Learn about the process and benefits of a contract compliance audit.
What is contract compliance?
Contract compliance refers to asset managers meeting the obligations they agreed to in a contract. On a larger scale, contract compliance encompasses how firms manage all of their agreements, whether with vendors, business partners, investors, or employees.
A contract compliance program — also called an obligation management program — includes the policies, procedures, and technology solutions firms use to reduce the risk of breaching a contract. The program might also include policies on how firms address contract-related disputes.
Contract compliance is an ongoing necessity for asset managers, and certain best practices, like contract management software, help firms overcome common challenges.
What contracts must asset managers comply with?
Asset managers in the private markets sign non-disclosure agreements, limited partnership agreements, side letters, non-reliance letters, transaction agreements, shareholder agreements, loan and credit agreements, and many more crucial contracts. Each of these agreements is part of the investment process and creates numerous obligations.
For example, private equity NDAs are crucial in the deal process, enabling asset management firms to receive target companies’ information and perform due diligence.
An LPA is the controlling document between the general partner (the asset manager) and the limited partners (the investors). It includes information on the duration of the fund, the fundraising period, the investment period, the GP’s commitment to the fund, management fees, distributions, and the limited partner advisory committee.
Side letters are unique agreements negotiated between GPs and LPs to modify or add to the terms in the LPA. Funds can have numerous and varied side letters, which often create additional obligations for GPs to comply with, including obligations related to:
- Fee and expense provisions
- Reporting requirements
- Environmental, social, and corporate governance standards
- Co-investment rights
- Most-favored nations elections
- Investment restrictions
- Capital concentration limits
- Key person provisions
- Transfer rights
Additionally, asset managers have contracts with vendors, service providers, employees, and other parties. While these may relate to non-core functions of the firm, the firm must also meet these obligations to mitigate risk.
What is the difference between contract compliance and regulatory compliance?
Compliance is a broad term, and both contractual compliance and regulatory compliance fall under its umbrella.
Contract and regulatory compliance differ in how obligations arise. Contract compliance stems from the firm’s agreements with its investors and other parties. Regulatory compliance stems from state and national laws. In the U.S., the Securities and Exchange Commission oversees registered financial advisers and firms, broker-dealers, and national securities exchanges.
Contract and regulatory compliance also differ in the effects of noncompliance. Breaching a contract with an investor or other party could lead to a civil dispute between the parties, an injunction, or damages. Violating a regulation could lead to administrative proceedings, civil lawsuits involving the SEC, enforcement actions, and fines.
Why is contract compliance important?
The most direct goal of a contract compliance program is to reduce the risk of noncompliance and its many consequences.
A legal claim between an asset manager and investor or other business could be costly and time-consuming. Such a claim would likely pull internal resources away from core functions and require working with expensive outside counsel.
There’s also a close link between contractual compliance and SEC compliance. The SEC requires GPs to adhere to their LPAs and side letters. The Commission heavily scrutinizes certain aspects of the GP and LP relationship, including whether firms charge fees and expenses appropriately. Failing to comply with a side letter or other contract provision could have regulatory consequences, including public enforcement actions and fines.
Additionally, if either a civil lawsuit or SEC action became public, it could harm the firm’s reputation and future fundraising efforts.
What are the challenges of contract compliance for asset managers?
Depending on the size of the asset management firm and its funds, it may have dozens or hundreds of agreements to comply with, and each of these contracts will have numerous terms. That volume makes for a complex obligation management process, made all the more difficult because of several common issues.
Time-consuming, manual processes
Firms often rely on spreadsheets and compendia put together by outside counsel to track obligations to investors. There are no repositories of digital contracts or automatic notifications. While in-house lawyers and business professionals can use a spreadsheet’s search feature, those search capabilities are neither powerful nor intelligent, and the text doesn’t link to the underlying contract, which they have to access separately.
Ad hoc software solutions
Many firms continue to rely on a mix of ad hoc software solutions to manage their contracts and obligations. These disparate systems along with manual processes create inefficiencies and cost in-house employees’ time.
Lack of visibility into contracts
Because many firms have yet to digitize their contracts and implement a contract lifecycle management solution, employees have to take additional steps to access underlying contract language. This inaccessibility means firms have a difficult time quickly answering questions regarding the contract and the firm’s obligations to investors and other parties.
Comparing similar provisions across a contract type is another time-consuming, manual endeavor that can take in-house lawyers or outside counsel hours to complete.
Variations in contract language
Firms often have similar provisions with several investors. Unfortunately, due to negotiations with each investor, the final contract language and obligations differ enough to impact the firm’s compliance efforts. Without easy visibility into the firm’s contracts, these variations or conflicting obligations can increase the risk of noncompliance.
Lack of ownership for compliance-related tasks
Firms often spread ownership of various obligations across several roles. Yet without a CLM solution, firms have a hard time establishing efficient workflows and keeping track of compliance-related tasks.
Who is responsible for contract compliance?
Responsibility for contract compliance programs or compliance-related tasks varies based on a firm’s size and products. Some firms have a chief compliance officer or outsourced chief compliance officer to head up the business’s broader regulatory and contractual compliance efforts. Other firms rely heavily on their general counsels.
Smaller fund managers are less likely to have someone devoted to contract management or contract compliance. Instead, they typically have several in-house lawyers and business professionals handle obligation management.
Do asset managers need contract compliance services?
Contract compliance services can help businesses:
- Assess and improve their contractual relationships
- Perform objective contract compliance audits
- Identify and mitigate risk
- Realize the full value of their agreements
- Improve internal processes
Does that mean asset managers need contract compliance services? Not necessarily. Contract consulting is an option, but more often than not managers are interested in regulatory consulting services or outside counsel to help them keep up with an evolving regulatory landscape.
Contract compliance best practices
Asset managers can take several steps to improve their obligation management programs and reduce the risk of noncompliance.
Introduce consistent contract language
Whenever possible, firms can use the same language in LPAs and side letters to create more consistent obligations across LPs. To achieve this, firms can create contract playbooks with preferred and fallback terms based on what is commercially appropriate.
Standardize contract management processes
Firms can standardize how they generate contracts and manage their obligations. In addition to contract playbooks, they can adopt contract management technology, outline specific workflows, and assign ownership for various tasks. The SEC requires firms to perform an annual compliance program review, giving asset managers a format for evaluating and improving their regulatory and contractual compliance workflows.
Adopt contract compliance software
By investing in contract management software, firms can take advantage of a central repository, greater visibility into their contracts, more robust search features, automatic notifications, and contract data analytics and reporting.
Perform contract compliance audits
The only way to ensure compliance is to review the firm’s obligations and its performance through contract audits. Firms should plan to perform a contract audit, whether they review all the business’s agreements or focus on a contract type.
Learn more about contract compliance
Here are 7 must-have contract management software features for asset managers.