In a little over 11 weeks, firms are going to have to hire a chief compliance officer, a requirement that could prove to be a tall task for fund shops, particularly smaller ones.

The key date is Oct. 5. That is when the Securities and Exchange Commission has said firms must have a CCO, a single person "competent and knowledgeable" in federal securities laws, with responsibility for the overall management of a fund complex's compliance program. The CCO will report directly to the board of directors, which is the only group that can hire, or fire, the compliance chief.

However, several in the industry have concerns. Some are worried that finding enough qualified applicants willing to take on such a large responsibility may be difficult, especially given the size of the industry. Others have anxiety over the salary a CCO could command.

The SEC hasn't exempted small fund groups from the same compliance mandates as larger complexes, including the appointment of CCOs. The regulator also doesn't expect the new rules to be burdensome to small firms, as their compliance programs are less complex. In fact, the SEC estimates that as many as one-half of registered investment advisors currently lack formal compliance policies, many of them smaller groups.

But while larger fund groups can more easily attract and adequately compensate CCOs, many small funds are asking veteran senior executives to serve dual roles, requiring them to wear the CCO hat in addition to carrying out their existing duties. Of course, such appointments inherently cause conflicts of interest, as executives must serve the needs of the advisory company while still being expected to bring compliance breaches directly to the funds' board of directors. That can amount to biting the hand that feeds them, said industry executives, and may come down to the all-important question of: With whom does the CCO's allegiance lie?

The new role is definitely not one that could or should be filled by a junior or administrative employee, counseled Jeff Squires, principal of Vista 360 of Milwaukee, a business advisory firm that provides compliance, operations and strategic business services. In fact, the SEC is expecting veteran, higher-level employees from the senior ranks to be appointed CCOs, he said.

The CCO must have enough authority to compel employees to comply with compliance policies and procedures. They will also be charged with compiling a written report to the board on an annual basis, addressing the operation of the fund's policies and procedures as well as those of its service providers. Beyond those guidelines, the CCO also has to be someone willing to accept a great deal of personal liability, Squires said. That personal liability is what many small fund group executives are most concerned with.

The Terrifying L' Word

Liability can leave CCOs wedged between a rock and a hard place, said industry leaders. Even the SEC acknowledged in its final regulations that a CCO who fails to fully inform the board of a material compliance failure, or fails to aggressively pursue non-compliance, would risk being fired by the board for poor performance of duties. This can be especially troubling for small fund groups, where one or two executives essentially run the firm while another manages the fund's assets.

For at least one small fund, it's the portfolio manager who has reluctantly agreed to serve as the fund's new CCO, said one manager, who spoke on condition of anonymity. If the CCO slips up and a compliance policy is violated, or a breach not quickly detected, that CCO's job is on the line. If the CCO should happen to be the fund's sole portfolio manager and is fired, who, then, manages the fund?

The new rules also say that a fund's CCO must meet with the board's independent directors without the presence of management company executives or interested directors, so that the CCO can freely discuss matters with the board. But, the manager added, when a CCO is also an executive of the fund, how can this requirement be met? "If you are an equity partner with the firm, are you going to rat out your partner?" he mused.

Fund groups of all sizes are deciding whether to hire a CCO from outside, appoint a current employee, outsource the CCO function to a service provider or "rent" a CCO, Squires noted.

CCO Sticker Shock

Some larger, deep-pocketed fund groups are hiring a brand new employee as CCO. According to one industry insider, a savvy 40 Act attorney would fit that bill nicely, but they don't come cheap. One well-known fund attorney told a large firm he wouldn't even consider such a position for less than $1 million a year, he explained. When compared to the $350,000 or more that independent directors of large fund firms earn each year, that $1 million CCO price tag isn't out of line, the insider said.

Of course, that would be cost-prohibitive to a small fund group, Squires said. In the majority of cases, small funds are simply appointing, with the board's blessing, an executive of the advisory company to serve as CCO.

The Hennessy Funds, managed by Hennessy Advisors of Novato, Calif., came up with the novel solution of suggesting one of the board's independent directors, a teacher with a background in back-office operations. The board agreed, and his board seat was given to a newly hired board trustee, said Neil Hennessy, president of the fund group. "The board knows he speaks his mind and is truly independent," he commented.


But funds are also turning to service providers that have crafted compliance programs, as well as truly independent outsiders serving as CCOs to multiple funds, Squires noted. While funds will, no doubt, be pleased to shift some of the burden, said fund industry executives, the real question is whether a compliance outsider can be truly effective if they aren't spending eight hours a day within an advisor's offices and only meet periodically with the firm's executives and board.

Also, service providers that provide such compliance services to fund groups in addition to other administrative services, such as transfer agency or fund accounting, may unwittingly be shooting themselves in the foot, said industry executives. "If they turn management in, how many nanoseconds will it take until an RFP goes out for a new administrator or transfer agent?" quipped one fund manager.

For its part, BISYS, rolled out its ComplianceEdge offering in mid-May. It provides the policies, procedures, testing, reporting and recordkeeping that funds will need to stay in compliance with new federal securities laws -- including a CCO. But BISYS said it won't offer the service to clients who aren't already using one of BISYS' administration, transfer agency, fund accounting or distribution services, said Lisa Hurley, EVP and general counsel with BISYS Fund Services. The addition of a compliance oversight component is really an extension of existing services, Hurley said. "We see this as stepping up a level," she said.

Moreover, concern over BISYS or other firms serving in this capacity while not being physically located within a fund group's headquarters, are unfounded, she said. The BISYS CCO assigned to handle a fund group's compliance will be working very closely with the fund board and a control person at the advisory firm, typically a separate CCO hired internally to supervise compliance, she added.

As for peeved fund advisors potentially severing fund servicing contracts if BISYS should detect and report a material compliance violation at the advisory firm, it's the fund board, not the advisor, that must hire or fire a fund group's internal or external CCO, and must also assess and bless all contracts with service providers, Hurley said.

However, the concern over outsourcing CCOs doesn't end there. Issues, such as those that arose at auditing firms, are possible, according to a regulatory source. One concern is whether the conflicts of interest will be too great or unmanageable if the firm providing the CCO also provides other kinds of consulting services to the advisor of the funds themselves. Problems could also arise if the individual designated as CCO has several assignments at a number of smaller firms or if the consulting firm providing the CCO has to fill the slot for competing advisors.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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