Insight Analytical Note

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Two Point Capital — Compliance failures / lack of annual review leading to CCO liability

Background:

  • Two Point Capital Management (“Two Point”) is a retail investment firm based in Pittsford, NY managing approximately $250 million over 200 accounts. It was founded by Jack McGowan, who served as CEO and CCO until February 2021.
  • In addition to not filing Form CRS, Two Point and McGowan personally were charged by the SEC with:
    • Failure to sufficiently tailor a compliance manual for Two Point’s business;
    • Failure to conduct an annual compliance review; and
    • Failure to maintain and enforce a written Code of Ethics.
  • This case is notable because:
    • The CCO was personally charged with compliance violations;
    • This is a standalone compliance case and does not implicate any investor harm; and
    • One of the charges is failure to conduct an annual review as required by 206(4)-7(b), which could be the first charge of its kind.

Key Allegations:

Failure to Adopt and Implement Reasonably Designed Compliance Policies and Procedures: Two Point used an off-the-shelf compliance manual that was not tailored to an investment business. The manual was published by an industry organization and never purported to be a compliance manual.

  • Analysis: While Two Point’s compliance manual appears to have been wholly inadequate, it is rare for the SEC to make judgments about compliance manual quality. The facts that the SEC used to support its charge of inadequacy were:
    1. The introduction to the manual stated that it was designed to provide guidance for ethics-based compliance rather than compliance with Rule 206(4)-7; and
    2. The manual never mentioned the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act, or the rules adopted thereunder.

Failure to Conduct an Annual Review: From 2012 until 2021, Two Point failed to conduct annual reviews of the effectiveness of its compliance program.

  • Analysis: Since annual compliance reviews do not need to be written, it is extremely difficult to bring an enforcement case with this allegation. In fact, this could be the first one. The SEC order did not describe the evidence used to support this allegation.

Failure to Implement a Code of Ethics: The Two Point compliance manual had a provision for a basic Code of Ethics, but the Code of Ethics did not contain the requirements of Section 204A and Rule 204A-1. The Two Point Code of Ethics mentioned a requirement to monitor employee trading, but Two Point never did so.

Takeaways:

  1. Don’t Panic: This appears to be a case of a completely deficient compliance program and a CCO who had no training or knowledge of investment adviser compliance. The CCO was also a dual-hatted CEO and founder, and it is not clear whether McGowan was charged as the CCO or CEO of the firm. For most private fund managers, this fact pattern never plays out.
  2. Written Annual Review: While 206(4)-7(b) does not require the annual compliance review to be documented, SEC staff have long been suspicious of firms that do not maintain such documentation. In fact, the new Private Fund Adviser rule proposal, which is likely to be adopted next year, will make written annual reviews a requirement. The Two Point case highlights the importance of this rule provision; managers should consider maintaining robust annual review documentation both as a way to demonstrate a culture of compliance and as a tool to smooth SEC examinations.
  3. Individual Liability with No Investor Harm: The SEC has long sought to find situations in which it could charge individuals, but this is arguably an unusual case in which to do so because of the lack of clear investor harm. Nevertheless, we expect the case to reignite the “CCO liability” debate, and SEC staff will once again be forced to explain their position on charging CCOs, a group the Commission has sought to appeal to and considers integral to securing the financial markets.