Examination Reveals Compliance Focus Areas

NASAA, the lobbying body of the various state securities divisions, recently released a set of examination findings which describe the common compliance deficiency areas for IA firms registered with the state securities commissions.  The exams, which were completed by state administrators, showcase a number of compliance issues for both registered investment advisers and fund managers.  According to the NASAA press release:

Examinations of 825 investment advisers conducted between January 1, 2011 and June 30, 2011 uncovered 3,543 deficiencies in 13 compliance areas, compared to 1,887 deficiencies in 13 compliance areas identified in a similar 2009 coordinated examination of 458 investment advisers.

Below we have summarized the findings released in the NASAA 2011 Examinations Findings (.ppt).

Deficiency Categories

Below are the categories which were covered, along with the percentages of advisers with at least one deficiency in such category:

• Registration (59.9%)
• Books and Records (45%)
• Unethical Business Practices (36.8%)
• Supervisory/Compliance (30.2%)
• Advertising (21.6%)
• Privacy (21.2%)
• Financials (19.8%)
• Fees (19.4%)
• Custody (12.6%)
• Investment Activities (3.9%)
• Solicitors
• Pooled Investment Vehicles (Hedge Fund)
• Performance Reporting

Discussion of Deficiencies

There are a number of slides devoted to providing more granular information on the various deficiencies.  Below are some of my thoughts when I read through these deficiencies:

• Properly completing ADV, including proper descriptions (AUM, fees, business overview, disclosures) and making sure there are no inconsistencies; unregistered IAs were not a large part of the deficiencies.
• Investment adviser books and records are what you would expect – a number of different items were not properly kept as required by regulations. Surprisingly, it seems that many IAs do not keep the suitability information on their clients as required.
• Under unethical practices, it seems that many of the deficiencies were likely caused by careless drafting of contract documents. Non-contract unethical business practices revolved around advertising and conflicts of the IA.
• One interesting note for Supervisory/Compliance is that a large number of IAs did not follow their own internal procedures. This might be worse than having inadequate procedures – if your compliance manual says you will do something, you should make sure it is being done.
• Financials might be what you would expect – issues with respect to net worth of the IA, bond issues and inaccurate financials.
• Advertising deficiencies focused on website issues. I would expect this to increase in the future as more IAs establish websites in the future. Additionally, social media deficiencies are likely to increase in the future as more firms use these tools to advertise their business. [Note: while the managed futures industry has different regulations, the concepts of social media regulation for the futures industry can be applied to securities compliance.]
• Custody is probably the single most misunderstood concept for IA firms. Most people view custody to be having physical possession of a client’s cash or securities.  However, if you directly deduct a fee from a client account (even if this is done by the custodian, i.e. Schwab) then in most states the IA is deemed to have “custody” of the account and must adhere to the custody requirements of the state.
• It is interesting to note that with respect to investment activities the following were some common deficiencies: preferential treatment (I assume, without disclosure), aggregate trades, and soft dollars.
• Solicitors have become a more prevalent issue over the last few months as more fund managers (who are RIAs) offer separately managed account programs. [Note: we will have more articles forthcoming on this issue shortly.] For solicitor issues the big items were undisclosed solicitors and issues with disclosure. Also, the agreement between the IA and the solicitor was a common deficiency.
• Hedge fund managers with no separately managed account business had many more deficiencies than IA only firms. Deficiencies with respect to hedge funds related to valuation, cross-trading and preferential treatment (again, we assume, without disclosure).

IA Compliance Best Practices

As a result of the report, the NASAA identified the following as best practices for IAs:

• Review and revise Form ADV and disclosure brochure annually to reflect current and accurate information.
• Review and update all contracts.
• Prepare and maintain all required records, including financial records.
• Back-up electronic data and protect records.
• Document all forwarded checks.
• Prepare and maintain client profiles.
• Prepare a written compliance and supervisory procedures manual relevant to the type of business to include business continuity plan.
• Prepare and distribute a privacy policy initially and annually.
• Keep accurate financials. File timely with the jurisdiction.
• Maintain surety bond if required.
• Calculate and document fees correctly in accordance with contracts and ADV.
• Review all advertisements, including website and performance advertising, for accuracy.
• Implement appropriate custody safeguards, if applicable.
• Review solicitor agreements, disclosure, and delivery procedures.

Conclusion

It is clear that NASAA is trying to be more of an influence on how the state administrators conduct examinations and the focus areas of those examinations.  While it is helpful for NASAA to release investment adviser compliance best practices, it would be more useful if they released more robust compliance materials such as sample compliance manuals/ policies and clearer guidance on state interpretations of regulations.  As Congress and the SEC determine whether to establish an investment adviser SRO, we are likely to see NASAA take a larger thought leadership role.  In any event, investment advisers and hedge fund managers should begin to start thinking about registration and implementing robust compliance policies and procedures which address all parts of state or SEC IA registration regulations.

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Cole-Frieman & Mallon LLP provides legal advice to hedge fund start ups and well as established fund complexes.  Bart Mallon can be reached directly at 415-868-5345.