Tag: ACA Compliance

Best Practices for Presenting Model and Hypothetical Performance

These are my notes from an ACA Compliance Webcast on this subject. I’m sure you can find a replay on the ACA website.

There were three great presenters:

  • Alicia Hyde, Partner, ACA Performance Services
  • Mike Sonnenburg, CIPM, Managing Director, ACA Performance Services
  • Kim Daly, Managing Director, ACA Compliance Group

Definitions

The first topic was what these terms mean:

Model–A list of investments and transactions for an investment strategy that are not actually held by the portfolio but can be backtested over historical periods and/or run contemporaneously. Model portfolios are typically constructed using individual securities (stocks and bonds), ETFs, pooled funds, or other investment products. Also known as a paper portfolio, a policy portfolio, or a target portfolio.

Hypothetical–Performance of a model or synthetic portfolio (i.e., non-actual performance). Hypothetical performance can be ex-post and/or ex-ante.

Backtested–Ex-post testing of an investment model to see how it would have performed historically. Backtesting attempts to demonstrate how an investment strategy, constructed with the benefit of hindsight, would have performed as if it had been implemented historically.

Simulated –Same as backtested; non-actual performance and can be ex-post or ex-ante.

Theoretical–Same as backtested; non-actual performance and can be ex-post or ex-ante.

Ex-ante–Projected future performance. Ex-ante performance is non-actual and, as such, is hypothetical.

Ex-post –Performance over historic (after the fact)periods. Ex-post may be non-actual or actual performance.

Contemporaneous (Live) Model–Performance derived from a live, or contemporaneous model, where investment decisions occur in real time. Live model performance is still considered non-actual.

Synthetic Portfolio–The ex-post combination of actual portfolio returns. For example, taking an actual equity portfolio and combining it with an actual fixed income portfolio to create a synthetic balanced portfolio. The underlying performance is that of actual portfolios, but they are synthetically combined according to a prescribed asset allocation. Synthetic performance is considered to be hypothetical performance.

The Law

The main limitation is section 206 that prohibits you from being fraudulent, deceptive or manipulative. That has been further extrapolated by the SEC in Rule 206(4)-1, the advertising rule. That rule has been further elaborated in the Clover No Action Letter.

All of this has been heightened by the F-Squared cases that failed to properly disclose that the adviser and the firms that used its services were not based on actual performance.

Presenting Model Performance

  1. Model portfolio performance must not be presented in a false or misleading manner.
  2. Model performance should not be linked to actual performance.
  3. ‘White-labeling’ third party model performance requires sufficient due diligence.
  4. Model portfolio performance must include specific, accurate, and robust disclosures.

Model Performance Disclosures

Disclosures should address these items:

  • The limitations inherent in model results,particularly the fact that such results do not represent actual trading and that they may not reflect the impact that material economic and market factors might have had on the adviser’s decision-making if the adviser were actually managing clients’ money
  • Any material changes to the conditions, objectives, or investment strategies of the model portfolio during the time period portrayed and, if so, the effect of any such change on the results portrayed
  • As applicable, that the adviser’s clients had investment results materially different from the results portrayed in the model

Include the following disclosures:

  1. The results do not represent the results of actual trading using client assets but were achieved by means of the retroactive application of a model that was designed with the benefit of hindsight.
  2. The returns should not be considered indicative of the skill of the adviser
  3. The client may experience a loss.
  4. The results may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the back-tested model if the model had been used during the period to actually manage client assets.
  5. The adviser, during the period in question, was not managing money at all, or according to the strategy depicted.
  6. The back-testing is for a strategy that the client accounts will follow or, if not, what difference there will be.

You can show projected returns

Sources:

Document Request List for Never-Before-Examined Advisers

aca compliance

In January, the Securities and Exchange Commission announced in its annual exam priorities for 2014 that it wanted to emphasize exams on never-before examined firms that had been registered before 2012. Then in February, the SEC officially announced its never-before-examined initiative. It looks a lot like the presence exams.

ACA Compliance got its hands on an initial document request list used by OCIE in conducting a never-before-examined exam.

Unlike other exam letters, this one explicitly states that it is part of OCIE’s never-before-examined initiative. It sounds like an on-site visit is not part of the initial protocol. But this may vary from region to region.

I’ve added this example to Compliance Building‘s collection of 13 other SEC Exam Document Request Examples. If you have an example and are willing to share it, you can send it to [email protected]. I will always delete any information about the firm and I will only publish any additional information about the letter that you consent to.

Disclosure: I’ve used ACA Compliance as a provider.

References:

Chief Compliance Officer and General Counsel Supervisory Responsibility and Liability Brian L. Rubin, Partner

ACA Compliance sponsored this webinar on Thursday. Brian L. Rubin, Partner, Sutherland Asbill & Brennan LLP was the presenter. These are my notes.

Section 203(e) of the Advisers Act:

If an investment adviser fails to reasonably supervise an employee or any other person subject to the adviser’s supervision, and that person violates the federal securities laws, then the SEC may take action against such investment adviser

In the Matter of Pegasus Investment Management, LLC, Peter Bortel, and Douglas Saksa (.pdf) (June 15, 2011) Pegasus VP Peter Bortel, under the supervision of President and CCO Douglas Saksa, allegedly did not disclose the arrangement to their fund investors and retained retained broker rebates for Pegasus, rather than passing it along to the investors. The SEC stated that Saksa failed to reasonably supervise Bortel within the meaning of Section 203(e)(6)

Direct Liability

CCO has direct liability for:

–Aiding and abetting, and causing firm violations such as:

•Responding to regulatory inquiries
•Responding to deficiency letters
•Adopt/implement policies and procedures
•Failing to file

– Permitting unregistered individuals to act

As an example the they cited In the Matter of the Buckingham Research Group, Inc., Buckingham Capital Management, Inc., and Lloyd R. Karp (.pdf) (November 17, 2010). The CCO allegedly represented in deficiency letter response that certain corrective action would occur (new policies/monitoring). The SEC claimed CCO was liable because he was responsible for establishing and administering the policies at issue and he “was aware of the compliance weaknesses and failures and either failed to act or failed to correct them”

Are you a supervisor?

Some factors are whether you have the ability to hire, fire, discipline, affect compensation. You would have the requisite degree of “responsibility, ability or authority” to “affect” the conduct of the employee whose behavior is at issue.

You can still be held liable as the SEC if you are overruled by superiors. (Scary!!)

In the Matter of Theodore W. Urban (.pdf), Adm. Proc. File No. 3-13655, Initial Decision (Sept. 8, 2010) Urban was General Counsel and headed Compliance, HR and Int. Audit. Urban had no authority to hire or fire employees outside of these departments, but he served on the board of directors and the firm’s credit and risk committee as a full voting member. SEC alleged that Urban was bad rep’s supervisor because of the role he played in monitoring bad rep’s actions. SEC also alleged that Urban failed to follow up on numerous red flags and took inadequate action regarding other red flags. As General Counsel, his opinions on legal/compliance matters were “viewed as authoritative and his recommendations were generally followed” by all business units.

The Administrative Law Judge found that Urban was a bad rep’s supervisor, but he had not failed to supervise because he performed his supervisory responsibilities “in a cautious, objective, thorough and reasonable manner”. The decision has been appealed to the SEC. So this ruling may change.

Combination/Separation of Legal and Compliance Functions

Some advantages to combining the roles:

  • Federal Sentencing Guidelines call for adoption of a compliance program overseen by senior personnel
  • Compliance is represented at senior management level
  • GC is actively involved in strategic business decisions, offering exposure to potential compliance issues
  • May be better positioned to push the firm toward appropriate actions/conclusions
  • Direct or tangential experience with regulations
  • “Noisy Withdrawal” trigger
  • Reduced headcount
  • GC is generally consulted on key compliance matters by senior management

Why separate the roles?

  • Respects the differing goals of legal versus compliance (legal protects the firm; compliance prevents and detects violations
  • Allows firms to acquire necessary skill set in each area
  • Avoids misplaced privilege claims
  • Creates necessary bandwidth to execute each role fully
  • Allows each person to serve appropriate stakeholders
  • Avoids conflicts at the board level/recusals
  • Compliance gets same standing as legal in organization charts

Reporting

How about the CCO Reporting to GC?

  • Centralizes legal and compliance in a single functional area. There is overlap.
  • Matters identified can be more quickly resolved due to combination of functions
  • GC may be in a good position to muster resources or provide a platform
  • Gives clout to the compliance function. To the extent legal has clout.

How about an Independent CCO

  • Highest degree of independence
  • Decisions to report matters up to senior management or to regulators not subject to approval by GC
  • CCO does not have to go outside reporting structure to raise matters to senior management
  • GC does not need to create time to supervise the CCO
  • Consistent with ICA 38a-1 and FINRA Rule 3130

As a case study, they used the Wunderlich case.

Avoiding Supervisory Responsibility

  • Document with written supervisory policies and procedures
  • Identify the direct supervisors of all employees
  • Specifically state that compliance personnel are limited to offering advice and recommendations and do not have the responsibility, ability or authority to affect the conduct of employees outside of their departments
  • Where misconduct is addressed, document which business-line supervisor is handling the issue and how
  • Make it clear that the role on committees and boards is only advisory in nature