Are your funds' compliancee processes up to par?

Fraud detection procedures in the mutual fund and ETF industry are thought to be as tight as a drum. Well, this is what investors are led to believe.

Of the more than 200 ETF and fund company executives surveyed in Money Management Executive's 2013 Regulatory Issues Survey, published in November, around half described what detection measures their firms currently have in place. For instance, one participant from the investment management, advisory, broker dealer and mutual fund industry says that "compliance reviews everything."

Another survey respondent listed that "compliance and the branch managers have many systems to look for questionable behavior." The study, completed in fall 2013, includes responses from vice presidents and C-Level executives. It was compiled by Lodestar Research and sponsored by Cincinnati-based Ultimus Fund Solutions, a mutual fund services provider. So begs the question: What kind of processes do you have in place to detect and prevent fraud at your firm?"Classic intent to deceive is how fraud is defined; it's very difficult to stop fraud. You can have verification methodologies but they only go so far," notes Todd Cipperman, Money Management Executive's regulatory columnist and founder of Cipperman Compliance Services.

But, Mike Wagner, president of Northern Lights Compliance Services, says the mutual fund industry probably has one of the best safeguards in place to prevent fraud.
"One of the inherit controls with respect to fraud as it relates to mutual fund companies is the fact that most of the processes are being done by different entities," Wagner notes. The wholly-owned compliance arm of NorthStar Financial Services Group currently has about 26 clients and 230 mutual funds under it watch, Wagner says.

Under Rule 38a-1 of the Securities and Exchange Commission's Investment Company Act of 1940, each fund is required to appoint chief compliance officers responsible for policies and procedures approved by the board. The impact of these preventative measures may not be plugging all the gaps for ethical investment advisory services, however.

The SEC said that a record $3.4 billion in monetary sanctions were ordered against "wrongdoers" in the fiscal year that ended in September. Approximately 686 enforcement actions were uncovered, which is 10% higher than 2012, and 22% higher than 2011.

"A strong enforcement program helps produce financial markets that operate with integrity and transparency, and reassures investors that they can invest with confidence," SEC Chairwomen Mary Jo White said Dec. 17.

Money Management Executive's survey highlights that the percentage of firms with dedicated chief compliance officers has dwindled from 2012, which could point to rises of fraud and the SEC's uptick in enforcement actions. However, Cipperman explains that compliance procedures can only go so far. Also, if you were thinking that large investment shops have an edge in protecting investors, you're sorely mistaken.

"It's a double edge sword," Cipperman says. "Big firms hire more service providers. I would also say in many ways it's easier to hide a fraud in a large firm whereas in small companies it's harder to hide fraud."

Wagner adds that "the theory is obviously the same, but the actual practices might be a bit different." He continues that "even the smaller entities that are involved in this, they have large enough staff to provide the segregation of duties that are needed for this control environment."

However, once fraud is detected, the survey asks the more than 200 participants to describe guidelines for communication with shareholders and the media in order to prevent further damage to the firm's brand.

While some survey participants noted that this was "above [their] pay grade" or that there was wasn't an effective strategy, others reported that they reach out by email and verbal means in order to substantiate full transparency.

For instance, one participant says that they would "communicate directly with shareholders, advising them of possible fraud activities within the firm and notifying clients whenever possible of possible fraudulent trading on their accounts."

Another fund executive notes that the company is "very transparent about our willingness to protect investor information and the need to communicate breaches if an issue occurs."One way to rectify the fraud situation is to get information out as soon as possible, says Wagner, a 42-year veteran of the auditing and compliance industry.

"The key from our perspective is to make sure the information is disseminated as quickly as possible in a form that is thorough, and is able to be explained to the shareholder if there was an issue," Wagner explains, while noting that it is also important to lay out "the steps they've been taking subsequent to finding that error that hopefully prevent a recurrence of that same situation."
Cipperman says that public relations and marketing communications is vital to exposing the truth.

"If you say you are a legitimate firm and come clean to the public, you have to make things right to investors and shareholders," Cipperman explains.

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