canadian Pension Plan Investment Board (the “Board”).    Prior to the Tomkins deal, Moore and his contact on the Board, a Managing Director (the “Managing Director”) worked on one successful going private transaction and another one that ultimately failed.  Moore and the Managing Director were friends as well and communicated regularly.

When the opportunity to acquire Tomkins arose, the Managing Director said nothing to Moore about the deal.  Moore checked in with the Managing Director periodically, during which he learned that the Managing Director was intensely involved in a deal;  Moore of course offered CIBC’s services in connection with the deal, but nothing came of it.  Moore also learned that the Managing Director was travelling to and from London with some frequency.

Moore and the Managing Director happened to attend the same charity event, where Moore observed the Managing Director in conversation with someone else.  The Managing Director would not introduce Moore, nor identify his companion.  Moore later learned from a colleague at CIBC that the Managing Director had been speaking with the CEO of Tomkins.  The penny dropped (Moore had also heard rumors of a Tomkins takeover) and Moore ultimately acquired 51,350 Tomkins ADRs on the NYSE as well as common shares on non-US exchanges.  Approximately three weeks later, Tomkins announced its acquisition by the Board and a Canadian private equity firm which triggered a 27% jump in the price of its ADRs.  Moore sold his position the following day, resulting in the $163,000 profit.

At first blush, one might be tempted into thinking that this is not an insider trading case.  Rather, Moore reached a (correct) conclusion based on his experience and analysis of the situation.   A close reading of the SEC’s complaint, however, highlights a number of additional facts that support an insider trading charge on the basis of misappropriation:

  • Moore was acting in the course and scope of his employment with CIBC; therefore any information he obtained with respect to his clients’ deals belong to CIBC (using such information for personal gain would be misappropriation);
  • Specifically, Moore was the Board’s primary access point for business with CIBC and vice versa;
  • Moore’s work with the Board focused on going private transactions, similar to Tomkins;
  • Moore’s ongoing contact with the Managing Director, as part of his role at CIBC indicated that the Managing Director was increasingly busy and unavailable.   The Managing Director declined Moore’s offer to assist in financing the deal.  In addition, given the failure of their most recent deal, one wonders whether Moore was worried about ongoing deal flow from the Board;
  • The Managing Director’s travels and secretiveness about his deal seems to have reinforced Moore’s belief that a large transaction was about to happen; the big reveal of course being the conversation between the Managing Director and Tomkins’ CEO at the charity event;
  • Perhaps most damning is Moore’s consciousness of guilt:  he went to great lengths to effect his Tomkins transactions quickly and under the radar, including conducting them through a little used offshore account, rather than his CIBC account.   He followed up repeatedly with his broker to make sure that the accounts were ready to trade, and subsequently in making the ADR trade via the NYSE, and common shares on  non-US exchanges.  At one point, he paid a penalty in order to move additional funds into his trading account.  Though he started communications with his broker on his CIBC email, he later switched to personal email.
  • In all, Moore invested approximately a third of his net worth on the purchases of Tomkins securities.  He sold his entire position the day after the announcement (and resulting price increase).

The SEC’s release and complaint are available on its website.

Though it is clear from these facts that Moore did not innocently trade in Tomkins securities, this case offers a lesson for all market participants that they should be cognizant not only of specific pieces of information that they might receive, but the totality of the circumstances that surround both their businesses and personal trading matters.   A moment taken prior to trading to consider all ramifications can make the difference between a long and healthy career in the industry, or permanently barred at 49 years old.

The SEC’s New “Bad Actor” Regulations: Implications for Fund Managers Using Rule 506

New SEC regulations disqualify an issuer from selling unregistered securities under a Rule 506 exemption if a “covered person” related to the issuer (or involved in the offering) is considered a “bad actor.”  See our companion article regarding general solicitations under Rule 506.

The bottom line:  fund managers relying on Rule 506 to sell unregistered securities will need to work with their legal counsel and/or compliance consultants to identify covered persons, conduct initial diligence and ongoing monitoring to check for events that trigger disqualification.  For many firms, diligence and monitoring will likely involve distributing questionnaires prior to offerings and subsequently on a periodic basis.

Covered Persons

The “covered persons” whose behavior can trigger disqualification under the new regulations include the issuer, its predecessors and affiliates, as well as:

  • The issuer’s directors and executive officers;
  • Any of the issuer’s non-executive officers who are participating in the offering;
  • The issuer’s general partners or managing members;
  • Beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • Promoters (as defined in Rule 405) connected with the issuer in any capacity at the time of the sale of securities;
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale of securities;
  • Any general partner or managing member of such a solicitor, and any of the solicitor’s directors or executive officers; and
  • Any of the solicitor’s non-executive officers who are participating in the offering.

If the issuer is a pooled investment fund, “covered persons” also include:

  • Any investment manager of the issuer;
  • The general partner or managing member of any such investment manager, as well as any of the investment manager’s directors or executive officers; and
  • Any of the investment manager’s non-executive officers who are participating in the offering.

Disqualifying events

The following are disqualifying events under the new regulations:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries (the criminal conviction must have occurred within 10 years of the proposed sale of securities or five years in the case of the issuer and its predecessors and affiliated issuers); 
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries (the injunction or restraining order must have occurred within five years of the proposed sale of securities); 
  • Final orders from the CFTC, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations or credit unions that:
    • Bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities; or
    • Are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years of the proposed sale of securities. 
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons; 
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws (the order must have been entered within five years of the proposed sale of securities), certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investments companies, and investment advisers and their associated persons; 
  • Suspension or expulsion from membership in a SRO or from association with an SRO member; 
  • SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities; and 
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities. 

It is important to note that the issuer will not be disqualified if the “disqualifying event” described above occurred prior to the effective date of the new rule:  September 23, 2013; however, issuers must disclose a disqualifying event that occurred before the effective date to investors.  The SEC requires that such disclosures be provided a reasonable time before the sale and be given reasonably prominent placement in the issuer’s offering materials.

Disqualification applies only for covered persons whose conduct is subject to a final order or conviction.  An arrest or allegation is not enough to trigger disqualification.  The SEC can also grant a waiver allowing the issuer to proceed under Rule 506, and the court or regulatory authority that ruled on the bad act can advise in writing that Rule 506 disqualification should not apply.

“Reasonable Care” Exception

If the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed at the time of the offering, the failure to disclose will not result in loss of exemption.

To establish that it has exercised “reasonable care,” an issuer must have made a factual inquiry into whether any disqualifications exist.  The scope of the inquiry will vary based on the circumstances of the issuer and the other offering participants, taking into account such factors as the risk of having a bad actor, the impact of screening mechanisms already in place, and the cost of the inquiry.

The JOBS Act and General Solicitation: Takeaways for Fund Managers

Post-JOBS Act, fund managers have two options in offering interests to prospective investors:  Rule 506(b), the traditional exemption allowing sales to accredited investors so long as the issuer refrains from “general solicitation;” and Rule 506(c), the exemption that allows an issuer to engage in general solicitation if certain conditions are met.

1.      The Traditional Route: Rule 506(b)

The exemption that fund managers used prior to the passage of the JOBS Act is now designated as “Rule 506(b).”  506(b) allows sales to an unlimited number of accredited investors (and 35 non-accredited investors) so long as an issuer refrains from general solicitation.  While the SEC has provided no comprehensive definition of general solicitation, it generally includes:

  • advertisements published in newspapers and magazines;
  • communications broadcast over television and radio;
  • seminars where attendees have been invited via general solicitation; and
  • other uses of publicly available media, such as unrestricted websites.

Rule 506(b) requires only that the issuer “reasonably believe” that the investors to whom it is selling interests are accredited.  Fund managers have fulfilled this requirement in a number of ways, typically through actual knowledge of prospective investors in their network, cultivating relationships that support this reasonable belief and ultimately seeking representations from their investors on their subscription applications.   With respect to non-accredited investors, the issuer must provide substantial information about the offering and have a reasonable belief that the investor (alone or with the assistance of a representative) has sufficient knowledge of financial matters that they can evaluate the prospective investment.  

2.      The New Exemption:  Rule 506(c).

Rule 506(c) allows issuers to engage in general solicitation when offering their securities,  provided that the issuer takes reasonable steps to verify that all investors to whom securities are actually sold are accredited.  What are “reasonable steps”?  The SEC provides a list of non-exclusive and non-mandatory verification methods:

  • verification of investor’s income:  reviewing a copy of an IRS form that reports income;
  • verification of investor’s net worth:  reviewing bank or brokerage statements, certificates of deposit, tax assessments and a credit report from at least one of the nationwide consumer reporting agencies, and obtaining a written representation from the investor (Note: these documents must be dated within the 3 months preceding the sale of interests);
  • verification by a third party:  a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, an attorney or CPA stating that such person or entity has taken reasonable steps to verify that the investor is accredited within the 3 months preceding the sale of interests and has determined that such investor is accredited; and
  • verification via prior investment:  persons who invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and remain investors of the issuer.

Other methods of verification may be acceptable, including retaining an independent service provider that conducts this type of diligence.  It should also be noted that an issuer who has taken reasonable steps to verify the accredited status of their investor will not lose their Rule 506(c) qualification because the investor is not, in fact, accredited.  Thus, deception by investors should not result in the issuer losing the benefits of Rule 506(c).

3.      Considerations Prior to the Use of 506(c)

Rule 506(c) is a radical departure from longstanding law.  As such, there are a range of considerations for fund managers considering an offering under the new exemption:

  • “Bad Actor” disqualification:  Issuers are prohibited from relying on Regulation D exemptions in the case of offerings involving certain “bad actors.”  We discuss this disqualification in more detail in our companion article.
  • Antifraud rules:  The SEC’s accompanying release specifically reminded private funds that they are subject to anti-fraud provisions of the Advisers Act;
  • Conflict with non-U.S. laws:  Other countries may have enacted securities laws that still include a ban on general solicitation;
  • State law:  While Rule 506(c) preempts many “blue sky” laws, state regulators concerned with potential fraud may create additional regulatory hurdles;
  • Potential regulation by the CFTC:  The CFTC has yet to issue guidance on whether general solicitation will preclude otherwise available exemptions.  For example, fund managers who utilize derivative financial instruments for hedging and who rely on the “de minimis” exclusion from registration with the CFTC are currently prohibited from general solicitation in the U.S; and
  • Election on Form D:  Prior to utilizing a general solicitation, issuers must formally notify the SEC on its Form D, checking the box in Item 6, indicating that it is relying on 506(c). 


While 506(c) appears to expand marketing opportunities for fund managers, additional regulatory and compliance requirements impose practical limitations on precisely how a fund manager should conduct its offering.  Stated another way, what is the real value of a general solicitation when, even before actually engaging in it, the fund manager must take concrete and documented steps to determine the accredited status of the targeted investors.  The bottom line is, the types of general solicitation described in Section 1, above are still largely off-limits for issuers relying on 506(c), except in the relatively rare cases in which there is a mechanism for pre-vetting seminar attendees, subscribers to a publication, users of a website, to name a few.  Despite the hoopla to the contrary, we will not be hearing advertisements for private funds on the radio during our morning commutes any time soon.


Calculating Regulatory Assets Under Management

How to Calculate Regulatory Assets Under Management (RAUM)

Registered investment advisers (“Advisers”) must filed an annual updating amendment to their Form ADV each year within 90 days of the Adviser’s fiscal year end.  If an Adviser’s fiscal year ended on December 31, 2013, its annual amendment should be filed on or before March 31, 2014.

Now is a good time to review a significant change made by the U.S. Securities and Exchange Commission (“SEC”) in 2012 to Item 5.F of Form ADV Part 1A: the requirement that the Adviser indicate the amount of “regulatory assets under management” or RAUM.

How does the SEC define RAUM?

RAUM is defined as the value of those “securities portfolios for which [the Adviser] provides continuous and regular supervisory or management services.”  Because RAUM is a metric designed to calculate gross assets under management for regulatory purposes an Adviser’s RAUM may be higher than its assets under management (typically  calculated on a net basis).  It is intended to capture a firm’s overall participation in the market, not necessarily the amount that it manages on behalf of clients.  The three-step process for calculating RAUM includes:

  1. Determine whether a client account is a “securities portfolio”
  2. Determine whether there is “continuous and regular” management
  3. Determine the value of the portfolio

Step One – “Securities Portfolio” Determination

The first step is to determine whether each client’s account qualifies as a “securities portfolio.”  An account should be treated as a securities portfolio if at least 50% of its total value is made up of securities.  When making this determination, consider the following:

  1. The SEC views cash and cash equivalents (i.e., bank deposits, certificates of deposit, bankers acceptances, and similar bank instruments) as securities;
  2. Include:
    • Accounts of foreign clients;
    • Family or proprietary assets; and
    • Accounts managed without any kind of compensation.
  3. All the assets of a private fund (defined in the instructions to Form ADV) are treated as a securities portfolio, regardless of the nature of the assets.

Step Two – “Continuous and Regular” Determination

The second step is to determine if the securities portfolio receives “continuous and regular supervisory or management services.”  The SEC identifies three factors that should guide all evaluations of whether an Adviser provides “continuous and regular supervisory or management services”:

  1. Terms of the advisory contract, i.e., does the Adviser agree to provide ongoing management services?
  2. Form of compensation:
    • If the Adviser’s compensation is based on the average value of the client’s assets, this suggests that the Adviser provides “continuous and regular supervisory or management services;”
    • Alternatively, compensation arrangements similar to the following suggest that the Adviser does not provide such services:
      1. The Adviser is compensated based upon the time spent with a client during a client visit; or
      2. The Adviser is paid a retainer based on a percentage of assets covered by a financial plan.
  3. Management practices: to what extent does the Adviser actively manage assets or provide advice?  Note that the Form ADV instructions explicitly state that the fact that the Adviser makes infrequent trades (e.g., based on a “buy and hold” strategy) does not mean its services are not “continuous and regular.”


Adviser is Deemed to Provide Continuous and Regular Supervisory or Management Services Adviser May Provide Continuous and Regular Supervisory or Management Services Adviser Does Not Provide Continuous and Regular Supervisory or Management Services
If it explicitly has discretion over the account and provides “ongoing supervisory or management services with respect to the account.”OR It does not have discretionary authority but:

  1. Has the ongoing responsibility to select or make recommendations as to specific securities or other investments based on a client’s needs;
  2. Such recommendations are accepted by the client; and
  3. The Adviser is responsible for arranging or effecting such purchase or sale.
If it:

  1. Has discretionary authority to allocate client assets among various funds;
  2. Does not have discretionary authority, but provides the same allocation services, and
  3. Satisfies the criteria set forth in the instructions regarding “continuous and regular supervisory or management services”;
  4. Allocates assets among other managers (a “manager of managers”, but only if it has discretionary authority to hire and fire managers and reallocate assets among them; or
  5. Is a broker-dealer and treats the account as a brokerage account, but only if it has discretionary authority over the account.
If it:

  1. Provides market timing recommendations (i.e., to buy or sell), but has no ongoing management responsibilities;
  2. Provides only impersonal investment advice (e.g., market newsletters);
  3. Makes an initial asset allocation, without continuous and regular monitoring and reallocation; or
  4. Provides advice on an intermittent or periodic basis, such as upon client request, in response to a market event, or on a specific date (e.g., the account is reviewed and adjusted quarterly).

Step Three – Valuation Determination

The third step is to determine the value of the securities portfolio.  Advisers must report the current market value of the assets held in securities portfolios, calculated within 90 days prior to the date of filing the Form ADV.  The same valuation method used to report account values to clients, or to calculate fees for investment advisory services, should be used for purposes of Form ADV.  Generally, Advisers should report the entire value of each securities portfolio for which the Adviser provides continuous and regular supervisory or management services.However, if the Adviser provides continuous and regular supervisory or management services for only a portion of a securities portfolio, it should include as RAUM only that portion of the securities portfolio for which it provides such services.  For example, it should exclude from its own RAUM the portion of an account:

  1. Under management by another person; or
  2. That consists of real estate or businesses whose operations the Adviser “manages” on behalf of a client but not as an investment.


The definition of RAUM: the value of those “securities portfolios for which [the Adviser] provides continuous and regular supervisory or management services,” assumes concepts that may be both unfamiliar and unclear.  We hope the step-by-step approach provided above will be a useful guide to firms as they prepare their annual updating amendments.

ADV Annual Updating Amendments

Annual Updating Amendments to Form ADV are due within 90 days of an adviser’s fiscal year end.  For most advisers, this will fall on March 31, 2014.  Significantly, SEC and state registrants as well as all Exempt Reporting Advisers (“ERA”) share this same timeline and should start planning their filings as soon as possible.   For ERAs, the short-form ADV contains fewer items (underlined below for ease of reference) so these firms may prefer to file it as soon as their year-end numbers are final to check it off their lists.

Where applicable, the ADV items listed below include the corresponding Schedules A-D.

1. Typical Updates Applicable to Most Firms

ADV Part 1A (all firms) includes a number of items that will nearly always be updated in the annual filing:

  • Item 5.F., Regulatory Assets Under Management (“RAUM”);
  • Item 7.B/Schedule D Section 7.B(1): Private Fund Reporting, which includes information about a fund’s asset levels and investor counts; and
  • Item 9, Custody: includes dollar amounts and client counts over which an advisor or its related persons have custody.

2. Consider Other Business Changes

The following items do not require amendments during the year and should be kept in mind for the annual filing.

ADV Part 1A (all firms):

    • Items 5, Information About Your Advisory Business:
      • A and B: employee counts;
      • C and D: client counts and client types (the latter includes percentages of head count and of RAUM);
    • Item 6, Other Business Activities (i.e., of the registrant)
    • Item 7, Financial Industry Affiliations (this looks similar to Other Business Activities in Item 6, but refers to the registrant’s “Related Persons,” as defined in the ADV instructions) and Private Fund Reporting (see also related sections of Schedule D); an
    • Item 12, Small Businesses (SEC registrants only).

ADV Part 1B (state registrants):

      • Item 2.H and J, questions regarding financial planning firms and sole proprietorships, respectively.

3. Other Items Requiring Prompt Amendments

The following are items that are amended promptly as they occur, rather than waiting for the annual filing.  If these were not amended during the year, they should be reflected on the annual amendment.

Part 1A (all firms):

    • Item 1, Identifying Information.  Among other things, this includes:
      • Addresses and telephone numbers;
      • Name and contact information for the Chief Compliance Officer; and
      • Business hours.
    • Item 3, Form of Organization;
    • Item 9.C. and D., Custody.  This includes information about:
      • How the firm manages custody rule requirements;
      • Whether a related person acts as custodian.
    • Item 11, Disciplinary Information and any applicable Disclosure Reporting Pages.

The above require amendment if the information provided becomes inaccurate in any way; the below require amendment only if information becomes materially inaccurate.  Note that some of these items have a corresponding section of Schedule D.

  • Item 4, Successions;
  • Item 8, Participation or Interest in Client Transactions; and
  • Item 10, Control Persons (includes Schedules A-C).

Part 1B (state firms):

  • Item 1, State Registration;
  • Item 2.A-F, I, Additional Information, including:
    • Person responsible for supervision and compliance;
    • Bond and minimum capital requirements;
    • Disclosure information and any applicable Disclosure Reporting Pages; and
    • Custody.

The above require amendment if the information provided becomes inaccurate in any way; the below requires amendment only if information becomes materially inaccurate.

  • Item 2.G, Other Business Activities.

Part 2:  If any information in the Firm Brochure and/or supplement(s) become materially inaccurate, an Other-than-Annual amendment is required.  Exception for Part 2A: the firm’s amounts under management (Item 4.E) and fee schedule (Item 5.A) need not be updated during the year, even if the firm is otherwise amending Part 2A.

4. Filing and Deliveries

State filing fees should have been submitted as part of IARD’s annual renewal program (see our post Investment Advisers: Compliance To-Do List for Year-End).  This program covers:

  • State registrants;
  • Exempt Reporting Advisers filing in one or more states;
  • SEC registrants notice filing in one or more states; and
  • SEC registrants that have Investment Adviser Representatives registered in one or more states.

If they have not done so already, SEC registrants and exempt firms should separately submit the IARD processing fee amount corresponding to their RAUM level before they intend to file their Annual Updating Amendment, considering mailing times for checks and adding two days for posting once received, even for electronic filings and wires.  IARD does not process filings where fees are owed.

IARD has a “Completeness Check” feature which is helpful as a quick reference for errors or missing information (including fees).  CCOs who need to obtain information from other departments might find it useful to circulate to those responsible for gathering information for any responses.  The Completeness Check also runs automatically when a filing is submitted, halting submission so the identified errors and missing information can be corrected.

Within 120 days of the firm’s fiscal year end (i.e., a month after the Annual Updating Amendment is filed or April 30, 2014 for most firms) all registrants must deliver or offer to deliver a copy of the updated Brochure (ADV Part 2A) to their clients.  Note that for most purposes, the term “client” in Form ADV refers to the direct clients of a firm and not to investors in any private funds the firm sponsors (though it is not uncommon for firms to elect to deliver or offer the ADV Part 2as a matter of investor relations).  Some key takeaways on deliveries:

  • They should be timely;
  • They should be documented.   While firms should be archiving their email, which will capture the outbound communication, it is a good idea to establish a standard wording for this communication and create a log (among other things, a log operates as a quick reference and is easier to supply in response to an examination request than digging through the email archive);
  • If offering rather than delivering, the offer must, per the ADV instructions, provide a summary of the material changes to the brochure (copying and pasting from Item 2 makes this easy).

IA Annual Review Process – Maximizing Effectivess

How to Maximize the Effectiveness of Your Annual Review Process

SEC-registered investment advisers are required to review and test their compliance program on an annual basis. State registrants and exempt firms may also conduct annual reviews as a matter of best practices. These firms should also note that most forms of a compliance manual (and especially if they are modifying a template for a SEC registrant) do require an annual review, so language about this may need to be revised.

For many firms, the annual review process will result in updates to their Policies and Procedures (“P&P”), anything from small tweaks to existing policies to adding policies that reflect new regulations.

1. When Should I Conduct the Annual Review?

The SEC does not require that the review take place by a certain time each year; however it is optimal practice to conduct the review around the same time each year and this is often done alongside annual employee training and the collecting of annual certifications. As discussed previously in our post on implementing compliance policies and procedures, any changes to the Code of Ethics (“Code”) should be done at this time as well, to avoid multiple rounds of employee certifications.

Year end and the new year can be very busy times for most firms or divisions within a firm – annual reports to clients and investors (if any), the annual audit, and various regulatory filings (among other items) compete for time that is already scarce. Conducting an annual review during this time is tempting because firms are already thinking of wrapping things up and starting again, but they might just be too busy so many firms schedule their annual reviews for shortly before or after this crunch time. Alternatively, there is no regulatory reason why the review could not be conducted mid-year at a time that is usually slower (taking into account that the review may be of the preceding 12 months, not necessarily the calendar year).

2. What Does an Annual Review Look Like?

An annual review can take many forms. Perhaps the most common is a checklist or matrix format; some CCOs follow an outline or questionnaire and still others keep a running log or journal that they update in real time. CCOs and their staff should take some time to consider which of these will fit best within their routine and is the most likely to capture important information.

a. Pros and Cons of Checklists, Matrices, Outlines and Questionnaires

These formats have the great advantage of listing the most common and key areas of an adviser’s compliance program; as such they provide a clear roadmap through the review process and can make it very efficient and systematic. They are easy to customize by adding and deleting items that are specific or not applicable to the firm.

However, this format may prove limiting, especially in years that saw complex or large-scale changes to a firm’s business generally or the compliance program specifically. It may be necessary to supplement the checklist with some form of narrative, exhibits or other relevant material that fully captures the year’s events.

b. Pros and Cons of Real-time Logs and Journals

Real-time logs and journals are excellent for capturing detail and especially while an occurrence or issue is fresh in one’s mind. These can also function as a sort of tickler file or to-do list during the year. For some, a narrative format is more comfortable and easier to use.

What these formats may not capture is the areas of the compliance program or firm’s business that were less active or did not have many concerns during the year. CCOs using this format will want to look at these areas (perhaps by referring to a checklist), perform tests if needed and include their findings in the annual review. Keep in mind that one function of the annual review is to look at the firm’s compliance program from a distance to see it more objectively. Accordingly, amid all the detail of the log, CCOs should step back to spot trends and macro-level issues as they work through the annual review process.

c. A Hybrid Approach

Sansome Stategies builds compliance programs based on continuous reporting to our clients: in our day to day interactions, in regularly scheduled monthly “check-ins” (call, email or meeting) and through formal quarterly reports. In this way, small “to do” items and big events alike are captured as they happen in all of their detail and discussed in the monthly check-in process. On a quarterly basis, we take stock of the preceding three months and are able to identify trends as they emerge, spot any issues quickly and perform any pre-determined quarterly reconciliations and reviews.

It may be easier than it appears to bring a similar process in house, especially if there are others who support the compliance department and already report to the CCO on these matters. Even in a department of one, the CCO may find it helpful run through a checklist (full or condensed) or review the log on a quarterly basis and document this in a way that can be easily used later in the annual review or for other audit purposes. Some of the work of the annual review has already been done a quarter at a time; at year end, these quarterly reports are easy to review alongside any of the more detailed color to produce an annual report.

3. Is a Risk Analysis the Same as an Annual Review?

An annual review and a risk analysis “speak to” and complement one another, but these are not interchangeable. The annual review focuses on two basic things: what do the P&P and COE require of the firm, and (sometimes, versus) what actually took place during the year. Though it will certainly be useful for the future, the annual review is primarily an exercise in looking back.

A risk analysis is a more holistic endeavor. While it likely will include the same types of compliance issues and may depend heavily on an analysis of what the firm does right now, it is very much forward-looking. It requires not only the CCO but firm management to anticipate conflicts of interest (actual, likely, possible, and the appearance of conflicts), determine aspects of the firm’s investment program, business model or structures that have or create particular risk and consider areas and issues beyond pure compliance (service providers, counterparties, human resources, geographical areas to name just a few).

A good risk analysis takes this a step further: it identifies both the risks alongside the provisions of the firm’s P&P, COE and other policies and practices that seek to address those risks. Because of this cross-reference, the CCO can pinpoint and test the areas that are linked to the firm’s particular risks, fine-tuning the firm’s processes where needed and especially as the firm changes over time. The CCO should consider and update the firm’s risk analysis as part of the annual review process.

4. The Review is Done, Now What?

Before you click save, close and start the new year (calendar, fiscal or of one’s own devising), the annual review must be presented to firm management. This is best done in person, though larger firms with multiple offices may need to have a conference call instead, and accompanied by a written report of the review’s findings. Like the review itself, the report can take many forms, including:

• The CCO’s completed checklist, outline or questionnaire with a cover letter or other narrative discussing key findings in some detail;

• Similarly, the CCO’s log accompanied by an executive summary that highlights key findings and refers to or excerpts from sections of the log;

• A separate written report, PowerPoint presentation or other document. Depending on the circumstances, this may or may not excerpt or include as exhibits the checklist, log or other system used to conduct the review.

In determining the appropriate format, consider not only what will translate well from the CCOs annual review system, but what will also be most meaningful for the audience, the firm’s senior management. This is also an opportunity for the CCO to highlight the both the department’s accomplishments and the firm’s strengths as well as set the stage for desired enhancements to the firm’s compliance program (e.g., hiring staff, obtaining software or other resources).

Though daunting on the face of it, and perhaps in some areas of executing it, the annual review is a valuable to tool to assess the effectiveness of a firm’s compliance program, take stock of its risks and strengths and empower it to respond nimbly to business and regulatory changes.


About Sansome Strategies 

Sansome Strategies is a compliance consulting firm specializing in high-touch, outsourced compliance services for businesses in the investment management industry. Clients include investment advisers, futures managers, broker-dealers, hedge funds, and private equity firms. Sansome Strategies provides tailored compliance management solutions to the unique needs of each client and is focused on helping clients build and enhance their business by simplifying the compliance and regulatory process.  For more information, please contact us here.

Implementing Effective Compliance Programs

We occasionally have the opportunity to post articles from industry experts.  Below please find an article from Katy McBride (bio below) on how to implement an effective compliance program.


10 Elements of an Effective Compliance Program
By Katy McBride

1. Organizational Leadership and Culture

The organization’s governing authority is knowledgeable about content and operation of the Program with specific individual(s) among high-level management assigned overall responsibility for the Program. One or more individuals is responsible for daily and ongoing operations of the Program. Employees are encouraged and comfortable talking openly and honestly about risk, within a culture of constructive challenge.

2. Designate a Compliance Officer and Compliance Committee

The Program identifies a compliance officer and compliance committee who are responsible for developing, operating and monitoring the Program. This team reports directly to the governing authority periodically and on an as needed basis.

3. Implement Written Policies and Procedures (including code of conduct/code of ethics)

The compliance officer is responsible for developing and distributing written compliance procedures to guide the organization and its employees. These procedures should include a code of ethics to guide employee conduct, detail fundamental principles, and create a framework for action within the organization.

4. Create and Retain Records

The Program will develop and implement a records system which ensures complete and accurate record documentation and addresses retention and destruction of records as well as privacy concerns. Records will be maintained within all applicable regulatory standards and easily retrievable for regulatory inquiry. It’s advised to use software for this – and one that can help you to successfully manage your business compliance needs.

5. Develop Effective Lines of Communication

The compliance officer and compliance committee must create and maintain effective lines of communication with all employees to support an ongoing culture of compliance. Questions, complaints, and suggestions will be encouraged and supported. When appropriate, confidentiality and anonymity of complainants will be protected to safeguard against retaliation.

6. Conduct appropriate training and education

The Program’s policies and procedures and code of conduct are widely promulgated and employees are trained on the Program’s objectives and policies. Proper training is required for all employees including organizational leadership, employees, and the organization’s agents as appropriate. The content may vary according to the specific group being trained, and may employ a variety of training methods to account for the skills and experience of the individual trainees. Training will be tracked, attested to, and documented.

7. Internal Auditing and Monitoring: Assess Effectiveness of Compliance Program

The Program will include monitoring and auditing systems designed to confirm adherence with laws and regulations and detect improper conduct. Ongoing evaluation with regular and periodic compliance audits by internal or external evaluators will identify and resolve problem areas and gaps in the Program.

8. Respond to Detected Gaps and Develop Corrective Action

Should the compliance officer or compliance committee receive reports or identify areas of non-compliance, it must take immediate steps to determine if there has been any violation of laws or policy statements, and take decisive action to correct the deficiency and impose remedial action as necessary. Additionally, the compliance officer must take immediate steps to prevent recurrence of similar deficiencies or misconduct, which may include modification of the compliance program, audit, corrective action, and employee training.

9. Enforcing Standards Through Clear Guidelines

Violations of the organizations policies and standards of conduct will be immediately addressed with corrective action to correct and prevent further misconduct. Appropriate action will be “case specific” and will be done throughout all levels of the organization. Disciplinary action will be proportional to the conduct.

10. Compliance as an Element of Employee Performance

The Program considers adherence to all compliance elements as a factor in evaluating employee performance and incentives employee participation in strengthening the Program. The organization promotes commonality of purpose: each employee individual interests, values, and ethics are aligned with the organizations risk strategy, appetite, tolerance, and approach.


About the Author 

Katy McBride is the Compliance and Operations Manager for LJM Partners, a Commodity Trading Advisor and Commodity Pool Operator registered with the CFTC and NFA member firm. Katy has over 9 years experience in compliance and operations management with both start up and fortune 500 organizations. Prior to her role at LJM, Katy provided consulting services to Registered Investment Advisors and Broker Dealers, where she developed and maintained full service customized compliance programs in addition to serving as Chief Compliance Officer and Director of Operations for several of her clients. Katy’s expertise includes regulatory compliance, broker-dealer compliance and risk management, Investment Advisor registrations, regulatory filings, and operations management. Katy has her bachelor’s degree from the University of California at Davis and holds her FINRA Series 7, 9, 10, and 66 licenses.

About Sansome Strategies 

Sansome Strategies is a compliance consulting firm specializing in high-touch, outsourced compliance services for businesses in the investment management industry. Clients include investment advisers, futures managers, broker-dealers, hedge funds, and private equity firms. Sansome Strategies provides tailored compliance management solutions to the unique needs of each client and is focused on helping clients build and enhance their business by simplifying the compliance and regulatory process.  For more information, please contact us here.