Compliance Testing Programs, Part 2: The Bottom-Up Approach to Building Your Compliance Program

Compliance Testing Programs, Part 2: The Bottom-Up Approach to Building Your Compliance Program

In part two of our panel recap where we discussed compliance testing programs for small and medium-size firms, we zero in on the foundation. (If you missed part one: a top-down approach, you can find it here.) Flipping the top-down approach that we discussed las week, we began to look at critical components of the business and how to review and test your procedures effectively. The following are some critical areas of an adviser’s business that require testing, along with tips to keep you in the game.

Code of Ethics

Personal Securities Transactions

  • Review employee trades for compliance with the firm’s restricted watch lists.
  • Use a log to track when securities are added to the list or removed and why so that there is some context to a particular event.
  • Review employee trades against the requirements of the firm’s code of ethics.
  • Review employee trades alongside the firm’s trade blotter. Regulators will be doing this, so you need to do it as well.
  • When it comes to this area of oversight, technology is one way to stay ahead of the volume because you will need to do more than hand pick a sample set of trades. The the SEC will be diving deeper into your data and you should too.

Gifts and Entertainment: Obviously you need to review expense reports to identify unreported gifts and entertainment. One CCO even admitted that their compliance department opens all mail and packages to perform real-time review of items being sent to associates, which tends to deter using the office for personal deliveries (much to Amazon's chagrin)!

Political contributions: Regulators are using big data to compare donor lists to names of associates. You need to stay on top of this and be creative with name searches as Timothy Smith can also be Tim Smith or T. Smith. Here, it's important to have access to public databases. This areas is most critical to firms that manage public funds.

Insider Trading

  1. Expert Networks: Develop a process for pre-approval, spot chaperoning (tag alongside the analyst), and post-event review to ensure sufficient attestations were received.
  2. Interactions with Public Company Management: Review emails, track individual meetings, train associates and occasionally participate in interactions with public company representatives to ensure your associates know how to safeguard non-public information and to avoid trading violations.

Portfolio Management

  1. Use technology to allow pre-programmed rules to block trades before they occur.
  2. Review client portfolios for compliance with investment mandates, restrictions and side letters.
  3. Ensure there is sufficient support for investment recommendations.
  4. Focus on trades which are not based on pro-rata allocations to understand if there is favoritism.

Trading and Investing

  1. Trade Surveillance: Test daily, weekly, monthly and annually for items such as unreported trade errors, abnormal trading practices, large gains or losses avoided, trades around interactions with public companies and experts.
  2. Best Execution: Test for approved broker usage, transaction cost analysis, volume weighted average price analysis, proper allocation and soft dollars. Best execution gets trickier for bonds, so don't assume that what you do for equities is sufficient for bond trading. You should also consider how best execution applies to trading in mutual fund shares, a current focus of SEC examinations.

Fees and Expenses

Regulators are definitely scrutinizing fees and expenses to protect the investor. Here are a few tests to consider:

  • Bills correspond to contractual terms and check or account debit as well
  • Adviser fees are appropriately offset with management fees
  • Unearned fees are credited
  • AUM is accurate for fee calculations
  • Expenses are consistently and properly disclosed in Form ADV and contracts
  • Allocations are proper
  • Expenses comply with internal policies and procedures

The panel discussion on critical areas for testing a compliance program was so rich and robust that we left the ad review and data security for another day. Stay tuned for more!

Dina has over 20 years of experience in the investment management industry, including as chief compliance officer, senior executive over legal and compliance, and board member for registered investment companies. She has worked at a Fortune 100 financial services firm. Recently, Dina co-founded and is Co-CEO of Global Rhino LLC. Global Rhino is an affiliate of Joot and is a boutique firm focusing on Management Consulting Services in order to bridge the gap between managing money and managing the business of asset management. Dina also serves as the Chief Strategy Officer for Joot. For more information, see