Can you "Rent a Cop"?
By William E. Vastardis

Thousands of investment advisers have a new position on their staffs as of October 5, 2004. Under the Security and Exchange Commission's (SEC's) new Rule 206(4)-7, by that date all registered advisers were required to have appointed a chief compliance officer (CCO). But that was just the beginning. Each adviser is also required to adopt written policies and procedures designed to prevent violations of the Advisers Act. Then, on October 26, 2004, the SEC decided to extend the range of its authority by requiring hedge fund advisers to register with the Commission, bringing under its umbrella the estimated 60 percent of hedge fund advisers that have avoided regulation up to now and subjecting them also to Rule 206(4)-7. These regulations are in addition to Rule 38a-1 of the Investment Company Act, which applies to investment managers who advise or sub-advise registered mutual funds. Rule 38a-1 also had an October 5 deadline.

During the run-up to the October 5 deadline, many advisers, especially smaller ones, grappled with the CCO appointment. The SEC's final release adopting Rule 206(4)-7 stressed that the CCO should be a single individual who is "competent, knowledgeable, and empowered." That person must have "sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures." They were uncertain whether anyone in their firm had both sufficient seniority and in-depth knowledge of the Advisers Act. They were concerned about the additional cost of hiring from outside, as well as the administrative burden of implementing the compliance program. They wondered if their operations warranted a full-time CCO or, conversely, if a senior staff member—the firm's top lawyer, for example—had enough extra hours in the day to also be an effective CCO. They considered appointing a junior employee (contrary to the SEC's stated objections) on the theory that "we're already compliant with the law, so the new requirement is really form and not substance." And, in the end, a not inconsiderable number of advisers outsourced their CCO; that is, they asked one of their existing service providers (most often the fund's administrator) to provide an individual, or turned to one of the third-party firms that have ramped up a compliance service to answer just this need.¹

The new rules do not preclude outsourcing a CCO. Bill Meck, senior assistant district administrator in the SEC's Philadelphia office, indicated that the general position on outsourced CCOs "is that you shouldn't do it" but went on to acknowledge that "it's not verboten, it's not forbidden." The SEC has suggested when outsourcing might be appropriate, e.g., if a company has "strongly imbedded business interests and is in favor of maintaining those conflicts of interest, the firm may be better off to bring in someone from the outside." Remarks by Commission staff most often concern outsourced mutual fund CCOs but can be construed to extend to adviser CCOs. For example, Lori A. Richards, an SEC director in the Office of Compliance Inspections and Examinations, is concerned that a "rent a cop" (her term) might not have the intimate knowledge of operations, not to mention the time and senior management access, to oversee implementation of the compliance program, particularly if he or she has taken on multiple assignments as CCO. She notes that the CCO must be "an integral part of senior management," and goes on to say, "The most effective organizations will not be those who employ 'compliance cops' without also imbuing a 'culture of compliance' top-down and consistently through all layers of management and staff."²

Under certain conditions, outsourcing your CCO may be an alternative. If you must outsource your CCO, here are some things to consider.

Some of the benefits of an outsourced CCO may include the following: (1) continual access to appropriate knowledge of the Advisers Act and regulatory developments, (2) knowledge of industry best practices garnered from involvement with more than one firm, (3) cost efficiencies relative to the salary of a qualified in-house CCO and his or her support staff, and (4) independence from management. Many investment management firms, especially those that will be newly registered with the SEC, simply do not have Advisers Act expertise in-house. Further, "the kind of support staff CCOs require...makes outsourcing not just attractive, but, for some firms, necessary," said Charles O'Neill, president of the recruiting firm Diversified Management Resources. "Smaller fund shops simply don't have the kind of money needed to develop that kind of support staff." And after all, third parties already play an extensive role in the operations of many advisers and their funds, having assumed such functions as fund accounting, shareholder servicing, and administration (including legal work). The industry already runs on a model of close cooperation between unaffiliated entities.³

What are the prerequisites to making an outsourced CCO the lynchpin of a robust compliance program? First, the adviser must have a strong compliance culture to begin with. As Ms. Richards of the SEC stated on another occasion, "Too many advisory firms seem to have forgotten that they owe the highest duty of fiduciary care to their clients... [Their] compliance staff can't do it alone; they must operate within an environment that recognizes and supports the role of strong compliance and ethical practices, whether the [compliance staff is] in the room or not." In fact, an individual who offers her services as an outsourced CCO would be foolhardy to sign on with a firm whose commitment to compliance is lukewarm, if only from the standpoint of personal liability when things go wrong. ⁴

But let's assume your firm has a strong compliance ethic—further, that you are prepared to send a clear, consistent, and repetitive message that the outsourced CCO is part of senior management and should receive full support and disclosure from all levels of the organization. The considerations then become commitment and proximity. Since the CCO is responsible for crafting and implementing the firm's compliance program, there is a presumption that she is intimately familiar with your operations. To ensure her routine involvement in the business, the outsourced CCO must make a substantial commitment to establish a true onsite presence. While video conferences and electronic mail make it possible to run a business from far-flung locations, they cannot substitute for the CCO's regular physical presence. This presupposes a limited number of CCO assignments for any one individual.

Ensuring this regular presence might also be difficult if the outsourced CCO is on the other side of the country—but not impossible. For example, the CCO might cultivate a regional presence, limiting his assignments to firms in a single city or part of the country. The CCO who already visits a client in Chicago once a month might expand his Chicago presence and organize site visits into one trip. Another example is the CCO whose clients employ the same custodian, administrator, or outside law firm, enabling her to leverage knowledge of and interaction with these important service providers.

An effective outsource provider should be fully aware of these considerations and of the consequences of failing to implement a strong compliance program, and should be prepared to address your concerns during the pre-hiring discussions. You should evaluate the candidate's current and potential competing commitments and be clear about your expectations of time commitment.

Here are some questions it is important to ask as you conduct your due diligence on a possible third-party CCO:

1. What is your expertise in the Advisers Act and related law? How did you obtain this expertise?
2. What is your expertise in the kinds of pooled products we offer? In mutual funds? In hedge funds?
3. How do you keep this expertise up to date?
4. How many CCO roles have you personally taken on (or plan to take on)? What assurances can you give us (contractual or otherwise) that you are limiting the number?
5. What are the size and capability of your support staff, if you have one? Are you prepared to submit to background checks, provide references, etc. in order to give us confidence about your integrity and good standing in the business community?

In short, an outsourced CCO may be an alternative if you do not have (or cannot cost-effectively obtain) the required competency and seniority in-house, under the following conditions:

• Your firm already operates in a climate of compliance.
• Senior management clearly broadcasts that it expects the CCO will obtain complete cooperation, support, and access from all levels of the firm.
• You are comfortable that the CCO has limited (and will continue to limit) her assignments to manageable levels, consistent with her geographical proximity and the time commitment you have made it clear you expect of her.

¹Examples include BISYS Fund Services and PFPC.
²Quotations in this paragraph are from Ms. Richards' speech to the Investment Company Institute/Independent Directors Council Mutual Fund Compliance Programs Conference, Washington, D.C., June 28, 2004.
³Quotations in this paragraph are from the Ignites' "People" article titled "Deadlines, Costs Drive Firms to Outsource CCO," June 14, 2004.
⁴Quotations in this paragraph are from Ms. Richards' speech at the IA Compliance Best Practices Summit, March 15, 2004.

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William Vastardis is founder and chief executive officer (CEO) of Vastardis Capital Services™. For more information, please Contact Us.

This article appeared in the January-February 2005 issue of The Monitor, a publication of The Investment Management Consultants Association (IMCA).