Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

We all want to trust our co-workers, employees, and bosses.  Unfortunately, case after case shows that people with the wrong incentives with the right opportunities may make the wrong decisions that dearly cost themselves and their firms.  With this in mind, we remind our clients and friends to ensure adequate supervision and controls over all personnel to avoid very painful consequences, conversations and decisions.  Below we list 10 employee supervision lessons gleaned from recent SEC cases, reports, and statements.  For reference, we have linked to our blog posts with more detailed information.

10 Employee Supervision Lessons

1. Partners need to be supervised, too.  A firm partner and designated COO stole $6 Million from his firm by overcharging clients and paying himself too much compensation.  His partner, the firm’s CEO, focused on portfolio management, and failed to uncover the scheme for 8 years.
   
2. The CFO controls all the money.  The  CFO of a private equity firm overcharged the fund for management fees and organizational expenses and arranged improper loans between the fund and the management company.  He then hid his activities by failing to ensure timely delivery of audited financial statements. 
   
3. The CEO should not be immune from supervision.  The CEO of a private equity firm charged cancelled plane tickets to the fund and took a direct loan from the fund despite protests from employees. 
   
4. Product salespeople have an inherent conflict of interest.  The SEC fined a large dual registrant $35 Million because its salespeople recommended single inverse ETFs to over 40,000 retail clients, many of whom expressed conservative investment objectives and long-term investment horizons.  
   
5. Portfolio managers may not heed risk limits.  A hedge fund PM, whose compensation was directly tied to fund performance, used a discretionary valuation model for certain swaps and swaptions, which maximized valuations, fund performance, and his own compensation.  Within 16 months after discovery of the mispricing, the firm ceased operations. 
   
6. You can’t even trust your Chief Compliance Officer.  A broker-dealer CCO used his access to confidential employee records to create false online bidding accounts at auction houses.  
   
7. Just having a Code of Ethics is not enough. An adviser’s Code of Ethics that required preclearance of personal trades failed to stop an illegal cherry-picking scheme because the employee did not self-report.  
   
8. Stop your employees from phishing.  An SEC investigative report found that employees continued to fall for phishing and spoofing schemes.  Many cases involved the wrongful wiring of funds to cyber-fraudsters.  The SEC advised companies to review and enhance their payment authorization and verification procedures and employee training.
   
9. You must monitor political contributions.  The SEC fined three fund managers for continuing to manage public plan money in the funds despite disqualifying political campaign contributions by firm employees.  
   
10. Don’t over-rely on automated tools.  A large BD/IA, relying on surveillance systems that contained technical errors, failed to prevent 5 registered representatives from stealing over $1 Million from clients over a 4-year period.