SEC Orders IA to Retain an Independent Consultant to Remediate Allocation Policy Violations

Updated: Aug 7, 2020

August 6th | 2020

The SEC recently disciplined an investment adviser for violations of two provision of the Advisers Act:

  1. Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction, practice, or course of business that operates as a fraud or deceit upon any client or prospective client; and

  2. Section 206(4) et seq., which require registered investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules promulgated thereunder.

The adviser in this case executed trades in its master account for two different types of clients and their corresponding strategies: day trade strategy for day trading clients; and a buy-and-hold strategy for buy and hold clients, which were the vast majority of the Firm’s clientele. The primary violations in this case stem from the fact that the adviser sometimes allocated profitable day trades in a manner that was unfair to buy and hold clients and inconsistent with the firm’s disclosures and internal policies. The Firm reasoned that buy and hold clients were not disadvantaged because they earned higher annual returns than the day trading clients. The SEC found this unpersuasive because it failed to consider the returns on other time periods, namely first day returns; failed to consider that the buy and hold client effectively bore all the risk; and the practice was inconsistent with the statements made on the adviser’s Form ADV.

In this case, the SEC focused on the compliance deficiencies related to the Firm’s allocation procedures. The Firm apparently had basic policies and procedures, but those policies and procedures did not explain how allocations would be made in a manner consistent with the firm’s disclosures. Consequently, the SEC ordered the Firm to retain an Independent Consultant to conduct a comprehensive compliance review and assist the Firm in developing and implementing written compliance policies and procedures “reasonably designed to promote [the Firm’s] compliance with the Advisers Act with respect to trade allocation, monitoring, and recordkeeping.”

The Firm’s Independent Consultant is required to submit a report to the SEC in six months detailing (1) the Independent Consultant’s review, findings, conclusions, and recommendations; (2) any proposals made by the Firm; and (3) a procedure for the Firm to adopt and implement the recommended changes in or improvements to its policies and procedures.

This case is an example where the SEC’s undertakings may have been more important and impactful than a big monetary fine. Allocations are a favorite area of examination, so the Firm may be well served by retaining the Independent Consultant beyond term required by the SEC’s undertaking.

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