The Friday List: 10 Crucial Tests for an Annual Compliance Review

Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues.  Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.

The annual compliance review is one of the most significant tasks undertaken by the Chief Compliance Officer.  As most firms observe a 12/31 fiscal year, many adviser CCOs are currently ankle/knee/armpit deep in the preparation of the annual report for fiscal 2019.  Our firm conducts the annual reviews for nearly all of our clients.  Over the years, we have developed an ongoing testing, reporting and remediation program that involves a forensic analysis of 8 major areas and approximately 40 sub-topics.  We spend several hundred hours per year testing our clients’ programs.  If you are already a CCS client, you don’t need to worry about the annual review because we have you covered.  If you are not yet a client and feel impending time pressure and panic, we offer below the ten crucial tests you should conduct for an annual compliance review.  Of course, we recommend much more, but you can start working on that for next year.

10 Crucial Tests for an Annual Compliance Review

1. Identified regulatory deficiencies: Conduct a remediation inventory to ensure your firm has addressed all regulatory deficiencies identified during SEC exams, prior annual compliance reviews, or other reviews (e.g. internal audits, third party due diligence).
2. Disclosure: Check the consistency of all statements made in Form ADV, the compliance manual, the website, and marketing materials.
3. Conflicts inventory: Perform an inventory of all potential conflicts of interest.  A conflicts inventory should include undisclosed fees, insider co-investing, favoring certain clients, and churning/reverse churning.
4. Investment oversight: Review a statistically significant sample of clients to ensure that each client’s holdings do not run afoul of the disclosed investment limitations or client-mandated policies contained in each client’s agreement.
5. Fees and billing:  Test a sample of clients to ensure the firm charged the advertised fees and did not systematically overcharge by using the wrong fee, failing to account for discounts (e.g. household billing), or use an inflated asset calculation (e.g. monthly average vs. beginning of month). 
6. Performance: Re-calculate performance figures over several periods (e.g. 1-month, 3-month, 12-month) to verify that presented performance can be supported.
7. Valuation: Review sales of several fair-valued (Level 3) securities to determine whether the firm engaged in a pattern of holding securities at a value that exceeded the ultimate sales prices. 
8. Soft dollars/best execution: Consult third party brokers to test a sampling of execution prices.  Review the eligibility of soft dollar services and payments. 
9. Personal trading: Interview several access persons to ascertain whether there is a systematic breakdown in reporting and/or pre-clearing personal securities transactions. 
10. Cybersecurity/BCP/DR:  If not already done during the year, the annual review cycle should prompt every firm to conduct a business continuity and disaster recovery test as well as retain a third party to conduct a cybersecurity test.