The Importance of Testing Compliance Procedures

The process of testing your compliance procedures goes hand-in-hand with the annual requirement of reviewing an advisor’s compliance manual. The lack of adequate testing of your procedures leaves you in the dark. How do you know your procedures are working effectively for your organization if you don’t test them?

There are many reasons to conduct periodic testing of your compliance manual procedures, but here are a couple:

1. The SEC dictates that certain rules require the adviser to test the procedures. For example, Rule 204A-1 requires investment advisers to “review access persons’ personal securities transactions”.
2. The SEC communicates through risk alerts that key areas of your compliance manual should be tested. For instance, in late 2021, they released a risk alert about client billing and the need for RIA’s to have an effective system in place to ensure client bills are accurate. During these exams the SEC tested the adviser’s fee billing calculations and found instances where clients were being overbilled.

The compliance manual should state that key procedures will be reviewed and tested on a periodic basis. For example, the manual should state that a firm’s trading should be reviewed periodically to ensure client trades are being executed in accordance with its best execution obligations.

So where do you begin and how much of your compliance procedures should be tested?

1. Where to Begin?

Conduct a risk assessment of your compliance manual and identify high risk areas, such as trading or trade allocation. Trading has a high risk of error because of the frequency and volume. Therefore, testing trades on a more frequent basis, like quarterly vs. annually, will reduce the risk of errors and help evaluate the firm’s trading practices and procedures in a timely fashion.

2. How Much Should You Test?

A good rule of thumb is to use statistical sample testing and randomly select a group of items. If your total trading population is greater than 1,000 trades, select a sample of 25. Conduct tests of each trade in the sample to determine if the trade was placed correctly. Were any errors found? If 1 error is identified, from the sample of 25, there is a 90% confidence rating that additional errors occur in your population.

You’ve gone through the effort of testing certain compliance procedures, so now what? If the testing of trades identified errors, more research needs to be done. Here are some items to consider:

• What were the circumstances of the testing error?
• Was there an event that occurred that affected that particular security?
• Was the information entered correctly and communicated properly to the broker?
• Based on the error, do the procedures need to be changed?

Testing your procedures before the SEC knocks on your door eliminates any surprise and stress that can come with an SEC exam. If you have an effective testing process in place, you can feel confident that your compliance manual is reasonably designed to prevent violations. Contact Joot today to learn more about our team and how we can help you develop a robust and tested compliance program.