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