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The Friday List: 10 Ways Compliance Contributes to Firm Value

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.

Senior executives may view spending on compliance as a necessary evil or a cost of doing business.  While compliance spending is certainly necessary and a cost, the compliance function, properly structured and implemented, can significantly contribute to a firm’s value.  We believe the added value can actually exceed the cost, and compliance spending can be viewed more broadly as an investment in the business.  So, for today’s list, we offer 10 ways that compliance contributes to firm value.


10 Ways Compliance Contributes to Firm Value


  1. Avoid Fines and Penalties:  All firms want to avoid the punitive and unplanned fines, penalties, and disgorgement associated with enforcement actions that a good compliance program can prevent.
  2. Protect Individual Reputations:  The SEC names a corporate officer in over 80% of enforcement actions.  Your name in an enforcement action could be career-ending, especially if you are barred from the industry.
  3. Attract Institutional Clients: Most institutional investors conduct Operational Due Diligence that includes an in-depth review of the compliance program.  A weak compliance program can disqualify a firm regardless of investment performance history.
  4. Increase Firm Multiple: Potential acquirers will assess a firm’s compliance program as a factor in the multiple offered.  An inadequate compliance program means more risk, and more risk means a lower multiple.
  5. Improve Operations:  Very often, the compliance procedures serve as a starting point for operational and desk procedures.  Also, the discipline of drafting and implementing procedures will serve as an example for finance, portfolio management, and product development.
  6. Reduce Executive Time:  Fewer compliance problems and the associated decline in operational problems means less time spent by executives dealing with non-productive headaches.
  7. Lower Legal Expenses:  A good compliance function will reduce the number of questions requiring outside counsel.  Firms will incur significant legal expenses when confronted with an avoidable enforcement action.
  8. Preserve Reputation:  An enforcement action undermines a firm’s reputation, the most valuable asset of any investment management firm.  Blue chip firms like to do business with other blue chip firms that have a reputation for integrity.
  9. Attract Employees: A quality compliance program will create a credible firm attractive to quality employees.  A “cowboy culture” will repel the top-notch employees needed to grow into an institutional franchise.
  10. Freedom from Fear:  You wouldn’t drive a car without good brakes.  Just like good brakes, a good compliance program allows firm management to move fast and seek new opportunities without fear of an unknown regulatory breakdown.

Brokers Can Block Disbursements to Senior Investors Under New FINRA Rule


Following recent SEC approval, FINRA’s new rule allowing firms to block disbursements to senior investors goes into effect on February 5, 2018.  The rules allow members to put a 25-day hold on suspicious disbursements of funds for any customers over the age of 65 and for any other customer that the member reasonably believes has a relevant mental or physical impairment.  The rule allows, but does not require, a member to hold funds if the member “reasonably believes that financial exploitation…has occurred, is occurring, has been attempted, or will be attempted.”  During the hold, the member must try to contact the designated “Trusted Contact Person” previously named by the account holder.  To enforce the rules, members must adopt and implement applicable written supervisory procedures and ensure retention of relevant records.


OUR TAKE: The new rules create significant compliance obligations for account opening, procedures, testing, and record retention.  They also will likely require a process to resolve potential conflicts between senior investors and the brokers that hold their assets.



Large IA/BD Fined $8 Million for Failing to Implement Suitability Procedures

The SEC fined a large IA/BD $8 Million because it failed to implement compliance policies and procedures for the sale of single-inverse ETFs.  Following warnings from FINRA and SEC OCIE staff, the respondent adopted policies and procedures requiring (i) every client to sign a Client Disclosure Notice and (ii) a supervisor to review all recommendations for suitability.  However, over a 5-year period thereafter, the SEC maintains that 44% of clients did not sign a Disclosure Notice and most did not undergo adequate supervisory reviews.  Consequently, the firm made several unsuitable recommendations including to retirement account clients.  The SEC cites violations of the Adviser’s Act’s compliance rule (206(4)-7), which requires advisers to adopt and implement policies and procedures reasonably designed to ensure compliance with the Advisers Act.

OUR TAKE: The SEC will severely punish recidivists who were notified of deficiencies during a prior exam.  In this case, the IA/BD specifically undertook to fix the identified suitability concerns but failed to implement those policies, thereby allowing the violative conduct to continue.


SEC Publishes List of Most Cited Exam Deficiencies

The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert listing the 5 most frequently identified compliance topics: weak compliance programs, insufficient and late filings, violations of the custody rule, Code of Ethics compliance deficiencies, and books and records.  OCIE highlights specific compliance problems including untailored “off-the-shelf” manuals, weak or absent annual reviews, and failure to follow procedures.  OCIE cited Form ADV and Form PF failures including inaccurate disclosures and late filings.  Other common deficiencies include failures (i) to follow the custody rule due to lack of knowledge about its requirements, (ii) to identify access persons, and (iii) to maintain complete and accessible books and records.

OUR TAKE: Compliance with the Advisers Act is not intuitive.  It requires a thorough knowledge of the specific requirements of the statute and all its rules.  Firms must hire a regulatory professional or a compliance services firm to assist with compliance or face significant exam deficiencies or an enforcement action.


Large Wrap Sponsor Pays $18.3 Million for Compliance Problems in Business Sold 8 Years Ago


A large dually registered adviser/broker-dealer agreed to pay over $18 Million to settle charges that it overbilled clients in a wrap program that it sold off in 2009, although it maintained an interest through 2013.  The SEC charges that the respondent overbilled clients by failing to (i) input lower negotiated fees into its system, (ii) track transferred accounts, (iii) rebate prepaid fees after termination; (iv) benefit investors when rounding, and (v) track lower rates when switching platforms.  The SEC faults the firm for failing to implement adequate compliance policies and procedures (Rule 206(4)-7) that would have required sample testing to discover the over-billing.  The SEC also charges violations of the books and records rule (204-2) because the respondent could not locate over 83,000 advisory contracts.

OUR TAKE: Selling or terminating a business line does not cut off regulatory liability for prior events.  Also, this case is a good example of how overbilling could occur and how to test for irregularities.


SEC Chief of Staff Outlines Compliance Challenges


SEC Chief of Staff Andrew (Buddy) Donohue recently described the future challenges facing compliance officers.  Mr. Donohue expressed concern about shrinking top-line growth in the asset management industry that could compromise the ability of compliance officers to obtain the funding necessary to implement the compliance program.  He also questioned the emerging trend of compliance taking a more active role to ensure compliance rather than assisting in identifying regulatory issues and developing policies and procedures.  Mr. Donohue warned that compliance must be viewed as a partner, not a “scapegoat or cost center.”  Mr. Donohue also inventoried the ever-expanding knowledge required including laws of multiple jurisdictions, overlapping statutes, and new technologies.  He advised compliance officers: “It is critical that you make it a priority to develop the necessary technical expertise, keep up with changing market dynamics, fully appreciate all of the firm’s businesses and follow regulatory developments and their impact on your firm and its operations.”  Despite his comments, Mr. Donohue expressed hope that his comments won’t “scare you away from a career in compliance.”

OUR TAKE: With over 40 years’ industry and regulatory experience, Mr. Donohue is a respected voice on regulatory and compliance issues.  Every CEO and Board should read this speech and ask whether their CCOs have the attention and resources to meet these challenges.


Compliance Outsourcing Has Doubled in Last 3 Years


A recent survey of registered investment advisers sponsored by WealthManagement.com and LPL Financial reports a significant increase in the number of firms outsourcing compliance and other non-revenue generating functions.  The percentage of firms outsourcing compliance has doubled over the last 3 years.  Nearly 1 in 5 RIAs now outsource compliance, a function deemed to be “necessary, but behind-the-scene activit[y] with less direct linkage to the customer experience.”  Other often-outsourced activities include HR, taxes, and bookkeeping, as advisors become more “focused on the activities that are most critical to their businesses” while “it is getting increasingly efficient to outsource those functions less important to growth and client satisfaction.”

OUR TAKE: Outsourcing compliance has become an accepted practice especially for advisers that don’t have the resources to hire and retain internal compliance talent.  A third party firm brings on-demand knowledge, scale, depth, experience, and independence.


Adviser Agrees to Hire Experienced CCO to Settle Compliance Charges


The SEC fined and censured an investment adviser and its president/CIO for failing to implement compliance policies and procedures after the SEC noted principal transaction and best execution deficiencies during 2 separate exams.  As part of the settlement, the respondent agreed to hire an experienced chief compliance officer and retain an independent compliance consultant.  The SEC alleged that the respondent promised, but failed, to implement required principal transaction and best execution policies following SEC exams in 2006 and 2009.  Even though the firm adopted policies and procedures, the SEC maintains that the firm violated those policies by continuing to engage in unlawful principal transactions and failing to monitor best execution.

OUR TAKE: Investment firms must hire a competent, experienced, and fully-engaged chief compliance officer to maintain and implement the compliance policies and procedures.  The SEC will not accept mere lip service when it comes to regulatory compliance, especially when a firm does not follow through on specific undertakings made in response to deficiency letters.


Large BD Failed to Remedy Mini-Flash Crashes

Failed to Remedy Flash Crash

A large broker-dealer agreed to pay $12.5 Million to settle charges that it violated the market access rule (15c3-5).  The SEC charges that senior executives had discretion to set pre-trade controls at levels that allowed significant erroneous orders to reach the exchanges.  In several cases over a 3-year period, erroneous orders caused mini-flash crashes in the affected security.  Despite these events, which should have been red flags, the SEC faults the respondent for taking no action to address the market access until contacted by SEC staff.

OUR TAKE: This is the type of breakdown that can easily occur at large firms where compliance is left to individual business units, and no designated person has overall responsibility to monitor trading practices.


Under-Resourced Compliance Department Leads to Enforcement Action for Illegal Cross-Trading

Compliance Department

The SEC fined and censured a fund manager because its under-resourced compliance department allowed unlawful cross-trading and principal trading.  The SEC charges that the firm engaged in illegal cross-trading and principal trading between registered funds and other affiliated clients by using an interpositioned broker as part of pre-arranged transactions.  Although the firm had relevant written policies and procedures, according to the SEC, “the individuals working on cross trading within [the firm’s] compliance department were underqualified, under resourced, and required additional training and resources to effectively implement [the] trading restrictions.”  The SEC faulted the firm, and not the compliance department, because “[s]enior members of the compliance department raised the need for additional compliance resources on multiple occasions to … senior management” but those requests were not met.  Much of the relevant monitoring was delegated to a “low-level administrative assistant” because of heavy compliance workloads.

OUR TAKE: The SEC will hold management accountable for failing to properly fund the compliance function, especially after the compliance department has informed management that more help is needed.  As a guide, we recommend that firms spend no less than 5% of revenues or 7% of operating costs on compliance infrastructure, including personnel and technology.