This week we have a contributed post from Deborah Prutzman, CEO of The Regulatory Fundamentals Group.
Since the summer of 2012 the SEC has embarked on a drive to change the culture within financial services firms, including those in the alternatives space. At first the SEC focused on education—both of its staff and of industry participants. Now the SEC is actively using enforcement as a hammer to drive deeper change. Enforcement cases in 2013 included a focus on boards that failed to properly steer the valuation process and on individuals who misled compliance, as well as the highly-publicized cases involving insider trading.
What does this mean for you in 2014?
1. The SEC will continue to focus on governance and on gatekeepers. This means you. Whatever your role-- as an adviser, on a board, or as a service provider-- you must have a grasp of key regulatory requirements. The SEC has announced an initiative to bring enforcement actions for inadvertent (or in technical terms “non-scienter”) violations. Do not let your firm be on that list. Take the time to learn what is required of you. Doing otherwise is like crossing the street with your eyes closed. Some may make it across, but do you want to be the one hit by a truck?
2. The SEC will continue to follow the money. This means continued focus on conflicts, valuation, expenses and compensation. Exam questions will change accordingly, as will enforcement proceedings and investor scrutiny. Recent enforcement proceedings illustrate that staff can be reluctant to raise issues with senior management that have the potential to hit the bottom line. Reflecting point #1, senior managers must encourage staff to raise these issues and demonstrate their importance by undertaking their own meaningful inquiries. Guidance may come from the UK regulators which have instructed management to undertake an internal conflicts assessment. (In fact, again reflecting point #1, UK regulators required some CEOs to attest that an assessment of conflicts has been presented to their firm's governing body and that the firm’s process for handling conflicts is adequate.)
3. Your protection will be a strong governance process. Senior management will need to be able to clearly articulate how it satisfies its “duty to supervise”— to drive both business results and to comply with legal requirements. There can always be a bad actor in an organization. Should enforcement personnel determine this to be the case, senior management will protect their firm and its staff during the enforcement process by showing that the individual acted alone. In short, strong governance provides coverage and credit if a bad actor is discovered. On a related note, the SEC relies heavily on cooperation and strong supervision can lead to meaningful cooperation in the regulator's eyes.
4. A strong governance process will include a full-fledged compliance program. This is compliance as an organic part of the organization and incorporates risk assessments and enhanced testing, not just the existence of a compliance manual. It will also include self-reporting and other behaviors underscored in the U.S. Federal Sentencing Guidelines.
5. Investors will focus on these issues even more in 2014 than in 2013. They will add a third leg to their due diligence efforts—legal and regulatory due diligence, which complements market and operational issues that were the focus of due diligence in the past.
The upshot of all this is that understanding the issues, and staying ahead of any changes, will help you run a tighter ship, understand your business better and protect you, your staff and your firm should something go awry. Doing so will not only keep regulators at bay, but will also instill greater confidence in your investors. In a tough market where investors are increasingly concerned with legal and regulatory exposure, managers who master regulatory requirements will enjoy a competitive advantage over firms that do not provide their investors with the same level of protection.