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Outsourcing Compliance: A Mission-Critical Reality

In light of all of the demanding regulations that asset managers now face at a time when the nation is gripped by a financial crisis, not to mention the inevitable additional oversight that the new presidential administration will impose on the financial services industry, chief compliance officers are taking a more critical look than ever before at their resources. One of the obvious solutions to the demands they face is outsourcing, which today has become a mission-critical reality for even the biggest fund complexes.

But outsourcing compliance is complex and must be carefully managed.

Chief compliance officers and experts met last month at the headquarters of SourceMedia, publisher of Money Management Executive, for a roundtable sponsored by Citi on what functions can be outsourced, what benefits besides economies of scale can be realized, and how to effectively oversee it.

In attendance were:

Lee Barney, editor, Money Management Executive: Starting from a high-level vantage point, how do you determine which regulatory compliance areas are appropriate to outsource, including legal, traditional compliance, Sarbanes-Oxley and risk management? How do you assess your internal resources and expertise against those of outside service providers?

Frederick Schmidt: All fund families have definitely been looking at internal resources and outside service providers for economies of scale. In the face of the severe economy and budgetary constraints, firms are weighing whether they are better off outsourcing various services to improve their margins and ease their budgets.

Smaller firms may not necessarily need a full-time person to carry out, for example, a CCO or treasurer's function, whereas an outsourced service provider can readily provide this service and leverage their expertise from serving other fund companies.

John F. Robbins: Some of the decisions are based on economies of scale, while others are based on rounding out core competencies.

And then, there are the specific initiatives that CCOs may want to undertake for the year but for which they don't have the infrastructure or head count to do it internally. For example, a CCO might want to outsource a transaction monitoring function to detect market-timing. I might have 10 guys looking at a myriad of factors but need five more operational functions covered.

Fred Naddaff: I agree. As a result of poor market performance, redemptions and overall expense pressures, advisers across-the-board are under stress. Compliance teams will not be immune to that pressure, and CCOs are looking for efficiencies and expertise. These resources may be available at a third-party provider that is servicing a much larger book, and therefore can bring a lot more experience and insight to the table. That's a built-in efficiency right there.

Robbins: There's been a big shift from the theoretical to the practical, where we set big agendas based on what we want to fix, because of the regulatory climate and, now, the financial crisis. Given these tremendous mandates, being realistic about what we can actually accomplish 2Q09 or 3Q09 is hard.

We need those external service providers to help us find a pragmatic solution-to shift from a reactive compliance-monitoring environment to an actual, proactive risk mitigation environment. That is the 800-pound gorilla.

It doesn't happen by taking your existing compliance teams and trying to teach them guidance and advisory functions. It happens by identifying and moving functions into areas where they can be more process-oriented. Then you can assign your experts to monitor red flags among your various business units-to work closely with executives to educate and proactively develop their awareness, so we can hopefully mitigate problems, as opposed to react to them once they have occurred.

Scot Draeger: The Securities and Exchange Commission's view on Rule 38a-1 and outsourcing is that there is a delineation between discretionary functions and operational or substantive areas of expertise. Anything dealing with true investment discretionary areas, such as fair-value pricing of hard-to-price securities or liquidity determinations, should be left for the investment adviser or the fund's board.

Whereas, there are a host of non-discretionary operational items-transfer agent, fund accounting, fund administration-that are ripe for outsourcing to efficiently reduce your costs.

Robbins: One of the challenges compliance departments face is that outsourcing is perceived as an additional, discretionary cost separate from the compliance team. The finance team may argue, hey, wait a minute, we are already paying for that anyway. But the argument is really about enhancing the level of surveillance and process and monitoring in order to do a better job. And it's often difficult to articulate that when you are not staring down the barrel of a gun, some SEC enforcement, God forbid, or other type of remediation effort.

Victor Frye: Certainly, in today's environment, the law is changing very quickly. It's very dynamic.