About our Contributors
ICS Group is a regulatory compliance consulting firm specializing in providing compliance support to the financial services and insurance industries. We help our clients comply with regulatory requirements and industry standards. Our clients include: registered investment advisers, private equity funds, hedge funds, mutual funds, broker-dealers, insurance companies and state pension plans. Our team of highly experienced compliance professionals know from first-hand experience what regulators are looking for, the industry standards that apply, and how to develop and implement cost-effective business-oriented solutions.
In Part 1 of ICSGroup’s Due Diligence Series, Managing Vendor Risks: Implementing an Effective Third-Party Due Diligence Program, we discussed the various aspects of an effective third-party vendor due diligence program. In this article, we focus on the keys to conducting adequate due diligence of sub-advisors to satisfy heightened fiduciary obligations. These fiduciary obligations apply to fund of funds and manager of managers as RIAs, pension plan sponsors under ERISA, and public pension plan administrators as the plan fiduciaries (collectively referred to as “fiduciaries”).
The Bernie Madoff Scandal, the largest Ponzi scheme in history, rocked the financial industry in 2008. In the aftermath of the scandal, Bernie Madoff’s “fund of funds” investment managers, investment advisors and others were charged for facilitating Bernie Madoff’s fraud by investing and allowing billions of dollars to be invested in Madoff and Madoff Securities without performing adequate due diligence, despite numerous warning signs.
Ivy Asset Management LLC, J.P., Jeanneret Associates Inc., Beacon Associates Management Corp., Andover Associates Management Corp., and their current and former owners and officers were held to have breached their fiduciary duties to the plans under ERISA to manage the Plans’ assets prudently, loyally and in the best interests of plan participants. The investment advisors, owners and officers each paid a portion of a $220 million settlement.
It is no longer sufficient due diligence for a fiduciary to rely on a sub-advisor’s marketing materials and industry reputation or signed representations and warranties from the sub-advisor in lieu of conducting its own comprehensive due diligence.
A comprehensive due diligence process that consists of a thorough compliance review of each sub-advisor is now considered best practice. Effective inquiry into the compliance controls that govern a sub-advisor’s pricing and valuation of assets will highlight issues related to inaccurate AUM or IRR and management fees. Uncovering ineffective cash management procedures can curtail potential embezzlement and custody issues. Having a formalized due diligence process can protect against reputational harm or headline risk, better defend against investor litigation and regulatory action, and form the basis for recommendations to enhance a sub-advisor’s compliance program.
Here are the keys to tapping into the true state of a sub-advisor’s compliance program:
- A due diligence questionnaire (“DDQ”) that is developed and maintained based on current SEC regulations and priorities.
- A DDQ that requires narrative responses rather than the typical yes or no responses.
- A controls-based DDQ that focuses on the controls in place to generate consistent compliant results and to identify compliance issues.
- A thorough document review which includes the following:
- Organizational charts and history of the firm;
- Personal trading policies and control procedures;
- Form ADV (specifically, to learn more about actual and potential conflicts of interest, fees and expenses, and consistency with written policies and procedures);
- Internal assessments to ensure best execution;
- Copies of PPMs and pitch books;
- Valuation policies and procedures;
- Cash management policies and controls;
- Copies of any correspondence with securities regulators and SROs, including prior exam reports; and
- For hedge funds, documentation of trade errors and internal controls to ensure compliance with investment guidelines.
After reviewing documentation, the due diligence process should include an in-person meeting with the senior team, the CCO and several randomly selected employees. The purpose of the in-person meetings is to assess the personal knowledge of the compliance policies and procedures, to obtain responses to any follow up questions and to determine the extent to which the compliance program has been operationalized within the firm. Most importantly, it will enable a fiduciary to establish that it met its fiduciary obligation to take reasonable steps to protect the assets of the plan or its clients.
During a compliance review, the presence of the following (or similar) red flags may be an indication that a deeper investigation of the sub-advisor would be prudent.
- The CCO does not have proper resources or experience to effectively manage the firm’s compliance program.
- Internal controls are not effective to ensure compliance with investment guidelines.
- Fees and expenses are inconsistent with the LPA or the advisory agreement.
- Responses to DDQs differ from verbal responses.
- DDQ responses cannot be validated by documentation.
- The lack of annual compliance review reports.
- The lack of annual or periodic compliance training.
- Employees are unable to articulate key policies and procedures at the firm.
- The sub-advisor maintains a shroud of secrecy over its compliance documents.
The due diligence obligation does not end after a fiduciary engages a sub-advisor. Fiduciaries should periodically re-evaluate their sub-advisors to ensure that they still meet or exceed the high standard that led to their selection. As events and situations change, fiduciaries should evaluate all of the information at their disposal to determine if the sub-advisor continues to be the best choice for their clients.
Although very effective in assessing a sub-advisor’s operations, operational due diligence teams or consultants may not possess the depth of compliance expertise necessary to conduct a comprehensive compliance due diligence assessment. ICSGroup can partner with ODD teams or consultants to assess the sub-advisors’ compliance programs. For help with developing a formalized compliance due diligence process of your sub-advisors, please contact ICSGroup.