Market gains since the Great Recession have rewarded investment firms with record assets under management. And the challenges posed by the COVID-19 pandemic have changed the way many of us work, perhaps for a long time.
Taken separately, those two developments can be quite positive and rewarding for investment advisers. But a combination of the two can result in regulatory action when a firm’s supervisory and oversight responsibilities are neglected during times of change.
On September 9, 2021, the U.S. Securities and Exchange Commission (SEC) filed an enforcement action against Cincinnati-based Horter Investment Management and its CEO, Drew K. Horter. The SEC cited failure to supervise a former employee now for misappropriating more than $728,000 from clients and a disregard for their own policies and procedures, which, while in place, were inadequate and failed to meet industry standards.
In its filing, the SEC alleged it found several violations during its investigation following the 2019 conviction of Kimm C. Hannan, an investment adviser representative (IAR) at Horter Investment now serving a 20-year prison term at the Lorain Correctional Institution in Grafton, Ohio.
Early Warning Signals
Horter Investment had experienced more than tenfold growth from the $93 million it managed in 2010 to the $1.1 billion it managed in 2016. Although the firm added about 100 sales personnel a year to keep pace, the compliance department remained relatively the same size. Like 95% of Horter Investment’s IARs, Hannan worked remotely as an independent contractor while employed from December 2014 through March 2017.
Shortly after Hannan started with the firm, the SEC’s examination staff had issued a deficiency letter unrelated to his work saying that Horter Investment had “failed to conduct adequate annual compliance reviews [and] failed to implement an effective compliance program.”
In addition, the consultant Horter Investment hired to review its compliance program following that exam noted the firm’s growth had “obviously outpaced its supervisory, compliance and operation capabilities.” That consultant advised the firm to develop more detailed procedures for supervising its remote IARs, according to the filing.
The SEC filing alleged, however, that neither Horter Investment nor Horter took significant steps to remedy the shortcomings of its compliance program during the time Hamman diverted money from client accounts into two of his own outside business activities. The SEC alleged that Hamman used the money for a variety of expenses unrelated to those businesses, including gambling; alimony and support payments for his ex-wife; personal credit card bills; rent on the building for his investment advisory services businesses; and his utilities, car payments and insurance.
Additional Red Flags Ignored
Overall, more than half the IARs hired by Horter Investments since November 2014 were identified as high or moderate risk, the filing said. In 2015, a consultant warned the firm that higher risk IARs required a program of closer supervision, especially during their first years with the firm. Similarly, in 2016, Horter Investment’s compliance officer was ignored when he reminded the firm it needed to develop its supervision program. Despite these warnings, Horter Investment and Horter did not institute such supervision procedures until right after they became aware of Hannan’s misappropriation and right before they terminated him.
At one point, following an inquiry by the Financial Industry Regulatory Authority (FINRA) into Hannan’s behavior at a previous firm, the Horter Investment’s compliance office recommended that Hannan be terminated. Horter rejected that recommendation. according to the filing. Red flags also had been raised by 17 distribution requests from Hannan’s Horter Investment clients to Hannan Properties, one of the reps’ outside business activities. All those flags went uninvestigated.
In addition, the filing said Horter delegated responsibility to his firm’s compliance officer for annual reviews in 2016 and 2017, but neither supervised the reviews nor ask for the results.
The SEC alleges Horter and his firm failed to reasonably supervise Hannan in four areas: by establishing supervisory policies and procedures, by implementing those policies and procedures, by following up on red flags, and by delegating supervisory authority.
Important Reminders About Supervisory Compliance
To properly supervise IARs, whether or not they are working remotely, electronic communications must be monitored by the Chief Compliance Officer (CCO) or an authorized representative.
A firm’s policies and procedures must set forth the standard of conduct to be adhered to by supervised persons. They should also address conflicts that may arise from personal trading by advisory personnel.
Compliance personnel must do more than just review questionnaires filled out by their IARs, especially as it relates to outside business activities (OBAs). Supervised personnel should disclose and get approval before engaging in an outside business activity.
If your firm has grown in recent years and has employees who work remotely, you should review all policies and procedures related to supervisory compliance. Inadequately supervised outside business activity can expose advisers to lawsuits and regulatory sanctions. Core Compliance & Legal Services can work with you to make certain your supervisory procedures meet regulatory standards. Contact us today at (619) 278-0020 or visit us online at corecls.com.