What is the cost of non-compliance? How much should an RIA spend on compliance? Are these compliance tools and services worth it? The answers to these questions become clearer when we look at both the direct and indirect impact of examination and enforcement actions taken by the SEC.
In its Fiscal Year (“FY”) 2019, the SEC brought 862 enforcement actions, a 7% increase from FY 2018. The law firm Morgan Lewis notes that the increase occurred despite the SEC shutting down for more than a month during the year and a partial hiring freeze for most of the period. RIAs and investment companies were involved in 36% (191) of these cases, a year over year increase of 22%. Individuals were named in 69% of all stand-alone cases (526 of the 862 total). Notably, the SEC obtained over $4.3 billion in penalties and disgorgement across all its FY 2019 cases.
But this figure does not represent the full cost of non-compliance.
That’s because the during FY 2019, the SEC also completed 3,089 examinations, of which 2,180 were of RIAs (about 15% of SEC-registered investment advisers). This is about 12% higher than in FY 2018. Two-thirds of all examinations resulted in deficiency letters, which required firms to take corrective action. Often, this action includes amending compliance policies and procedures, updating disclosure documents, and returning fees to investors (about $13 million). More than 150 of these exams resulted in an enforcement action.
The SEC does not sue most firms that have deficiencies or violations in their compliance program. While we don’t have exact data on the number of SEC exams that result in costs to the RIA (for remedial measures), we know that many SEC exams can take up to 100 hours of RIA staff time. On average, an RIA will spend 20-40 hours gathering the requested information and 12-24 hours of onsite engagement with the staff. Another 10-20 hours of post-onsite activity usually occurs as the SEC asks for additional information. Finally, most exams result in a few deficiencies, which require further remediation by the RIA’s CCO and employees. In many cases, the RIA hires an outside consultant to help with cleanup, which costs anywhere from $10,000 or more and requires another 10-20 hours of RIA employee time.
What is the total cost of non-compliance?
On the low end, an RIA can assume about 100 hours of work to address issues raised during an SEC exam. If we assume the value of that time is $200 per hour, then the cost of remediating a few deficiencies is about $20,000.
For moderate deficiencies, an RIA will often need to hire an outside consultant, which can add at least another $10,000. The more deficiencies an RIA has in its compliance program, the more this amount increases. If the SEC determines there are not enough compliance resources at the firm, then the RIA might need to hire a full-time compliance associate to the tune of $60,000 or more (plus benefits and other related costs). The middle point of non-compliance is around $30,000 and can be as high as $100,000 in the first year and over $60,000 per year ongoing.
In the worst-case scenario, the SEC will bring an enforcement action. Even if the action is settled, the RIA is looking at tens of thousands of dollars in legal expenses. Plus, the principals will need to spend a considerable amount of time addressing the matter. Penalties start at $50,000 and go up depending on the severity. Disgorgement often starts at around $10,000 and increases. The total cost of an exam that leads to an enforcement action is at least $200,000. The SEC reports that the median amount of total money ordered in FY 2019 was $550,000.
Fines and Enforcement Actions – Some Recent Examples
To further illustrate the repercussions of non-compliance, here are some examples of unintentional misconduct by firms in FY 2019.
- In re Raymond James & Associates, Inc. et al., Exchange Act Rel. No. 86985 (Sept. 17, 2019)
A dually registered BD-RIA failed to conduct suitability reviews, enact policies and procedures around fee-based advisory accounts; overvalued certain assets; and charged clients excess advisory fees.
Result: $15.2 million paid.
- In re Ronaldo Gonzalez, Exchange Act Rel. No. 86711 (Aug. 20, 2019)
CEO failed to supervise a former trader who committed fraud.
Result: CEO suspended from industry for 12 months and had to pay $40,000 fee.
- In re Kornitzer Capital Management, Inc. and John C. Kornitzer, Investment Advisers Act Rel. No. 5416 2019 (Dec. 10, 2019)
President and CEO of an RIA failed to follow a client’s instructions to reduce high concentration in the client’s portfolio; the firm failed to adopt and implement policies and procedures regarding client objectives and guidelines.
Result: Firm had to pay $4.98 million, and the firm and CEO had to pay another $2.7 million.
- In re Deer Park Road Management Company, LP & Scott E. Burg, Investment Advisers Act Rel. No. 5245 (June 4, 2019)
The RIA failed to adopt written policies and procedures regarding the valuation of client assets.
Result: Firm had to hire a new CCO and a third-party valuation agent and paid $5 million; the CEO/CCO had to pay $250,000.
- In re Foundations Asset Management, LLC et al., Exch. Act Rel. No. 86446 (July 24, 2019); SEC v. McKinley Mortgage Co. LLC et al., Lit. Rel. No. 24076 (Mar. 22, 2018)
The RIA and its two principals acted as unregistered brokers, failed to disclose compensation and conflicts of interest to clients, and made false and misleading statements in their Form ADV.
Result: The firm paid more than $264,000, and the two principals had to pay over $75,000. Plus, the firm and its principals are being sued in federal court for fraud – outcome pending.
- In re BB&T Securities, LLC, Investment Advisers Act Rel. No. 5119 (Mar. 5, 2019)
A dual registrant failed to disclose conflicts of interest in its Form ADV and investment advisory agreement regarding its brokerage practices.
Result: Over $5.7 million paid plus substantial remediation.
What can you do to get ready for an eventual exam?
- Get your house in order. Many advisers think they have a good program. That is until the SEC arrives when numerous program gaps are discovered. The absolute best time to prepare for an examination is BEFORE you are notified of one.
For more help on preparing for an examination, download our free CCO’s Guide to Surviving a Regulatory Examination.
- Don’t be penny wise, pound foolish. Yes, hiring a compliance associate or outside consultant costs money and will not directly increase revenue. However, a good compliance program can make your business safer and more efficient, which means your client-facing staff can focus more of their time on investors. Weaknesses in your compliance program will cost you at least $20,000 in time and expenses and will likely be around $100,000 a year or more. Plus, you’ll eventually need compliance technology or new hires that you previously avoided.
- Get ready for Form CRS and (for broker-dealers) Regulation Best Interest. These will be exam priorities in FY 2020.
- Be ready for other areas of focus. Other examination priorities for FY 2020 include protecting retail investors (Reg BI; conflicts of interest; disclosure of fees and expenses; senior and retail investors; portfolio management), RIAs (best execution, prohibited transactions, fiduciary advice, new advisers), information security and anti-money laundering (AML).
 SEC’s Division of Enforcement, 2019 Annual Report available at https://www.sec.gov/files/enforcement-annual-report-2019.pdf.