Section 203(e)(6) of the Investment Advisers Act of 1940 permits the SEC to bring an enforcement action against a registered investment adviser or an associated person who, among other things, has failed to supervise a person who commits a violation, if such person is subject to their supervision.
Notwithstanding the confusion recently created after the New York Court of Appeals upheld the right of a hedge fund manager to dismiss a Chief Compliance Officer (“CCO”) who reported alleged violations of the securities laws (See our Communiqué from last week), a “failure to supervise” enforcement action is serious and, depending on the circumstances, can be brought against senior members of a firm including the CCO. Fortunately, Section 203(e)-6 also provides a “safe harbor” that will help guard against SEC actions for failure to supervise.
Section 203(e)-6 in part reads:
“…no person shall be deemed to have failed reasonably to supervise any person, if–
- there have been established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, insofar as practicable, any such violation by such other person, and
- such person has reasonably discharged the duties and obligations incumbent upon him by reason of such procedures and system without reasonable cause to believe that such procedures and system were not being complied with.”
Subparagraph A simply means that you have adequate policies and procedures and is the easier part of the safe harbor to satisfy. Satisfying subparagraph B is more difficult. In order to adequately demonstrate that you “reasonably discharged” your duty to supervise and put these procedures into practice, you need to establish compliance workflow routines and related documentation. Timely testing related to areas where supervision is expected (among them, personal trading, portfolio management, and review of electronic mail) should be part of these workflow routines. It is also important to document compliance procedures and supervision. No two compliance programs are exactly alike; accordingly, the documentation and testing related to supervision should be unique to each firm.
Having a great compliance manual encompassing written policies and procedures that are customized to adequately address your unique business model, risks and conflicts of interest is thus nothing more than a good start. If you cannot demonstrate that your firm has followed its compliance policies and procedures, you are failing. SEC examiners will expect firms to be able to demonstrate and provide documentation evidencing how their compliance program functions on a daily basis and how the various compliance issues are addressed including how the program is monitored (i.e. supervised).
The best advice we can offer CCOs, who are clearly “supervisors” and who want to avoid an action for failure to supervise, is to be proactive. If your firm is newly registered, don’t put your compliance program on hold (See our recent Communiqué regarding the SEC’s intentions to potentially start the examination of newly-registered private fund advisers this fall). In addition, make sure you have adequate resources to satisfy your responsibility which may require discussions with senior management.