United States: Swinging For The Fences Every Time: Benefits Of Periodic Third-Party Compliance Audits

Last Updated: March 22 2016
Article by Eva Carney and Kimberly M. Versace

"You hit home runs not by chance but by preparation." —Roger (61 HRs in '61) Maris

Investors are coming to expect that their investment advisers periodically will engage an independent third-party to review their compliance programs. Investment adviser management teams, in turn, are finding that the benefits of recurrent compliance audits may be considerable.

When an advisory firm periodically brings in an experienced third-party compliance audit team, investors gain a degree of comfort that the advisory firm operates consistently with applicable law and industry standards and, accordingly, that the investors' assets are safe. For their part, the firm and its management team gain (1) an independent evaluation of how the firm's ongoing efforts to address compliance risks stack up against industry standards, best practices and investor and regulators' expectations; (2) an understanding of any current limitations on the firm's ability to produce an appropriate audit trail of its business decision-making and operations; and (3) constructive, tailored and current advice on how best to address any operational, compliance program, or staffing gaps or weaknesses identified in the audit.

Firms that undergo periodic compliance audits typically also find that, when they receive a regulatory inquiry or a call announcing an SEC examination, they are better prepared to produce documentation in a timely fashion and to respond to, and productively engage with, the regulatory staff. Many firms also share the conviction that obtaining periodic third-party input about their compliance programs, and making appropriate enhancements to their programs in response to that input, will foreclose a good deal of time- and labor-intensive probing when an SEC examination team comes knocking.

Below we outline the key components of a compliance audit and expand on our views that periodic compliance audits, when done well, are worth the expense and effort involved.


A standard compliance audit seeks to replicate a full-scale SEC on-site investment adviser examination and for this reason sometimes is referred to as a "mock" audit.

Compliance audits require a significant commitment of advisory personnel's time and attention, though certainly not the many months consumed by the typical SEC examination. Like the SEC examination, a compliance audit will begin with a comprehensive document request letter and include on-site interviews with personnel from the firm's various business functions and follow-up requests for information and records as the audit progresses.

Compliance Program/Business Records Review

Registered investment advisers are required to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the Investment Advisers Act of 1940. The centerpiece of a registered firm's compliance manual is the code of conduct, which must address how the particular firm handles conflicts of interest and polices personal securities trading by its personnel. The SEC has said that it expects these policies and procedures to be tailored to the business of the particular firm and designed to prevent, detect, and correct violations of the Advisers Act by the firm and its personnel.

The compliance audit team will focus on the firm's key risk areas and will review, among other matters as appropriate, the firm's approach to limiting the risk of insider trading and to identifying circumstances in which advisory personnel may act inconsistently with the firm's fiduciary duties to clients. During the document review process, the audit team, like an SEC examination team, expects prompt delivery of any and all records requested for the review, including the trade blotter, other trade detail, and performance and fees backup.

Interviews of Firm Personnel

The audit team will request interviews of senior firm personnel, business unit leaders and, as appropriate, trading personnel. These interviews are a means of evaluating the extent to which compliance with applicable laws and firm policies, procedures and contractual requirements is a firm-wide priority. The interviews also permit the team to gain a more complete picture of the firm's business and risks than may be evident from documentation alone. Compliance auditors, taking their lead from SEC examination practice, typically also seek interviews with personnel, if any, who have been identified through the records review as repeat offenders of the firm's policies and procedures. The objective will be to make a judgment as to whether these persons pose risk to firm investors such that additional review of the person's firm activities is required. The interviews may also be used to evaluate the extent and effectiveness of any retraining received or remediation to which those interviewed have been subject once the firm identified their missteps.

Feedback and Reporting

As their review process progresses, the audit team will make suggestions for modifications and enhancements to the compliance program. If this is not the advisory firm's first compliance audit, the team's feedback also will encompass the sufficiency of any program or staffing changes made to address issues identified in previous engagements.

Examiner feedback is a critical part of the compliance audit process. It may prove highly valuable, whether it flags program deficiencies, staffing weaknesses, or training needs, or reflects the reviewers' efforts to share best practices or alternative approaches to a process or issue. At the same time, it is important to note that if a third-party compliance audit firm is engaged directly by an advisory firm, the communications and evaluation that follow may need to be shared directly with investors and regulators. To maintain the communications and evaluations as privileged, advisory firms will want to engage outside counsel to lead the compliance audit. Counsel then can engage the third party compliance consultant to perform the work, with the written agreement between the audit firm and the adviser's outside counsel reflecting that the audit firm is conducting its work under counsel's direction, in order to facilitate counsel's provision of legal advice to counsel's client. This approach will accord the protections of the attorney-client privilege to the work and communications, fostering full and frank discussion about any program deficiencies or staffing gaps or weaknesses and robust exchanges with respect to recommended modifications and enhancements.

After completing their audit work, compliance auditors typically will offer to prepare, as part of the engagement, a comprehensive report detailing the issues identified during the audit. Due to concerns that such reports may carry more weight with an SEC examination team than may be warranted, we typically advise against receiving a comprehensive written report from the audit team. Instead, we typically suggest getting a verbal report of the team's findings and recommendations, followed by a short, non-privileged writing that outlines the scope of the examination – i.e., who staffed the mock audit, how long it lasted, and the areas that were examined. The advisory firm then may include that document in its (nonprivileged) compliance files and share it with the SEC without having to address potential waivers of privilege, should an SEC examination ensue at a later time.


Admittedly, investing the time and effort to undergo a compliance audit and to follow through with recommended enhancements puts pressure on senior management, supervisory personnel and Compliance and Operations resources, but the potential benefits are worth the effort. A well-staffed and appropriatelytailored compliance audit that is conducted at outside counsel's direction will provide a firm with an independent, expert view of its compliance program. Undertaking an audit periodically will keep the firm current as the audit will provide insight into the effectiveness of the firm's current supervisory system and compliance staff, and into whether the firm's compliance program has kept up with regulatory developments and any changes in the firm's business and operations. Periodic compliance audits also will expose the advisory firm to the current thinking about compliance risks, regulatory "hot button" topics and industry best practices.

Of course, obtaining full value from any audit – whether it is the firm's first or its fifth – requires full cooperation and investment of time and effort from all affected advisory personnel. Put another way, advisory firms get the most out of third-party compliance audits when they give the audit team the same level of cooperation that they would give an examination team from the SEC.

The exercise of identifying and gathering all of the documents requested by the compliance audit team requires dedication of significant Compliance and Operations resources. If completed diligently, however, the exercise will alert the firm to record maintenance and even documentation gaps, if those exist.

Likewise, ensuring that the "right" personnel make themselves available for interviews by the team may tax the schedules and patience of some personnel. These efforts nonetheless will assist the chief compliance officer and senior management in evaluating the implementation of the compliance program across the firm and identifying any gaps in personnel's understanding of and adherence to policies and procedures. In addition, mock interviews will give those who participate in them valuable experience and a more nuanced understanding of what will be expected during an SEC formal examination than any compliance training session might. A firm can anticipate that its personnel who have recent compliance audit interview experience are more likely to approach SEC staff interviews calmly and competently.

Comprehensively and timely addressing any program weaknesses identified during the compliance audit process, and making enhancements to compliance infrastructure and processes as appropriate, will require expenditure of personnel and budget resources. The result, however, will be a more robust compliance program and a firm that is better prepared to address investor inquiries about its compliance risks. Moreover, remediation and program and process strengthening may remove the identified issues from the potential list of deficiencies that could be cited by the SEC staff at the conclusion of a formal examination of the firm. Indeed, enhancements implemented in response to issues identified in a compliance audit may help to foreclose what would otherwise have been a time-consuming, deep dive by SEC examiners into those issues. These actions also may make for a smoother formal examination, should the SEC staff pay a visit, since the firm may present a different, lower risk profile to the SEC examiners than if it had not made the changes. In our experience, a firm's proactive engagement of compliance auditors typically resonates with the SEC examination staff, and increases the likelihood of a good examination outcome.

As the new year begins, we urge advisory firms to make plans for a third-party audit of their compliance program, whether this will be their first mock audit or just one in an ongoing series.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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