Historically, compliance requirements for investment management companies have been driven by regulations. Events during the past few years related to late trading, market timing and selective portfolio disclosure, however, have resulted in growing concern among the investor community and regulatory agencies on the robustness of compliance programs in place at mutual fund companies.
By devising and implementing policies and methodologies, and by effectively leveraging technology, mutual fund companies can reduce the risk of failing to comply with regulatory requirements, with the additional benefit of increasing investor confidence. Following are seven key compliance imperatives that will have a major impact on the mutual fund industry over the next year and suggestions on how firms can meet the challenges posed by the requirements successfully.
1. Late Trades and Market Timing
Revelations of late trading and market timing have resulted in an increased focus on market timing and portfolio valuations. Mutual fund companies have to fulfill fiduciary responsibilities with respect to late trading and prevent market timers from exploiting pricing anomalies, thereby diluting the returns of the majority of investors. To reduce the risk of such behaviors arising, companies need to establish clearly defined policies on internal deadlines. Deploying third-party behavior-detection applications that monitor and report suspicious activities, such as trading after the 4 p.m. deadline, can enable firms to detect violations. Companies also can leverage third-party fund management service providers to improve processing efficiencies.
2. Money-Laundering Prevention
The USA Patriot Act includes requirements related to identifying clients, and detecting and reporting suspicious client behavior. Mutual funds deal with a large number of clients, and it becomes difficult to have adequate systems in place to track, analyze and report suspicious client behavior. Many companies already have a chief compliance officer in charge of the compliance function. The challenge lies in being able to implement the program at the lowest level in the organization - i.e., at the broker or trader level. The risk of compliance failure can be reduced by institutionalizing compliance training at all levels and requiring employees to remain current on the latest requirements through online training programs. Technology also can be leveraged effectively through the use of behavior detection tools that monitor and report on suspicious customer behavior, including monitoring high-risk clients and their trades, and detect hidden relationships across unrelated clients. Additionally, many mutual fund companies are creating centralized customer databases for a single customer view to identify customers and their relationships.
3. Supervisory Controls
Compliance with SEC Rule 206 (4) 7 requires the establishment of a compliance program, including a chief compliance officer, to ensure compliance, including monitoring net asset value (NAV) valuations and ensuring adherence to portfolio objectives as agreed to with customers. Furthermore, mutual fund companies must ensure that (a) supervisory control procedures are performed by persons who are independent of the activities being tested and verified; and (b) the persons who directly supervise such activities enforce written policies and procedures with respect to transmittals of funds or securities from customer accounts to certain third parties, customer address changes and customer investment objective changes. Further, the compliance program should include monitoring and periodic reporting, and independent reviews of customer accounts. Technology solutions can be leveraged to monitor customer activities effectively.
4. Self Dealing
Self dealing involves fund managers directing funds to high-performance funds or to funds that charge the highest fees, while avoiding low- or mid-ranking funds. Failure to monitor and disclose self dealing by investment advisers or a fund's employees can result in costly fines. Mutual funds also have to be concerned with minimizing the chances of opposite trading, whereby funds in the same family take opposite sides of a trade to decrease trading costs and secure a better price for the favored fund. The risk of incurring fines due to self dealing can be reduced by leveraging technology to create built-in controls that monitor and prevent self-dealing transactions.
5. Breakpoint Violations
Mutual funds are responsible for ensuring that customers receive the breakpoints that are due to them. The challenge is to ensure that brokers have access to the information they need from funds or their customers to assess correctly when breakpoints are due. Mutual funds can start by determining the operational challenges that prevent breakpoints from being calculated.
6. Best Execution and Soft-Dollars Violations
Ensuring that order flows are directed by investment advisers based on quality of execution rather than to favored broker-dealers in exchange for soft-dollar research services is an increasing challenge for mutual funds. Avoiding conflicts of interest relating to broker-dealer commissions for trade execution as well as research services can be achieved by laying down checks and balances to measure the quality of executions.
7. E-Mail and Instant Messaging Content Management
Mutual funds, like other financial institutions, must adhere to corporate policies and regulations relating to e-mail content and storage, and the use of instant messaging for corporate communications. SEC Rule 17 CFR 240, for example, mandates that all communication between stockbrokers and their clients - including e-mail and IM messages - be retained for three years and remain easily accessible for the first two years. Additionally, mutual funds have to prevent leakage of confidential memos and other sensitive information, such as intellectual property or trade secrets, and prevent nonpublic information related to fund portfolios from being made available. This can be achieved by implementing e-mail surveillance solutions that detect messages with suspicious content, create audit trails and have the ability to conduct detailed content searches. An appropriate data security and migration strategy to address e-mail and communication backup and archiving concerns will reduce the risk of failure.
About The Author
Atul Seth is a senior associate with the banking and capital markets group at Bangalore, India-based Infosys Technologies. (The company's U.S. headquarters are located in Fremont, Calif.) Seth has spent more than seven years managing the implementation of large-scale IT applications, assisting companies in selecting the right IT systems and redesigning business processes.