Valuation Key Focus of SEC CCOutreach
November 26, 2007
Chief compliance officers should make the valuation of distressed securities their No. 1 priority, Andrew J. Donohue, director of the division of investment management at the Securities and Exchange Commission advised at last week's national CCOutreach meeting, the agency's educational program for CCOs.
It is "imperative" that fund CCOs and advisory officials focus on making sure that distressed securities and derivative products be accurately reflected in funds' net asset values, Donohue said.
Referring to the subprime crisis and its effect on markets, Donahue said that not only funds and their advisors, but also hedge funds, even if they are not mandated to do so, have a fundamental obligation to provide accurate valuations.
Donahue's remarks came at the opening of a day-long program that included the panels "Compliance and Operations-The Importance of Synergy" and "COO's Role in a Changing Environment."
Both panels combined senior SEC officials and representatives from managed fund companies.
Even as panel participants noted there are differences in the CCO's role and how to best perform it at small firms and large firms, participants agreed that senior management must emphasize the importance of compliance.
There was a consensus that one methodology of effective COOs is to get businesspeople to "own" compliance in their realms. And, in order to accomplish this, compliance efforts must be supported by the company's top executives.
One speaker at the morning's second panel on the CCO's changing role, Carsten Otto, CCO at Morgan Stanley Advisers, said that compliance efforts must come from top management. "If you have the right tone from the top, it empowers CCOs."
The session that covered compliance and operations started with the assertion by SEC Associate Director Robert Plaze, from the division of investment management, that compliance considerations and operational aspects of financial companies complement each other.
Due to career paths within the financial services industry, most senior management comes from trading, hence they understand investment risks, Plaze said.
However, operations skills and their interaction with compliance is less of a core competency among senior management, Plaze said. As a result, CCOs have to rely on operations personnel to make risk assessments. This can be a time intensive oversight process for a CCO, especially if the underlying products are complicated derivatives, Plaze noted. Thus, one of the prime challenges for compliance people is identifying the risk in operations.
Plaze advised fund companies to draw up thorough lists of potential risks. If these are not robust, or appear not to reflect the complexity of the business, it can be a red flag for the agency.
Another participant on the operations panel, Marianne O'Doherty, CCO at the hedge fund Smith Breedan Associates, said that some of the downgrades in valuation attributable to the subprime crisis were never expected to happen-and that compliance officers should now exercise extreme caution.
"If you had $100 million of securities that were downgraded beyond investment grade, you have to take a look at what else might happen," O'Doherty said.
Plaze added that CCOs were clearly caught off guard by the subprime crisis. It can be difficult to build a compliance effort against a scenario that hasn't occurred, he admitted, but after it has happened, the SEC will fully expect CCOs to catch subsequent deteriorations.
The panel on the CCO's changing role developed some themes that were touched on in the first panel.
Otto said that "there can be no exceptions for stars" in the application of compliance procedures.
In addition to applying standards uniformly for all employees, he ticked off two ways CCOs can reinforce compliance best practices. The first method, he said, is to involve the firm's board, noting that the board can supply leverage and function as the eyes and ears of CCOs.
A second technique is to use client input to ensure business leaders are in line. As an example of this, he described a situation in which a potential client's questions about the firm's compliance approach pre-investment was used to make sure business leaders adhered to procedures.
Another topic the panel discussed was how to ensure compliance standards are met when introducing new products. Jenny McCann, CCO at hedge fund Treaty Oak Capital Management, said one step in vetting new products is to consult with her CCO peers at other firms who may already oversee such products. She suggested that CCOs insert themselves into discussions about the new product launch as early as possible.
"You don't want to be late to the game, and you must be able to document the process," McCann said.
By the same token, when an organization has undergone a structural change, such as merger or acquisition activity, it behooves the CCO to make sure the firm can make the same performance claims as it had been making prior to the deal. Any changes that result from mergers, acquisitions or spin-offs must be discovered by the CCO and communicated to clients if appropriate, she said.
A related topic that CCOs must grapple with is ensuring that procedures exist when new people are brought into the organization either by an acquisition or in the course of personnel changes, to bring all employees up to speed on compliance practices. One approach is to add responsibility gradually so that the business isn't taking big risks on new people.
The CCOutreach program also featured one panel on fixed-income and derivative compliance issues and one on examination and risk assessment processes.
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