The Chief Compliance Officer has extraordinary (and in some cases, unwarranted) access to employee records in addition to other confidential information such as executive meetings and emails. Firms should pursue enhanced background due diligence on potential CCO candidates, create information barriers so that the CCO does not have access to non-regulatory information, and implement a supervisory structure that ensures CCO accountability. Alternatively, consider outsourcing to a third-party firm that has limited access to firm systems as well as direct legal liability for breaches of confidentiality.
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.
Over the last several years, an increasing number of investment
management firms have chosen to outsource the Chief Compliance Officer role and
associated compliance function. In our
experience, these firms make this decision for rational business reasons based
on an assessment that outsourcing the compliance function is better than hiring
a full-time employee. Usually, firms
consider outsourcing because of an external event such as a less-than-perfect
SEC exam or an institutional due diligence process that suggests unknown weaknesses. Some firms decide to outsource after yet
another internal CCO changes jobs. Other
times, firm management simply gets frustrated with the inherent limitations of
the one internal compliance person.
Regardless, we list below the top 10 reasons investment firms should outsource
the CCO role and compliance function rather than hire an in-house employee.
10 Reasons Outsourcing Compliance Beats Hiring an In-House
Experience: A team of professionals can draw on decades of aggregate compliance experience to address a firm’s regulatory challenges.
Knowledge: No one person can provide the depth of knowledge of several compliance professionals working collaboratively.
Independence: A third party firm offers investors and other stakeholders an independent assessment of a firm’s compliance strengths and weaknesses.
Industry best practices: A multi-person team working with multiple clients across the country has the industry vision to inform the compliance program.
Accountability: A compliance firm stands behind its work and advice with a service level agreement and professional liability insurance.
24/7/365 support: A person may take PTO, but a team of professionals is available at all times for any emergency including unplanned client due diligence and SEC exams.
Personal liability: Serving as CCO involves significant personal liability, which is better left to professionals that understand and accept the regulatory and career implications.
Frees up internal resources: Internal personnel can focus on core activities such as portfolio management and fund-raising.
Management: Senior managers can avoid the confusing and time-consuming process of hiring, retaining, and managing an internal CCO, only to start the process anew in the event the CCO leaves.
Cost savings: Because of program efficiencies, outsourcing generally costs less than hiring a full-time employee.
The SEC will offer no quarter to RIAs who ignore their basic compliance responsibilities. At a bare minimum, firms must appoint a dedicated and qualified CCO, adopt tailored policies and procedures, annually test the program, and generally attempt to comply with the Advisers Act. The initiation of proceedings, rather than a settled order, suggests that the SEC intends to pursue aggressive penalties.
“We’ve always done it this way” is not a legitimate excuse for failing to comply with regulatory requirements. The firm engaged in the undisclosed revenue sharing for nearly 20 years before the SEC uncovered the conflict of interest. Perhaps, the firm never considered that its longstanding practice violated the securities laws. This is why we recommend retaining a fully-dedicated and experienced chief compliance officer either as a full-time employee or through a compliance services firm.
OUR TAKE: Compliance officers should avoid signing certifications that facilitate securities transactions. If the situation requires a certification, a CCO must conduct adequate due diligence to ensure the accuracy of all statements made. Also, we would recommend that a CCO obtains back-up certifications from others in the organization.
The SEC fined and barred a CCO/AML Officer from the industry for failing to file Suspicious Activity Reports and otherwise ignoring his AML due diligence responsibilities. The SEC accuses the CCO/AML Officer and his firm with ignoring clear red flags that suggested significant churning of penny stocks. Red flags included questionable customer backgrounds, absence of a business purpose, multiple accounts with the same beneficial owners, rapid transactions, and law enforcement inquiries. The firm sold over 12.5 billion shares of penny stocks over a 9-month period. The SEC also charged the firm and its clearing firm.
OUR TAKE: This is what we call “voodoo compliance” i.e. using purported compliance as a tool to further securities law violations. The SEC has become wise to firms that implement sham compliance programs.
The President of a broker-dealer was fined and barred for failing to supervise an inexperienced and ineffective Chief Compliance Officer. The CCO failed to properly monitor and halt excessive mutual fund trading by a registered rep. The CCO had difficulty analyzing the firm’s trade blotter and mutual fund reports even after a compliance consulting firm was hired to assist. FINRA faults the President for failing to recognize the CCO’s failures and take the necessary action to implement an adequate supervisory system. FINRA blames the President because he “was ultimately responsible for supervision.”
OUR TAKE: Do you know if your CCO is competent? Firm leaders do not satisfy their obligations to implement a compliance and supervisory system by merely calling somebody the Chief Compliance Officer. A CCO must be competent, have the necessary resources, effectively implement policies and procedures and test them. Then, firm management must monitor the CCO to ensure that the CCO adequately performs the role.
OUR TAKE: The SEC doesn’t often prosecute standalone (i.e. not dual hat) CCOs without an underlying client loss, but it will if the CCO ignores obvious compliance deficiencies of which he has notice. This is what we call “compliance voodoo” i.e. an appearance of compliance infrastructure without an effective program. This CCO had a compliance manual, did some quarterly testing, and hired a third party consultant. But, neither the CCO nor the firm took any action to actually implement relevant procedures to address cited compliance deficiencies.