When new compliance oversight regulations under the Investment Company Act and Investment Advisors Act from the SEC went into effect in October 2004, many small and mid-size registered investment advisers and funds struggled to create the compliance ability in-house with their limited resources. More recently, however, many have found relief by placing the burden on stronger shoulders.
Rule 206(4)-7 for investment advisers and Rule 38a-1 for investment companies stipulate that SEC-registered advisers and funds appoint a "competent and knowledgeable" chief compliance officer (CCO) to administer policy and procedure, and have the responsibility and authority to enforce federal securities laws at the firm. The requirement seems plain enough, but for firms with limited staffs and operating budgets, the duties are too extensive to pass on to an investment professional, and it often is prohibitively expensive to hire a full-time CCO.
Dallas-based Prudent Bear Funds, a manager of two actively managed short funds with a combined value of $1 billion, learned this lesson through a year of trial and error. "I became the compliance officer when the rule went into effect, basically because as a small organization, there was no other logical person to do it who knew enough about all the different aspects of our fund to take on the responsibility," reports Gregg Jahnke, director, Prudent Bear Funds. "As I got further into it and was doing it for over a year, I began to realize that my background was 20 years in the investment business, helping select good stocks, ... and my appetite for doing compliance-type things was not that great."
Further compounding Jahnke's apprehension in the CCO role is the lack of clarity surrounding the liability associated with the position. The SEC has not made clear who would take the fall, or how severe the punishment would be, in the event of a regulatory violation. "It's certainly one of the less appealing aspects of being the named compliance officer," Jahnke explains. "The liability is extraordinarily uncertain."
Rather than continue to bear the liability, Jahnke decided to regain his focus on investment operations by handing his firm's compliance to someone else entirely. In summer 2006, he settled on New York-based Alaric Compliance Services.
Formed in January 2006 as a spin-off venture of EOS Compliance Services, Alaric acts as an outsourced service provider for compliance for small and mid-size investment advisers and fund companies. Essentially, Alaric becomes the acting CCO and supporting compliance staff for its clients. "The whole concept is that there is a tier of the market for which, on a cost-effective basis, it's more economical for them to hire a compliance department than it is to build one themselves," says Guy Talarico, Alaric's CEO.
Alaric monitors the day-to-day activity of Prudent Bear Funds, and as the firm's CCO, ensures Prudent's compliance with all applicable regulations, including provisions on portfolio management, best execution, personal trading, record keeping and data privacy protection, among others. To do so, Alaric built an electronic interface with the firm through which it receives the trade log, holdings sheets and personal trading activity, relates Talarico. Using analytical tools from Greenwich, Conn.-based compliance vendor Financial Tracking, Alaric assesses the various data to ensure that the firm is conforming with regulatory requirements. Further, says Talarico, "We also build Excel spreadsheets where we download information from the portfolio accounting systems and the trading systems from our clients. Then we're able to mix and match information from multiple sources and do a systematic review."
When Talarico decided to head his own firm, he identified the breadth of the regulatory requirements for investment advisers and funds, and created a prototype compliance program to ensure that these needs are met, he says. The program is customized from client to client after research into the inner workings of the firm. For Prudent Bear Funds, Jahnke says, Alaric came up with an 80-point plan with checks occurring daily, monthly and quarterly, depending on the process. "[Alaric] is really performing most of the higher-level functions that the compliance officer would take on to make sure that on a daily basis we're following the limits that are in our prospectus," says Jahnke.
A Risky Proposition
But the question still remains: With an outsourced compliance arrangement, how do you know your CCO is going to do the job correctly and effectively? Were Alaric to drop the ball on any regulatory requirement when working on behalf of Prudent Bear Funds, there would be plenty of blame and, most likely, fines to go around.
"Outsourcing [compliance] can be a cheaper alternative, or a more efficient alternative, but it's not something that you can leave alone and let it operate by itself," argues Michael Leary, treasury and compliance director, JPMorgan Fund Services, part of the Worldwide Security Services division, the bank's institutional investor services arm. "There's still a requirement for oversight and certain issues with providers' overall knowledge of the firm, lack of customization and also with being viewed as an outsider."
"Hiring an outsourced compliance department doesn't absolve you of the responsibility for not meeting the requirements," adds Alaric's Talarico, who says his firm mitigates some of the risk it takes on by researching and choosing its clients wisely. "When we become the chief compliance officer of a firm, we do as much due diligence on the firm as they do with us because the CCO has certain levels of personal liability that come along with the task," he points out. Talarico says he has, on multiple occasions, refused to work with a client based on its state of operations and the risk it would place on Alaric.
While Prudent Bear's Jahnke recognizes that there is a cost to outsourcing that is distributed to investors, he says the expense is considerably less than the price tag on a dedicated CCO and improves investor value by allowing him to focus on managing their money. "It might -- and I would stress might -- in the long run end up costing shareholders a little bit more to do it this way, but it's giving them a level of professionalism that we didn't have when I was doing the job," he asserts.
Alaric's Talarico estimates the salary of a CCO at a mid-size firm to be more than $300,000 before factoring in the cost of benefits, bonuses and overhead. By using an outsourced model, he contends, his clients, including Prudent Bear Funds, typically save as much as half of the cost of hiring a full-time CCO. <<<