Rules have changed the investment industry fundamentally by creating the position of CCO and requiring a written compliance program.
This year marks the 10th anniversary of the Securities and Exchange Commission's adoption of a series of rules designed to formalize compliance programs in the investment management industry. Rule 206(4)-7 under the Investment Advisers Act of 1940 and Rule 38a-1 under the Investment Company Act of 1940 codified the need for investment advisers and investment companies to appoint a chief compliance officer, adopt compliance policies and procedures, and conduct an annual review.
These rules have changed the investment industry fundamentally, primarily by creating the position of CCO and requiring a written compliance program. For advisers and mutual funds, the disclosures in Form ADV and the Statement of Additional Information of the CCO's name and length of service provide basic information to anyone who reviews those documents for due-diligence purposes.
Prior to the enactment of the compliance rules, an external examination would reveal only disciplinary matters. However since the rule was enacted, third parties, including regulators, have an opportunity to gauge the value of compliance in an organization by their choice of chief compliance officer — for better or for worse — for investment advisers of all sizes. The compliance rules provide an extraordinary opportunity for firms to showcase their compliance program and choice of individual to lead it, as well as document their annual reviews. The disclosure documents, such as Form ADV Part 2, also demonstrate to employees, management and third parties the compliance competencies of the investment adviser organization. But while some firms take advantage of this opportunity, others wait for an SEC deficiency letter, or worse, enforcement action, to make the required changes.
THE RULE CHANGES
For the choice of a chief compliance officer, ask whether any of the questions highlighted in the box above are true. An affirmative answer to any one of them can lead to an unfavorable risk rating, but more importantly, these answers show that the opportunity of naming an experienced compliance professional has been lost. Culture can be defined as a way of thinking, behaving or working that exists in a place or organization. The choice of CCO is probably the single best identifier of the culture of compliance at an investment advisory firm. A strong CCO will have the ability and authority to keep a firm out of regulatory trouble, and if that is not there, there is always risk that the operations are not in compliance and that compliance issues will be missed.
The second key indicator is the Form ADV Part 2. An external review of an ADV Part 2 and comparison to an investment adviser's website can provide clear insight into the quality of a firm's compliance program.
Virtually every adviser who presents any performance information needs to have the information supported and footnoted appropriately. Unsupported representations in the public domain (CNBC interviews, websites, third-party articles) can lead regulators to charge breach of fiduciary duty, misrepresentation or violations of the antifraud provisions of the federal securities laws. Violations of the rules governing performance disclosures can be glaring, meaning that when they are present, it is apparent there is no compliance professional working with the firm.
Many of the descriptions in the ADV Part 2 explain attributes of the compliance program, including a description of the investment selection process, use of soft dollars and a code of ethics. Use of boilerplate disclosures in these documents are clearly evident to all who review them and can become very expensive to defend if regulators focus on them compared with your firm's practices.
The most problematic element of the compliance rule is the fact that Rule 206(4)-7 does not require the annual review to be in writing. At the time of adoption, the SEC requested comments as to whether the “in writing” requirement should be included and whether the review should be completed by a third-party professional. Ultimately, the rule did not require either. Examinations by regulators request documentation that the review has been conducted annually. Firms that have a documented annual review (in a compliance binder or file) where the review provides documentation of changes in the program from year to year are able to provide that information to regulators or third parties immediately. Firms that have failed to implement a written annual review process have to search for notes and completed questionnaires or hire a third party immediately to conduct a review in response to the apparent lack of documentation. The SEC's decision not to require a written review has resulted in countless compliance violations by advisers who did not understand that they were required to conduct and document an annual review. In securities regulation parlance, ignorance is never an excuse: You play by the rules or choose a different career path.
Compliance with federal and state securities laws is not an easy task. In nearly every industry, regulations have been adopted that require compliance with the rules to be documented and administered by a professional. This 10th anniversary is an opportune time to get prepared.
Debra M. Brown is the managing member of Brown & Associates, which provides compliance and regulatory services for financial services companies including mutual funds, investment advisers and certain broker-dealers. She can be reached at dbrown @selfauditor.com.
