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Making Compliance Headway

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Four years since the passage of the SEC’s “compliance program rule”–requiring registered investment advisors to adopt and implement compliance policies and procedures, appoint a chief compliance officer, and conduct an annual compliance review–and advisors are still grappling with exactly what theirannual review process should entail.

That’s just one of the findings of the recently released 2007 Investment Management Compliance Testing Survey conducted by the Investment Adviser Association (IAA), ACA Compliance Group, Old Mutual, and IM Insight. Since the SEC has provided little guidance on how advisors should test their compliance programs, the IAA and the other groups intended the study to be a tool for advisors to use to benchmark their compliance testing programs against those of their peers. The study also provides ideas on new testing techniques advisors can use as well as advisor practices related to personal trading, soft dollars, gifts and entertainment, political and charitable contributions, business continuity, and books and records.

The study notes that while the industry has done a pretty good job of appointing chief compliance officers and adopting and implementing compliance policies and procedures, the annual review is presenting “challenges” for many advisory firms. The study cites an SEC study conducted last year, which found that more than 40% of advisors examined during a four-month period in 2006 received a deficiency letter on their annual review process. In not providing formal guidelines, the SEC deliberately provided advisory firms the latitude to tailor their compliance programs to suit their specific businesses. While this flexibility is good because it doesn’t box advisory firms into a one-size-fits-all compliance schedule, this freedom to tailor their compliance rulebook makes it harder for the SEC’s inspection staff to do “quality control work” on compliance areas across all types of advisory firms, says Karen Barr, IAA’s general counsel. SEC examiners may say a compliance control looks good in one shop, but it doesn’t in another, she says. The “issue is making sure the [SEC] inspection staff is reasonable in evaluating firms,” Barr adds, noting that advisors already complain many examiners are not being fair. IAA, she says, “has been trying to educate the [SEC] staff that all of these [advisory] firms are different.” The study also notes that the flexibility has also left advisors with testing-related questions like: “Should we be doing more rigorous testing? Are we performing the right kinds of tests? Should we prepare a written report summarizing the results of the annual review?” The survey found that nearly all firms document the annual review in some manner: 49% use workpapers; 46% use lengthy written reports; 37% use a short memorandum; and 30% document using informal notes. Only 3% of firms, the survey found, do not document the annual review.

The online survey included responses from 457 advisory firms, which ranged from sole proprietorships to large, national firms. It’s hard to make any meaningful comparisons between the two surveys, Barr notes, because last year’s survey only included responses from 56 firms. In this year’s survey, the typical firm (31%) had between $1 billion and $10 billion in assets under management; 41% had between 11 and 50 employees; 63% of the firms were not affiliated with another entity; and 62% of the firms had been in business between five and 25 years.

Most firms–even large ones–also have small compliance staffs, with the firms’ CCO often holding two or more titles, the study found. At about one third of the firms (35%), only one employee performed full-time legal and/or compliance functions, the study found. At more than a quarter (28%) of the firms, no employee had full-time legal or compliance duties. Only 14% of the firms reported more than three full-time legal/compliance employees. Also, of the firms that had more than $20 billion in assets under management, 29% had fewer than four full-time legal/compliance employees. Seventy-eight percent of the firms reported that the CCO wore two or more hats, often also acting as COO and CFO.

Clients served by the advisors varied as well. Forty-eight percent of the firms served high-net-worth folks with a typical account size of $1 million or more. Forty-five percent of the firms served institutional investors–endowments and corporations–while 38% served ERISA clients.

The majority of firms (57%) said they conduct compliance testing on an ongoing, rolling basis, which is what the SEC encourages. Thirty percent of respondents, however, said they conduct annual reviews. “It is quite possible that at least some of these firms are, in fact, testing throughout the year, but simply have not recognized their activities as such,” the study adds. When conducting compliance tests, the bulk of the firms (73%) found only minor compliance issues, 8% uncovered “significant issues,” and 19% detected no issues, the study says.

The survey is proof that most firms are indeed developing a culture of compliance. The study found that 77% of respondents said they immediately told the CEO or president of “material compliance issues/breaches.” Ninety-three percent of firms also told senior management the results of the annual review. In 68% of the firms, the CCO is one of the most senior executives, and 65% of the firms said they conduct annual or more frequent compliance training and their senior management participated in SEC exams.

While firms conduct a wide variety of personal trading tests, many advisors do not perform basic tests routinely conducted by SEC examiners when reviewing personal trading, the survey reveals. Advisors also do their utmost to avoid soft dollars. Of the firms that utilize soft dollars, the survey says “most do not use more than a small percentage of the total client commissions to obtain third-party soft dollar products and services.” Virtually no advisors polled participate in client commission arrangements, as contemplated in the SEC’s recent interpretive release, the study says, and “virtually no advisors ‘unbundled’ full-service brokerage by attempting to place a dollar value on proprietary research.”

When it comes to written policies regarding political contributions, most advisors (65%) don’t have any. Even more advisors (78%) do not have written policies regarding charitable contributions, however larger firms were more likely to have written policies regarding contributions. For instance, 70% of the firms with $10 billion or more in assets under management had a written political contribution policy, while only 28% of the firms with less than $250 million had a policy, the study says. Among the firms that did have a contribution policy, 46% prohibited political contributions by their firm, while 23% prohibited employees from making political contributions to officials related to clients or potential clients.

Despite recent SEC scrutiny of advisors’ gift and entertainment habits, the survey says that a surprising 35% of the 85% of the firms that have written gift and entertainment policies do not perform testing to determine compliance with that policy. However, the study notes that 16% of those firms prohibited gifts and/or entertainment. At most firms (70%) the gift and entertainment policy was part of the firm’s code of ethics.

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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