In 2004, the SEC adopted Investment Company Act Rule 38a-1 “to protect the chief compliance officer from undue influence by fund service providers seeking to conceal their or others’ non-compliance with the federal securities laws.”1 Rule 38a-1(c) prohibits affiliated persons of funds from coercing, manipulating, misleading or fraudulently influencing a fund’s Chief Compliance Officer (“CCO”) in the performance of his or her duties.2
On August 27, 2013, the SEC resolved the first case alleging a violation of Rule 38a-1(c) since the Rule’s adoption — a period of nearly 10 years.3 The SEC accepted Carl D. Johns' Offer of Settlement, and he agreed to be barred from the securities industry for a period of five years for having misled the CCO of the advisory firms he worked for relating to his personal trading. In re Johns, Investment Advisers Act Release No. 3655, Investment Company Act Release No. 30675 (August 27, 2013) (“Order”).4
The SEC’s Order affirms the importance of the position of the CCO and the severity of the sanctions the SEC will seek against persons who violate Rule 38a-1(c) by intentionally misleading and defrauding a Chief Compliance Officer.
The SEC Order Instituting Administrative and Cease-and-Desist Proceedings
The SEC alleged that from January 1999 to January 2011, Mr. Johns was associated with two SEC registered advisers — Boulder Investment Advisers, LLC and its affiliated adviser, Rocky Mountain Advisers, LLC (together “the Advisers”), both of whom were advisers to various investment companies (collectively “the Boulder Funds”).5 During his employment, Mr. Johns actively traded in securities for his personal accounts, including securities of companies in Boulder Funds’ portfolio.6 Between 2006 and 2010 Mr. Johns executed around 850 personal securities transactions.7 Rule 17j-1(d) required Mr. Johns to provide quarterly reports of his personal securities transactions and annual reports of his securities holdings to the Advisers.8
Furthermore, the Advisers’ and the Boulder Funds’ Code of Ethics (1) mandated that Mr. Johns pre-clear all securities transactions with the CCO, (2) restricted trading in the same securities that the Boulder Funds were buying or selling, and (3) required proof of compliance with the Code of Ethics in the form of an annual certification.9
The Order alleged that between 2006 and 2010, although Mr. Johns certified that he was in compliance with the Code of Ethics annually, he did not comply with the SEC’s quarterly and annual reporting requirements and the Code of Ethics because he failed to pre-clear approximately 640 of his trades, which included about 91 trades in securities “held or to be acquired”10 by the Boulder Funds, and 14 trades that did not comply with the Code of Ethic’s trading restrictions.11 Mr. Johns also concealed his personal securities trading activities by submitting false quarterly and annual reports and falsely certifying his annual compliance with the Code of Ethics.12 Mr. Johns took additional steps to mask his personal trading activities from the CCO including deleting securities holdings from his brokerage statements before submitting them to the CCO, backdating trade confirmations and falsifying several pre-clearance request approvals that were not reviewed or approved by the CCO.13
The SEC also alleged that in late 2010, when the CCO noticed irregularities in the documents specifying Mr. Johns’ personal securities transactions and questioned Mr. Johns to determine his compliance with the Code of Ethics, Mr. Johns made misleading statements to the CCO by falsely telling her that some of his brokerage accounts were closed.14
The SEC found that Mr. Johns willfully violated Section 17(j) and Rules 17j-1 and 38a-1(c) of the Investment Company Act when he misled the Advisers’ and Boulder Funds’ CCO in the performance of her duties by making untrue statements about his brokerage accounts and altering the Boulder Funds’ compliance files.15
As a result of Mr. Johns’ conduct, the SEC ordered that he be barred from the securities industry for a period of at least five years, and that he pay disgorgement of $231,169 as well as prejudgment interest of $23,889, and a civil money penalty in the amount of $100,000 to the United States Treasury.16
The Order demonstrates that the SEC is committed to supporting the role of the CCO and that those who mislead a CCO will suffer serious consequences. CCOs should take comfort in the Order.
1Final Rule: Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204, 11 (February 5, 2004).
217 CFR 270.38a-1.
3Although this is the first case in which the SEC has alleged a violation of Rule 38a-1(c), it has brought several cases alleging violations of Rule 38a-1 generally. See, e.g., In re Morgan Asset Management, Inc., Securities Act Release No. 9116, Securities Exchange Act Release No. 61856, Investment Advisers Act Release No. 3009, Investment Company Act Release No. 29203 (April 7, 2010). See also In re Northern Lights Compliance Services, LLC., Investment Company Act Release No. 30502 (May 2, 2013).
4The SEC’s sanctions were also based on Mr. Johns violating Section 17(j) of the Investment Company Act and Rules 17j-1(b) and 17j-1(d) thereunder.
5In re Johns, Investment Advisers Act Release No. 3655, Investment Company Act Release No. 30675 (August 27, 2013) (Mr. Johns also served as an officer of, and assisted in managing portfolios for, numerous registered investment companies).
8Id. See generally 17 CFR 270.17j-1.
9Order, supra note 5.
10See 15 USC § 80a–17 (“Transactions of certain affiliated persons and underwriters (j) Rules and regulations prohibiting fraudulent, deceptive or manipulative courses of conduct — It shall be unlawful for any affiliated person of … a registered investment company or any affiliated person of an investment adviser of … a registered investment company, to engage in any act, practice, or course of business in connection with the purchase or sale, directly or indirectly, by such person of any security held or to be acquired by such registered investment company … .”).
11Order, supra note 5.
15Order, supra note 5 (Mr. Johns willfully violated Section 17(j) of the Investment Company Act and Rules 17j-1(b) and 17j-1(d) thereunder by failing to pre-clear or report hundreds of his transactions, by submitting false quarterly and annual reports, by falsely certifying his annual compliance with the Code of Ethics and by concealing his improper trading activities).