In 2003, members of the Securities and Exchange Commission realized that when errant investment gurus break the law, they tend not to be forthright about it with compliance officers. As a result, the SEC sought to target not only non-compliant activity, but also efforts to cover it up.
As compliance professionals are quick to point out, they can be the first ones to take the heat when securities law violations are discovered. In some instances, Chief Compliance Officers (CCOs) have been sanctioned by the SEC for not properly supervising compliance procedures and policies. To beef up penalties against fraud while also protecting compliance professionals, in 2004 the SEC passed Rule 38a-1(c) of the Investment Company Act. With the adoption of Rule 38a-1(c), fund employees can be charged for lying to CCOs or otherwise obstructing their work, which reduces the CCO's liability.
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What is Rule 38a-1(c) of the Investment Company Act of 1940?
Under Rule 38a-1(c) of the Investment Company Act, investment fund personnel such as officers, directors, employees or advisers are prohibited from "coercing, manipulating, misleading, or fraudulently influencing" the fund's Chief Compliance Officer. The rule, which the Securities and Exchange Commission adopted in 2004, aims to protect CCOs from those who attempt to obstruct their work.
Rule 38a-1(c) was a component of regulators' broader initiative to spur compliance among investor companies. The initiative's compliance policy hallmarks included requirements that CCOs report directly to a fund's board of directors, and that investment companies implement written compliance procedures. Previously, many investment companies had not established a formal compliance policy and only offered employees a code of ethics to follow.
Rule 38a-1(c) is similar to other prohibitions under securities law, including a provision in the Sarbanes-Oxley Act that makes it illegal to unduly influence auditors, and Rule 13b2-2(b)(1) of the Securities Exchange Act.
How has Rule 38a-1(c) been enforced?
The Securities and Exchange Commission did not bring any charges under Rule38a-1(c) until nearly 10 years after adopting the rule. Regulators first invoked the rule when they charged a former assistant portfolio manager at a Boulder, Colo. investment advising firm with forging documents and misleading the CCO to hide personal trades.
According to the SEC, beginning in 2006 portfolio manager Carl D. Johns did not pre-clear or report hundreds of trades. Johns allegedly went to great lengths to hide the unlawful trading, including handing in false reports and certifications while physically altering brokerage statements, trade confirmations and pre-clearance approvals. Among other violations, he allegedly put together documents designed to look like pre-clearance requests approved by the CCO.
When the CCO pointed out in 2010 that there were questionable items in documents he had submitted, Johns lied and falsely claimed that some of his accounts were closed. The charges against Johns represent the first time the SEC invoked Rule 38a-1(c), and the agency settled the case rather than bring it to trial.
What is the penalty for violating Rule 38a-1(c)?
Investment company personnel charged with violating Rule 38a-1(c) can receive heavy sanctions by the Securities and Exchange Commission, including financial penalties and being prohibited from working in the securities industry.
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Johns agreed to pay more than $350,000 to settle his case. The sanction consisted of a $100,000 penalty, a disgorgement of $231,169 and prejudgment interest of $23,889. The sanction also took into account charges that Johns violated other Investment Company Act rules, but it was his effort to obstruct the CCO's duties that was highlighted by the SEC.
"Securities industry professionals have an obligation to adhere to compliance policies, and they certainly must not interfere with the chief compliance officers who enforce those policies," said Julie Lutz, acting co-director at the SEC's Denver Regional Office. "Johns set out to cover up his compliance failures by creating false documents and misleading his firm's CCO."
The settlement with Johns also barred him from working in the securities industry for a minimum of five years.
Federal Register: Compliance programs for investment companies and advisers
New rules for funds and advisers tighten the SEC's compliance processes
What does the SEC's first sanction under Rule 38a-1(c) suggest for future compliance enforcement?
The 2013 sanction issued against Johns to settle charges of violating Rule 38a-1(c) and other SEC rules underscores the growing importance of the Chief Compliance Officer's role at investment companies. Regulators have signaled that they are focusing not only on trading rule violations, but also on any efforts to obstruct the compliance professionals who are tasked with enforcing the rules.
In a speech at the National Society of Compliance Professionals meeting on Oct. 22, 2013, SEC Chair Mary Jo White noted that the case against Johns demonstrates the importance of the CCO's work to the agency. "We want to encourage companies to give you the recognition that you deserve, the resources that you need and the authority that your role demands, so you can succeed and, as a result, our markets are safe and can succeed," she said.
White also said that the SEC would be "looking for more cases to bring to drive that message home."
SEC Chair encourages CCO support at National Society of Compliance Professionals meeting
SEC finds three investment advisory firms violated compliance program initiative
This was first published in January 2014