Sound and Defensible Compliance: The need to effectively monitor and address critical compliance exceptions

Sound and Defensible Compliance: The need to effectively monitor and address critical compliance exceptions

The Current Situation Increasingly, financial companies are finding that the data generated by their daily business and trading activities have become both a blessing and a curse. For investment advisers, broker-dealers and hedge fund managers, effective use of information can help streamline processes and add value through increased efficiency. When it comes to data pertinent to the risks faced by the firm s clients, however, the firm s fiduciary or regulatory duty mandates careful review of information to avert compliance failures that have the potential to harm both clients and the firm. Nowhere is this responsibility more clearly illustrated than in the areas of insider trading, personal trading practices and best execution. While meeting strict regulatory and fiduciary responsibilities in these areas is one of the most critical compliance functions a firm has, more and more financial companies are turning to compliance software to fill the gap, control risk and fulfill their obligations. But, as exceptionally helpful as these solutions are, they can only inform the process of compliance. Just as important is the use of technology to demonstrate robust and effective compliance systems during client due diligence and regulatory exams. That is, an effective compliance regime results from both regular reviews of data outputs as well as the adoption of and training regarding policies and procedures that reflect the facts and circumstances of the firm s investment operations, affiliations and clients. Sound and Defensible Compliance:The need to effectively monitor and address critical compliance exceptions 2011 National Regulatory Services. All rights reserved. Printed in U.S.A. 1

Insider Trading Under Scrutiny Although insider trading has been an area of regulatory scrutiny for decades, the SEC has recently doubled its efforts to bring to justice those trading illegally on material nonpublic information to the detriment of other market participants. In congressional testimony provided in March 2009, SEC commissioner Elisse Walter announced the development and deployment of technological tools by the Commission to identify trading patterns to signify illegal trading activity by advisers, hedge funds and other financial industry participants and their staff. Also, in October 2009, the SEC filed the largest hedge fund insider trading case in history against Galleon Management, LP and its founder and chief executive, among others. Speaking at a news conference shortly after the announcement of the Galleon case, Robert Khuzami, the new SEC Enforcement Director, suggested that insider trading was a systemic problem at many hedge fund firms and expressed determination to aggressively seek out and pursue those engaged in unlawful trading activities. Since then, there have been scores of indictments resulting from an unprecedented number of overlapping investigations based on the Commission s stepped-up efforts, and it looks like more allegations will be levied in the coming months and years. In response, advisers, broker-dealers and hedge fund managers are examining the effectiveness of their own internal surveillance efforts. Scrutinizing employee and portfolio trades ahead of market moving issuer events such as earnings surprises, M&A activities, news and changes in analyst recommendations, to name a few, all should be monitored for and analyzed on an ongoing basis. In light of the responsibilities imposed on the boards of directors of registered investment companies by Rule 38a-1 under the Investment Company Act of 1940, many such directors are also demanding stronger controls regarding the trading and monitoring practices of the investment managers of funds overseen by the directors. Obviously, these advisers efforts include revisiting policies and procedures and scheduling mandatory staff training sessions. However, they continue to struggle with how best to utilize the information on-hand to identify potential abuse occurring right under their noses. Focus on Personal Trading Similarly, the personal trading practices of firm insiders have been an area of focus by SEC examiners for years. When investment advisory personnel invest for their own accounts, conflicts of interest can arise between the employee s interests and those of the adviser s clients. Advisory personnel may, for example, usurp an investment opportunity that would have been appropriate for the firm s clients, or abuse their positions by frontrunning client trades by personally benefit from the market effect of trades placed for the adviser s clients. To address these and other issues, the SEC Code of Ethics Rule requires, among other things, that firms monitor the personal trading activities of their supervised persons with access to certain information regarding client portfolio holdings, transactions or recommendations to identify improper trades or patterns of trading by those access persons. Unfortunately, far too many financial companies view the Code of Ethics Rule provisions solely as recordkeeping requirements and fail to adequately scrutinize employee trades for these and other abuses. Others squander countless hours and resources manually comparing personal securities transaction reports to the firm s trading activity and other written procedures, such as pre-clearance requirements, despite the fact that personal trading information can be effortlessly and effectively evaluated for these and other compliance breaches through appropriate software analysis. 2 Sound and Defensible Compliance:The need to effectively monitor and address critical compliance exceptions 2011 National Regulatory Services. All rights reserved. Printed in U.S.A.

Best Execution Obligation Another area of compliance requiring assiduous assessment of information generated by trading activities is the area of best execution. Investment advisers who manage or supervise client portfolios with brokerage discretion have a fiduciary obligation to seek best execution. This obligation calls for advisers to execute securities transactions for clients in such a manner that the client s total cost or proceeds in each transaction is the most favorable under the circumstances. When evaluating brokers, an adviser is duty-bound to weigh such factors as the price obtained for a security, the value of research provided, the commission rates charged, the ability to negotiate commissions, the ability to obtain volume discounts, execution capability, financial responsibility and responsiveness to the investment adviser. Best execution reviews require consolidation and careful consideration of qualitative factors as well as quantitative data. That is, the subjective input of analysts, portfolio managers and traders must be considered and appropriately integrated with the raw numbers generated by the firm s trade blotter. Broker-dealers have the responsibility of complying with NASD Rule 2320 which reads in part: In any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. A Unified Solution To address these and other critical compliance issues, National Regulatory Services, (NRS) and Financial Tracking Technologies, LLC (Financial Tracking), offer a comprehensive solution that brings the regulatory expertise of NRS s world-class consulting services together with the automated analysis and alerting systems of Financial Tracking all on a workstation shared between the client and NRS. With this service combination, NRS can now better assist advisers, broker/dealers and fund managers in the development of written policies and procedures designed specifically to address the firm s compliance risks and help to encode those procedures into Financial Tracking s solutions. While it is true that no compliance officer, system or program will be able to identify and avert all problems all of the time, it is important to remember that reasonableness is the standard. Rule 206(4)-7 under the Advisers Act requires that advisers adopt policies and procedures reasonably designed to prevent, detect and correct violations of the Advisers Act, while FINRA requires broker-dealers establish and maintain a system to supervise the activities of each registered representative, registered principal, and other associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable NASD Rules. To help ensure maximum compliance, NRS consultants can now remotely monitor for compliance exceptions and immediately alert Chief Compliance Officers to potential issues by using the automated analysis capabilities of Financial Tracking s technology. This arrangement ensures timely guidance regarding how best to address the issue and document the firm s response before it leads to expensive monetary and reputational consequences for the firm. In this day and age, it is simply not reasonable to allow compliance problems to arise that could have been averted through sound and defensible utilization and review of data already compiled by the firm. However, these efforts must be appropriately integrated into a comprehensive compliance program tailored to the firm s practice. Sound and Defensible Compliance:The need to effectively monitor and address critical compliance exceptions 2011 National Regulatory Services. All rights reserved. Printed in U.S.A. 3

About NRS National Regulatory Services (NRS) is the nation s leader in compliance and registration products and services for investment advisers, broker-dealers, hedge funds, investment companies and insurance institutions. NRS has the practical expertise, proven capability and unparalleled reach to deliver integrated and effective compliance solutions to a wide range of users within the financial services industry. NRS delivers these solutions through three interrelated offerings comprehensive education, best-in-class technology and expert consulting services enabling our clients to meet their regulatory requirements and minimize risk. For more information, visit: www.nrs-inc.com. About Financial Tracking Technologies, LLC Founded in 1999, Financial Tracking is the proven leader in automated compliance software giving clients choice across 16 modular components. The SEC is a client. Financial Tracking has hundreds software interfaces with third parties such as prime brokers, custodians, fund administrators, broker/dealers, portfolio accounting and trade order management systems, allowing seamless data integration and rapid onboarding. Companies using its software include money managers, hedge funds, regulators, mutual funds, fund of funds, broker/dealers, public companies and private equity firms. For more information, visit: www.financial-tracking.com. 4 Sound and Defensible Compliance:The need to effectively monitor and address critical compliance exceptions 2011 National Regulatory Services. All rights reserved. Printed in U.S.A.

For more information, visit www.nrs-inc.com or call 1-860-435-0200. 09.21.11