SEC Final Rules Mandate Policies to Prevent Securities Violations
January 12, 2004
BACKGROUND
In December, 2003 the Securities and Exchange Commission (“SEC”) adopted new Rule 38a-1 under the Investment Company Act of 1940 (“Investment Company Act”) and new Rule 206(4)-7 under the Investment Advisers Act of 1940 (“Advisers Act”), and amended Advisers Act Rule 204-2 (the “books and records rule”) in order to prevent violations of the federal securities laws. The rules require every investment company (“fund”) and investment adviser (“adviser”) registered with the SEC to:
* Adopt and implement policies and procedures reasonably designed to prevent violations of the federal securities laws;
* Review such policies and procedures annually for their adequacy and the effectiveness of their implementation; and
* Appoint a chief compliance officer to be responsible for administering such policies and procedures.
Funds and advisers must be in compliance with the new rules on or before October 5, 2004. Because its limited resources permit infrequent compliance examinations, the SEC has created additional mechanisms to try to ensure that funds and advisers do not violate the federal securities laws. In the SEC’s experience, funds and advisers with effective internal compliance programs administered by competent compliance personnel are much less likely to violate these laws. As a result of the enactment of these new rules by the SEC, funds and advisers that have not already done so, are required to adopt such internal compliance programs.
ADOPTION AND IMPLEMENTATION OF POLICIES AND PROCEDURES
Investment Advisers
Pursuant to Rule 206(4)-7, every registered investment adviser is required to adopt and implement a compliance program reasonably designed to prevent violation of the federal securities laws, including the Advisers Act, detect violations that have occurred, and correct promptly any violations that have occurred. An adviser is prohibited from giving investment advice to clients unless the adviser is in compliance with the rule.
Although Rule 206(4)-7 does not enumerate specific elements that advisers must include in their policies and procedures, every adviser should adopt policies and procedures that take into consideration the nature of the fund’s operations. The SEC cited the following as areas that, at a minimum, the policies and procedures of advisers should address to the extent that they are relevant to that adviser:
* Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, disclosures by the adviser, and applicable regulatory restrictions;
* Trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services ("soft dollar arrangements"), and allocates aggregate trades among clients;
* Proprietary trading of the adviser and personal trading activities of supervised persons;
* The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
* Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
* The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
* Marketing advisory services, including the use of solicitors;
* Processes to value client holdings and assess fees based on those valuations;
* Safeguards for the privacy protection of client records and information; and
* Business continuity plans.
All advisers, in designing its policies and procedures, should first identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations, and then design policies and procedures that address those risks. For example, smaller advisory firms without conflicting business interests would require much simpler policies and procedures than larger firms that have multiple potential conflicts as a result of their other lines of business or their affiliations with other financial service firms. However, even small advisers may have arrangements, such as soft dollar agreements, that create conflicts. Advisers of all sizes, in designing and updating their compliance programs, must identify these arrangements and provide for effective control of the resulting conflicts.
Where appropriate, every adviser’s policies and procedures should employ, among other methods of detection, compliance tests that analyze information over time in order to identify unusual patterns. These include, for example, an analysis of the quality of brokerage executions (for the purpose of evaluating the adviser’s fulfillment of its duty of best execution), or an analysis of the portfolio turnover rate (to determine whether portfolio managers are overtrading securities), or an analysis of the comparative performance of similarly managed accounts (to detect favoritism, misallocation of investment opportunities, or other breaches of fiduciary responsibilities).
The rule does not require advisers to consolidate all compliance policies and procedures into a single document, and does not require advisers to memorialize every action that must be taken in order to remain in compliance with the Advisers Act. For example, in some cases it may be enough for the compliance policies and procedures to allocate responsibility within the organization for the timely performance of many obligations, such as the filing or updating of required forms.
Under Rule 206(4)-7, every adviser is required to review its policies and procedures annually to determine their adequacy and the effectiveness of their implementation. The review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies or procedures. For example, an adviser that is acquired by a broker-dealer or by the corporate parent of a broker-dealer should assess whether its policies and procedures are adequate to guard against the conflicts that arise when the adviser uses that broker-dealer to execute client transactions, or invests client assets in funds or other securities distributed or underwritten by the broker-dealer.
In addition, although the rule requires only annual reviews, advisers should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and regulatory developments. Thus, all registered advisers should begin reviewing their policies and procedures in light of the SEC’s adoption of the new rule.
Investment Companies
Pursuant to new Rule 38a-1 under the Investment Company Act, a registered fund’s board of directors (including a majority of its independent directors) must approve a written compliance program. Such a program should be reasonably designed to prevent violations (by, for example, separating operational functions such as trading and reporting), detect violations of securities laws (by, for example, requiring a supervisor to review employees’ personal securities transactions) and correct promptly any material violations.
Procedures must provide for the oversight of compliance by the fund’s advisers, principal underwriters, administrators, transfer agents, and any other entities employed by the fund, such as pricing services, auditors and custodians (collectively “service providers”), through which the fund conducts its activities. Rule 38a-1 requires fund boards to approve the policies and procedures of fund service providers, and requires the fund’s policies and procedures to include provisions for the fund to oversee compliance by its service providers.
Rule 38a-1 requires a fund to review annually its policies and procedures, as well as those of its service providers. The rule does not require a fund’s board to conduct the review. However, the board would have the benefit of the review in the report submitted by the fund’s compliance officer (see below). All funds should begin reviewing their compliance policies immediately.
Registered fund procedures should address the areas identified for advisers above, as well as the following critical areas:
* Pricing of portfolio securities and fund shares;
* Processing of fund shares;
* Identification of affiliated persons with whom the fund cannot enter into certain transactions, and compliance with exemptive rules and orders that permit such transactions;
* Protection of nonpublic information;
* Compliance with fund governance requirements; and
* Market timing
* The corresponding italicized headings below generally discuss a few of these six critical areas for funds, although Rule 38a-1 does provide for more in-depth treatment.
Pricing of portfolio securities and fund shares. Rule 38a-1 requires funds to adopt policies and procedures that require the fund to monitor for circumstances that may necessitate the use of fair value prices; establish criteria for determining when market quotations are no longer reliable for a particular portfolio security; provide a methodology or methodologies by which the fund determines the current fair value of the portfolio security; and regularly review the appropriateness and accuracy of the method used in valuing securities, and make any necessary adjustments.
Identification of affiliated persons. Funds should have policies and procedures in place to identify affiliated persons and to prevent unlawful transactions with them, so as to prevent self-dealing and overreaching by persons in a position to take advantage of the fund.
Protection of nonpublic information. Under Rule 38a-1, fund advisers should incorporate their Advisers Act §204A policies (regarding insider and improper personal trading based on material, nonpublic information) into the policies required by the rule.
Market timing. Under Rule 38a-1, a fund must have procedures reasonably designed to ensure compliance with its disclosed policies regarding market timing. The rule addresses the procedures that funds should have in place to provide for monitoring of shareholder trades or flows of money in and out of the funds in order to detect market timing activity, and for consistent enforcement of the fund’s policies regarding market timing.
CHIEF COMPLIANCE OFFICER
Investment Advisers
Rule 206(4)-7 requires every registered adviser to designate a chief compliance officer to administer the compliance policies and procedures. An adviser’s chief compliance officer should be competent and knowledgeable regarding the Advisers Act and should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm. Thus, the compliance officer should have a position of sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures. However, advisers are not required to hire an additional executive to serve as chief compliance officer, but need only to designate an individual as the adviser’s chief compliance officer.
Investment Companies
In addition to the aforementioned regulations concerning the appointment of a chief compliance officer for advisers, Rule 38a-1 also requires, among other things, that a fund board (including a majority of independent directors) approve the designation of a separate chief compliance officer for the fund who must report directly to the board of directors and who can be hired or fired only by the fund’s board of directors (including a majority of independent directors) The chief compliance officer must furnish the board with a written report on the operation of the fund’s policies and procedures and those of its service providers. In addition, the independent members of the board of directors are required to meet privately with the fund’s chief compliance officer in executive session at least once a year, without anyone else, such as fund management or interested directors, present.
In addition, the fund’s contracts with its service providers might also require service providers to certify periodically that they are in compliance with applicable federal securities laws, or could provide for third-party audits arranged by the fund to evaluate the effectiveness of the service provider’s compliance controls. The chief compliance officer could conduct (or hire third parties to conduct) statistical analyses of a service provider’s performance of its duties to detect potential compliance failures.
RECORDKEEPING
Under Rule 38a-1 and amendments to existing Rule 204-2 (the books and records rule), funds and advisers are required to maintain copies of their compliance policies and procedures, as well as any records documenting their annual review of those policies and procedures, for at least five years, in an easily accessible place for the first two years. These rules permit funds and advisers to maintain these records electronically (For more detailed information on electronic recordkeeping, see our September 24, 2003, Hedge Fund & Investment Managers Advisory entitled, “Electronic Recordkeeping By Investment Companies and Investment Advisers.”).
The required policies and procedures do not all need to be contained in a single document. For example, many firms issue policies and procedures in loose-leaf form, and distribute revised sections periodically within the firm. These firms may comply with the recordkeeping requirements by keeping the current policies and procedures, and retaining the superseded section(s) for the requisite period of time. This practice is permissible so long as the firm can indicate to the SEC examination staff the version of compliance policies and procedures that were in effect as of a given date.
EFFECTIVE DATE
New rules 38a-1 and 206(4)-7 and the amendments to rule 204-2 will be effective on February 5, 2004. The compliance date of the new rules and rule amendments is October 5, 2004 (“compliance date”). The nine month transition period until the compliance date does not reduce the immediacy of the need for all funds, including those that already have compliance policies in place, to undertake a review of their policies and procedures, in light of recent revelations of unlawful practices involving market timing, late trading, and improper disclosures of nonpublic portfolio information.
All funds and advisers must:
* on or before the compliance date, designate a chief compliance officer and fund boards must have approved the chief compliance officer;
* on or before the compliance date, adopt compliance policies and procedures that satisfy the requirements in the new rules; and
* complete their first annual review of the compliance policies and procedures no later than eighteen months after the adoption or approval of the compliance policies and procedures.
Additionally, in the case of funds:
* these policies and procedures must have been approved by the board on or before the compliance date; and
* the chief compliance officer of a fund must submit the first annual report to the board within sixty calendar days of the completion of the annual review.
PRIVATE SECTOR INITIATIVES
In the SEC proposal for Rules 38a-1 and 206(4)-7, four additional approaches to require the private sector to assume greater responsibility for compliance with the federal securities laws were considered. Those possible approaches included: (1) a requirement that funds and advisers undergo third-party compliance reviews; (2) an expansion of the role of independent public accountants to include the performance of certain compliance reviews; (3) the formation of one or more self-regulatory organizations for advisers or funds; and (4) the requirement that certain advisers obtain fidelity bonds from reputable insurance companies.
The SEC has decided not to adopt any of these approaches under new Rules 38a-1 or 206(4)-7. Nonetheless, the SEC may reconsider whether to propose rules requiring funds and advisers to obtain compliance reviews from third-party compliance experts. Such compliance audits could be a useful supplement to the SEC’s examination program and would assure the frequent examination of advisers and funds.
EFFECT ON REQUIREMENTS UNDER EXISTING RULES
These new rules encapsulate or are similar to many other existing rules governing investment advisers. Therefore, the rules may not have a significant impact on many advisers. For example, many advisers have already adopted and implemented comprehensive compliance procedures and/or have hired a chief compliance officer pursuant to Section 203(e)(6) of the Advisers Act, which requires advisers to supervise their employees in order to prevent securities violations.
These new rules do not alter the policies and procedures that advisers have already adopted as required pursuant to certain other rules, such as new Rule 206(4)-6 under the Investment Advisers Act, requiring the establishment of proxy voting policies, Section 204A under the Advisers Act, requiring the adoption of policies reasonably designed to prevent the misuse of material non-public information by an investment adviser, and Rule 17j-1 under the Investment Company Act, requiring advisers to adopt a written code of ethics designed to prevent certain affiliated person from engaging in fraudulent, manipulative and deceptive actions.
ADDITIONAL REQUEST FOR COMMENT
In addition, the SEC is seeking comment on additional measures or refinements to Rule 38a-1 that would further enhance the independence and effectiveness of chief compliance officers. The SEC requests further comment about whether its definition of “material compliance matters” adequately addresses its concern that fund boards receive compliance information they reasonably need to know in order to oversee fund compliance.
For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.