The Office of Compliance Inspections and Examinations has issued a Risk Alert outlining staff observations related to hiring and employing supervised persons with disciplinary histories. The series of examinations, called the Supervision Initiative, drew on the findings of over 50 examinations of investment advisers managing approximately $50 billion in assets and nearly 220,000 clients. The Risk Alert encourages advisers to consider the risks presented by hiring and employing individuals with disciplinary histories and to adopt policies and procedures to address those risks.
Observations. According to the Risk Alert, nearly all of the examined advisers received deficiency letters. Nearly half of the disclosure-related deficiencies identified by the staff were due to the firms providing inadequate information about disciplinary events, such as relying on self-reporting, providing incomplete information, and failing to update and deliver disclosure documents such as Form ADV.
Many firms did not adopt and implement compliance policies and procedures to address the risks of employing individuals with disciplinary histories, according to the staff. For example, these firms did not have processes in place reasonably designed to identify whether self-attestations about disciplinary events accurately described those events and whether the self-attestations were the subject of reportable events.
The staff also reviewed firm-wide practices and observed issues that were not necessarily attributable to the hiring and supervision of individuals with disciplinary histories. The Risk Alert noted that while some of these issues are commonly identified in OCIE examinations, they were frequently identified under the Supervision Initiative.
Many advisors did not adequately supervise or set appropriate standards of conduct for their supervised persons, the staff observed, including the failure to document the responsibilities of, and expectations for, these individuals. Some firms failed to oversee the fees charged by the supervised person, which resulted in clients paying for services they did not receive or being charged undisclosed fees.
Other firms did not have sufficient guidelines for their advertising policies and procedures, including for supervised persons who prepared their own advertising materials and websites. In these cases, advertisements were disseminated despite not complying with the advertising rule.
The staff also observed that geographically-dispersed supervised persons were operating in a self-directed matter that was inconsistent with the firm’s policies and procedures, including individuals with disciplinary histories who work remotely.
Where policies and procedures were in place, some firms did not implement them or did not document that the supervised persons performed the duties assigned to them. These included monitoring the appropriateness of client account types and maintaining true, accurate, and current books and records.
In addition, the staff observed that several firms had adopted policies and procedures that were inconsistent with their actual business practices and disclosures. The most frequent areas of inconsistent compliance practices related to commissions, fees, and expenses, the staff found. Regarding annual compliance reviews, many firms did not adequately document the reviews or appropriately assess applicable risk areas.
Several firms had undisclosed compensation arrangements resulting in conflicts of interests that could potentially impact the impartiality of the advice supervised persons gave to their clients. In particular, the staff found that forgivable loans were made to the advisers or their supervised persons with terms contingent on certain client-based incentives. This may have influenced the investment decision-making process or resulted in higher fees or expenses. In addition, some supervised persons were required to incur all transaction-based charges for client transactions, creating incentives to trade less frequently on their clients’ behalf.
Improving compliance. The Risk Alert outlined how firms can improve compliance when they employ supervised persons with disciplinary histories. Firms should adopt written policies and procedures that specifically address what should occur prior to hiring persons that have reported their disciplinary history. Firms can also enhance their due diligence to identify disciplinary events in a new hire’s history, including background checks, internet and social media searches, fingerprinting, third-party research of new employees, contacting personal references, and verifying educational claims.
Because firms with written policies and procedures specifically addressing the oversight of supervised persons with disciplinary histories were far more likely to identify misconduct than firms without written protocols, the staff recommended establishing heightened supervision practices. In addition, written policies and procedures that address client complaints are more likely to lead to supervised persons reporting those complaints, the staff observed.
In addition, the staff observed that several firms had adopted policies and procedures that were inconsistent with their actual business practices and disclosures. The most frequent areas of inconsistent compliance practices related to commissions, fees, and expenses, the staff found. Regarding annual compliance reviews, many firms did not adequately document the reviews or appropriately assess applicable risk areas.
Several firms had undisclosed compensation arrangements resulting in conflicts of interests that could potentially impact the impartiality of the advice supervised persons gave to their clients. In particular, the staff found that forgivable loans were made to the advisers or their supervised persons with terms contingent on certain client-based incentives. This may have influenced the investment decision-making process or resulted in higher fees or expenses. In addition, some supervised persons were required to incur all transaction-based charges for client transactions, creating incentives to trade less frequently on their clients’ behalf.
Improving compliance. The Risk Alert outlined how firms can improve compliance when they employ supervised persons with disciplinary histories. Firms should adopt written policies and procedures that specifically address what should occur prior to hiring persons that have reported their disciplinary history. Firms can also enhance their due diligence to identify disciplinary events in a new hire’s history, including background checks, internet and social media searches, fingerprinting, third-party research of new employees, contacting personal references, and verifying educational claims.
Because firms with written policies and procedures specifically addressing the oversight of supervised persons with disciplinary histories were far more likely to identify misconduct than firms without written protocols, the staff recommended establishing heightened supervision practices. In addition, written policies and procedures that address client complaints are more likely to lead to supervised persons reporting those complaints, the staff observed.