Under Rule 206(4)-7, an investment adviser registered with the SEC is required to (a) adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws; (b) revise those policies and procedures each year for adequacy and effectiveness; and (c) designate a chief compliance officer to be responsible for overseeing and administering said policies and procedures.
Since the rule’s implementation almost a decade ago, there has been a distinct trend among SEC-registered investment advisers towards outsourced CCO services to satisfy 206(4)-7(c). Despite initial reluctance on behalf of the SEC to fully embrace the practice of firms using outsourced CCOs, registered investment advisers have found widespread success with this arrangement. As the SEC and state regulators continue to ramp up compliance requirements for all industry participants, the outsourced CCO arrangement has increasingly become a fixture in the modern landscape of the industry.
The Outsourced CCO Arrangement
The SEC requires that the CCO is a “supervised person,” defined as “any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment adviser, or another person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser.”
An outside compliance professional endowed with the overarching duty of overseeing and implementing the firm’s compliance program and equipped with the authority to do so fits the bill. In an outsourced CCO arrangement, the outside compliance professional becomes the named CCO on Form ADV and can be made responsible for everything from drafting, maintaining, and implementing a firm’s compliance manual, to conducting formal, periodic compliance reviews and risk assessments, to providing compliance education and training to the firm’s staff.
Explaining the Trend
When the new Compliance Rule 206(4)-7 became effective in 2004, investment advisers scrambled to find a cost-effective and legitimate way to comply with the SEC’s heightened requirements. Small firms found themselves in a particularly challenging position because of fewer personnel and resources. Even the most experienced advisers well-versed in SEC rules and regulations found it extremely difficult, time-consuming, and stressful to try to singlehandedly perform all the duties required of a CCO without outside help.
In 2004, Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations, emphasized the need for CCOs to have “intimate knowledge of the firm’s operations in order to administer an effective compliance program. It would therefore be logical to infer that a reasonable amount of time would have to be spent not only overseeing the structure of the compliance program but its implementation as well. Because of this, I am wary about whether a compliance ‘rent-a-cop’ could really be up to the task.”
Nevertheless, the arduous ongoing compliance requirements imposed on investment advisers, in conjunction with the numerous benefits yielded by those who engaged in outsourced CCO arrangements, have resulted in a steady increase in the prevalence of outsourced CCOs. Charles Schwab’s 2012 Benchmarking Study revealed that 35% of firms reported outsourcing compliance, up from 23% three years ago. Indeed, this past year has seen no shortage of the consequences of inadvertent noncompliance due to investment adviser’s self-reliance. In 2012, Ron Rhoades, president and CCO of an investment adviser firm, expert in securities laws and regulations, and chair-elect of the National Association of Personal Financial Advisors, stepped down over a registration error he made that cost his firm tens of thousands of dollars. He stated afterward that, had he used a compliance consultant, such a mistake would not have occurred.
Benefits of Outsourced CCO Services
Cost-Effectiveness: One of the most compelling arguments for engaging in an outsourced CCO arrangement is the sheer cost of hiring a full-time in-house CCO, which is typically significantly more expensive than using an outsourced CCO. This is particularly true in light of what employment entails: competitive salary, benefits, vacations, sick days, paid time off, among other things. Furthermore, employee turnover would be especially problematic in this position, whereas an outsourced CCO would be part of a compliance company that retains its institutional knowledge even if that particular employee leaves.
The other option is placing the title on an existing employee with other duties. While this may be less expensive in the short run, investment advisers should consider whether this exposes them to a heightened risk of substantial penalties and losses, and determine whether that risk is worth it. Oftentimes, investment advisers find that the cost-benefit analysis clearly sways in favor of using a compliance professional.
Compliance Expertise: One mistake that firms often make is assuming that they will not commit any compliance violations as long as they act properly and “do the right thing.” Unfortunately, the SEC requires more than good-faith dealing and does not excuse inadvertent oversight or honest misinterpretation of the rule. By using the services of compliance specialists, investment advisers can capitalize on the industry expertise of entire companies applied entirely to this one aspect of their business.
Reallocation of Time and Resources: Firms often attempt to handle the CCO requirement internally until they realize what an enormous undertaking it is. Registered investment advisers have enough on their hands managing and growing their businesses. Many of their responsibilities are non-delegable, but compliance is not one of them. Firms that use outsourced CCO services can save valuable time and resources that can be devoted to other aspects of the business.
Independence: Using an outside compliance professional to oversee and implement a firm’s compliance program has the advantage of independent and unbiased third-party compliance review, which may hold more weight with the SEC. CCOs are required to detect and report internal violations, and take corrective action as needed. Having an outsourced CCO handle these tasks rather than a fellow employee increases the likelihood of objectivity and accuracy.