Internal Conflicts When Considering Compliance Outsourcing

Internal Conflicts When Considering Compliance Outsourcing

Just as each firm must tailor its policies and procedures to address their specific business, there is no 'one size fits all' model when it comes to outsourcing compliance needs.

As regulators increasingly compel the financial services industry to bolster compliance, many small firms face the challenge of deciding  who will be the Chief Compliance Officer [CCO].  

Gone are the days when the compliance function was delegated to “whoever had the time” to perform it. Over the past two decades, the role of compliance has morphed into a profession and its functions have a direct impact on a firm’s bottom line.

At a small firm, the compliance hat is often one of several worn by the firm’s owners and/or managing principals—and that is a factor that impairs the firm’s ability to compete.  Small firms are subject to the same rules and regulations that apply to large firms. However, smaller firms’ resources are often limited. Many of them do not employ a full time CCO, so traditionally the owner/managing principal carries out that function. Alternatively, the firm may either elect to hire a part-time compliance officer to perform the regulatory required tasks, or outsource that functionality to a consulting firm, which is similar to hiring an accountant to perform the firm’s annual audit.

Compliance outsourcing is a topic of much debate, lately.  Proponents of this approach maintain that it allows smaller firms to avail themselves of the expertise of a full-time professional.  While this approach may be suitable for smaller firms with complex compliance needs, there are pros and cons to consider. On one hand, outsourcing frees up time for the firm principals, which they can invest in growing their business. On the other—and this is the argument made by those opposing the outsourced approach—an outsider or consultant may have a difficult time instilling the compliance culture.  

Earlier this month, the Securities and Exchange Commission warned about the risks associated with outsourcing compliance needs.  Their research revealed that in many instances outside compliance officers failed to communicate regularly with the firm’s principals and often they also did not have access to firm’s documents. 

In outsourcing the creation of a compliance program, it is not uncommon that a financial advisory firm is required by the outsourcing company to answer a series of generic questions in a standard template. This inevitably leads to the creation of a “check the box” mentality.   Opponents to this model warn that while this process can be a conversation starter, it requires a level of customization that the small firm may not be qualified to manage on their own.  As a result, more time must be spent with the consultants to customize policies and procedures.  This, of course, can translate into substantially higher fees than originally anticipated. 

Although a firm may decide not to outsource their compliance functionality, hiring outside consultants has become quite a common practice.  Even with the help of a third party, smaller firms still face significant challenges and conflicts when the CCO is also wearing other hats, such as managing principal in charge of sales, recruiting and even operations.  This inevitably leads to a number of conflicts that cannot be ignored. 

Here are the top five conflicts that arise when a managing principal elects to act also as CCO:

  1. Risk: Without taking some risk, growth is hard to manifest. Within the firm, the compliance department is probably the most risk averse. As such, striking a balance between compliance, business development and growth is a rather challenging juggling act.
  2. Diplomacy: Every good firm needs a great diplomat. Diplomacy is about negotiating. Compliance is usually taking a firm stance leaving minimal room for advisor-initiated interpretation. Acting as a diplomat and a compliance officer is dichotomous.
  3. Decision Making: Running a business is expensive. Deciding how to allocate resources is a difficult task and one that is left to senior management. When it comes to allocating resources for the future of the firm conflicts can easily arise. For example, from the compliance perspective the firm might favor investing in new technology and archiving solutions. However, from a sales point of view it might sound more appealing to invest in media advertising.
  4. Time: Time management requires prioritization and organization. It is about achieving more while being more effective. An effective manager knows what tasks are “urgent” versus what tasks are “important”. This is where the conflict arises between compliance and business growth. What is urgent to the compliance officer may not be to the professional responsible for new business development.
  5. Leadership: Advisors look to the managing principals of their firms for direction. However, a busy executive often does not have much time to lead. A leader instead focuses on the vision of the firm, motivating employees and listening to others. A manager is often busy focusing on planning, corporate organization, budgeting and decision-making. Compliance tends to be more focused on management while the executive is more focused on leadership…the difference although subtle, is relevant.

 

Just as each firm must tailor its policies and procedures to address their specific business, there is no “one size fits all” model when it comes to outsourcing compliance needs.  Investment advisors and broker-dealers firms must review their expertise and resources to come up with an individualized plan.

 

Wendy Lanton is Chief Compliance Officer at Melville, NY-based Lantern Investments.

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