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SURVIVING AN SEC INSPECTION

Prepared by Richard D. Marshall, Esq.

Kirkpatrick & Lockhart LLP

New York, NY

OVERVIEW OF SEC INSPECTIONS

Road Map of an SEC Inspection

The SEC’s Power to Conduct Inspections

The SEC’s ability to conduct inspections arises from the intersection of two separate powers: (1) the power to require registrants to create and to keep certain records relating to their business and (2) the power to conduct searches (or inspections) of those records without obtaining a search warrant.

With respect to the record-keeping requirements, the Investment Company Act of 1940, as amended (“Investment Company Act”), and the Investment Advisers Act of 1940, as amended (“Advisers Act”), authorize the SEC to require registered investment companies and advisers to maintain certain records and to make those records available to the SEC for inspection.1 The SEC has specified numerous documents that investment companies2 and advisers3 are required to keep and to make available to the SEC staff.

With respect to warrantless searches, the Supreme Court generally has permitted an agency to exercise broad inspection powers over an industry that historically has been subject to pervasive regulation, provided that the inspection powers are appropriately defined and are necessary to protect the public.4 It would appear that investment companies and advisers are thus subject to the SEC’s sweeping inspection powers.5 Thus, the SEC can bring an enforcement action immediately to prevent a registered adviser from obstructing its inspection powers.6

Who Conducts the Inspection

SEC inspections are, for the most part, conducted by the personnel in the SEC's regional offices. A few personnel in Washington also conduct or assist with inspections. Most SEC inspectors are not attorneys or accountants; they have general training or experience in the securities industry. (SEC personnel who conduct investigations, on the other hand, are usually attorneys.)

How the SEC Targets Advisers for Inspection

Before the SEC inspection staff ever contacts a registrant, they generally gather background information about it. This includes a review of information in the registrant's filings with the SEC (such as the adviser's Form ADV and registration statements for investment companies), prior enforcement proceedings against the registrant and its personnel, press reports about the registrant, prior inspections reports on the registrant, and information obtained from complainants, informants, or other regulators.

SEC inspections are either "routine" or "for cause." Cause inspections occur because the SEC is concerned that violations of law may be occurring or because it seeks to gather information about an industry practice. Routine inspections are conducted as part of a regular inspection cycle whose mission is to inspect all registrants, or a designated category of registrants, on a regular basis. In general, routine inspections are less likely to lead to enforcement cases than for cause inspections because, in a routine inspection, the SEC staff begins the inspection without a special focus or concern.

“Smart Examinations”

In recent years, the SEC has characterized its examinations as “smart.” According to the Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), smart examinations have two characteristics. First, their “goal is to focus [the SEC’s] attention on the firms which need it the most – which [are] those firms presenting the most risk to investors.”7 Second, “the scope of an examination is highly variable, and largely depends on the examiner’s professional judgment of the adviser’s own internal controls.” 8

This focus on compliance procedures has several consequences in planning for an SEC inspection. First, it is more important than ever to plan ahead for the inspection by developing effective compliance procedures. Second, the SEC now routinely requests internal audit reports and reports of internal investigations. If an adviser wishes to protect these documents from disclosure to the SEC, it is important to structure the reports at the outset so that they can be protected by the attorney-client privilege. Third, the SEC now routinely reviews the adequacy of an adviser’s responses to previously detected compliance deficiencies. Accordingly, it is important for an adviser to review any detected problems carefully and to make an informed decision concerning the appropriate response. Senior SEC staff have also indicated that an enforcement action is less likely if the adviser reports serious compliance deficiencies to the SEC. While this recommendation is controversial, consideration should be given to reporting violations to the SEC in appropriate cases.

“Sweeps”

The SEC has disclosed several recent sweep inspections targeted to specific areas: soft dollars, performance advertising, fair value pricing, and mutual fund supermarkets. Other sweeps have received less public attention and have not been disclosed by the SEC. Sweep inspections are targeted to a particular subject and generally involve the commitment of significant resources by the SEC. Often, these inspections are closely coordinated so that, for example, both soft dollar brokers and advisers are examined simultaneously. Frequently, sweep examinations are conducted in cooperation with the Division of Enforcement, making an enforcement referral more likely.

When an adviser is the subject of a sweep examination, the inspection should be treated as a serious matter, with a high likelihood of an enforcement referral if problems are detected. Accordingly, extra care should be devoted to controlling the inspection process and to effective advocacy of the adviser’s case to the inspection staff.

How the SEC Conducts Inspections

An SEC inspection can begin either with a surprise visit or telephone call from the SEC staff or a letter requesting that certain documents be ready for inspection on a particular date. The SEC is not required to give a registrant advance notice of an inspection, although it frequently does so.

In the event the staff gives advance notice it generally identifies a date known as the inspection date. This is a date that has been selected, frequently at random by the SEC staff, as the date when a broad array of records will be reviewed. The SEC's inspection will report primarily on the activities of the firm on the inspection date.

The inspection is conducted at the registrant's offices and the SEC staff's offices. At the registrant, the SEC reviews the records requested and typically questions the registrant's personnel about them. The SEC continues its inspection in its offices, reviewing the information it gathered during its on-site visit to the registrant. Sometimes, weeks and even months can pass before the SEC finishes the inspection. Frequently, the SEC will ask the registrant for additional information many weeks after it has left the registrant's offices.

The specific steps the SEC takes to conduct an inspection are set forth in its Examination Manuals, which are publicly available through a request under the Freedom of Information Act ("FOIA") and have been widely reprinted.9 These manuals are over ten years old, however, and do not necessarily reflect current SEC inspection techniques. In general, SEC inspections use sampling techniques similar to those employed by accountants. An inspection tests for compliance with the federal securities laws.

Possible Outcomes of an Inspection

Most SEC inspections do not result in enforcement actions. In recent years, inspections of investment advisers and investment companies have had the following dispositions:10

Investment Advisers

Investment Companies

Deficiency Letter 85% 82%

Enforcement Referral 5% 5%

No Action 6% 12%

Other 4% 1%

There are several possible outcomes of an SEC inspection. These are, in increasing order of seriousness: (1) no further action; (2) an oral notice of deficiencies; (3) a deficiency letter; (4) an office reprimand from the SEC staff; or (5) a referral to the SEC enforcement staff.

Sometimes, the SEC staff will comment on supposed violations of law during the inspection. While it is important to respond to these comments, they may not reflect the views of the senior staff who are supervising the inspection. It is not uncommon for junior SEC staff members to conclude during their field work that violations of law have occurred, only to have their supervisors reverse these determinations. The converse is also true. Sometimes, junior SEC staff members will leave a registrant believing that no violations were detected, only to have their supervisors determine that violations are indeed present.

If minor violations are detected after the inspection is completed, senior SEC staff may discuss these violations orally with the registrant and ask that they be corrected. Normally, if the registrant agrees orally to correct these minor problems, no further action by the SEC results.

If more serious violations are detected, the SEC typically sends what is called a deficiency letter to the registrant. This letter sets forth the violations the SEC inspection staff found during the inspection and requests that the registrant take action to correct the problems and to confirm to the SEC in writing that corrective action has been taken. A deficiency letter is usually sent if the SEC staff has determined not to refer the matter to its enforcement attorneys. In some instances, however, the SEC staff may send a deficiency letter and refer a matter to its enforcement attorneys. The SEC saves all deficiency letters and the responses to them and reviews these letters before its next inspection of the registrant. A registrant is not required to acquiesce in every conclusion in the SEC's deficiency letter. Frequently, registrants engage in lengthy debate with the SEC staff about the supposed violations and an appropriate response.

Occasionally, the SEC will conclude that deficiencies are serious, but not quite serious enough to warrant referral to the SEC's enforcement attorneys. In this case, the SEC staff may ask the registrant to visit the SEC's offices where the SEC will emphasize that it found serious violations and is concerned about the registrant's operations. Such meetings are almost always coupled with a deficiency letter.

Finally, if serious violations are uncovered during the inspection, the inspection staff may refer the matter to the SEC's enforcement attorneys. It is important to understand that SEC inspectors are not trained to conduct SEC investigations and do not do so. SEC investigations are conducted by separate groups of attorneys. Once an inspection has led to an enforcement referral, the registrant will typically be contacted by the SEC enforcement staff. At this stage, the rules discussed herein for surviving an SEC inspection do not apply.

A Registrant's Rights During an Inspection

Many of the rights citizens normally enjoy in their dealings with the government are unavailable during an SEC inspection. For example, the SEC does not need a search warrant to enter a registrant's offices and inspect required records.11 An individual or sole proprietorship that is registered as an adviser cannot refuse to produce required records based on the Fifth Amendment privilege against self-incrimination.12 In addition, there is probably no right to be represented by counsel during an SEC inspection.13 Finally, the self-evaluative privilege, which protects from disclosure certain information reflecting a critical self-evaluation of problems within a firm, is probably unavailable.14

There are several rights, however, that registrants can assert during an SEC inspection. First, the Privacy Act of 197415 requires the SEC staff, before it requests information from an individual, to notify the individual of: (1) the authority for requesting the information and whether providing the information is mandatory or voluntary; (2) the purpose for gathering the information; (3) the routine uses to be made of the information; and (4) the effects, if any, of failing to produce the requested information.16

There are two important consequences of the Privacy Act for registrants. First, that Act prevents the SEC from conducting undercover or sting operations. Anytime the SEC staff requests information from a registrant, it must identify itself and explain its authority for requesting the information.

Second, the SEC must tell a registrant whether it is gathering information pursuant to its inspection powers or its law enforcement powers. If a law enforcement inquiry is underway, the Privacy Act notice can alert a registrant to this fact so that it can take appropriate steps to protect itself.

Second, the SEC staff cannot mislead a registrant during an inspection. In a leading case where the SEC staff gathered information by pretending to be seeking a general, educational background in industry practices, when in fact an investigation was underway, a Court of Appeals refused to enforce an SEC subpoena prepared based on information gathered during these visits.17 This case suggests that the SEC may later be prevented from prosecuting a registrant if it operates under false pretenses to deceive that registrant during an inspection.

Strategies for Surviving an SEC Inspection

A few simple rules can help a registrant survive an SEC inspection.

Plan Ahead

Once the SEC begins an inspection, there is little a registrant can do to prevent the SEC from uncovering violative conduct. Advance planning is the key to surviving an inspection. Particularly valuable is a good compliance program and regular compliance reviews or audits.

First, establish an effective compliance system. The SEC is more likely to institute an enforcement action if it detects violative conduct during an inspection that the registrant failed to correct. Correspondingly, an enforcement action is less likely if the registrant detected and corrected the problem on its own before the SEC arrived.18 The elements of an effective compliance system are discussed below.

Second, observe the record-keeping requirements. Because SEC inspection resources are scarce, inspectors often must rely on a first impression of a registrant based on the appearance of its records to determine whether an intensive inspection of that registrant is warranted. If minor violations of the record-keeping rules are immediate-ly evident or the registrant's records appear to be in disarray, the SEC staff will form an impression that the registrant's business is disorderly. This will usually cause the SEC staff to prolong the inspection and to look more carefully at every area inspected. To the contrary, neat and orderly records can give the SEC staff an immediate sense that the registrant has control of its operations.

Control the Process

Given the possible serious consequences of an SEC inspection, the SEC staff should not be allowed to wander around a registrant's offices with no controls over their access to information. It is entirely appropriate to designate a contact person to control the inspection. All requests for information from the SEC staff should be directed to this contact person. This person will be responsible for gathering the requested information and submitting it to the SEC. The contact person should review all documents before they are produced to the SEC to ensure that irrelevant or privileged documents are not inadvertently produced. In addition, the contact person should keep a record of all requests by the SEC and of the documents that are produced in response to those requests so that it will be possible to reconstruct the information that was made available to the SEC. In addition, when the SEC requests to interview the registrant's employees, the contact person should arrange these interviews and seek to determine the scope of the proposed interviews. Every person who is interviewed should be prepared as if they were testifying in an SEC investigation. The contact person should be present during the interviews to protect the witnesses' rights, to prevent the disclosure of irrelevant or privileged information, and to take notes so that the registrant will have a record of the substance of the interviews.

Advocate Your Case

As noted above, SEC inspectors are not trained to conduct investigations or to prosecute enforcement actions and do not do so. Separate enforcement groups within the SEC perform these functions. A prime goal once the inspection begins should be to advocate the registrant's case to the inspection staff in order to persuade them not to refer the matter to the Division of Enforcement. This can be accomplished in several ways.

First, argue your case to the inspection staff. If the inspection staff indicates during the inspection that violations have been detected, the registrant should promptly explain either why the questioned practices are legal or why they are inadvertent and isolated. Once a registrant receives a deficiency letter, it should promptly contact the inspection staff, either to defend the legality of questioned practices or to emphasize that any violations are unintentional. Effective advocacy to the SEC inspection staff, if done quickly, can forestall a referral to the SEC's enforcement attorneys.

Second, never refuse to produce records that are subject to the SEC's inspection powers. Such conduct frequently leads the inspection staff to refer the matter to the SEC's enforcement attorneys. On occasion, the SEC has brought an enforcement action against a registrant for refusing to produce, or unreasonably delaying the production of, records that are subject to its inspection powers.

Third, cooperate with the SEC. During an inspection, a registrant is only required to produce the records that are described in the SEC's rules as subject to its inspection powers. A registrant is not required to talk to the inspection staff or to answer any of their questions. In most cases, however, it is exceedingly foolish to limit the SEC inspectors to the required records. If the inspection staff believes that other records must be reviewed, or that personnel of the registrant must be questioned about certain records, they can simply refer the matter to the SEC's enforcement attorneys, who, in appropriate cases, can subpoena the information sought. Refusing to produce records or to answer questions may only serve to engender suspicion and transform an inspection into an enforcement matter.

In certain circumstances, however, it is entirely appropriate, and even essential, to refuse to provide information requested by the inspection staff. For example, a registrant should preserve all applicable privileges, including the attorney-client privilege. In addition, certain highly sensitive personal information does not belong in a government file that could be obtained, through a Freedom of Information Act request, by the press or competitors. When the inspection staff requests information that should appropriately be withheld, it is wise to request a meeting with the senior inspection staff to explain why the requested information should not be produced.

Finally, don't fight over details. A registrant that flatly refuses to make minor changes in response to a deficiency letter may find itself under investigation by the SEC's enforcement attorneys.

End the Inspection Quickly

Because of the complexity of the Investment Company Act and the Advisers Act, if the inspection staff continues an inspection long enough, it is likely to find some violations by the registrant. As a general rule, the longer the inspection staff stays at a registrant, the more violations they are likely to find. Because of this, a registrant should take every step to conclude the inspection as quickly as possible. This can be done in several ways.

First, produce requested information quickly. The longer the SEC staff waits at a registrant for requested information, the more opportunity they have to observe irregularities in the information they have already received or to think of new areas of possible inquiry. Correspondingly, quick and complete production of requested information gets the SEC staff out of the registrant's office, and on to another inspection, more quickly.

Second, give the SEC staff proper facilities. Many registrants crowd SEC inspectors into small rooms without electrical outlets or telephones and refuse to copy requested records. These techniques only make it more difficult for the SEC staff to conclude their work and thereby prolong the inspection. They also unnecessarily annoy the SEC staff.

Finally, pre-review of requested records must be quick. Many registrants require that counsel review any information before it is submitted to the SEC staff. This procedure is entirely appropriate, but must be performed expeditiously so that the inspection is not delayed.

Do Not Lie To The SEC

A provision of the federal criminal code broadly prohibits false statements to the SEC staff and other federal officers.19 This provision applies to oral statements as well as written representations,20 and also applies to unsworn oral statements.21 In the Second Circuit, the elements of a violation of this criminal provision are the following:

the defendant (1) knowingly and willfully (2) made a statement (3) in relation to a matter within the jurisdiction of a department or agency of the United States, (4) with knowledge that it was false or fictitious and fraudulent.22

In other circuits, materiality is an essential element of a violation of this criminal provision.23 Courts have interpreted the jurisdictional requirement broadly, holding that "[a]n agency has jurisdiction within the meaning of the statute when it has authority to act upon the information."24

Based on these precedents, it would appear that a registrant's personnel can be criminally prosecuted for making false statements or providing false documents to SEC inspectors. To guard against this possibility, the following precautions should be observed.

First, to repeat, be scrupulously honest with the SEC. A serious regulatory problem will only become more serious if personnel of the registrant lie to the SEC.

Second, as noted above, keep a record of information provided to the SEC. Sometimes, misunderstandings arise between the SEC staff and a registrant over what the SEC was told during an inspection. It is important for the registrant to keep a record of all information, including any oral statements to the SEC staff, so that the registrant can credibly rebut any claims that it misled the SEC staff. Such record-keeping is facilitated by designating one contact person at the registrant to review and to respond to all requests from the SEC staff.

Third, keep promises made to the SEC. Registrants frequently promise to take corrective action in response to deficiency letters and then fail to take the promised action. As noted above, the SEC saves all responses to deficiency letters and reviews these responses before it conducts an inspection. If a registrant failed to take the corrective action it promised to take, this can lead to an impression that the registrant is uninterested in compliance and is intentionally violating the law.

The SEC recently has taken enforcement action against investment advisers and their principals who failed to correct the same deficiencies uncovered by the Commission’s examination staff in consecutive examinations, even in the absence of identifiable harm to clients. These actions include:

In the Matter of Gofen and Glossberg, Inc., Advisers Act Rel. No. 1400 (Jan. 11, 1994) (custody violations);

In the Matter of Howard M. Borris & Co., Inc., et al., Advisers Act Rel. No. 1460 (Jan. 9, 1995) (books and records, custody and reporting violations);

In the Matter of Louis E. Sharp, Exchange Act Rel. No. 35215 (Jan. 11, 1995) (books and records, reporting and cash solicitation rule violations); and

In the Matter of Stephen C. Schulmerich, et al., Advisers Act Rel. No. 1358 (Jan. 4, 1995) (books and records and reporting violations).

Preserve Confidentiality

Information that is produced to the SEC frequently contains extremely sensitive business information such as client names, investment strategies, or salaries of key employees. Once this information is placed in the SEC's files, it is subject to disclosure to numerous sources, including production to the registrant's competitors or the press, pursuant to the FOIA. In spite of this, registrants frequently neglect to take steps to protect the confidentiality of highly sensitive information provided to the SEC, although procedures exist for doing so.

First, request confidential treatment under the FOIA. An SEC release25 sets forth procedures for requesting confidential treatment of information provided to the SEC. In general, these procedures help to ensure that the person who submits the documents has an opportunity to oppose a FOIA request for the documents. These procedures should be followed with respect to documents submitted to the SEC during an inspection.

Second, request in writing the return of documents. The SEC retains certain documents produced during the inspection. However, the SEC frequently does not need to retain all information obtained during the inspection because much of this information is not needed to document their findings. Thus, the SEC may be willing to return some documents. This is beneficial because documents that are no longer in the SEC's possession cannot be produced by the SEC to third parties.

THE NEED FOR A COMPLIANCE PROGRAM

Statutory Obligation to Supervise

Section 203(e)(6) of the Advisers Act permits the SEC to sanction an adviser, or an associated person of an adviser, if the person “has failed reasonably to supervise, with a view to preventing violations of the provisions of such statutes, rules, and regulations, another person who commits such a violation, if such person is subject to his supervision. For purposes of this paragraph, no person shall be deemed to have failed reasonably to supervise another person if (1) 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 (2) 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.” An adviser’s duty to supervise is “comparable to the duty to supervise imposed on broker-dealers.” 26

This statutory obligation to supervise is different from theories of secondary liability based on a person’s participation in culpable conduct. For example, a person or firm can be held liable for causing or aiding and abetting another’s violations if the person or firm substantially assisted the primary violator and acted with the requisite scienter. Liability for failure to supervise is not predicated on this type of direct involvement in another’s wrongs.

Control Person Liability and Liability in SEC Actions

The Securities Act of 193327, the Securities Exchange Act of 1934, as amended (“Exchange Act”)28, and the Investment Company Act29 all impose liability on a person who controls another person. However, this liability is subject to a good faith defense, which can be established by showing that an adequate compliance system is in place. As one court observed, “[t]he controlling inquiry is whether or not sufficient precautionary measures were taken to prevent the type of loss which in fact occurred.”30 A firm can satisfy the good faith defense to control person liability by establishing an adequate system of supervision of its employees.31

In addition, an effective compliance program can protect the firm from liability in an SEC proceeding. Since the SEC frequently must prove scienter to obtain injunctive relief against the firm,32 an adequate program of supervision can be asserted as a defense in an SEC injunctive action. Thus, if the firm has implemented procedures to prevent violative conduct by its employees, the firm may not be held liable for such conduct.33 However, if any employee was not adequately supervised, the firm can be sanctioned in an action brought by the SEC.34

Special Statutory Obligations to Supervise

The 1988 Insider Trading Act expressly requires investment advisers to "establish, maintain and enforce written policies and procedures reasonably designed, taking into consideration the nature of such [firm's] business, to prevent the misuse . . . of material, nonpublic information by [the firm] or any person associated with it." A firm must "vigilantly review, update and enforce" such procedures35 or it may be subject to liability in an action brought by the SEC. It is a violation of the Act to fail to adopt written procedures and to enforce them, even if the firm's employees do not engage in insider trading.36 The procedures required by the Act apply to any misuse of material nonpublic information. The Act is "intended to be broad enough to include market abuses such as . . . 'scalping' by investment advisers and 'frontrunning' by broker-dealers." 37

In addition, the 1988 Insider Trading Act permits the SEC to bring an action against any "person who, at the time of the violation, directly or indirectly controlled the person who committed" the insider trading violation.38 The SEC can recover the greater of $1 million or three times the profit gained or loss avoided as a result of the controlled person's violation.39 “Controlling person may include not only employers, but any person with power to influence or control the direction or the management, policies, or activities of another person.”40 In such an action, the SEC must prove, for persons other than broker-dealers and investment advisers, that the controlling person recklessly41 disregarded the fact that the controlled person was "likely to engage" in insider trading and failed to take "appropriate steps" to prevent the violation. With respect to investment advisers, the SEC need only establish that the firm failed to establish, maintain and enforce written policies and procedures "reasonably designed" to prevent the misuse of material nonpublic information and that this failure "substantially contributed to or permitted" the insider trading.42

In addition, Rule 17j-1 under the Investment Company Act requires an investment company to establish procedures to regulate personal trading by persons with access to information about the investment company’s trading.

Directors’ Duty of Care

In 1996, the Delaware Chancery Court stated that a directors’ duty of care requires that the directors establish appropriate compliance systems within the firm.43 Prior to this decision, it had generally been recognized that “absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.”44 In reversing this view, the Chancery Court stated that:

“it is important that the board exercise a good faith judgment that the corporation’s information and reporting system is in concept and design adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations, so that it may satisfy its responsibilities. . . . a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under the some circumstances may, in theory at least, render a director liable for losses caused by noncompliance with applicable legal standards.”45

The SEC has recently imposed a similar duty upon directors to create an appropriate compliance system to ensure that SEC disclosure documents are properly prepared. For example, where a public company filed a misleading proxy statement, the SEC criticized the conduct of the directors because they had failed to establish an appropriate compliance system for preparing public filings:

“An officer or director can rely upon the company’s procedures for determining what disclosure is required only if he or she has a reasonable basis for believing that those procedures have resulted in full consideration of those issues. . . . Procedures or mechanisms established to identify and address disclosure issues are effective only if individuals in positions to affect the disclosure process are vigilant in exercising their responsibilities.”46

Federal Sentencing Guidelines

Chapter 8 of the United States Sentencing Guidelines (“Guidelines”) sets forth the guidelines for imposing criminal penalties on organizations. Under the Guidelines, the penalties imposed on an organization can be reduced if the organization adopted an “effective program to prevent and detect violations of law.” 47

Business Considerations

The good reputation of an adviser is essential to its success. In an advisory relationship, the client entrusts its money to the adviser. Such trust presupposes that the client views the adviser as competent and ethical. Compliance violations can undermine the view of the client, or potential client, that the adviser is competent and trustworthy. Such an erosion of an adviser’s reputation can easily damage its business.

ELEMENTS OF A SUCCESSFUL COMPLIANCE PROGRAM

Federal Sentencing Guidelines

Under the Guidelines, an effective compliance program “means a program that has been reasonably designed, implemented, and enforced so that it generally will be effective in preventing and detecting criminal conduct. . . . The hallmark of an effective program to prevent and detect violations of law is that the organization exercised due diligence in seeking to prevent and detect criminal conduct by its employees and other agents.”48 According to the Guidelines, seven elements evidence an effective compliance program:

The organization must have established compliance standards and procedures to be followed by its employees and other agents that are reasonably capable of reducing the prospects of criminal conduct.

Specific individual(s) within high-level personnel of the organization must have been assigned overall responsibility to oversee compliance with such standards and procedures.

The organization must have used due care not to delegate substantial discretionary authority to individuals whom the organization knew, or should have known through the exercise of due diligence, had a propensity to engage in illegal activities.

The organization must have taken steps to communicate effectively its standards and procedures to all employees and other agents, i.e., by requiring participation in training programs or by disseminating publications that explain in a practical manner what is required.

The organization must have taken steps to achieve compliance with its standards, i.e., by utilizing monitoring and auditing systems reasonably designed to detect criminal conduct by its employees and other agents and by having in place and publicizing a reporting system whereby employees and other agents could report criminal conduct by others within the organization without fear of retribution.

The standards must have been consistently enforced through appropriate disciplinary mechanisms, including as appropriate, discipline of individuals responsible for the failure to detect an offense. Adequate discipline of individuals responsible for an offense is a necessary component of enforcement; however, the form of discipline that will be appropriate will be case specific.

After an offense has been detected, the organization must have taken all reasonable steps to respond appropriately to the offense and to prevent further similar offenses – including any necessary modifications to its program to prevent and detect violations of law. 49

SEC Guidance

In conducting smart examinations, OCIE’s Director has indicated that the following questions will be asked: 50

“Is a system of compliance procedures in place and operating?”

“Is the compliance system working as designed?”

“Are exceptions and problems identified and resolved promptly?”

“Are your procedures in writing and made available to all appropriate personnel?”

“Are compliance officers and staff trained in implementing the procedures?”

“Are remedial actions fully documented?”

Elements of a Successful Compliance Program

A number of elements of an effective compliance program can be distilled from the above guidance.

Hire good people and train them. Competent, well intentioned, and well trained employees are likely to seek to adhere to firm procedures. Thus, it is important to screen employees before they are hired to detect persons with a propensity for engaging in improper activities.

In addition, employees cannot be expected to adhere to firm procedures and legal requirements unless they are aware of those requirements. Thus, employees should be trained in compliance issues when they are hired. A program of continuing education is also necessary to alert employees to changes in firm procedures or regulatory requirements and to remind them of key compliance issues.

Establish written compliance procedures. Although an adviser is not required to establish written compliance procedures, except with respect to insider trading and personal trading in connection with investment companies, comprehensive written procedures enhance the control environment and remove the possibility of confusion concerning the proper procedures to be followed.

Clearly assign compliance responsibilities to people with the power to discharge those responsibilities. The law requires that each employee of an adviser be supervised. Thus, it is important for each employee to be assigned a supervisor, and for that supervisor to have the authority to exercise his or her supervisory obligations. Sometimes, it may be difficult to determine whether one person supervises another. As the SEC has acknowledged, [“[e]mployees of brokerage firms who have legal or compliance responsibilities do not become ‘supervisors’ . . . solely because they occupy those positions. Rather, determining if a particular person is a ‘supervisor’ depends on whether, under the facts and circumstances of a particular case, that person has a requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.”51 The hallmark of a supervisory relationship is “the power to hire, fire, reward and punish.” 52

Test for violations. Three testing procedures are recommended. First, an appropriate system of exception reporting should be developed. Such a system provides an independent verification that existing compliance procedures are being followed. Given the complexity of advisory regulations, a system for detecting the inevitable violations of these regulations is essential. Second, a mechanism should be created to permit employees to report possible violations without being subject to punishment.53 Third, employees should be required periodically to certify that they are in compliance with relevant firm procedures and are unaware of violations of those procedures by others. Although employee certifications alone cannot constitute an appropriate system of compliance, it is relatively easy and prudent periodically to ask employees whether violations of law are present.

Respond to red flags and learn from mistakes. Many of the most serious failure to supervise cases involve situations in which warnings of possible violative conduct are not properly investigated. The SEC has made clear that such warnings must be diligently investigated:

Even where the knowledge of supervisors is limited to “red flags” or “suggestions” of irregularity, they cannot discharge their supervisory obligations simply by relying on the unverified representations of employees. Instead, . . . “[t]here must be adequate follow-up and review when a firm’s own procedures detect irregularities or unusual trading activity.” . . . Moreover, if more than one supervisor is involved in considering the actions to be taken in response to possible misconduct, there must be a clear assignment of those responsibilities to specific individuals within the firm. 54

Thus, whenever warnings of possible violative conduct are present, supervisors must conduct an appropriate investigation.55

It is also important to respond to past violations appropriately. This means that the individuals responsible for violations should be punished and the firm should review its compliance procedures to determine whether changes to those procedures could prevent a recurrence of the violation.

CONCLUSION OF THE INSPECTION

Prior to the creation of OCIE, there was no set procedure for providing notice when an inspection was completed. In some cases, many months would elapse after the field work was completed before a registration received a deficiency letter. There was no predictable period after the inspection was completed when the deficiency letter could be expected. In addition, if the inspection did not uncover any violations of law, the SEC staff usually would provide no notice whatsoever to the registrant.

These practices have been changed. All inspections should now be completed within ninety days of the completion of the field work, which is the last day the registrant sees the SEC staff in its offices. In addition, when no violations are detected during the inspection, the SEC staff will now send a letter advising the registrant of this fact.

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PROFESSIONAL BACKGROUND

Richard D. Marshall became a member of the firm of Kirkpatick & Lockhart LLP in its New York office on December 1, 1994. Previously, Mr. Marshall had been Senior Associate Regional Administrator in the New York office of the Securities and Exchange Commission. In that position, Mr. Marshall supervised a staff of seventy that conducted inspections of investment companies and advisers in the New York region and pursued enforcement matters related to those entities. Mr. Marshall has also been a branch chief in the Division of Enforcement of the Securities and Exchange Commission in Washington, D.C.

Since entering private practice, Mr. Marshall has conducted compliance reviews of investment companies, investment advisers, and broker-dealers; represented individuals and regulated entities in investigations by the Securities and Exchange Commission and self-regulatory organizations; created hedge funds; and provided advice and sought no-action relief for investment companies, investment advisers, and broker-dealers.

Mr. Marshall speaks and writes regularly on topics related to the federal securities laws and is an editor of The Investment Lawyer, a legal publication devoted to issues related to money management.

Mr. Marshall is a graduate of Yale University (B.A., 1975), the University of Toronto (M.A. 1977), and the University of Chicago (J.D. 1980). He is admitted to the Bars of New York and the District of Columbia.

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1See Section 204 of the Advisers Act and Section 31(a) of the Investment Company Act.

2Rules 31a-1, 2, and 3 under the Investment Company Act.

3Rule 204-2 under the Advisers Act.

4In United States v. Biswell, 406 U.S. 311 (1972), the Supreme Court upheld a statute authorizing surprise inspections of firearm dealers because (1) the sale of firearms had historically been regulated and such regulation required periodic inspections of the dealers; (2) a requirement that a search warrant be obtained prior to any inspection would impede the regulatory system because it would impair the “necessary flexibility as to time, scope, and frequency” of inspections; (3) “[w]hen a dealer chooses to engage in this pervasively regulated business and to accept a federal license, he does so with the knowledge that his business records . . . will be subject to effective inspection”; and (4) “where, as here, regulatory inspections further urgent federal interest and the possibilities of abuse and the threat to privacy are not of impressive dimensions, the inspection may proceed without a warrant where specifically authorized by statute.” In contrast, in Marshall v. Barlow’s, Inc., 436 U.S. 307 (1978), the Supreme Court held that OSHA could not inspect a workplace without obtaining a search warrant.

5See SEC v. Olsen, 354 F.2d 166, 170 (2d Cir. 1965)(registered investment adviser subject to SEC’s inspections powers: advisory “‘records assume the characteristic of quasi-public documents and their disclosure may be compelled without violating the Fourth Amendment.’”).

6See SEC v. Hammon Capital Management Corp., Lit. Rel. 8580 (D. Colo. Oct. 17, 1978)(five days after a registrant blocked access to its records, a district court entered an injunction ordering the registrant to make its records available for inspection; the registrant was later suspended for ninety days for failing to make its records available for inspection, In re Hammon Capital Management Corp., 47 S.E.C. 426 (Jan. 8, 1981)).

7Lori Richards, “The SEC’s Examination Program for Investment Advisers: A More Targeted Approach,” Investment Lawyer at 5 (Sept. 1996).

8Id

9See Thomas P. Lemke and Gerald T. Lins, Regulation of Investment Advisers, App. W (1993)

10SEC Annual Reports.

11See New York v. Burger, 482 U.S. 691, 702-03 (1987); Donovan v. Dewey, 452 U.S. 594, 600 (1981); SEC v. Olsen, 354 F.2d 166, 170 (2d Cir. 1965).

12See SEC v. Olsen, supra at 168; Baltimore City Dept. of Social Services v. Bouknight, 493 U.S. 549, 556 (1990); Shapiro v. United States, 335 U.S. 1 (1948). Although the privilege against self-incrimination applies only to tes-timony, the courts have held that the act of producing records can be testimonial and therefore protected by the Fifth Amendment. See Braswell v. United States, 487 U.S. 99, 104 (1988) ("By producing the re-cords, respondent would admit that the records existed, were in his possession, and were authentic."). The privilege against self-incrimina-tion can only be asserted by an individual or sole proprietorship. United States v. Doe, 465 U.S. 605 (1984). For this reason, "a corporate custodian . . . may not resist a subpoena for corporate records on Fifth Amendment grounds." Braswell v. United States, supra, at 109.

13See SEC v. Alan F. Hughes, Inc., 481 F.2d 401 (2d Cir.), cert. denied, 414 U.S. 1092 (1973) (Sixth Amendment right to counsel only applies in criminal cases); Collins v. CFTC, 737 F. Supp. 1467 (N.D. Ill. 1990) (Sixth Amendment right to counsel does not apply in CFTC proceedings); Conception v. Secretary of Health, Educ. & Welfare, 337 F. Supp. 899 (D.P.R. 1971) (lack of assistance of counsel at administrative hearing does not deny procedural due process); United States v. McPhaul, 617 F. Supp. 58 (W.D.N.C. 1985) (under the Administrative Procedures Act, 5 U.S.C. §555(b), which provides right to have counsel present whenever a person is compelled to appear, respondents had right to counsel at production of documents pursuant to IRS summons, but not at any subsequent examination of documents), appeal dismissed without opinion, 786 F.2d 1158 (4th Cir. 1986); United States v. Steel, 238 F. Supp. 575, 577 (S.D.N.Y. 1965) (during an SEC investigation, "no constitutional rights of movant would have been violated if the Commission had declined to permit any assistance of counsel to her."); Burda v. National Ass'n of Postal Supervisors, 592 F. Supp. 273, 278 (D.D.C. 1984) (no constitutional right to counsel during an Office of Personnel Management audit of a health benefit plan), aff'd without op., 771 F.2d 1555 (D.C. Cir. 1985).

14See Joseph E. Murphy and Roselee M. Oyer, The Self-Evaluative Privilege and Beyond, INSIGHTS, March 1993, p. 11; FTC v. TRW, Inc., 628 F.2d 207, 210-11 (D.C. Cir. 1980); United States v. Noall, 587 F.2d 123 (2d Cir. 1978), cert. denied, 441 U.S. 923 (1979); United States v. Westinghouse Elec. Corp., 788 F.2d 164 (3d Cir. 1986).

155 U.S.C. §552a.

16This notice is typically provided by delivering a copy of the SEC's Forms 1661 or 1662 to the registrant.

17See SEC v ESM Government Sec., Inc., 645 F.2d 310 (5th Cir. 1981).

18See Richard D. Marshall, Compliance as a Defense for Investment Companies and Investment Advisers, Investment Company Institute (Oct. 20, 1989). Speech by Lori Richards before the National Regulatory Service Conference (Sept. 18, 1997)(“If you’ve identified and corrected the problem before the examination began, we will generally refrain from making an enforcement referral.”)

1918 U.S.C. §1001.

20See United States v. Mahler, 363 F.2d 673 (2d Cir. 1966)(false oral state-ments to the SEC).

21United States v. Clifford, 409 F. Supp. 1070 (E.D.N.Y. 1976) (unsworn oral misstatement to bank examiners).

22United States v. Bilzerian, 926 F.2d 1285, 1299 (2d Cir.), cert. denied, 112 S. Ct. 63 (1991).

23See United States v. McGough, 510 F.2d 598 (5th Cir. 1975); Unites States v. Oren, 893 F.2d 1057 (9th Cir. 1990).

24United States v. Bilzerian, supra, at 1300 (false statements in Schedules 13D and 14D-1 actionable under Section 1001). In a case where false statements were made to the SEC during an investigation that ultimately led to a deter-mination that the SEC lacked jurisdiction over the conduct under investigation, a court held that this criminal provision nonetheless applied. United States v. Di Fonzo, 603 F.2d 1260, 1266 (7th Cir. 1979), cert. denied, 444 U.S. 1018 (1980).

25 Confidential Treatment Procedures under the Freedom of Informa-tion Act, Securities Act Release No. 6241, reprinted in [1980 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,652 (Sept. 12, 1980).

26TBA Fin. Corp., SEC No-Action Letter, [1983-84 Transfer Binder] Fed. Sec. L. Rep. (CCH) 77,563 at 78,792 (Dec. 7, 1983).

27Section 15 of the Securities Act.

28Section 20(a) of the Exchange Act provides that “[e]very person who, directly or indirectly, controls any person liable under any provision of this title or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.”

29Section 48(a) of the Investment Company Act.

30Kravitz v. Pressman, Frohlich & Frost, Inc., 447 F. Supp. 203, 213 (D. Mass. 1978). See also Lorenz v. Watson, 258 F. Supp. 724, 732-33 (E.D. Pa. 1966)(“it is necessary for the defendants to show that some precautionary measures were taken to prevent the injury suffered,” because a contrary ruling “would substantially diminish the protection afforded by Section 20 of the Act, and would amount to an invitation to avoid the burden and responsibility of supervising the activities of one’s employees.”); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1573 (9th Cir. 1990)(en banc).

31An employer probably will be deemed to control its employees for purposes of this statutory liability. See Hollinger v. Titan Capital Corp., supra at 1574 (an employer “controls” its employees as a matter of law); Hunt v. Miller, 908 F.2d 1210, 1214-15 (4th Cir. 1990). But see Carpenter v. Harris, Upham & Co., 594 F.2d 388, 394 (4th Cir. )(control person liability not present where employee engaged in conduct that was prohibited by his employer).

32Aaron v. SEC, 446 U.S. 680 (1980). In a close case, an opinion from outside counsel can protect the firm from liability because scienter will not be present. See Hawes & Sherward, Reliance on Advice of Counsel as a Defense in Corporate and Securities Cases, 62 Va. L. Rev. 1 (1976).

33SEC v. Geon Industries, Inc., 531 F.2d 39 (2d Cir. 1976) (refusing to issue an injunction against a broker-dealer whose registered representative both traded and tipped others because the firm was not negligent in supervising the employee). Accord, Zweig v. Hearst Corp., supra (absolving a newspaper for the scalping activities of its employees because the firm had attempted to supervise the employees); O'Connor & Associates v. Dean Witter Reynolds, Inc., supra, at 1194 (firm not liable where employee traded on inside information because employee was "on a frolic of his own").

34Oppenheimer & Co., [1979 Transfer Binder] Fed. Sec. L. Rep. (CCH) 82,125 (July 5, 1979) (censuring a firm for failing to supervise an employee who traded on inside information in his own account).

35House Committee on Energy and Commerce Report No. 100-910, 100th Cong., 2d Sess. 21 (1988).

36Cong. Rec. House, H7469 (Sept. 13, 1988)(remarks of Cong. Dingell). In the Matter of Gabelli & Company, Inc. and GAMCO Investors, Inc., Advisers Act Rel. No. 1457 (Dec. 8, 1994). In this action, Mario Gabelli, the chief investment officer of the adviser, also served as the chairman of the board and chief executive officer of Lynch Corporation, a publicly traded company; he regularly received material, non-public information about Lynch. The adviser’s policies and procedures (1) generally prohibited insider trading, (2) required all employees to report to counsel when in possession of inside information, (3) included a restricted list, and (4) restricted trading in Lynch securities during the three days of, before and after board meetings and the issuance of press releases by Lynch. The Commission found that the adviser’s insider trading policies and procedures did not adequately take into account Gabelli’s multiple roles with the adviser and Lynch. Among other things, the Commission found that the policies and procedures relied too much on self-reporting by Gabelli and did not provide for “objective, third-party review to determine whether he possessed material, non-public information when he bought or sold Lynch securities.” As a result, the Commission found that the adviser had violated Section 204A of the Advisers Act.

37Cong. Rec. House, E3079 (Sept. 23, 1988)(remarks of Rep. Markey).

3815 U.S.C. §78u-1(a)(1)(B).

3915 U.S.C. §78u-1(a)(3).

40House Committee on Energy and Commerce Report No. 100-910, 100th Cong., 2d Sess. 17 (1988).

41Recklessness means "an objective standard of supervision" which requires proof of "a gross deviation from the standard of care that a responsible person would exercise in the situation" and "encompasses a heedless indifference as to whether circumstances suggesting employee violations actually exist." House Committee on Energy and Commerce Report No. 100-910, 100th Cong., 2d Sess. 18 (1988). The recklessness standard may fall "well below the standard of 'actual knowledge' of circumstances suggesting violation by the control[led] person." 134 Cong. Rec. E3079 (Sept. 23, 1988)(remarks of Rep. Markey).

4215 U.S.C. §78u-1(a)(3).

43In re Caremark International, Inc. Derivative Litigation, 1996 WL 549894 (Del. Ch. Sept. 25, 1996).

44Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del. 1963).

45Caremark, supra at *11.

46Report of Investigation In the Matter of W.R. Grace, Inc., Exchange Act Rel. 39,157 (Sept. 30, 1997), reprinted in [1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) 85,963 at 89,897 and n. 16. See also Report of Investigation In the Matter of the Cooper Companies, Inc. As It Relates to the Conduct of Cooper’s Board of Directors, Exchange Act Rel. 35,082 (Dec. 12, 1996), reprinted in [1994-95 Transfer Binder] Fed. Sec. L. Rep. (CCH) 85,472 at 86,065 (“The Commission considers it essential for board members to move aggressively to fulfill their responsibilities to oversee the conduct and performance of management and to ensure that the company’s public statements are candid and complete.”).

47Guidelines §8A1.2, Commentary 3(k).

48Id.

49Id.

50Speech by Lori Richards before the National Regulatory Service Conference (Sept. 18, 1997).

51In the Matter of Gutfreund, Exchange Act Rel. 31554 (Dec. 3, 1992), reprinted in [1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) 85,067 at 83,608-09.

52In the Matter of Huff, Admin. Pro. 3-6700 (March 28, 1991)(concurring opinion).

53Many state laws prohibit a firm from punishing “whistle-blowers.” For example, New York law prohibits an employer from punishing an employee for reporting either to the firm or to a regulator violations of law that present a danger to public health and safety. However, it is unlikely that any violations of the federal securities laws would qualify for this protection. N.Y. Jur. 2d §§502-07 (1996).

54Gutfreund, supra at 83,606.

55This process is complicated, however, by the difficulty of protecting the written product of such a review from disclosure to regulators or private litigants. See M. Goldsmith and C. King, Policing Corporate Crime: The Dilemma of Internal Compliance Programs, 50 Vand. L. Rev. 285 (1997).

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