This October is the deadline for funds to comply with the Securities and Exchange Commission's new Rule 38a-1, requiring all registered investment companies and investment advisors to designate a chief compliance officer. The new CCO will be empowered with full responsibility and authority to develop, administer and enforce appropriate policies and procedures for the firm. One area that will surely generate significant attention will be an examination of all third-party relationships, including outsourced transfer agency and shareholder servicing functions.
Ultimate Responsibility
Traditional thinking has held that outsourcing the service also entailed outsourcing the risk, but the truth is far more grim. Ultimately, it is still the investment company that is held responsible and liable for infractions, regardless of the culpability of the outsourced service provider. This has acted as a wake-up call for many fund companies, and has led to questions that have exposed issues of concern in the area of compliance.
An investment company's recourse is only as good as its contract. Since most service-level agreements with outsourced shareholder servicing firms were likely signed prior to the recent crackdown, it is possible there are gaps in contracts that can expose a firm to liability. During negotiations with outsourced providers, leverage in securing favorable terms in the contract will be highly dependent on the size of the firm. Existing contracts need to be inspected with a fine-tooth comb, and if possible, need to have gaps plugged up. Areas such as the provisions governing the standard of care and indemnification need to be re-examined under the light of the new regulatory environment.
Of course, keeping services internal allows for much greater control. Being the master of your own destiny would take away the lingering uncertainties and potential exposure that working with an outsourced provider might have. Internal controls would involve defining and designing compliance measures that would satisfy regulatory and insurance requirements, and would put you in the driver's seat in terms of mitigating risks.
Hands-on Control
An additional level of comfort can be provided by knowing the specific people who will be performing the TA functions for the firm. Control over the hiring, training and development of internal resources will ensure that the culture and commitment of the firm are embedded in the employees actually doing the work. In a large outsourced relationship, this selection and engagement of employees is often done without input from the fund. Knowing your employees as well as your customers and suppliers will increase the ability to support the core principles of a particular firm.
Keeping services internal will also ease regulatory inspection pains. When services are outsourced, it is simply one more additional step that needs to be proven to regulators. In the future, the SEC's inspection staff will review fund companies in a more mechanized way. Inspectors will require forensic documents to match up orders and sales files. Reports and data dumps will be necessary for regular reviews. All of these requirements will be easier to meet if services are in-house. Rather than putting in a request and being placed in a queue for weeks or even months, an in-house service will allow you to generate the information that you need on your schedule with your direct involvement in this critical process.
Many executives have already noted that the new compliance requirements will lead to increased costs with outsourced service providers. The new compliance officer will be expected to make decisions based on information, and firms will need to generate additional reports. And these additional reports and other extended data requirements to mainframe outsourced service providers will lead to greater fees. The new rules will require funds to provide information on: pricing of portfolio securities and fund shares, processing of fund shares, identification of affiliated persons, protection of non-public information, compliance with fund governance requirements and market timing. Due to the inflexible coding of mainframe transfer agency systems, many of these changes in reporting requirements for service providers' clients will not only be extremely expensive, but may not be deliverable in the timeframe necessary to meet compliance regulations.
With newer technology offering lower cost and data flexibility benefits over mainframes while allowing scalability for future growth, the added control and peace of mind through keeping shareholder services internal is a powerful motivator for fund companies looking to meet regulatory compliance.
Satnam Gambhir is president of Envision Financial Systems.
