Raising the Bar for Compliance Best Practices


New York, NY – Although not required by regulation, a growing number of U.S. investment advisers have decided over the past year to develop different types of programs to conduct due diligence of their external research providers in order to limit their firm’s risk and mitigate their liability.  Along the way these firms have raised the bar for all other investment advisers as they have established a new level of “best practices” that customers may come to expect from the firms with institutional grade risk management platforms.

No Regulatory Requirements

In most industries, companies have numerous regulatory requirements to conduct appropriate due diligence on the external vendors they use as part of a rigorous risk management program – particularly if they are paid a significant amount, or if their failure could create substantive risk for the firms.

However, this is not the case with asset manager’s use of external research providers, even though investment advisers pay their brokers and independent research providers millions of dollars in client commissions and hard dollar fees for their research.  What is more surprising is the fact that investment advisers aren’t required to conduct due diligence on their external research providers when these firms could introduce significant risk to an asset manager’s research process.

Fulfilling the Spirit vs. the Letter of the Law

Despite the lack of a requirement, a case could be made that U.S. regulators want investment advisers to go farther than just the letter of the law to address the risks in their businesses.

In a speech to the National Society of Compliance Professionals last week, Carlo di Florio, director of the SEC’s Office of Compliance Inspections and Examinations, said the following. “When NEP staff examines, for example, an investment adviser’s adherence to its fiduciary obligations… our examiners are looking at how well firms are meeting both the letter and spirit of these obligations.”

Di Florio added, “If we believe that a firm tolerates a nonchalant attitude toward compliance, ethics and risk management, we will factor that into our analysis of which registrants to examine, what issues to focus on, and how deep to go in executing our examinations.”

In addition, regulators we have spoken with admit that conducting due diligence on an investment adviser’s external research vendors could be seen as meeting their fiduciary duty of care to their clients.  Unfortunately, many asset managers have relied on the fact that conducting this type of due diligence is not considered to be normal practice in the industry.

Best Practices for Research Due Diligence

However, “best practices” for conducting due diligence on external research providers are definitely changing.  Over the past six months, the team at Integrity Research has spoken to or met with the General Counsels or Chief Compliance Officers at over fifty different sized hedge funds, mutual funds, pension funds, and other long-only asset managers.  The following are our findings from these discussions.

Undertaking a Major Internal Due Diligence Initiative. Over the past ten months, a small but influential group of U.S. hedge funds and mutual funds have decided to review all, or a large portion, of their external research providers.  Typically these due diligence teams have been made up of members of these firms’ legal, compliance, and research management groups.  The due diligence has been based on sending out questionnaires, reviewing documents, and conducting telephone interviews with compliance professionals or executives at the research firms.  As a result of these reviews, these asset managers have requested some of the research firms they used to either shore up their compliance controls or modify their research processes.  In other cases, these firms have decided to fire some firms due to the riskiness of their research process or their lack of compliance oversight.

Hiring a “Research Compliance Officer”. A few U.S. asset managers have decided to take a more measured approach to conducting due diligence on their external research providers.  These firms have typically hired a senior person to head up their due diligence of external research providers.  Given their more limited resources, these firms have typically taken a “risk based” approach to their due diligence efforts – focusing first on the research firms that seem to be the most risky types of research they use.  As a result, these firms have started their due diligence with primary research providers, including expert networks, channel check providers, and survey providers.  In addition, many of these firms have rolled out their due diligence process to any new research providers their analysts and PMs are interested in adding.

Outsourcing their Research Due Diligence Program. Investment advisers have decided to work with an external vendor to implement their research due diligence program.  In some instances, these asset managers have requested third party due diligence on specific ‘high risk’ research providers.  Asset managers have also engaged external vendors to initiate a due diligence program which the asset managers can maintain internally.  External vendors include law firms or research due diligence specialists like Integrity Research.

Practical Benefits of a Due Diligence Program

The investment advisers that have implemented some form of due diligence program for their external research vendors have all agreed that doing so brings their firms two major benefits.  These include:

Limiting Headline Risk. Most asset managers admit that the reputational damage that can be done to their businesses if it becomes known that they are being investigated for receiving and using inappropriate information from an external research provider can be devastating.   Certainly, investors in hedge funds FrontPoint Partners and Level Global would agree.  Consequently, these buy-side firms expect that a research due diligence program will help them identify and address or eliminate any research sources which might be considered too risky for them to rely upon.

Mitigating Enterprise Liability. Everyone acknowledges that it is impossible to stop bad actors – either from their own firms or from external research providers – from trying to break the law if that is their intent.  However, all General Counsels and Chief Compliance Officers want to make sure that an incident involving individual bad actors won’t create a larger liability for the entire firm.  The asset managers that have implemented external research due diligence programs all believe that these initiatives will go a long way to convincing regulators of their firms’ “culture of compliance” and will reduce the likelihood that regulators will target the firm at large.


Despite the fact that investment advisers are not required by U.S. regulation to conduct due diligence of their external research providers, a growing number of firms have made various commitments to implement this type of program.

Some firms have made considerable investments in large multi-functional teams to conduct due diligence of their research providers.  Another group of asset managers have hired senior level personnel to develop a due diligence program by starting with their highest risk providers.  Other firms have chosen to hire external vendors to help them develop and implement a rigorous research due diligence program.

All of these firms have rolled out their programs in order to reduce the risk and liability associated with the use of external research providers.  Consequently, these investment advisers are raising the standard for compliance “best practices” for all other asset managers in dealing with their research vendors.


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