Compliance Costs Mount as Regulatory Burden Grows
Compliance costs faced by advisory firms increase with each new regulation, with proposed rules in 2015 and expected new ones this year likely to add to the burden. What’s a chief compliance officer – and the advisory firm that hired the CCO – to do?
The number of new requirements that advisers face has only grown in recent years, and a number of knowledgeable professionals trace this growth curve to the SEC’s passage of Rule 206(4)-7, the Compliance Program Rule, about 10 years ago. That rule requires advisory firms to adopt reasonable compliance policies and procedures, conduct an annual compliance review, and retain a CCO.
"Since the SEC started requiring advisers to implement a formal compliance program and hire a chief compliance officer, there has been a steady stream of new regulations that each demand a significant compliance infrastructure," wrote Investment Adviser Association general counsel Bob Grohowski and assistant general counsel Sanjay Lamba in the IAA’s newsletter this month.
"The Compliance Program Rule itself is in some ways the biggest problem," said Wilmer Hale partner and former SEC Division of Investment Management associate director Matthew Chambers. "In some ways, it allows the SEC to add requirements without making a rule," he said, referring to the agency staff’s not-infrequent tendency to cite firms for violating the rule whenever other violations are found. The logic is that if an adviser is charged with being non-compliant in any given area, it must mean that its compliance policies and procedures do not properly address it. When a firm settles such charges, it must then go through the expense of making the necessary improvements to its compliance plan.
Not everyone shares the view that the Compliance Program Rule started the trend. "It’s the way the rule is administered," said Stroock partner and former SEC Division of Investment Management deputy director Robert Plaze, noting that the rule calls for "reasonable" policies and procedures, not policies and procedures that cover every possible specific violation that might occur. "The SEC should not bring the rule into as many enforcement cases as it does."
Whichever way one looks at the effect of the Compliance Program Rule and its administration, there is no arguing that the regulatory compliance burden and the corresponding cost placed on advisory firms has grown.
"The reality is that many investment advisers have finite resources to devote to compliance, and managing the rising costs of regulatory compliance is, in effect, a zero-sum game," said Grohowski and Lamba.
"Compliance is a cost of day-to-day business," said Aaron DeAngelis, chief compliance officer of Spring Mountain Capital, which invests in fixed income, private equity and hedge funds. "You can’t soft dollar it. The cost has to be borne by the adviser."
Since passage of the Compliance Program Rule, "there has been a steady stream of new regulations that each demands a significant compliance infrastructure," Grohowski and Lamba asserted. That list includes:
Formal implementation of codes of ethics,
Surprise exams under the Custody Rule,
Procedures to address identity theft,
Narrative disclosures in brochures,
Reporting obligations for advisers managing private funds,
Proposed anti-money laundering requirements,
Proposed additional data reporting requirements on Form ADV,
Proposed liquidity management rules,
Proposed derivatives risk management rules,
Proposed enhanced portfolio holdings report, and
Expected proposals in 2016 on transition planning, stress testing and executive compensation.
These rules are not the only source of increased regulatory costs. Guidance from the SEC staff, as well as targeted scrutiny in specific areas, such as cybersecurity, from agency examiners also increase advisory firm costs, Grohowski and Lamba said.
What apparently spurred the IAA article is the expectation that the SEC may propose a new rule in the near future that will require advisers to hire third parties to conduct compliance reviews. "While the scope of this proposal is unclear, one thing is absolutely certain – it would impose yet another incremental cost of regulatory compliance on investment advisers," they said.
"By our estimates," they continued, "smaller advisers would likely pay between $10,000 [and] $15,000 per engagement for even the most limited type of third-party engagements. These costs could increase exponentially (e.g., $50,000 to over $100,000) as the size and complexity of the adviser increases. For more comprehensive reviews, the costs would be much higher."
Cause and effect
"The SEC seems to think that the cost for this is not a problem and that the money just comes out of thin air," said Chambers. One result of the increased cost burden may be that there ultimately are fewer advisers, resulting in less competition and less innovation, he said. On the other hand, he noted that "these things tend to go in cycles" and that the costs for compliance may "flatten out."
Patomak Global Partners managing director Ben Brown, who previously served as counsel to former SEC commissioner Daniel Gallagher, noted the additional costs placed on advisory firm CCOs. "We’ve seen some Monday-morning quarterbacking" in a number of recent SEC enforcement actions against investment advisers, sometimes leading to allegations that CCOs failed to take appropriate actions, he said. This makes it more difficult for firms to retain good compliance officers and "in this environment, firms are facing ever-increasing costs to attract qualified compliance professionals, who justifiably insist on more comprehensive functions and additional levels of support."
Grohowski and Lamba made a similar point, noting that "the costs of hiring and retaining compliance staff will likely increase, both due to the specialization necessary to handle all of these areas and due to personal liability concerns arising from recent SEC enforcement actions."
To pay just for the cost of conducting third-party compliance reviews, Grohowski and Lamba suggested that "advisers might stop engaging consultants to address ad hoc compliance issues and devote fewer resources to staff training or routine but lower-risk compliance areas."
What to do
It’s important for advisory firms to comply with the rules, so there are limited options available that would both enable compliance and protect an adviser’s profit margin, but some do exist. These include:
Raise advisory fees, or at least do not reduce them. Profitability is a valid consideration for mutual fund boards, and it simply may be the most effective way to address increased compliance costs, Chambers said.
Outsource functions that may result in cost savings, suggested Chambers.
Business arrangements that involve greater compliance risks should be avoided. "For example," said Plaze, "if you have an affiliated broker, don’t use it for client transactions. Don’t accept custody of client assets. Keep your procedures for allocating securities among clients and your fee structure simple. Don’t just avoid conflicts of interest, don’t go near them." He also emphasized the need to evaluate compliance risks and associated costs when considering a practice or business arrangement that involves either a conflict or the risk of operational failure. "As an economist might say, you need to consider whether the marginal benefits to your business from the proposed activity exceed the marginal costs."
Ensure that your compliance program passes muster before a visit by SEC examiners, said Brown. That will reduce costs by removing the risk of fines or your compliance plan program and/or CCO facing allegations.
Use technology more effectively. This may allow you to reduce staff time spent on certain procedures, said Chambers.
If your firm is a large firm, economies of scale may be employed, such as devoting one employee’s time solely to managing risks, said Plaze. A smaller group would have to assign these duties to an existing employee, such as the portfolio manager.
Plaze noted that one area of solace may be that "fund costs are going down" as a result of a movement toward investing in exchange-traded funds and passive investments, both of which are generally lower-cost investments. "This will help offset the compliance costs."
On the other hand, he shared a concern about the cumulative compliance costs from recent rule proposals affecting mutual funds, such as the proposed rules for liquidity risk management and for derivatives. "It would be a shame," he said, "if just as mutual fund costs are going down because of competition from ETFs, the cost of complying with the new SEC rules started pushing them up."