Registered Investment Adviser Compliance Update

The SEC’s Division of Enforcement has indicated that one of its focuses for 2018 was on retail investors. This focus has translated into increasing number of cases involving investment advisers. According to the Enforcement Division’s recently published reports, cases involving investment advisers and investment companies were the second largest group of actions in the last year, just behind fraud cases. Many of the investment adviser cases have been brought, at least in part, on the failure of the adviser to adhere to its own policies and procedures (See, e.g., In the Matter of Pennant Management, Inc., Adm. Prc. File No. 3 18884 (Nov. 6, 2018) (https://www.sec.gov/litigation/admin/2018/ia-5061.pdf ).

The Enforcement Division also continues to focus on fee and expense allocation issues. In the Lightyear Capital LLC matter (https://www.sec.gov/litigation/admin/2018/ia-5096.pdf), the SEC settled charges that a private equity fund manager failed to allocate expenses to employee funds and co-investors and failed to note in the disclosure documents for the flagship fund that these parties would not bear their proportional share of expenses. In the NB Alternatives Advisers LLC matter, the SEC settled charges that a fund manager misallocated personnel expenses to the fund’s portfolio companies in contradiction to the disclosures made to investors (https://www.sec.gov/litigation/admin/2018/ia-5079.pdf). In another matter, the SEC settled charges that a venture capital fund adviser failed to properly offset the management fees it was charging, in violation of its offering memorandum disclosure and its limited partnership agreement (https://www.sec.gov/litigation/admin/2018/ia-4951.pdf). Finally, in the Yucaipa Master Manager, LLC matter, the SEC settled charges that a fund manager improperly allocated expenses to its fund clients, including allocating manager, employee and service provider costs to the fund, improperly allocating expenses between different funds, failure to disclose the methodology of allocating expenses and failing to adopt written policies and procedures reasonably designed to prevent conflicts of interest arising from the adviser’s allocations of expenses to and among clients (https://www.sec.gov/litigation/admin/2018/ia-5074.pdf).

The SEC continues to focus its enforcement efforts on violations of the SEC’s “Pay to Play” Rule, relating to investment advisers that make or solicit political contributions to government officials in an attempt to influence those officials charged with awarding advisory business. Some of the 2018 cases in this area involved relatively modest amounts of money that were, in some cases, returned to the donor. https://www.sec.gov/litigation/admin/2018/ia-4875.pdf; https://www.sec.gov/litigation/admin/2018/ia-4970.pdf.

In addition, the SEC’s Office of Compliance Inspections and Examinations (the “OCIE”) published several risk alerts during 2018, two of which we thought it particularly relevant to highlight – best execution and electronic messages.

Best Execution

On July 11, 2018, the OCIE issued a risk alert that summarized the most common deficiencies of investment advisers with respect to their best execution obligations under the Investment Advisers Act of 1940 (the “Advisers Act”).

The Advisers Act establishes certain operating standards for SEC-registered investment advisers (“RIAs”). When an RIA has the ability to select a broker-dealer and execute client trades, it must seek “best execution.” While cost is one of the factors considered when determining “best execution,” it is not the only factor. As the Staff has stated, “An adviser must execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances.” In directing brokerage, an adviser should consider the full range and quality of a broker-dealer’s services including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility and responsiveness to the adviser.

As the SEC has stated, “the determinative factor [in an adviser’s best execution analysis] is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account.” The OCIE identified the following key weak areas discovered in the compliance reviews:

  • Advisers not being able to demonstrate that they periodically and systematically evaluated best-execution performance.
  • In performing reviews, advisers did not evaluate any qualitative factors (execution capability, financial responsibility, etc.).
  • Advisers did not include input from their traders and portfolio managers as part of best execution reviews.
  • Advisers did not seek comparisons from other broker-dealers.
  • Advisers did not properly disclose their best execution practices.
  • Advisers did not properly disclose their soft dollar arrangements.
  • Advisers did not properly administer mixed-use allocations.
  • Advisers had inadequate policies and procedures for best execution.
  • Advisers did not follow their own best execution policies and procedures.

Electronic Messaging

On December 14, 2018, the OCIE issued a risk alert covering the use of electronic messaging by RIAs and their personnel, excluding email on the firms’ systems. The OCIE found that written business communications were conveyed electronically using electronic systems such as text/SMS, instant messaging, personal email and private messaging applications.

As noted by the OCIE Staff, Advisers Act Rule 204-2 requires advisers to make and keep certain books and records relating to their investment advisory business, including typical accounting and other business records as required by the SEC. Specifically Rule 204-2(a)(11) requires advisers to make and keep a copy of “each notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the investment adviser circulates or distributes, directly or indirectly, to ten or more persons.” The SEC has stated that, “regardless of whether information is delivered in paper or electronic form, broker-dealers and investment advisers must reasonably supervise firm personnel with a view to preventing violations.”

The OCIE Staff noted that not all of the electronic communication methods being used for business purposes by advisory personnel were consistent with the advisers’ compliance requirements. The OCIE Staff suggested some examples of practices that may assist advisers in meeting their record retention rules.

These include:

  • Permitting only those forms of electronic communication for business purposes that the adviser determines can be used in compliance with the books and records requirements of the Advisers Act.
  • Specifically prohibiting business use of applications and other technologies that can be readily misused by allowing an employee to send messages or otherwise communicate anonymously, allowing for automatic destruction of messages or prohibiting third-party viewing or back-up.
  • In the event that an employee receives an electronic message using a form of communication prohibited by the firm for business purposes, requiring in firm procedures that the employee move those messages to another electronic system that the adviser determines can be used in compliance with its books and records obligations, and including specific instructions to employees on how to do so.
  • Where advisers permit the use of personally owned mobile devices for business purposes, adopting and implementing policies and procedures addressing such use with respect to, for example, social media, instant messaging, texting, personal email, personal websites and information security.
  • If advisers permit their personnel to use social media, personal email accounts or personal websites for business purposes, adopting and implementing policies and procedures for the monitoring, review and retention of such electronic communications.
  • Including a statement in the firm’s policies and procedures informing employees that violations may result in discipline or dismissal.

A full copy of the OCIE risk alert is found here.

2019 Examination Priorities

In December 2018, the OCIE released their 2019 Examination Priorities. These provide a preview of key areas where the OCIE intends to focus its resources in the upcoming year. While they do not encompass all of the areas that will be covered in examinations, they are important areas to focus on in advance of a potential SEC examination.

These are:

  1. 1.Matters of importance to retail investors, including seniors and those saving for retirement;
  2. Compliance and risk in registrants responsible for critical market infrastructure;
  3. Continued inspection and examination of FINRA and MSRB;
  4. Digital Assets;
  5. Cybersecurity; and
  6. Anti-Money Laundering for Broker-Dealers.

The full text of the OCIE 2019 examination priorities is available here.

Digital Assets

For firms actively engaged in the digital asset market, the OCIE will conduct examinations focused on, among other things, portfolio management of digital assets, trading, safety of client funds and assets, pricing of client portfolios, compliance and internal controls.

While not specifically mentioned, one of the key compliance issues that funds active in this space need to consider are the application of the Custody Rules to certain digital assets.


Cybersecurity continues to be a focus for the OCIE Staff. As noted in their report, “[e]xaminations will focus on, among other things, proper configuration of network storage devices, information security governance generally, and policies and procedures related to retail trading information security.” Specific to investment advisers, OCIE will emphasize cybersecurity practices at investment advisers with multiple branch offices, including those that have recently merged with other investment advisers, and continue to focus on, among other areas, governance and risk assessment, access rights and controls, data loss prevention, vendor management, training and incident response.

AML for Broker-Dealers

The Bank Secrecy Act requires broker-dealers (but not investment advisers) to establish anti-money laundering (“AML”) programs. These programs must, among other things, include policies and procedures reasonably designed to identify customers, perform customer due diligence, monitor for suspicious activity and, where appropriate, file suspicious activity reports (“SARs”) with the Financial Crimes Enforcement Network. SARs are used to detect and combat terrorist financing, public corruption, market manipulation and a variety of other fraudulent behavior.

In 2019, the OCIE will continue to prioritize examining broker-dealers for compliance with their AML obligations, including whether they are meeting their SAR filing obligations, implementing all elements of their AML programs and robustly and timely conducting independent tests of their AML programs. The goal of these examinations is to ensure that broker-dealers have policies and procedures in place that are reasonably designed to identify suspicious activity and illegal money laundering activities.

Although these requirements do not specifically apply to investment advisers, we consider it to be best practice for advisers to implement robust AML policies and procedures that would pass SEC scrutiny if similar provisions are applied to advisers in the future.