By Rodney F. Tonkovic, J.D.
SEC Commissioner Daniel Gallagher has issued a statement concerning his voting against two settled enforcement actions against chief compliance officers. Gallagher said that he has long called on the Commission to "tread carefully" when acting against compliance personnel and that he felt compelled to explain his dissents. According to Gallagher, the Commission must examine Investment Advisers Act Rule 206(4)-7 and consider whether amendments or guidance are needed to clarify the roles and responsibilities of compliance personnel.
BlackRock and SFX. In an action against BlackRock Advisors, LLC, CCO Bartholomew A. Battista was charged with causing the firm's violations of Rule 206(4)-7. Battista allegedly failed to ensure that BlackRock had compliance policies and procedures to assess and monitor the outside activities of employees and disclose conflicts of interest to fund boards and advisory clients. In its action against SFX Financial Advisory Management Enterprises, Inc., the Commission alleged that CCO Eugene Mason failed to ensure that the firm had compliance policies and procedures to assess and monitor the outside activities of employees and disclose conflicts of interest to fund boards and advisory clients.
Gallagher observed that in both instances the order states that the CCO was responsible for the implementation of the firms' policies and procedures, illustrating a Commission trend toward strict liability for CCOs under Rule 206(4)-7. This, Gallagher warns, sends a troubling message to CCOs that they could be held accountable for conduct that, under Rule 206(4)-7, is the responsibility of the adviser itself. A CCO, he said, will opt not to take ownership of their firm's compliance policies and procedures, or worse, will opt for less comprehensive policies and procedures in order to avoid liability "when the government plays Monday morning quarterback." Small advisers are especially at risk, Gallagher added.
It's Rule 206(4)-7's fault. Gallagher lays the blame for this state of affairs on Rule 206(4)-7, which he describes as "not a model of clarity." The rule, Gallagher explains, offers no guidance on the distinction between the role of CCOs and management in carrying out the compliance function, and the Commission has offered no guidance in the 11 years since the rule was adopted.
The only guidance available to market participants, therefore, is enforcement actions, which, according to Gallagher, have "contorted the rule to treat the compliance function as a new business line, with compliance officers assuming the role of business heads." The Commission interprets the rule as being directed at CCOs, Gallagher said, but the rule expressly states only that the CCO administers the firm's compliance policies and procedures – responsibility for the implementation of those policies and procedures rests with the adviser itself.
Gallagher finds this uncertainty as to the contours of the rule troubling due to the vital role played by compliance personnel. He notes that CCOs are the only line of defense for the vast majority of advisers, and, unlike broker-dealers, there are no SROs standing between the SEC and advisers. Gallagher said that he is concerned that a vigorous compliance function will be disincentivized and that targeting compliance personnel could result in perverse incentives. He calls for restraint even in the investigation stage, noting that the months or years that the process takes can cause psychological and reputational damage that are just as chilling as the "scarlet letter" of a violation.
Take a look at the rule. In closing, Gallagher urges the Commission to take a hard look at Rule 206(4)-7 to consider whether amendments or guidance are needed to clarify the roles and responsibilities of compliance personnel. The status quo, where compliance personnel are improperly held accountable for the misconduct of others, simply will not do, Gallagher says.