Why the Great Resignation poses a new level of compliance risk

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Foreside’s Mark Fairbanks writes that as regulations constantly evolve, the departure of key personnel is a bigger threat. Here’s why third-party experts can mitigate legal risk and improve performance, he says.

When it comes to “key-man” risks in asset management, many assume these threats reside exclusively in either the front office or within a firm’s investment operations. Amid the Great Resignation, however, fund managers are quickly discovering that turnover in other areas can be just as debilitating to the business, especially to those business operations not perceived as core to the firm’s success. 

The compliance function, in particular, generally is taken for granted, and often not appreciated for its role in back-office distribution to advance new growth initiatives, and do so with regulatory confidence. Yet, when key compliance personnel retire or pursue greener pastures — or when it becomes obvious these functions are understaffed — that confident feeling can quickly fade.

At a time when the available workforce feels as if it’s shrinking, and experienced talent is more elusive than ever, demands on compliance teams and for compliance professionals seem to be growing exponentially. As the FCPA Blog recently observed, the proportion of risk, regulatory, and compliance staff at Citibank, to cite just one example, has ballooned from under 5 per cent of the bank’s total employees in 2008 to approximately 15 per cent of its total workforce in 2019. Moreover, the pressure in certain circles is intensifying. The SEC in the last week of January fired a shot across the bow to the private equity industry through a risk alert that called attention to inconsistent disclosures, misleading performance information, and other failures in marketing observed across the asset class.

While the world’s largest banking institutions can afford to throw money at the talent problem, either by adding staff or enticing the best candidates into back-office distribution roles, most traditional fund managers will struggle to cope when faced with a sudden departure. Within the back-office distribution function, in particular, turnover doesn’t just create bottlenecks that can slow near-term AUM growth, it creates legal risks that grow more acute each day. Asset managers that, among other things, maintain a FINRA member broker-dealer primarily for the purpose of providing back-office distribution services, are increasingly turning to dedicated third-party specialists. They don’t just fill the void, but bring deep expertise, elastic bandwidth and innovation to a critical function.

Understanding the Role of Compliance in Back-Office Distribution

Part of the challenge to recruit and retain compliance professionals is that asset managers rarely appreciate all that goes into the roles within back-office distribution. Top candidates don’t merely bring legal acumen, they also must have a mix of soft and technical skills. Most of all, professionals are expected to stay on top of ever-evolving regulatory regimes, understanding not just the letter of the law but more importantly ongoing precedent and how regulators are interpreting new rules.

New waves of regulation keep coming: Effective last May (and with a pending compliance date of November 4, 2022), the SEC rolled out 430 pages of new marketing rules for investment advisors. Among the changes, the SEC’s redefined what constitutes an “Advertisement”; outlined new conditions applicable to testimonials or third-party ratings; and prescribed how exactly advisors can document investment performance in advertising.  

The Specialist Advantage: Addressing the Compliance Risks

It only takes one bad FINRA or SEC exam to create expensive complications and reputational damage for firms and individuals. (If professionals are licensed with a broker-dealer, they can be held personally liable for violations.) Meanwhile, other emerging asset categories, including crypto currencies and ESG, are creating new opportunities for fund managers, but also new compliance risks in the absence of clear direction from regulators.

ESG compliance has been a moving target for both fund managers and investors for several years. The DOL, five years ago, issued interpretive guidance in favor of incorporating ESG considerations into the fiduciary duties of plan sponsors; In 2020, it amended its “investment duties” regulations to reverse previous guidance; and then, this past October, proposed a new rule, that yet again opens the doors for fiduciaries to consider ESG as part of manager selection.

Staying on top of these regulations doesn’t just inform how investment advisors can market ESG products, but also to whom they should be marketing these strategies to in the first place. The SEC, for its part, spent much of 2021 soliciting and compiling public comments for an upcoming release of new rules related to climate change and other environmental disclosures. 

The Specialist Advantage: Finding Cost-Savings and Fresh Innovation

Beyond hedging against the Great Resignation, third-party specialists also yield considerable cost savings. It stands to reason that as fee compression puts pressure on profit margins, and as the costs of compliance and compliance technology steadily increase, the incentive grows for asset managers to look hard at any area that can be efficiently outsourced. For example, one recent trend has seen asset managers shutter their limited purpose broker-dealer and outsource their non-core operations — in overhead, fixed fees and net capital requirements alone, savings can start at USD150K a year.

And yet job cuts are not necessarily involved with transferring distribution compliance to a third-party. Asset management staff frequently wear many hats, and the ability to have employees focus on the manager’s core business and not be distracted by managing a regulated broker-dealer is a benefit. Moreover, a “lift-out” in which certain in-house personnel transition to the specialist vendor, can also facilitate cohesion and limits severance costs for outgoing employees. The point is that managers have options.

From the perspective of in-house compliance teams, the biggest advantage is in working with experts who knows precisely where the regulatory boundaries lie and through their client base have seen nearly every scenario across every asset class. It’s often the case that in-house compliance teams live on one end of a very wide risk spectrum: they either overlook material risks that will attract regulatory scrutiny or adopt an overly conservative posture that prevents firms from fully articulating their edge or promoting new strategies effectively. Specialists who work across hundreds of clients — and are in regular contact with regulators — bring an innate understanding around how different regimes interpret law that by design is principle-based and broad in scope.

The expanding reach of ETFs illustrates the benefit of third-party expertise. For traditional mutual fund managers that are looking to roll out ETF products for the first time — or convert a mutual fund into an ETF — in-house staff, unless they’ve navigated these waters at previous employers, rarely understand the regulatory nuances involved. These may include compliance program policies and ETF-specific operating procedures; developing Authorized Participant contacts and approaches to AP contract negotiation, as well as other overlooked requirements to create a dedicated ETF-servicing capability. An outsourced specialist can implement these protocols in as little as one month’s time.

The Great Resignation is not a fleeting phenomenon. Outsourcing back-office distribution compliance can certainly mitigate the recruiting and retention challenges, that are only become more acute for highly skilled positions in narrow niche. But the benefits extend well beyond risk mitigation and cost savings: It’s also about turning regulation from an obstacle into a catalyst for innovation.

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