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Outsourcing Mutual Fund Compliance

The last decade has been rough for the mutual fund industry.

Market timing and late trading scandals in 2003 led to a substantially more demanding regulatory environment. This has included the adoption of a rule requiring funds to designate a compliance officer and implement a comprehensive program for complying with federal laws and regulations on investment fund operations.

This means boards of directors must have the tools for overseeing compliance and take on the oversight.

The 2002 Sarbanes-Oxley Act on corporate accounting also brought a dramatic increase in the number and complexity of financial filings. Section 302, for instance, requires that the company's "principal officers,'' typically the Chief Executive Officer and Chief Financial Officer, certify and approve the integrity of their company financial reports each quarter.

All of which has led fund boards to reconsider the traditional roles played by fund officers and service providers. And look to "outsource" compliance activities, when possible. Which typically is most of the time.

From its earliest beginnings, the mutual fund business model has relied upon "outsourcing" virtually all of their activities. Funds are unique in that they usually have no employees of their own. Each function within a mutual fund, from the investment management delivered by the investment advisor, to accounting, safekeeping of the securities and the preparation and delivery of shareholder statements, is performed by different organizations which specialize in each service. Most mutual funds do not have marketing and sales people. Those functions are generally performed by the adviser with the assistance of the distributor.

Because funds are externally managed, it is not unusual for the fund's investment adviser or administrator to provide the people to serve as officers to the fund. This seems to be changing, however, as fund boards see a need for experienced, highly qualified compliance and financial officers who are independent of the fund's service providers. Most service organizations no longer wish to assume the risk and overall responsibility of having their employees serve in these roles because of the personal and corporate liability of the position.

Generally speaking, investment management organizations focus on security selection, through market research and financial analysis of individual markets and companies. While mutual funds are the embodiment of the investment management skill, it is often the case that the investment advisor is also leveraging its resources to support various other investment products such as separately managed accounts, and alternative investment products.

A compliance program must constantly evolve in response to changing regulatory requirements and business risks; new, more complex product offerings and evolving technology. It is not at all clear that investment firms are prepared to provide a qualified person who can focus on a mutual fund's compliance requirements.

In many firms, the financial and accounting personnel may not have the specific familiarity and experience to meet the needs and expectations of the role, and when they do, they often are challenged with available time to focus on maintaining this knowledge in the dynamic and evolving regulatory landscape.

In many cases, the adviser personnel do not have experience with mutual fund operations and the impact fund operations can have on the financial reporting that goes with them. This question reflects the widespread opinion that accounting is fungible - that's just not true.

This means ... 'outsourcing' talent. Finding qualified and experienced people who can fill these roles whom are available in today's marketplace, on a consulting, retained or contractual basis.

These are people with specific knowledge of mutual fund accounting and financial administration and reporting; applicable rules and regulations governing open-end mutual funds; the interplay of the service providers involved in fund operations and the role and responsibilities of the fund board.

In addition to overseeing a fund's compliance policies and procedures, the compliance officer is expected to take measures to assure that each service provider has implemented effective compliance policies and procedures that are administered by competent personnel.

Transparency and candor are important in any discourse about compliance. Anything short of it may detract from a relationship of trust between the board and the compliance officer.

While there is no one "right" approach to compliance, the value of independence in this role is becoming increasingly clear to fund boards. While many of the functional activities of the financial officer of a fund have remained the same, other duties and responsibilities have been mandated and the resultant liability for failure to properly oversee and comply has increased.

The increase in visibility, accountability, and liability of a fund financial officer has been a significant reason most fund accounting agents serving the mutual fund industry no longer provide employees to serve their clients in this capacity.

Mutual funds are increasingly complex, intensively regulated investment products that are highly transparent both to investors and regulators.

Conscientious, knowledgeable, and resourceful personnel, armed with appropriate resources, are key contributors to an effective effort by funds to meet the requirements of today's compliance and financial reporting environment.

George Stevens is a director, chief compliance officer at Beacon Hill Fund Services.