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News June 20, 2005 Issue

Got Plans for the Summer?

The next Division of Investment Management director is nowhere in sight. The confirmation of Rep. Christopher Cox (R-CA) as the new SEC Chairman could take months. There doesnít seem to be any rulemaking on the brink of adoption, and there are no new scandals making headlines.

Could the summer of 2005 give CCOs a much-needed breather?

"It would be sort of nice to have a little routineness, after the past year and a half," said the CCO of a Massachusetts advisory firm. "Iím looking forward to it."

IM Insight asked a number of CCOs and in-house lawyers about their goals for the summer. The number one response: reviewing and revising their policies and procedures and testing their compliance programs.

Aaron DeAngelis, CCO of Brandywine Asset Management, said that he plans to conduct training and generally "look at where we stand on things." Many of his summer projects involve "taking stock" and determining whether his firm is "hanging out" in any particular area. Those projects, he said, will be wrapped up into his firmís annual review. "Iím trying to cope with some of it that way" rather than "waiting until the last minute," he said. DeAngelis said that he is planning on bringing in a third-party firm to conduct the overall review. "Iíve been prepping my firm that they are going to pay an independent third party," he said.

The general counsel of a mid-sized East Coast firm said that he plans to spend the summer "just assessing where we stand relative to everything thatís on paper, and making sure we have the processes in place to monitor everything." The lawyer also said that he wants to double check to make sure that his firm is keeping all the backup material that, based on the firmís procedures, "we would hope" is being kept.

"I am planning on spending a lot of time this summer testing," said Gardner Lewis Asset Management CCO Judy Werner. "Iím going through and making sure that everything is working as it should." To do that, Werner said she is "running a lot of reports and checking a lot of client dispersions to see what pops out." Looking at dispersions of client account performance, she explained, "tells me whether our trade allocation is working." She also said that she plans to work with the individuals in her firm who perform reconciliations "to make sure that the processes are working properly."

Of course, the turnover in leadership at the SEC may not necessarily translate into a summer lull for all advisers. "The chairman of the SEC doesnít audit me," noted Stanley Hargrave, partner and CCO of Independent Financial Advisors. Regardless of whatís going on at SEC headquarters, he said, the examiners in the regional offices "keep ticking away like the Energizerô bunny." Interestingly, however, Hargrave reported that in his region (Los Angeles) examiners seem to be "getting a little slow" in issuing standard deficiency notices. "I am told that they are lagging almost six months after the audit closes," he said.

Hargrave said that he has "tons of stuff" on his to-do list. "What most advisers donít get, unfortunately, is that you need to be active in managing your firm internally now." Prior to the creation of the CCO post, he explained, the attitude at some firms was that "Yeah, you can wait for the audit." Going forward, however, Hargrave warned that "you had better be active in getting your processes cleaned up, getting them in writing, and getting your firm to a higher level of compliance." Training, he added, is key: "You have to sit down with [employees], you have to do compliance checks" and make sure they "understand and follow the procedures."

Another CCO agreed that the summer would be busy, but cited business initiatives, rather than the threat of a pending SEC exam, as the primary driver. "Whether the SEC is going to examine us or not is really not a big issue, although weíve been preparing for it," said William Corson, CCO of Lee Munder Capital Group. The more pressing issue, he explained, is ensuring that compliance is woven into the business fabric of his firm as a whole. For example, said Corson, he wants compliance to be consulted when his firm negotiates contracts, prepares RFPs, or develops new business products. Staying abreast of business developments, explained Corson, "keeps us busy in and of itself."

Like other CCOs, Corson said that he plans to spend the summer "going through the process of reviewing existing policies and procedures and making adjustments," and, as necessary, "changing behaviors" within his firm through education and training. When a firm makes changes to its compliance procedures and undertakes to monitor various things, explained Corson, the firm needs to confirm that everything is working as intended. "Youíve got to go back and check that everyone is doing what they said they were going to do. Itís part of the whole change that youíre looking for." Moreover, Corson noted that whenever a firm analyzes its compliance strengths and weakness, that analysis leaves work to be done. "The presumption is that when youíre identified a weakness, it requires a follow-up," he said. "The follow-up has to be embedded into your whole audit cycle."

The CCOs and lawyers also described a variety of specific projects that they hoped to get to this summer:

Trading. Although Corson described review of the trading area as "a constant process," he added that in preparation for anticipated changes by the SEC to the scope of the Section 28(e) safe harbor, his firm is "making sure that we have a very strong understanding of specific costs and how weíre using our commissions." Heís also working on confirming that his firm is "documenting in detail how weíre using those commissions." In addition, his firm is looking at how it is using third-party research and other third-party services. "Itís really a cost accounting process," explained Corson. "Weíre saying ĎOkay, guys, how much of this are you using?í"

Similarly, DeAngelis said that he is attempting to anticipate changes to the soft dollar regime and "trying to see where we would stand" if the SEC took the position that softing mixed use products was not covered by Section 28(e), or if it otherwise cut back on the scope of the safe harbor. "Iím trying to put a price on what we would lose if it comes down to no more mixed use," said DeAngelis. He noted that "some of the vendors" are already taking the position that for some products, "itís no longer mixed use, you have to pay hard dollars for it." Last month, for example, he said that one vendor informed his firm that its portfolio management system had to be paid for in hard dollars.

DeAngelis said that he intends to retain a third-party vendor to do a mock exam of his firmís trading practices. He said that he plans to guide the scope of the audit so that it will produce results that are most helpful to him.

Hargrave suggested that advisers take another look at their trade error correction policies, noting that SEC examiners are increasingly scrutinizing that area. "They are now getting to be very concerned with the explicit written rules of how you take care of trading errors," he said. "They want this in your compliance manual, in writing. And they want this as part of your ADV." If firms resolve erroneous losses by giving clients the option of taking a credit against future advisory fees (as opposed to paying the client a cash refund for the trading error), examiners are asking advisers whether they have notified their clients that if they terminate the adviserís services prior to the credit being used up, the adviser will pay them the remaining amount of the credit in the form of a check. "They want to be sure thereís no incentive for the client to stay with you so that you can work off those fees," explained Hargrave.

Proxies. DeAngelis said heís going to be reviewing his firmís proxy procedures "to make sure that what we say in there is absolutely buttoned down." He noted that groups such as the AFL-CIO are "out there rating people and doing these surveys" on how institutional money managers vote proxies. He also indicated that the review was prompted by the recent interest by plaintiffsí attorneys and the SEC in whether and how advisory firms participate in class action settlements.

The general counsel of the East Coast adviser similarly reported that one of his summer projects involves "looking at what we say we do for proxy voting, and making sure that that is actually the case."

Privacy. Hargrave noted that the new Reg. S-P disposal rules are raising issues at advisory firms, particularly those that rely on outside firms. "The staff has been out there talking about this recently," he said. He urged advisers to look at how any outside vendors they may rely on are complying with the new disposal rules. "Do you have information on the outside firm? Are they certified? What sort of net worth do they? How do they shred?"

DeAngelis said that he plans to "brush up" his firmís privacy procedures to include the new disposal requirements of Reg. S-P.

Advertising. The elimination of AIMR-PPS may will create a summer project for some advisory firms. "Iím going through and revamping all my performance disclosures for the change to AIMR-GIPs," said DeAngelis. To that end, he said that heís bringing in Karyn Vincent Performance Services to assist in that effort and conduct a full day of training on AIMR-GIPS. Vincent is a CFA who has been "very instrumental" in working with the CFA Institute (formerly AIMR), said DeAngelis. "Sheís awesome."

Code of ethics. The East Coast general counsel said that heís looking into automating his firmís code of ethics review process. Thatís "not likely something that we would have done absent the change in the regime," he added.

DeAngelis said that heís going to add some language to his firmís code about making personal political contributions, noting that heís heard that SEC examiners have written up firms for failing to have policies for monitoring employeesí personal political contributions. Heís also going to take another swing through his firmís gift policy. And, he added, he plans on holding a refresher class on code of ethics, gifts, and personal securities trading.

E-mail. The CCO of the Massachusetts advisory firm described this as one of her top priorities this summer. "Weíre going to be testing the e-mail retention system," she said. "We have it in place, but we havenít really, really put it through its paces." Specifically, she plans to do a word search "and see what comes out." She also said she plans to test the systemís retrieval capabilities.

"What sort of precipitated this is that we had a sit-down meeting with the board, and we were talking about the various aspects of compliance," explained the CCO. "One of the things we were taking about was business continuity and e-mail retention, which sort of goes hand-in-hand." She said that the group identified e-mail retention as "one of things that we had never really tested in terms of disaster recovery and in terms of compliance." Early indicators were good: she said that one individual at her firm had deleted an e-mail and then decided that they wanted it back. "So we said, ĎLetís test it.í" Fortunately for the individual, the firm was able to retrieve the e-mail. However, "it wasnít as easy to get back as we had hoped," she said.

Corson said that his firm is working on using its existing technology to manage e-mails. "We are looking to see what information do we have, how do we access it, and what does it mean," he said. "We are trying to put it in the context of what is required or what may required."