Last August, the Securities and Exchange Commission (SEC) issued a cease-and-desist proceeding against Carl Johns, a Colorado-based portfolio manager, for violating Rule 38a-1 of the Investment Company Act – known as the compliance officer rule.
The rule outlaws fund staffers from taking “any action to coerce, manipulate, mislead, or fraudulently influence the fund’s chief compliance officer in the performance of his or her duties.” Private equity compliance officers will be aware of a similar rule (Rule 206(4)-7) that protects them under the Investment Advisers Act.
In one way, the Johns case highlights the SEC’s desire to protect compliance officers who don’t seem to have the support of their firm’s senior management. In a recent speech, SEC chairman Mary Jo White said that under her leadership the commission would “be looking for more cases [like Johns] to drive that message home.”
But having the SEC in your corner may be something of a double-edged sword for CCOs. Aside from preventing senior partners from keeping the chief compliance officer quiet about potential rule violations, the rule also examines whether a firm has robust enough compliance policies and procedures that the CCO could reasonably rely upon to perform his or her duties. It’s that second part of the rule that industry lawyers are paying close attention to, speculating that the SEC’s new message of CCO protection really may mean more scrutiny.
In the past, the SEC was unlikely to invoke Rule 206 to sanction firms for inadequate policies and procedures; the firm needed to exhibit something worse, say legal sources. But that attitude is changing, and the rule is allowing the agency to consider enforcement action for small-time violations.
“It used to be that you first had to have a number of substantive violations of other rules [before enforcement], and they [the SEC] would routinely tack a compliance officer rule violation on too,” says George Raine, regulatory partner at Ropes & Gray. “Now in a couple of cases [the SEC] are saying, ‘you may not have other violations but we are going to write you up simply for violating the compliance officer rule.’”
For some CCOs, that message then is less a friendly arm around the shoulder, and more of a disguised warning that minor rule violations are being taken more seriously by examiners (many cite the agency’s widely reported vigilance on the technical aspects of the custody rule as a case in point).
But sources close to the SEC’s thinking say the agency’s zero-tolerance approach on matters that may seem trivial is really a strategy to give compliance officers some more leverage internally. No doubt CCOs have a bigger voice at the firm after the partnership receives a long deficiency letter.
“In the [private equity] industry we have a number of CCOs who are not opposed to us coming in, conducting an exam and pointing out deficiencies,” says Jane Jarcho, the SEC’s investment adviser examination director. “They tell us that it is easier to justify requests for more compliance resources after an SEC exam. They acknowledge it can be hard to get some firms to spend money on compliance.”
One of the SEC’s goals in supervising the private equity industry is to see that compliance officers have a direct line to the firm’s key decision-makers, says Jarcho, who adds that compliance officers should be persistent to key decision-makers that “good compliance is good business.”
In fact, a CCO without enough confidence to stand up to the firm’s top brass will doom the organization’s compliance function, Igor Rozenblit, a private equity specialist in the SEC’s Asset Management Unit’s Division of Enforcement, told PE Manager.
“Often CCOs could be doing more to dig into their own business. It is something I imagine is uncomfortable for the partners, but it’s a tough job being a CCO, it’s not an easy one.”
SEC officials further recommend the compliance team puts itself in the shoes of regulators when conducting a gap analysis, often stressing their mission is to detect even the smallest of compliance missteps.
“Investors do not want someone who ignores minor violations, and waits for the big one that brings media attention,” said the SEC’s White. “Instead, they want someone who understands that even the smallest infractions have victims, and that the smallest infractions are very often just the first step toward bigger ones down the road.”
The renewed focus on minor violations is part of the SEC’s “broken window” policy. The idea is that seemingly trivial violations that are overlooked or ignored feed bigger ones. And, perhaps more importantly, they foster a culture “where laws are increasingly treated as toothless guidelines”, White said in a recent speech.
Looking back to chairman White’s message about the compliance officer rule, it is clear then that the SEC wants to provide CCOs with support and protection. But make no mistake about it; the agency is also sending the message that it is ready and willing to take action if they are not heard.