From the bare text of the SEC’s regulation, it would seem that anyone in a private equity fund manager’s organization could serve in the role of chief compliance officer. However, the implementing release, the Sentencing Guidelines and subsequent SEC enforcement actions makes it clear that regulators expect more.
Additionally, fund investors are increasingly taking a closer look at a firm’s compliance program and comparing it to peer firms. This review typically includes an examination of the individual designated as the firm’s chief compliance officer and the structure of the firm’s compliance program. This review will continue to evolve as more and more private equity firms become registered investment advisors because of Dodd-Frank.
Designating existing personnel
Given limited operating budgets, a firm may merely assign additional compliance responsibilities to its in-house counsel, chief financial officer or other executive. This is likely the most cost-effective way to start a compliance program. However, the additional role and responsibility of a chief compliance officer may create a large burden on the affected executive and often, others in the organization will be required to help in the day-to-day operations of the compliance program.
Merely adding compliance responsibilities to an existing position without providing appropriate support could be a red flag during future routine SEC examinations. The SEC explicitly stated that a firm does not need to hire a new individual to fill the role of chief compliance officer, but the SEC’s subsequent actions have indicated that it takes a serious look at the time commitment assigned to the role. If an existing executive in the firm is appointed to the compliance role, the likely follow-up during a SEC examination will be a question about which responsibilities the executive gave up in order to run the compliance program. The firm will need to be prepared to answer questions about how the executive’s required time commitment and responsibilities, both compliance and non-compliance, have been managed.
Outsourcing compliance functions
Firms that are less familiar with compliance might be wise to obtain outside assistance to jump-start the development of their compliance program. For example, a firm could have a consultant advise it about regulatory requirements, review transactions and perform ongoing reviews around key areas of conflict of interest. Outsourcing some of these compliance roles would allow the firm to tap into a broader pool of knowledge and experience about the regulatory framework and industry best practices.
Outsourcing some compliance functions could create an additional safeguard against potentially bad acts or transactions that could be perceived as advantageous to the firm at the expense of its limited partners. For example, an outsourcing provider is not likely to acquiesce to the desires of a client firm if the action violates an SEC rule – the provider may be more likely to sever the relationship than approve a violation.
An outsourcing provider can bring the benefit of its experience with other firms, and the knowledge of best practices and industry standards. Since the Advisers Act allows firms to craft a program that is appropriate for its risks, there is no right or wrong way to structure a compliance program.
“A firm should not expect an outsourcing provider to be eager to take on its compliance obligations without first becoming more familiar with it”
Outsourcing can be a less expensive, or a more efficient, alternative for a firm, particularly among smaller advisors. However, it is not an approach that will free a firm from its oversight duties; a firm’s obligations cannot be outsourced, only its operations can. Hiring an outsourced compliance department does not remove the firm’s responsibility for meeting the applicable requirements under the Advisers Act – there is still a requirement for oversight. A firm that chooses to outsource its compliance role will have to be prepared to address its provider’s lack of knowledge of the firm and lack of customization to the particular issues that affect the firm. If a firm outsources the function, it needs to be prepared to answer questions about the ability of its outsourcing provider to enforce policies against the firm’s employees and principals.
A firm should not expect an outsourcing provider to be eager to take on its compliance obligations without first becoming more familiar with it. A competent compliance outsourcing firm is likely to conduct due diligence on the private equity firm before agreeing to take on some of its compliance functions. If problems arise, both the private equity firm and the compliance provider will be entangled in liability. Good compliance outsource providers are known to refuse to work with a firm based on the firm’s state of operations and the risk it would place on the provider.
Hiring from outside
For many private equity firms that have been in business for some time, finding a compliance officer may seem a little redundant considering the safeguards they already have in place. However, a firm will benefit from adopting the SEC’s required formal compliance program and designating a chief compliance officer.
Hiring an experienced chief compliance officer may be the best way to implement a compliance program. A firm may be fortunate to find someone who is familiar with the requirements of the Advisers Act and has experience with the operations of a private equity firm. More likely, a firm will be faced with the decision to choose between an individual with extensive private equity experience and limited compliance experience under the Advisers Act, and an individual with extensive compliance experience under the Advisers Act and limited experience in the private equity industry.
A lawyer as chief compliance officer
Federal regulations for investment advisors do not impose any professional or licensing requirements on the role of the chief compliance officer. Frequently, candidates come from the legal field and often, a private equity firm will designate its existing general counsel as chief compliance officer. Part of the role of chief compliance officer is to interpret SEC rules and decisions, and craft the firm’s policies and procedures based on those legal boundaries.
A chief compliance officer need not be a lawyer, although having legal training is helpful. External law firms and consultants can help interpret regulations and keep a firm up to date on legal requirements, or write its compliance manual. Presumably, if a firm is going to take on the expense of hiring a chief compliance officer, it would want to reduce its external compliance expenses. Therefore, hiring a chief compliance officer with a legal background could reduce some of the firm’s compliance expenses on legal fees.
For a firm that does not yet have a general counsel, hiring a lawyer to take on both the roles of general counsel and chief compliance officer is an option. However, concerns about attorney-privilege come into play when the role is shared. These concerns are real and should be dealt with thoughtfully. For example, communications ordinarily would not be subject to attorney-client privilege for a chief compliance officer, whereas they would apply for a general counsel.
An accountant as chief compliance officer
Many chief compliance officer candidates come from the accounting field. Often, a firm starts by designating its chief financial officer as the chief compliance officer. Having a financial background and familiarity in dealing with complex regulations may enable a chief compliance officer to better understand the financial arrangements and financial implications of transactions.
A specialist in auditing may bring his or her skills in uncovering fraud and other issues that employees may try to hide. If a firm focuses on back-end detection, it must be sure that it does not overlook the need to have front-end training to create a culture of compliance within the entire firm.
Doug Cornelius is the chief compliance officer at Beacon Capital Partners, a real estate private equity firm, where he oversees the development and management of the compliance program. He previously worked as a senior attorney in real estate at Goodwin Procter.
This is an excerpt from The US Private Equity Fund Compliance Companion, published by Private Equity International, and available for purchase here.