Market Exposure: The Importance of a Comprehensive Compliance Review

In 2002, the Sarbanes Oxley Act was enacted to augment the regulation of accounting and disclosures for public companies. This was in direct relation to aggressive accounting methods, the technology bubble, and other instances of corporate malfeasance. The ensuing financial crisis and market crash of 2007-2009 uncovered a lack of oversight exhibited by numerous Ponzi schemes, as well as negligent lending practices in the real estate mortgage market. The response to this was more regulation ranging from the Volcker Rules, restrictions on proprietary trading, an update to the Investment Adviser Act’s custody rule, and new SEC leadership focusing on a broken windows approach to regulatory exams. Each market event continued to expose further weaknesses in internal controls, regulatory agency, and current law.

There is now much speculation over what the next problem area will be. There has already been a market correction this year and several economists surmise that a nine-year-long bull market could indicate an impending recession. What could a potential market sell-off uncover that is not currently at the forefront of industry concern?

A significant area of exposure is the advertising of investment performance to high net worth and retail investors. Currently, the only real law in existence is rule 206(4)-1, otherwise known as the “Advertising Rule.” There are a handful of no-action letters from the SEC that provide further guidance, but the reporting of investment returns is generally unregulated with regards to:

1. How returns are produced and what information is relevant to the investor;
2. How information is presented and what qualifies as “sufficient disclosure”; and
3. What internal controls the adviser has to consistently and transparently report accurate performance information. 

The SEC released a Risk Alert in September 2017 that highlighted several of the most common deficiencies relating to investment adviser advertising. Most relate to having poor policies and procedures and insufficient disclosure. As a result, enforcement actions were taken against several firms in the form of fines of over $50,000 for not having these areas properly supervised and addressed within a compliance framework. Most of these firms operate in the institutional market, but were selling products to high net worth individuals. Is the SEC fully focused on this? A former examiner once commented, “Marketing is definitely a priority for the SEC, but it is never in the top three. I think that may be changing.” In fact, amending the Advertising Rule, which was a long-term agency objective, is now listed on the SEC’s regulatory agenda in the Proposed Rule Stage.

To further bolster this sentiment, on October 1, 2017, the SEC updated the recordkeeping rule in order to conduct a more thorough review of performance advertising during examinations. Related to rule 204-2(a)(16), the SEC removed the 10 or more persons condition and replaced it with “any person.” Advisers will now be required to maintain the materials listed in rule 204-2(a)(16) that demonstrate the calculation of the performance or rate of return in any communication that the adviser circulates or distributes, directly or indirectly, to any person. The SEC also amended rule 204(a)(7) to require advisers to maintain originals of all written communications received, and copies of written communications sent, by an investment adviser relating to the performance or rate of return of any or all managed accounts or securities recommendations.

Given the wide variety of performance streams that are shown by investment advisers, potentially inclusive of hypothetical returns, insufficient supporting records, missing disclosures, and outdated methodologies, a solution is needed before more damage can be fomented. The Global Investment Performance Standards (GIPS^®) provide a framework that could help to mitigate risk in reporting investment performance. However, the GIPS standards are still relatively unknown to retail investors. Some firms that are hesitant to adopt GIPS compliance are still seeking certifications of their performance numbers. ACA’s GIPS compliance verification and investment performance certification services not only give advisers third-party assurance on their performance reporting, but also offer guidance on industry best practices. This gives prospective clients an added level of comfort.

A comprehensive compliance program is an important tool for mitigating risk, and recent regulatory actions indicate an increased focus on marketing and advertising mechanisms. Advisers can be proactive and make decisions now that could help them avoid potential regulatory and reputational risks in the future.

About the Author

Richard J. Kemmling, CPA, CIPM, CGMA is a Partner at ACA Performance Services, a division of ACA Compliance Group. His primary responsibilities include serving as a partner on GIPS compliance verification engagements, as well as performance certifications and focused performance reviews. He also co-leads the division’s executive committee. Richard has worked with firms of all sizes and asset classes around the world. He is a frequent speaker globally on the GIPS standards and has been quoted and interviewed by several industry media outlets. In addition, he serves on the United States Investment Performance Committee. Prior to joining ACA, Richard served as a partner and president of a large global verification firm. He earned his Bachelor of Arts degree in Accounting from the University of Washington and an MBA from the University of Chicago’s Booth School of Business.