Compliance: A Key Cornerstone of Operational Due Diligence

Oct 20 2011 | 9:27am ET

By Nick Rice, PAAMCO -- Given recent scandals in the investment management industry and increasing regulatory oversight, compliance has become an increasingly important and useful focus area when conducting due diligence on asset managers. The responsibilities and duties attached to managing money on another’s behalf mean that providers of financial services merit close regulatory oversight. The importance of the finance industry to the economy also demands a robust regulatory environment to ensure stable and orderly capital markets. Regulation helps customers of the investment industry by improving protection of their assets and helps service providers by increasing public confidence in financial services and financial markets.

How Does Regulation Affect Investment Managers?

Managers will generally be required to register with the regulatory authorities in the jurisdictions in which they conduct business. Registration brings with it a requirement to comply with the rules of the regulator. These may require the manager to file returns, prepare reports, create compliance policies and procedures, implement internal controls, conduct compliance testing and ensure compliance training for staff, among other tasks. Compliance requirements may also come from other entities besides the main regulatory authorities, for example, stock exchange rules that restrict specific trading or require disclosure of certain positions.

Strong Compliance Culture Now A Necessity

In addition to meeting specific requirements, it is also important that the manager has a strong compliance culture. It is not enough to have policies and procedures. It is not enough to have good intentions. To maintain and reinforce a culture of compliance, the firm’s management must cultivate a culture of doing not only what is required by law, but also what is right – whether or not a regulator is looking. By doing so, the firm will establish a culture that guides and reinforces employees as they make decisions and choices each day. This can be encouraged by providing regular compliance training to employees and by senior management setting the tone by demonstrating that they take compliance seriously. SEC-registered managers are required to adopt a Code of Ethics which encourages staff to adopt a high-level, principles-based approach to thinking about compliance issues.

If managers are meeting compliance requirements, we can gain some comfort that assets are being protected from certain unfair or imprudent business practices. Secondly, a strong compliance environment decreases the likelihood of a publicly disclosed compliance breach and the reputational risk arising from association with such a manager. Thirdly, a strong compliance culture helps protect investors from negative alpha events which can arise from compliance issues, such as the suspension or removal of a portfolio manager. 

What To Look For When Conducting Operational Due Diligence Around Compliance

The first step is to understand the manager’s compliance framework by asking the following questions:

  1. What entities are they regulated by?
  2. Which employees of the manager are responsible for compliance? Are those individuals independent from the front office?
  3. Do the manager’s compliance model and resources seem reasonable and appropriate given the manager’s size and activities?
  4. Does the manager utilize an external compliance consultant? If so, what is the extent of the consultant’s involvement and is it appropriate?

Managers should have a detailed Compliance Manual for staff to reference which contains policies and procedures surrounding all key compliance areas. The manager should also have a compliance monitoring program to ensure that procedures are being followed and that controls are operating effectively.

It’s also important to know what communication your managers have had with their regulator(s). Have they been the subject of any formal inspections or investigations? Have they been required to make any non-standard disclosures to a regulatory body? How has the manager responded to regulatory problems? Where there has been communication, ask to view the correspondence in order to corroborate what the manager has told you. Significant regulatory breaches are generally a matter of public record, so research should include a review of the firm’s disciplinary history on the regulator’s web-site, as well as general internet searches for stories in the financial press.

Other Compliance Areas To Focus On

Certain compliance areas warrant additional work owing to their importance in protecting our interests as investors. Specific areas to focus on include:

  • Trade allocation
  • Best execution
  • Soft commissions
  • Personal account dealing
  • Trade errors

Review the manager’s documented procedures around these areas and ensure that they are appropriate. Look for evidence that the documented procedures are being adhered to. This will generally take the form of reviewing the manager’s periodic compliance testing in these areas.

Following the financial crisis of 2008, regulation has become increasingly politicized. As a result, large amounts of new regulation are being enacted resulting in an increased regulatory burden on managers. It is important that managers understand the impact of regulatory changes on their business and ensure they have adequate resources to meet the growing compliance requirements.

Nick Rice, ACA, CFA is an Operational Due Diligence Manager and a member of the PAAMCO Operational Due Diligence Committee. He has primary responsibility for operational due diligence on European-based fund managers. Nick also serves as Compliance Manager for PAAMCO Europe LLP. Before joining PAAMCO, he worked for Marble Bar Asset Management LLP with broad responsibilities in the finance function. Prior to that, Nick was employed by Ernst & Young Bermuda where his principal role was auditing hedge funds. He graduated from the University of Warwick with a B.A. in Classical Civilization.


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