What's It Take / Industry Trends
In an effort to be a bit more entertaining in an area that usually has none, what follows is one consultant's view of what it takes for some firms to realize the need and value for taking an honest swing at having a functioning compliance program. For those reading this who have already found what it took to have a compliance program, there are some current compliance trends interspersed throughout and you may find enjoyment in reading about other's plights. As a compliance consultant to small firms, my colleagues and I see all kinds of firms in various states of non-compliance when we first walk in the door. That being the case, you still have to give that firm credit for having recognized the need for seeking help in an area that is not necessarily intuitive and have taken the next step. For this edition of
What's It Take we look at the Ugly Regulatory Audit.
The Ugly Regulatory Audit
Well there is no mystery here as to what it took for some firms to seek help in their compliance program. They get "shown the cliff" by a regulator during an audit which many times is the first audit the firm experiences. We will look at this process through the eyes of Mr. CCO (who is more a partner of the firm but just drew the short straw and was named CCO). The start is with the notice of audit from the SEC or a Self Regulatory Organization (SRO - think FINRA). Mr. CCO has that sinking feeling like he was just notified that a final exam is taking place in the first week of class. However, after the initial panic, Mr. CCO rationalizes, "How hard can this be? Firms worse than ours pass these things and we are doing nothing wrong!" Ahh the bliss of naiveté.
Then comes the document request list, "Hmmm, it seems we don't have a lot of this stuff - well maybe they will help us with some items, and we'll do the rest later. After all we are doing nothing wrong, What's the worst that can happen?"
Current Trend - SEC Strategic Plan for 2010-2015
The Securities and Exchange Commission ("SEC" or "Commission") has released for comment its Strategic Plan for Fiscal Years 2010 to 2015. The Strategic Plan addresses many of the overall goals and outcomes sought by the SEC as a matter of principle and as a result of its congressional mandate to protect investors, promote fair and efficient markets, and facilitate capital growth. The broad goals outlined in the Strategic Plan include the familiar precepts of the SEC: (1) foster and enforce compliance with the federal securities laws; (2) establish an effective regulatory environment; (3) facilitate investor access to information; and (4) enhance the Commission's performance by maximizing its resources.
Not surprisingly, there is also a noticeable change in the Commission's approach. It is no secret that the Commission is in the process of making significant, long-term changes to its regulatory and enforcement approach in the wake of recent events that raised questions about the regulatory body's effectiveness. To achieve its goal of fostering compliance with the securities laws, the SEC plans to more actively encourage those organizations it regulates to adopt a strong "culture of compliance." To this end, the SEC plans to better communicate its findings from inspections and enhance its publication of major enforcement actions as a deterrent. The agency is completely re-assessing its risk-based approach to examination of registrants and plans to substantially increase the number of cause and special examinations conducted through its use of a more robust risk assessment process.
To establish an effective regulatory environment, the Strategic Plan directs the SEC staff with drafting rules and regulations to ensure that they are clearly written, easily understood, and tailored toward specific ends and provide for regular review of its rulemaking process. The Strategic Plan also states that the SEC will seek to harmonize the regulatory systems that apply to broker-dealers and investment advisers. It remains unclear whether this means the establishment of a self-regulatory organization for registered investment advisers or the expansion of the authority of FINRA to include oversight of SEC-registered investment advisers as well as broker-dealers. What is clear is that the oversight of registered investment advisers shall be increased.
The final two precepts of the Strategic Plan are to increase investor's access to information and to improve the performance of the SEC. The SEC believes that a critical component of effective regulation is ensuring that investors have sufficient access to information to permit them to make informed investment decisions. The SEC believes that providing investors with greater availability of background information on broker-dealers and investment advisers will help facilitate better decision-making. Finally, the Commission's goal of enhancing its performance and maximizing its resources includes greatly expanding internal training programs to expand staff expertise, and hiring programs designed to attract more economists, trading and investment specialists, and staff that have significant experience in fraud detection.
The first sign that things may not go well is the opening interview where twice the number of regulators than what Mr. CCO expected arrive and they are in suits despite your lower level business casual dress code (the Hawaiian shirt does not impress them). During the opening interview, our poor soul attempts to "get to know" the audit staff and loosen the tension with a few one-liners or some self-deprecating humor. These efforts are met with icy stares and not a whiff of acknowledgement of even his best humorous material. Questions come one after another and answers Mr. CCO feels good about are not met with any acknowledgement of a good answer and questions that Mr. CCO doesn't feel great about are met with a furious round of pen on paper note taking.
After the opening interview, the parade of documents provided to the examiners convinces Mr. CCO that they have clearly found something and he starts to wonder what life in the pokey will be like. In addition to requesting large amounts of documents (some he didn't even know he had), Mr. CCO asks himself the same questions every morning when the Staff shows up, "Why are they still here? We have a simple operation and we are doing nothing wrong, it would seem that they should have been done days ago." By now the Firm's staff has picked up on the fact that the regulators are very different from other visitors and have a way of going silent upon approach. So, the staff turns to Mr. CCO and asks if everything is okay? (i.e. do I need to update my resume'?) and, When are they going to be done? (i.e. I hope they leave before they look into my area).
Hedge Fund Legislation
There is legislation being drafted that would effectively eliminate the number of clients exemption hedge funds use to avoid registration as an investment adviser. As currently constructed, the registration requirement does not apply to firms with fewer than 15 clients. With hedge funds, the fund itself is considered the client not the participating investors. Thus, a company with only one fund (or 14 for that matter) does not have to register with the SEC regardless of the number of assets under management or how many investors are served by those fund(s).
The new legislation will likely amend the registration requirement either by counting investors as clients or by eliminating the client exclusion altogether. What may save some funds from registration is that lawmakers are considering the possibility of raising the minimum assets under management that triggers the requirement to register. Upon passage hedge funds will be looked at as any other investment adviser and will be required to register with the SEC. The smaller funds may be able to avoid registration with the SEC, but still may need to register with the States in which they do business.
The timing of the passage of the legislation is unclear. There are estimates that the bill could be on the President's desk before the end of the year, but those estimates may be a bit aggressive. The one certainty is that lawmakers view the need to increase transparency and protect investors (as well as clients) as a clear necessity. Thus, the passage of this legislation is a certainty and it's only a matter of when it is passed.
At last the day arrives where the regulators notify Mr. CCO of the exit interview. At last an end to this water torture! Going in he feels like a defendant in a criminal case (and for some this may be a prelude) and wonders if a blindfold and a last cigarette are in order. The regulators proceed to cite specific rules violations that go on, and on, and on. As one CCO/Partner put it, I knew we were in trouble when the lead examiner punctuated each violation with a glare by looking over her glasses perched low on her nose (picture the most strict elementary school teacher you ever had). The examiners also punctuate certain deficiencies with the rhetorical question, "Did you not realize that (fill in your deficiency here)?" and they accompany the question with that disdainful scorn that only a regulator can muster. Mr. CCO's commitment to running a regulated entity is questioned and just like telling the policeman that you did not know the speed limit, Mr. CCO finds that professing your naiveté and that the firm is doing nothing wrong does not spare the verbal and written flogging. Clarity hits him in the face like a freezing cold Chicago wind. Mercifully, the regulators finally leave, but they are not done as they inform Mr. CCO they will continue working offsite and there may be yet more citations in their coming letter of deficiency items.
Once the deficiency letter arrives, Mr. CCO's stomach rolls over at the memory of the exit interview. That help and guidance he expected from the regulators does not come in any form other than the ruler cracking the back of his knuckles (hmmm, I just dated myself didn't I). The letter looks and reads with its legalese syntax as if judgment day has come and it's up to Mr. CCO to respond appropriately to avoid a certain warmer climate. Now here at the end, all that money that Mr.CCO was saving by not administering compliance looks like fools gold and will soon be used on professional fees to get him and his firm out of the current mess.
Following editions will look at other paths that many firms followed to find the answer to the question What's It Take? For those who have bad memories, my apologies. For those who have yet to find what it takes for them, consider this one of the three ghosts in the compliance version of A Christmas Carol which has now visited you before.......
Jeff Groves
President
ComplianceWorks Inc.