[Federal Register: December 24, 2003 (Volume 68, Number 247)]
[Rules and Regulations]
[Page 74713-74730]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr24de03-22]
[[Page 74713]]
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Part II
Securities and Exchange Commission
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17 CFR Parts 270, 275, and 279
Compliance Programs of Investment Companies and Investment Advisers;
Final Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 270, 275, and 279
[Release Nos. IA-2204; IC-26299; File No. S7-03-03]
RIN 3235-AI77
Compliance Programs of Investment Companies and Investment
Advisers
AGENCY: Securities and Exchange Commission.
ACTION: Final rule; request for comments.
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SUMMARY: The Securities and Exchange Commission is adopting new rules
under the Investment Company Act of 1940 and the Investment Advisers
Act of 1940 that require each investment company and investment adviser
registered with the Commission to adopt and implement written policies
and procedures reasonably designed to prevent violation of the federal
securities laws, review those policies and procedures annually for
their adequacy and the effectiveness of their implementation, and
designate a chief compliance officer to be responsible for
administering the policies and procedures. In the case of an investment
company, the chief compliance officer will report directly to the fund
board. These rules are designed to protect investors by ensuring that
all funds and advisers have internal programs to enhance compliance
with the federal securities laws.
DATES: Effective Date: February 5, 2004.
Comment Date: Comments requested in section II.F of this release
should be received on or before February 5, 2004.
Compliance Date: October 5, 2004. Section III of this release
contains more information on the compliance date.
ADDRESSES: To help us process and review your comments more
efficiently, comments may be sent to us in either paper or electronic
format. Comments should not be sent by both methods.
Comments in paper format should be submitted in triplicate to
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450
Fifth Street, NW., Washington, DC 20549-0609. Comments in electronic
format may be submitted at the following e-mail address: rule-
comments@sec.gov. All comment letters should refer to File No. S7-03-
03; if e-mail is used, this file number should be included on the
subject line. Comment letters will be available for public inspection
and copying in the Commission's Public Reference Room, 450 Fifth
Street, NW., Washington, DC 20549. Electronically submitted comment
letters will also be posted on the Commission's Internet Web site
(http://www.sec.gov).\1\
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\1\ We do not edit personal or identifying information, such as
names or e-mail addresses, from electronic submissions. Submit only
information you wish to make publicly available.
FOR FURTHER INFORMATION CONTACT: Hester Peirce, Senior Counsel, Office
of Regulatory Policy at (202) 942-0690, or Jamey Basham, Special
Counsel, Office of Investment Adviser Regulation at (202) 942-0719,
Division of Investment Management, Securities and Exchange Commission,
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450 Fifth Street, NW., Washington, DC 20549-0506.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``SEC'' or ``Commission'') is adopting new rule 38a-1 (17 CFR 270.38a-
1) under the Investment Company Act of 1940 (15 U.S.C. 80a)
(``Investment Company Act''), new rule 206(4)-7 (17 CFR 275.206(4)-7)
under the Investment Advisers Act of 1940 (15 U.S.C. 80b) (``Investment
Advisers Act'' or ``Advisers Act''), and amendments to rule 204-2 (17
CFR 275.204-2) under the Advisers Act, and to Part 1, Schedule A, Item
2(a) of Form ADV (17 CFR 279.1).\2\
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\2\ Unless otherwise noted, when we refer to rule 38a-1 or any
paragraph of the rule, we are referring to 17 CFR 270.38a-1 of the
Code of Federal Regulations in which the rule is published, as
amended by this release; when we refer to rule 206(4)-7 or any
paragraph of the rule, we are referring to 17 CFR 275.206(4)-7 of
the Code of Federal Regulations in which the rule is published, as
amended by this release; and when we refer to rule 204-2 or any
paragraph of the rule, we are referring to 17 CFR 275.204-2 of the
Code of Federal Regulations in which the rule is published, as
amended by this release.
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Table of Contents
I. Background
II. Discussion
A. Adoption and Implementation of Policies and Procedures
1. Investment Advisers
2. Investment Companies
B. Annual Review
1. Investment Advisers
2. Investment Companies
C. Chief Compliance Officer
1. Investment Advisers
2. Investment Companies
D. Recordkeeping
E. Private Sector Initiatives
F. Additional Request for Comment
III. Effective Date
IV. Cost-Benefit Analysis
A. Benefits
B. Costs
V. Consideration of Promotion of Efficiency, Competition and Capital
Formation
VI. Paperwork Reduction Act
A. Rule 38a-1
B. Rule 206(4)-7
C. Rule 204-2
VII. Summary of Final Regulatory Flexibility Analysis
VIII. Statutory Authority Text of Rules
I. Background
Earlier this year the Commission proposed rules that would require
investment companies (``funds'')\3\ and investment advisers to adopt
written compliance procedures, review the adequacy of those procedures
annually, and designate a chief compliance officer responsible for
their administration.\4\ We proposed the rules because it is critically
important for funds and advisers to have strong systems of controls in
place to prevent violations of the Federal securities laws and to
protect the interests of shareholders and clients. The proposed rules
were designed to foster, among other things, improved compliance by
clarifying the compliance obligations of fund management and to
strengthen the hand of fund boards and compliance personnel when
dealing with them.\5\
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\3\ In this release, we use the term ``fund'' to mean a
registered investment company or a business development company,
which is an unregistered closed-end investment company. See section
2(a)(48) of the Investment Company Act (15 U.S.C. 80a-2(a)(48)). We
use the term ``mutual fund'' to mean a registered investment company
that is an open-end management company defined in section 5(a) of
the Investment Company Act (15 U.S.C. 80a-5(a)).
\4\ Compliance Programs of Investment Companies and Investment
Advisers, Investment Company Act Release No. 25925 (Feb. 5, 2003)
(68 FR 7038 (Feb. 11, 2003)) (``Proposing Release'').
\5\ Forty-eight commenters, most of which were investment
advisers, fund management companies, and organizations representing
those groups, submitted comments in response to the Proposing
Release. Commenters generally supported the proposal to require
funds and advisers to adopt and implement compliance programs, but
many sought changes. The comment letters and a summary of comments
prepared by our staff are available for public inspection and
copying in the Commission's Public Reference Room, 450 5th Street,
NW., Washington, DC (File No. S7-03-03). The comment summary is also
available on the Commission's Internet Web site (http://www.sec.gov/rules/extra/s70303summary.pdf.
)
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In recent months, the Commission and State securities authorities
have discovered unlawful conduct involving a number of fund advisers,
broker-dealers, and other service providers that confirms the need for
these rules. Fund advisory or distributor personnel have engaged in, or
actively assisted others in engaging in, inappropriate market timing,
late trading of fund shares, and the misuse of material, nonpublic
information about fund portfolios.\6\
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These personnel, including in some cases senior executives of fund
advisers, have placed their personal interests or the business
interests of the fund adviser ahead of the interests of fund
shareholders, thus breaching their fiduciary obligations to the funds
involved and their shareholders. These individuals have harmed the
funds, their management organizations, and the confidence of fund
investors.
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\6\ The Commission has already obtained settlements in a number
of actions arising from such violations. See, e.g., In re Putnam
Investment Management, Investment Advisers Act Release No. 2192
(Nov. 13, 2003) (finding that an investment adviser failed to
disclose potentially self-dealing securities trading by several of
its employees, failed to have reasonable procedures to prevent
misuse of material nonpublic information, and failed to reasonably
supervise the employees who committed violations); In re Connelly,
Securities Act Release No. 8304 (Oct. 16, 2003) (finding that a
former executive of an investment adviser to a fund complex, in
contravention of fund disclosures, approved agreements that
permitted select investors to time certain funds in the complex); In
re Markovitz, Securities Act Release No. 8298 (Oct. 2, 2003)
(finding that a former hedge fund trader violated the Federal
securities laws and defrauded investors by engaging in late trading
of mutual fund shares).
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Our response to these events is twofold. First, we are conducting
an intensive investigation of funds, advisers, broker-dealers, and
others.\7\ We will aggressively pursue and punish those who have
violated the Federal securities laws and breached their fiduciary
obligations to clients. When appropriate, we will actively work with
other Federal law enforcement authorities and State authorities to see
that the full weight of the law is brought to bear against those who
have betrayed mutual funds and fund investors. Second, we will review
all of our rules to determine what changes may be required to prevent
this type of conduct.
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\7\ To date, we have brought 10 enforcement actions. See SEC v.
Mutuals.com, Inc., Civil Action No. 303 CV 2912D (N.D. Tex. Dec. 4,
2003) (alleging that dually registered broker-dealer and investment
adviser, three of its executives, and two affiliated broker-dealers
assisted institutional brokerage customers and advisory clients in
carrying out and concealing thousands of market timing trades and
illegal late trades in shares of hundreds of mutual funds); SEC v.
Invesco Funds Group, Civil Action No. 03-N-2421 (PAC) (D. Colo. Dec.
2, 2003) (alleging that investment adviser, with approval of its
president and chief executive officer, entered into market timing
arrangements with more than 60 broker dealers, hedge funds, and
advisers without disclosing these arrangements to the affected
mutual funds' independent directors or shareholders); SEC v.
Security Trust Company, Civil Action No. 03-2323 (D. Ariz. Nov. 24,
2003) (alleging that unregistered financial intermediary and three
of its senior executives facilitated and participated in late
trading and market timing schemes by a group of related hedge
funds); SEC v. Pilgrim, Civil Action No. 03-CV-6341 (E.D. Penn.
filed Nov. 20, 2003) (alleging that investment adviser and two
senior executives permitted a hedge fund, in which one of the
executives had a substantial financial interest, to engage in
repeated short-term trading of several mutual funds and that one of
the executives provided nonpublic portfolio information to a broker-
dealer, which passed it on to its customers); SEC v. Druffner, Civil
Action No. 03-12154-RCL (D. Mass. Nov. 4, 2003) (alleging that five
brokers, with the assistance of their branch office manager, evaded
attempts to restrict their trading and conducted thousands of market
timing trades in numerous mutual funds); SEC v. Scott, Civil Action
No. 03-12082-EFH (D. Mass. filed Oct. 28, 2003) (alleging that two
senior investment executives of an investment adviser engaged in
repeated short-term trading in their personal accounts of funds over
which they had investment decision-making responsibility and about
which they had access to nonpublic information); In re Sihpol,
Administrative Proceeding No. 3-11261 (Sept. 16, 2003) (charging
former broker with playing a key role in enabling certain hedge fund
customers to engage in late trading in shares of funds). See also
supra note . A number of State actions are also pending.
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We are taking our first regulatory actions designed to curb the
abusive practices recently uncovered and to prevent their recurrence.
In companion releases, we are proposing to amend our rules regarding
mutual fund share pricing and prospectus disclosure.\8\ In this
release, we are adopting new rules requiring advisers and funds to
adopt strong compliance controls administered by a chief compliance
officer.
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\8\ Amendments to Rules Governing Pricing of Mutual Fund Shares,
Investment Company Act Release No. 26288 (Dec. 11, 2003) (68 FR
70388 (Dec. 17, 2003)) (``Companion Late Trading Release'');
Disclosure Regarding Market Timing and Selective Disclosure of
Portfolio Holdings, Investment Company Act Release No. 26287 (Dec.
11, 2003) (68 FR 70402 (Dec. 17, 2003)) (``Companion Disclosure
Release'').
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II. Discussion
The Commission is adopting new rule 206(4)-7 under the Advisers Act
and new rule 38a-1 under the Investment Company Act.\9\ The new rules
require each registered investment adviser and each fund to adopt and
implement compliance programs that conform to the new rules. Failure of
an adviser or fund to have adequate compliance policies and procedures
in place will constitute a violation of our rules independent of any
other securities law violation. The new rules will thus permit the
Commission to address the failure of an adviser or fund to have in
place adequate compliance controls, before that failure has a chance to
harm clients or investors.
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\9\ We also are adopting related amendments to rule 204-2 under
the Advisers Act and a technical amendment to Form ADV.
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A. Adoption and Implementation of Policies and Procedures
1. Investment Advisers
Under rule 206(4)-7, it is unlawful for an investment adviser
registered with the Commission to provide investment advice unless the
adviser has adopted and implemented written policies and procedures
reasonably designed to prevent violation of the Advisers Act by the
adviser or any of its supervised persons.\10\ The rule requires
advisers to consider their fiduciary and regulatory obligations under
the Advisers Act and to formalize policies and procedures to address
them.\11\
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\10\ Rule 206(4)-7(a). See also section 202(a)(25) of the
Advisers Act (15 U.S.C. 80b-2(a)(25)) (defining ``supervised
person'' as ``any partner, officer, director (or other person
occupying a similar status or performing similar functions), or
employee of an investment adviser, or other person who provides
investment advice on behalf of the investment adviser and is subject
to the supervision and control of the investment adviser'').
\11\ In response to several comments, we revised the text of the
rule so that a violation of the rule would be deemed to be
``unlawful'' rather than ``a fraudulent, deceptive, or manipulative
act, practice or course of business.'' This change, which responds
to commenters' concerns regarding the optics of the rule, does not
change its substance; failure to comply with its terms will result
in a violation of section 206(4) of the Act.
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Commenters generally supported these new requirements, but some
expressed concerns for how they would be applied to smaller advisers.
The Commission is sensitive to the burdens the rule may impose upon
smaller advisory firms.\12\ The rule requires only that the policies
and procedures be reasonably designed to prevent violation of the
Advisers Act, and thus need only encompass compliance considerations
relevant to the operations of the adviser. We would expect smaller
advisory firms without conflicting business interests to require much
simpler policies and procedures than larger firms that, for example,
have multiple potential conflicts as a result of their other lines of
business or their affiliations with other financial service firms.\13\
The preparation of these simpler policies and procedures and their
administration should be much less burdensome.
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\12\ In the Proposing Release, we requested comment on whether
we should except a subset of investment advisers or funds from the
requirements of the rules. Some commenters suggested that we except
small advisers, but we believe that the flexibility of the rules
obviates the need for this exception.
\13\ 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 the effective control of the
resulting conflicts.
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Rule 206(4)-7 does not enumerate specific elements that advisers
must include in their policies and procedures.\14\ Commenters agreed
with
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our assessment that funds and advisers are too varied in their
operations for the rules to impose of a single set of universally
applicable required elements. Each adviser should adopt policies and
procedures that take into consideration the nature of that firm's
operations. The policies and procedures should be designed to prevent
violations from occurring, detect violations that have occurred,\15\
and correct promptly any violations that have occurred.\16\
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\14\ Advisers already are subject to requirements to maintain
written compliance policies and procedures in certain areas. The new
rules do not alter those requirements. See, e.g., Investment Company
Act rule 17j-1(c)(1) (17 CFR 270.17j-1(c)(1)) (requiring each
investment adviser and principal underwriter of a fund to ``adopt a
written code of ethics containing provisions reasonably necessary to
prevent'' certain persons affiliated with the fund, its investment
adviser or its principal underwriter from engaging in certain
fraudulent, manipulative, and deceptive actions with respect to the
fund); Advisers Act rule 206(4)-6 (17 CFR 275.206(4)-6) (requiring
investment advisers to adopt and implement written policies and
procedures reasonably designed to ensure that the adviser votes
securities in the best interest of clients); Advisers Act section
204A (15 U.S.C. 80b-4a) (requiring each adviser registered with us
to have written policies and procedures reasonably designed to
prevent the misuse of material nonpublic information by the adviser
or persons associated with the adviser); Regulation S-P (``Privacy
of Consumer Financial Information'') (17 CFR 248.30) (requiring
investment advisers to ``adopt policies and procedures that address
administrative, technical, and physical safeguards for the
protection of customer records and information'').
\15\ Where appropriate, advisers' policies and procedures should
employ, among other methods of detection, compliance tests that
analyze information over time in order to identify unusual patterns,
including, 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).
\16\ In the Proposing Release, we noted that the compliance
policies and procedures should be designed to prevent, detect, and
correct promptly any material violation of the federal securities
laws (or in the case of advisers, the Advisers Act). A number of
commenters suggested that these objectives were unrealistic and
recommended that the rules be designed instead to promote compliance
with the securities laws. While we understand that compliance
policies and procedures will not prevent every violation of the
securities laws, we believe that prevention should be a key
objective of all firms' compliance policies and procedures.
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Each adviser, 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. We expect that an adviser's policies and procedures, at a
minimum, should address the following issues to the extent that they
are relevant to that adviser:
[sbull] 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;\17\
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\17\ Rule 206(4)-6 under the Advisers Act (17 CFR 275.206(4)-6)
requires registered investment advisers to adopt and implement
written policies and procedures that are reasonably designed to
ensure that the adviser votes securities in the best interest of
clients. Similarly, funds must disclose the policies and procedures
that they use to determine how to vote proxies relating to portfolio
securities. Form N-1A, Item 13(f) (17 CFR 239.15A; 274.11A); Form N-
2, Item 18.16 (17 CFR 239.14; 274.11a-1); Form N-3, Item 20(o) (17
CFR 239.17a; 17 CFR 274.11b); and Form N-CSR, Item 7 (17 CFR
249.331; 17 CFR 274.128).
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[sbull] 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 aggregated trades among clients;
[sbull] Proprietary trading of the adviser and personal trading
activities of supervised persons;\18\
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\18\ Section 204A of the Advisers Act (15 U.S.C. 80b-4a)
requires registered investment advisers to have written policies and
procedures reasonably designed to prevent the misuse of material
nonpublic information by the advisers or persons associated with the
advisers. Rule 17j-1(c)(1) under the Investment Company Act (17 CFR
270.17j-1(c)(1)) requires funds and each investment adviser and
principal underwriter of a fund to ``adopt a written code of ethics
containing provisions reasonably necessary to prevent'' certain
persons affiliated with the fund, its investment adviser or its
principal underwriter from engaging in certain fraudulent,
manipulative, and deceptive actions with respect to the fund.
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[sbull] The accuracy of disclosures made to investors, clients, and
regulators, including account statements and advertisements;
[sbull] Safeguarding of client assets from conversion or
inappropriate use by advisory personnel;
[sbull] 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;\19\
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\19\ Rule 204-2(g)(3) under the Advisers Act (17 CFR 275.204-
2(g)(3)) and rule 31a-2(f)(3) under the Investment Company Act (17
CFR 270.31a-2(f)(3)) require advisers and funds that maintain
records in electronic formats to establish and maintain procedures
to safeguard the records.
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[sbull] Marketing advisory services, including the use of
solicitors;\20\
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\20\ Rule 206(4)-3 under the Advisers Act (17 CFR 275.206(4)-3)
requires written agreements setting forth procedures to govern
solicitation activities conducted by certain third parties on behalf
of an adviser.
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[sbull] Processes to value client holdings and assess fees based on
those valuations;
[sbull] Safeguards for the privacy protection of client records and
information;\21\ and
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\21\ Regulation S-P requires investment advisers to ``adopt
policies and procedures that address administrative, technical, and
physical safeguards for the protection of customer records and
information.'' Regulation S-P (``Privacy of Consumer Financial
Information'') (17 CFR 248.30). Regulation S-P also applies to
funds.
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[sbull] Business continuity plans.\22\
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\22\ We believe that an adviser's fiduciary obligation to its
clients includes the obligation to take steps to protect the
clients' interests from being placed at risk as a result of the
adviser's inability to provide advisory services after, for example,
a natural disaster or, in the case of some smaller firms, the death
of the owner or key personnel. The clients of an adviser that is
engaged in the active management of their assets would ordinarily be
placed at risk if the adviser ceased operations.
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Rule 206(4)-7 does not require advisers to consolidate all
compliance policies and procedures into a single document. Nor does it
require advisers to memorialize every action that must be taken in
order to remain in compliance with the Advisers Act. 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.\23\
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\23\ Advisers who are also registered as broker-dealers are not
required to segregate their investment adviser compliance policies
and procedures from their broker-dealer compliance policies and
procedures.
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2. Investment Companies
Rule 38a-1 requires fund boards to adopt written policies and
procedures reasonably designed to prevent the fund from violating the
Federal securities laws.\24\ The procedures must provide for the
oversight of compliance by the fund's advisers, principal
underwriters,\25\ administrators,\26\ and
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transfer agents \27\ (collectively, ``service providers'') through
which the fund conducts its activities.\28\
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\24\ Rule 38a-1(a)(1). For purposes of rule 38a-1, ``Federal
securities laws'' means the Securities Act of 1933 (15 U.S.C. 77a),
the Securities Exchange Act of 1934 (15 U.S.C. 78a), the Sarbanes-
Oxley Act of 2002 (Pub. L. 107-204, 116 Stat. 745 (2002)), the
Investment Company Act, the Advisers Act, Title V of the Gramm-
Leach-Bliley Act (15 U.S.C. 6801) (governing disclosure of nonpublic
personal information), any rules adopted by the Commission under any
of these statutes, the Bank Secrecy Act (31 U.S.C. 5311-5314; 5316-
5332) (imposing restrictions designed to prevent financial
intermediaries from being used in money laundering activities) as it
applies to funds, and any rules adopted thereunder by the Commission
or the Department of the Treasury. Rule 38a-1(e)(1).
\25\ A ``principal underwriter'' of a fund (other than a closed-
end fund) is ``any underwriter who as principal purchases from such
company, or pursuant to contract has the right (whether absolute or
conditional) from time to time to purchase from such company, any
such security for distribution, or who as agent for such company
sells or has the right to sell any such security to a dealer or to
the public or both, but does not include a dealer who purchases from
such company through a principal underwriter acting as agent for
such company.'' Section 2(a)(29) of the Investment Company Act (15
U.S.C. 80a-2(a)(29)).
\26\ An ``administrator'' is ``any person who provides
significant administrative or business management services to an
investment company.'' Investment Company Act rule 0-1(a)(5) (17 CFR
270.0-1(a)(5)).
\27\ Section 3(a)(25) of the Securities Exchange Act of 1934 (15
U.S.C. 78c-(3)(a)(25)) defines a ``transfer agent'' as ``any person
who engages on behalf of an issuer of securities or on behalf of
itself as an issuer of securities in (A) countersigning such
securities upon issuance; (B) monitoring the issuance of such
securities with a view to preventing unauthorized issuance, a
function commonly performed by a person called a registrar; (C)
registering the transfer of such securities; (D) exchanging or
converting such securities; or (E) transferring record ownership of
securities by bookkeeping entry without physical issuance of
securities certificates.''
\28\ In this release, we use the term ``service provider'' to
refer only to a fund's advisers, principal underwriters,
administrators, and transfer agents. By limiting the term in this
manner, we are not lessening a fund's obligation to consider
compliance as part of its decision to employ other entities, such as
pricing services, auditors, and custodians.
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a. Service Providers. Most of the operations of funds are carried
out by service providers, which have their own compliance policies and
procedures. Commenters pointed out that the proposed rule appeared to
require a fund to adopt, as its own, the policies and procedures of its
service providers.\29\ The final rule 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.
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\29\ Some commenters urged us to permit funds to simply rely on
their service providers' policies and procedures. We have not
adopted this suggestion because it would permit funds and their
boards to absolve themselves of responsibility for compliance
activities of the service providers through which funds conduct most
of their activities.
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Rule 38a-1 provides fund complexes with flexibility so that each
complex may apply the rule in a manner best suited to its
organization.\30\ A fund complex could, for example, adopt compliance
policies and procedures that encompass the activities of the funds, the
adviser and affiliated underwriters and transfer agents, while
approving the policies and procedures of other service providers, such
as subadvisers, over which it has oversight responsibility under the
rule. Another fund complex could adopt policies and procedures that
would cover solely activities of the funds, and could approve the
policies and procedures of each of its service providers.
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\30\ In this release, we use the term ``fund complex'' to mean a
group of funds that share a compliance program and a common
investment adviser and/or distributor.
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b. Board Approval. Rule 38a-1 requires a fund's board, including a
majority of its independent directors, to approve the policies and
procedures of the fund and each of its service providers.\31\ The
approval must be based on a finding by the board that the policies and
procedures are reasonably designed to prevent violation of the Federal
securities laws by the fund and its service providers.\32\
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\31\ In this release, we refer to directors who are not
``interested persons'' of the fund as ``independent directors.''
Section 2(a)(19) identifies persons who are ``interested persons''
of a fund. 15 U.S.C. 80a-2(a)(19).
\32\ Rule 38a-1(a)(2). In response to comments seeking
clarification of the board's responsibilities, we have added
language to the rule text explicitly stating the basis for approval.
If the policies and procedures of a service provider are included
within the policies and procedures adopted by the fund, separate
approval by the board is not required. A fund that is approving
policies and procedures of service providers is required to make
findings only with respect to activities of the service provider
that could affect the fund.
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Some commenters expressed concern that the rule would require
directors to review lengthy compliance manuals and devote considerable
time at each meeting to approving numerous amendments. Directors may
satisfy their obligations under the rule by reviewing summaries of
compliance programs prepared by the chief compliance officer, legal
counsel or other persons familiar with the compliance programs. The
summaries should familiarize directors with the salient features of the
programs (including programs of service providers) and provide them
with a good understanding of how the compliance programs address
particularly significant compliance risks.\33\
In considering whether to approve a fund's or service provider's
compliance policies and procedures, boards should consider the nature
of the fund's exposure to compliance failures. In the case of a money
market fund, for example, the board should consider whether the
policies and procedures sufficiently address the fund's compliance with
rule 2a-7.\34\ Boards should also consider the adequacy of the policies
and procedures in light of their recent compliance experiences, which
may demonstrate weaknesses in the fund or service provider's compliance
programs. We urge boards to also consider best practices used by other
fund complexes, and to consult with fund counsel (and independent
directors with their counsel), compliance specialists and other experts
familiar with compliance practices successfully employed by similar
funds or service providers.
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\33\ Rule 38a-1 does not require fund boards to approve
amendments to policies and procedures of the fund or its service
providers. Such a requirement would, as commenters pointed out,
inundate fund boards with review of minor changes and detract from
their ability to address significant responsibilities committed to
them by the Act and our rules. Moreover, such a requirement could
delay funds and their service providers from making needed changes.
Instead, the rule requires the fund's chief compliance officer to
discuss material changes to the compliance policies and procedures
in his or her annual report to the fund board. Rule 38(a)-
1(a)(4)(iii)(A). As we note below, however, serious compliance
issues must be raised with the board immediately. See infra note 83.
\34\ 17 CFR 270.2a-7.
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The Commission understands that, in some cases, the fund may employ
the services of a service provider that is not an affiliated person of
the fund, such as a transfer agent or administrator, and that provides
similar services to a large number of funds. In such cases, it may be
impractical for the fund or its compliance officer to directly review
all of the service provider's policies and procedures. In such cases,
we will consider a fund's policies and procedures to have satisfied the
requirements of this rule if the fund uses a third-party report on the
service provider's procedures instead of the procedures themselves when
the board is evaluating whether to approve the service provider's
compliance program.\35\ The third-party report must describe the
service provider's compliance program as it relates to the types of
services provided to the fund, discuss the types of compliance risks
material to the fund, and assess the adequacy of the service provider's
compliance controls.\36\
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\35\ In these limited circumstances, we would also consider the
fund to have satisfied the rule's requirement with regard to annual
review of service providers, as discussed in section II.B.2. of this
release, supra, and with respect to the chief compliance officer's
annual report with regard to service providers, as discussed in
section II.C.2. of this release, supra, if such reviews and reports
use such third-party reports provided to the fund no less than
annually. If the fund uses such reports for its approval of a
service provider's compliance program or the annual review or
reporting on the program, the fund must also gather and take into
account other relevant information, such as its experience with the
service provider.
\36\ See, e.g., Codification of Accounting Standards and
Procedures, Statement on Auditing Standards No. 70, Reports on
Processing of Transactions by Service Organizations (American Inst.
of Certified Public Accountants).
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c. Policies and Procedures. Funds' or their advisers' policies and
procedures should address the issues we identified for investment
advisers above.\37\ In
[[Page 74718]]
addition, we expect policies and procedures of funds (or fund service
providers) to cover certain other critical areas. In light of our
recent enforcement actions against a number of fund managers and
service providers,\38\ we are taking this opportunity to review the
application of these policies and procedures to several important areas
of compliance with the Federal securities laws by funds and their
service providers.
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\37\ See supra text accompanying notes 17 through 22. Funds are
also subject to requirements to maintain written compliance policies
and procedures in certain of our rules. The new rules do not
supplant these requirements. See, e.g., Investment Company Act rules
2a-7(c)(7) (17 CFR 270.2a-7(c)(7)) (requiring boards of money market
funds to establish written procedures ``reasonably designed * * * to
stabilize the money market fund's net asset value per share'') and
17j-1(c)(1) (17 CFR 270.17j-1(c)(1)) (requiring funds to ``adopt a
written code of ethics containing provisions reasonably necessary to
prevent'' certain persons affiliated with the fund, its investment
adviser or its principal underwriter from engaging in certain
fraudulent, manipulative, and deceptive actions with respect to the
fund); Form N-1A, Item 13(f) (17 CFR 239.15A; 274.11A) (requiring
funds to disclose the policies and procedures that they use to
determine how to vote proxies relating to portfolio securities); 31
CFR 103.130(c) (requiring funds to develop an anti-money laundering
program, which includes the establishment and implementation of
``policies, procedures, and internal controls reasonably designed to
prevent the mutual fund from being used for money laundering or the
financing of terrorist activities and to achieve compliance with the
applicable provisions of the Bank Secrecy Act and the implementing
regulations thereunder''); Regulation S-P (``Privacy of Consumer
Financial Information'') (17 CFR 248.30) (requiring funds to ``adopt
policies and procedures that address administrative, technical, and
physical safeguards for the protection of customer records and
information'').
\38\ See supra notes 6 and 7 and accompanying text.
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[sbull] Pricing of portfolio securities and fund shares. The
Investment Company Act requires funds to sell and redeem their shares
at prices based on their current net asset value, and to pay redemption
proceeds promptly.\39\ The Investment Company Act requires funds to
calculate their net asset values using the market value of their
portfolio securities when market quotations for those securities are
``readily available,'' and, when a market quotation for a portfolio
security is not readily available, by using the fair value of that
security, as determined in good faith by the fund's board.\40\ These
pricing requirements are critical to ensuring fund shares are purchased
and redeemed at fair prices and that shareholder interests are not
diluted.
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\39\ Section 22(e) of the Investment Company Act generally
prohibits mutual funds from suspending the right of redemption and
prohibits funds from postponing the payment of redemption proceeds
for more than seven days. 15 U.S.C. 80a-22(e). Rule 22c-1(b) under
the Act generally requires that a fund's net asset value be computed
at least once daily, Monday through Friday, at a time or times
specified by the fund's board of directors. 17 CFR 270.22c-1(b).
\40\ Section 2(a)(41) of the Investment Company Act and rule
2a41-1 (17 CFR 270.2a41-1).
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When fund shares are mispriced, short-term traders have an
arbitrage opportunity they can use to exploit a fund and disadvantage
the fund's long-term investors by extracting value from the fund
without assuming any significant investment risk. Mispricing may occur
with respect to portfolio securities traded on a foreign market that
closes before the time at which the fund prices its shares.\41\ If an
event affecting the value of the portfolio securities occurs after the
foreign market closes but before the fund prices its shares, the
foreign market closing price for the portfolio security will not
reflect the correct current value of those securities when the fund
prices its shares. In 1984, we stated that, in these circumstances, a
fund ``must, to the best of its ability, determine the fair value of
the securities, as of the time'' that the fund prices its shares.\42\
We believe that funds that fail to fair value their portfolio
securities under such circumstances may violate rule 22c-1 under the
Investment Company Act.\43\ Fund directors who countenance such
practices fail to comply with their statutory valuation obligations
\44\ and fail to fulfill their fiduciary obligation to protect fund
shareholders. Accordingly, 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;\45\ provide a methodology or
methodologies by which the fund determines the current fair value of
the portfolio security;\46\ and regularly review the appropriateness
and accuracy of the method used in valuing securities, and make any
necessary adjustments.\47\
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\41\ Mispricing may also occur when a domestic trading market in
a security closes before the time the fund prices its shares, or
when market quotations for a security are not reliable because,
e.g., sales have been infrequent or there is a thin market in the
security. See Accounting Series Release No. 118 (Dec. 23, 1970) (35
FR 19986 (Dec. 31, 1970)). Thus, in addition to monitoring for
events that may necessitate fair value pricing, funds must pay
attention to circumstances that would suggest the need for using
fair value pricing.
\42\ Pricing of Redeemable Securities for Distribution,
Redemption, and Repurchase, Investment Company Act Release No. 14244
(Nov. 21, 1984) (49 FR 46558 (Nov. 21, 1984)), at n. 7 (emphasis
added) (proposing amendments to rule 22c-1). Subsequent to the
issuance of this release, our staff has reminded funds of their fair
valuation obligations. In 1999 and 2001, the Division of Investment
Management issued interpretive letters elaborating on funds'
obligations under sections 2(a)(41) of the Investment Company Act
and rule 22c-1 (17 CFR 270.22c-1) thereunder. Letter from Douglas
Scheidt, Associate Director and Chief Counsel, SEC Division of
Investment Management, to Craig S. Tyle, General Counsel, Investment
Company Institute (Dec. 8, 1999) (http://www.sec.gov/divisions/investment/guidance/tyle120899.htm
); letter from Douglas Scheidt,
Associate Director and Chief Counsel, SEC Division of Investment
Management, to Craig S. Tyle, General Counsel, Investment Company
Institute (Apr. 30, 2001) (http://www.sec.gov/divisions/investment/guidance/tyle043001.htm
).
\43\ 17 CFR 270.22c-1.
\44\ Section 2(a)(41) (15 U.S.C. 80a-2(a)(41)) of the Investment
Company Act.
\45\ In some cases, funds have adopted policies and procedures
requiring the use of fair value pricing in circumstances when prices
may be affected by events subsequent to the close of trading, but
have established criteria that result in infrequent use of fair
value pricing, which provides an opportunity for price arbitrage.
See, e.g., Susan Lee, The Dismal Science: The Feeling's Not Mutual,
Wall St. J., Nov. 24, 2003, at A15. As we have stated previously,
funds must fair value their portfolio securities whenever market
quotations become unreliable. See supra note 42. The failure of a
fund to establish sufficiently sensitive criteria for using fair
value pricing should be recognizable in subsequent reviews of the
accuracy of the prices used to compute the net asset value of the
fund.
\46\ In determining fair value, some funds use correlations
between the exchange prices of foreign securities and other
appropriate instruments or indicators, such as relevant indices,
American Depository Receipts, and futures contracts. Software
developed by vendors is today available to assist funds to determine
the fair value of portfolio securities.
\47\ In a companion release, we are proposing to amend funds'
disclosure requirements with respect to the use and the effects of
fair value pricing. See Section II.B of Companion Disclosure
Release, supra note 8.
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[sbull] Processing of fund shares. Our rules require forward
pricing of fund shares.\48\ An investor submitting a purchase order or
redemption request must receive the price next calculated after receipt
of the purchase order or redemption request.\49\ Accordingly, rule 38a-
1 requires that a fund have in place procedures that segregate investor
orders received before the fund prices its shares (which will receive
that day's price) from those that were received after the fund prices
its shares (which will receive the following day's price).\50\ Because
fund purchase and redemption orders are ultimately transmitted to
transfer agents engaged by the fund, we have expanded the service
providers covered by the rule to include transfer agents.
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\48\ Rule 22c-1(a) (17 CFR 270.22c-1(a)).
\49\ Id. We adopted the forward pricing requirement in 1968 to
eliminate so-called ``backward pricing'' that permitted sales and
purchases of fund shares at a stated price. We concluded that
backward pricing resulted in dilution of the value of fund shares,
and that it disrupted fund management by encouraging short-term
trading in funds by speculators seeking to take advantage of fund
prices that did not reflect the current value of the fund portfolio.
Adoption of Rule 22c-1 under the Investment Company Act of 1940
Prescribing the Time Pricing of Redeemable Securities for
Distribution, Redemption, and Repurchase, and Amendment of Rule 17a-
3(a)(7) under the Securities Exchange Act of 1934 Requiring Dealers
to Time-Stamp Orders, Investment Company Act Release No. 5519 (Oct.
16, 1968) (33 FR 16331 (Nov. 7, 1968)).
\50\ Rule 38a-1(a)(1). In most cases, we expect these matters
will be addressed by the policies and procedures of fund transfer
agents. See Companion Late Trading Release, supra note 8, for a
detailed discussion of how fund share transactions are processed by
intermediaries.
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Many funds today have contractual provisions with transfer agents
and other intermediaries that obligate those
[[Page 74719]]
parties to segregate orders received by time of receipt in order to
prevent ``late trading'' based on a previously determined price.
Reliance on those contractual provisions alone would be insufficient to
meet the requirements of the new rule.\51\ Funds should not only
approve and periodically review the policies and procedures of transfer
agents, as required by the rule, but should also take affirmative steps
to protect themselves and their shareholders against late trading by
obtaining assurances that those policies and procedures are effectively
administered.\52\
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\51\ In a companion release, we are proposing amendments to rule
22c-1 under the Investment Company Act that would eliminate the need
for funds and their transfer agents to rely on the segregation of
orders by fund intermediaries other than a registered transfer agent
or clearing agency. See Companion Late Trading Release, supra note
8.
\52\ We discuss methods funds can use to oversee such policies
and procedures later in this Adopting Release, in connection with
the chief compliance officer's oversight of service providers. See
infra text accompanying footnote 91.
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[sbull] Identification of Affiliated Persons. To prevent self-
dealing and overreaching by persons in a position to take advantage of
the fund, the Investment Company Act prohibits funds from entering into
certain transactions with affiliated persons.\53\ Funds should have
policies and procedures in place to identify these persons and to
prevent unlawful transactions with them.
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\53\ See, e.g., section 17(a) (15 U.S.C. 80a-17(a)) (prohibiting
first and second-tier affiliates of a fund from borrowing money or
other property from, or selling or buying securities or other
property to or from the fund, or any company that the fund
controls); section 17(d) (15 U.S.C. 80a-17(d)) (making it unlawful
for first- and second-tier affiliates of a fund, the fund's
principal underwriters, and affiliated persons of the fund's
principal underwriters, acting as principal, to effect any
transaction in which the fund or a company controlled by the fund is
a joint or a joint and several participant in contravention of
Commission rules); rule 17d-1(a) (270 CFR 270.17d-1(a)) (prohibiting
first- and second-tier affiliates of a fund, the fund's principal
underwriter, and affiliated persons of the fund's principal
underwriter, acting as principal, from participating in or effecting
any transaction in connection with any joint enterprise or other
joint arrangement or profit-sharing plan in which any such fund or
company controlled by a fund is a participant unless an application
regarding such enterprise, arrangement or plan has been filed with
the Commission and has been granted); section 10(f) (15 U.S.C. 80a-
10(f)) (prohibiting a fund from purchasing securities in a primary
offering if certain affiliated persons of the fund are members of
the underwriting or selling syndicate); section 17(e) (15 U.S.C.
80a-17(e)) (limiting the remuneration that first- and second-tier
affiliates of a fund may receive in transactions involving the fund,
and companies that the fund controls); and section 12(d)(3) (15
U.S.C. 80a-12(d)(3)) and rule 12d3-1 (270 CFR 270.12d3-1) (together
prohibiting a fund from acquiring securities issued by, among
others, its own investment adviser).
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[sbull] Protection of Nonpublic Information. The federal securities
laws prohibit insider trading, and section 204A of the Advisers Act
requires advisers (including advisers to funds) to establish, maintain,
and enforce written policies and procedures reasonably designed to
prevent the adviser or any of its associated persons from misusing
material, nonpublic information. Fund advisers should incorporate their
section 204A policies into the policies required by rule 38a-1. These
policies typically include prohibitions against trading portfolio
securities on the basis of information acquired by analysts or
portfolio managers employed by the investment adviser. A fund's
compliance policies and procedures should also address other potential
misuses of nonpublic information, including the disclosure to third
parties of material information about the fund's portfolio,\54\ its
trading strategies,\55\ or pending transactions, and the purchase or
sale of fund shares by advisory personnel based on material, nonpublic
information about the fund's portfolio.\56\
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\54\ In a companion release, we are proposing to require funds
to disclose their policies and procedures with respect to the
disclosure of fund portfolio holdings. See Section II.C of Companion
Disclosure Release, supra note 8.
\55\ Thus, funds' and investment advisers' policies and
procedures should preclude fund or advisory personnel from divulging
a fund's portfolio schedule that has not been made generally
available to the public. Divulging portfolio holdings to selected
third parties is permissible only when the fund has legitimate
business purposes for doing so and the recipients are subject to a
duty of confidentiality. See, e.g., Selective Disclosure and Insider
Trading, Securities Act Release No. 7881 at text accompanying n. 29
(Aug. 15, 2000) (65 FR 51716 (Aug. 24, 2000)) (noting that ``issuers
and their officials may properly share material nonpublic
information with outsiders, for legitimate business purposes, when
the outsiders are subject to duties of confidentiality''). See also
Dirks v. SEC, 463 U.S. 646, 655 at n. 14 (1983) (``Under certain
circumstances, such as where corporate information is revealed
legitimately to an underwriter, accountant, lawyer, or consultant
working for the corporation, these outsiders may become fiduciaries
of the shareholders. The basis for recognizing this fiduciary duty
is not simply that such persons acquired nonpublic corporate
information, but rather that they have entered into a special
confidential relationship in the conduct of the business of the
enterprise and are given access to information solely for corporate
purposes.'') (citations omitted). We understand that many funds
provide portfolio information in response to requests by rating
agencies and similar organizations only after receiving written
assurances that the information will be kept confidential and that
persons with access to the information will not use the information
to trade securities.
\56\ We urge funds and advisers to require persons who have
access to nonpublic information to trade securities of the fund
exclusively through identifiable accounts to enable the fund to
monitor for excessive, short-term trading. Alternatively, although
not required by section 17(j) of the Investment Company Act (15
U.S.C. 80a-17(j)) or rule 17j-1 (17 CFR 270.17j-1), funds and
advisers should consider amending their codes of ethics to cover,
and thus require reporting of, trades by persons who have access to
nonpublic information about the portfolio, including information
about the accuracy of the prices of portfolio securities used to
calculate net asset value.
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[sbull] Compliance with Fund Governance Requirements. A fund's
board plays an important role in overseeing fund activities to ensure
that they are being conducted for the benefit of the fund and its
shareholders. Fund boards, among other things, are tasked with
approving the fund's advisory contracts,\57\ underwriting
agreements,\58\ and distribution plans.\59\ The Investment Company Act
requires that fund boards of directors be elected by fund
shareholders,\60\ and that a certain percentage be ``independent
directors.''\61\ To rely on many of our exemptive rules, independent
directors must constitute a majority of the board, must be selected and
nominated by other independent directors, and if they hire legal
counsel, that counsel must be an independent legal counsel.\62\
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\57\ Sections 15(a) and (c) of the Investment Company Act (15
U.S.C. 80a-15(a) and (c)).
\58\ Sections 15(b) and (c) of the Investment Company Act (15
U.S.C. 80a-15(b) and (c)).
\59\ Section 12(b) of the Investment Company Act (15 U.S.C. 80a-
12(b)) and rule 12b-1(b)(2) (17 CFR 270.12b-1(b)(2)).
\60\ Section 16(a) of the Investment Company Act (15 U.S.C. 80a-
16(a)).
\61\ Section 10(a) of the Investment Company Act (15 U.S.C. 80a-
10(a)) (prohibiting more than 60 percent of a fund's directors from
being interested persons of the fund); section 10(b)(2) of the
Investment Company Act (15 U.S.C. 80a-10(b)(2)) (requiring, in
effect, that independent directors comprise a majority of a fund's
board if the fund's principal underwriter is an affiliate of the
fund's investment adviser); section 15(f)(1) of the Investment
Company Act (15 U.S.C. 80a-15(f)(1)) (providing a safe harbor for
the sale of an advisory business if directors who are not interested
persons of the investment adviser constitute at least 75 percent of
a fund's board for at least three years following the assignment of
the advisory contract). See also rule 6e-3(T)(b)(15) (17 CFR 270.6e-
3(T)(b)(15)) (exempting certain funds underlying insurance products
from various Investment Company Act provisions provided that
independent directors constitute a majority of the boards of those
funds).
\62\ See rule 10f-3 (17 CFR 270.10f-3), rule 12b-1 (17 CFR
270.12b-1), rule 15a-4 (17 CFR 270.15a-4), rule 17a-7 (17 CFR
270.17a-7), rule 17d-1(d)(7) (17 CFR 270.17d-1(d)(7)), rule 17e-1
(17 CFR 270.17e-1), rule 17g-1(j) (17 CFR 270.17g-1(j)), rule 18f-3
(17 CFR 270.18f-3), and rule 23c-3 (17 CFR 270.23c-3). See also rule
0-1(a)(6) (17 CFR 270.0-1(a)(6)) (defining ``independent legal
counsel'').
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The consequences of failing to meet the Investment Company Act's
governance requirements are severe.\63\ Therefore, a fund's policies
and procedures should be designed to guard against, among other things,
an
[[Page 74720]]
improperly constituted board,\64\ the failure of the board to properly
consider matters entrusted to it, and the failure of the board to
request and consider information required by the Investment Company Act
from the fund adviser and other service providers.\65\
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\63\ See, e.g., In re Charles G. Dyer, Investment Company Act
Release No. 25107 (Aug. 9, 2001) and SEC v. Centurion Growth Fund,
No. 94-8199-CIV-UNGARO-BENAGES, (S.D. Fla. Apr. 22, 1994),
Litigation Release No. 14063 (Apr. 28, 1994) (56 SEC Docket 1776).
\64\ A board lacking a sufficient number of disinterested
directors, for example, would be improperly constituted. To avoid
this, fund procedures should provide for a process of determining
that independent director candidates are not ``interested persons''
and, after their election, for a periodic reassessment that they
continue not to be interested persons. See rule 31a-2 (17 CFR
270.31a-2(a)(4)) under the Investment Company Act (requiring the
maintenance of ``any record of the initial determination that a
director is not an interested person of the investment company and
each subsequent determination that the director is not an interested
person * * * includ[ing] any questionnaire and any other document
used to determine that a director is not an interested person of the
company'').
\65\ Section 15(c) requires fund directors ``to request and
evaluate * * * such information as may reasonably be necessary to
evaluate the terms of any contract whereby a person undertakes
regularly to serve or act as investment adviser of such company.'' A
board that fails to acquire sufficient information about the
advisory fee and other fund expenses will be unable to negotiate
effectively on behalf of the fund. As a result, the fund may pay a
higher than necessary advisory fee, fail to benefit from economies
of scale as a result of insufficient breakpoints in the advisory
fee, or bear too many operating expenses.
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[sbull] Market Timing. In a companion release today, we are
proposing amendments to our mutual fund disclosure rules to require
funds to disclose their policies on ``market timing,'' i.e., the
excessive short-term trading of mutual fund shares that may be harmful
to the fund.\66\ Many funds' prospectuses already disclose market
timing policies, and failure to adhere to those disclosed policies
violates the antifraud provisions of the Federal securities laws.\67\
Moreover, a fund adviser that waives or disregards those policies for
the benefit of itself or a third party has breached its fiduciary
responsibilities to the fund.\68\ Thus, under rule 38a-1 a fund must
have procedures reasonably designed to ensure compliance with its
disclosed policies regarding market timing. These procedures should
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.\69\ If the fund permits any waivers of those policies, the
procedures should be reasonably designed to prevent waivers that would
harm the fund or its shareholders or subordinate the interests of the
fund or its shareholders to those of the adviser or any other
affiliated person or associated person of the adviser. In this regard,
we strongly urge fund boards to require fund advisers, or other persons
authorized to waive market timing policies, to report to the board at
least quarterly all waivers granted, so that the board can determine
whether the waivers were proper.
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\66\ See Section II.A. of the Companion Disclosure Release,
supra note 8.
\67\ Failure to adhere to statements made in the prospectus may
render the prospectus disclosure materially misleading and thus
violate provisions of the Federal securities laws that prohibit
fraud. See, e.g., section 17(a) of the Securities Act (15 U.S.C.
77q), section 10(b) of the Securities Exchange Act (15 U.S.C. 78j)
and rule 10b-5 (17 CFR 240.10b-5) thereunder, and section 34(b) of
the Investment Company Act (15 U.S.C. 80a-33(b)).
\68\ An investment adviser has a fiduciary duty to act in the
best interests of a fund it advises. Section 206 under the Advisers
Act (15 U.S.C. 80b-6) and section 36(a) under the Investment Company
Act (15 U.S.C. 80a-35(a)). See also Rosenfeld v. Black, 445 F.2d
1337 (2d Cir. 1971); Brown v. Bullock, 194 F. Supp. 207, 229, 234
(S.D.N.Y.), aff'd, 294 F.2d 415 (2d Cir. 1961); In re Provident
Management Corp., Securities Act Release No. 5115 (Dec. 1, 1970) at
text accompanying note 12.
\69\ See, e.g., C. Meyrick Payne, Strengthening the Role of
Mutual Fund Directors after the Canary Scandal, Management Practice
Bulletin (Oct. 2003) (http://www.mfgovern.com/reports/2_canaryscandal.html
) (explaining that ``periodic sales and redemption
data'' are useful for detecting practices such as late trading and
market timing).
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B. Annual Review
1. Investment Advisers
Rule 206(4)-7 requires each registered adviser to review its
policies and procedures annually to determine their adequacy and the
effectiveness of their implementation.\70\ 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.
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\70\ Rule 206(4)-7(b).
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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. For example, we expect all registered advisers will begin
reviewing their policies and procedures in light of our adoption of
these rules.
2. Investment Companies
Similarly, rule 38a-1 requires a fund to review its policies and
procedures, as well as those of its service providers, annually.\71\
The rule does not require a fund board to conduct the review; the board
would, however, have the benefit of the review in the report submitted
by the compliance officer. We expect all funds will begin reviewing
their compliance policies and procedures currently, not only in light
of the adoption of these rules, but also in light of the recent
revelations of unlawful practices involving fund market timing, late
trading, and improper disclosures and use of nonpublic portfolio
information.
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\71\ Rule 38a-1(a)(3).
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C. Chief Compliance Officer
1. Investment Advisers
Rule 206(4)-7 requires each adviser registered with the Commission
to designate a chief compliance officer to administer its compliance
policies and procedures.\72\ 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.\73\ 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.\74\
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\72\ Rule 206(4)-7(c). We are also making a technical amendment
to the item related to chief compliance officers on Form ADV, the
registration form that advisers use to register with us under the
Advisers Act. Form ADV, Part 1, Schedule A, Item 2(a) (17 CFR
279.1). The revision requires each registered adviser and each
applicant for registration as an adviser to identify a single
compliance officer.
\73\ Having the title of chief compliance officer does not, in
and of itself, carry supervisory responsibilities. Thus, a chief
compliance officer appointed in accordance with rule 206(4)-7 (or
rule 38a-1) would not necessarily be subject to a sanction by us for
failure to supervise other advisory personnel. A compliance officer
who does have supervisory responsibilities can continue to rely on
the defense provided for in section 203(e)(6) of the Advisers Act
(15 U.S.C. 80b-3(e)(6)). Section 203(e)(6) provides that a person
shall not be deemed to have failed to reasonably supervise another
person if: (i) The adviser had adopted procedures reasonably
designed to prevent and detect violations of the federal securities
laws; (ii) the adviser had a system in place for applying the
procedures; and (iii) the supervising person had reasonably
discharged his supervisory responsibilities in accordance with the
procedures and had no reason to believe the supervised person was
not complying with the procedures.
\74\ The rule does not require advisers to hire an additional
executive to serve as compliance officer, but rather to designate an
individual as the adviser's chief compliance officer. Several
commenters who complained of the burdens this proposed requirement
would impose on them appeared to have assumed that they would be
required to hire an additional person to fill the position of chief
compliance officer.
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[[Page 74721]]
2. Investment Companies
Rule 38a-1 requires each fund to appoint a chief compliance officer
who is responsible for administering the fund's policies and procedures
approved by the board under the rule.\75\ A fund's chief compliance
officer should be competent and knowledgeable regarding the Federal
securities laws and should be empowered with full responsibility and
authority to develop and enforce appropriate policies and procedures
for the fund. The chief compliance officer of a fund, like the chief
compliance officer of an investment adviser, should have sufficient
seniority and authority to compel others to adhere to the compliance
policies and procedures.
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\75\ Rule 38a-1(a)(4).
---------------------------------------------------------------------------
The rule contains several provisions, some of which were not
included in our proposal, designed to promote the independence of the
chief compliance officer from the management of the fund.\76\ First,
the chief compliance officer will serve in her position at the pleasure
of the fund's board of directors, which can remove her if it loses
confidence in her effectiveness. The fund board (including a majority
of independent directors) must approve the designation of the chief
compliance officer, and must approve her compensation (or any changes
in her compensation).\77\ The board (including a majority of the
independent directors) can remove the chief compliance officer from her
responsibilities at any time,\78\ and can prevent the adviser or
another service provider from doing so.\79\
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\76\ In the Proposing Release we requested comment on whether
the chief compliance officer should be a senior manager of the fund
because such a person would be in a better position to compel
compliance with the fund's policies and procedures, and would less
likely be intimidated in the performance of her duties. We are not
adopting such a requirement because, as several commenters pointed
out to us, it is very difficult to ascertain who is a ``senior
manager'' in some organizations. Instead, we have described the
authority we believe an individual must possess to be designated as
a chief compliance officer, and have added a provision to the rule
making it unlawful to exert undue influence on the chief compliance
officer in the performance of her duties (see infra text
accompanying note 86).
\77\ Rule 38a-1(a)(4)(i). These requirements were not included
in proposed rule 38a-1. Compensation would include any bonus. In
approving a change in compensation, the board should assure itself
that the chief compliance officer is not denied any customary cost
of living increase or any full customary bonus and that fund
managers are not otherwise retaliating against the chief compliance
officer for having informed the board of a compliance failure or for
having taken aggressive actions to ensure compliance with the
federal securities laws by the fund or service provider.
\78\ Rule 38a-1(a)(4)(ii).
\79\ In a change from the proposed rule, the chief compliance
officer can only be discharged from her responsibilities with the
approval of the board. Rule 38a-1(a)(4)(ii).
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Second, the chief compliance officer will report directly to the
board of directors. She must annually furnish the board with a written
report on the operation of the fund's policies and procedures and those
of its service providers.\80\ The report must address, at a minimum:
(i) The operation of the policies and procedures of the fund and each
service provider since the last report, (ii) any material changes to
the policies and procedures since the last report,\81\ (iii) any
recommendations for material changes to the policies and procedures as
a result of the annual review,\82\ and (iv) any material compliance
matters since the date of the last report.\83\ We have added a
definition of the term ``material compliance matter'' to the rule, to
clarify that the report should inform the board of those compliance
matters about which the fund's board reasonably needs to know in order
to oversee fund compliance.\84\
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\80\ If the fund is a unit investment trust, the fund's
principal underwriter or depositor must approve the chief compliance
officer, must receive all annual reports, and must approve the
removal of the chief compliance officer from his or her
responsibilities. Rule 38a-1(b).
\81\ A change would be ``material'' in this context if it is a
change that a fund director would reasonably need to know in order
to oversee fund compliance.
\82\ Id. The report should also discuss the fund's particular
compliance risks and any changes that were made to the policies and
procedures to address newly identified risks.
\83\ Rule 38a-1(a)(4)(iii). Our proposal would have required the
report to include only compliance matters that resulted in remedial
action; our final rule contains no such limitation because we are
concerned that a fund or its service providers might abuse the
limitation and fail to impose remedial actions in order to avoid
having to report a compliance failure to the board.
\84\ Rule 38a-1(e)(2). Serious compliance issues must, of
course, always be brought to the board's attention promptly, and
cannot be delayed until an annual report. In addition, individual
compliance matters that, taken in isolation, may not be material may
collectively suggest a material compliance matter, such as a
material weakness in the compliance programs of the fund or its
service providers. See, e.g., Personal Investment Activities of
Investment Company Personnel, Investment Company Act Release No.
23958, at n. 25 (Aug. 20, 1999) (64 FR 46821 (Aug. 27, 1999)).
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Third, we are requiring that the chief compliance officer meet in
executive session with the independent directors at least once each
year, without anyone else (such as fund management or interested
directors) present.\85\ The executive session creates an opportunity
for the chief compliance officer and the independent directors to speak
freely about any sensitive compliance issues of concern to any of them,
including any reservations about the cooperativeness or compliance
practices of fund management.
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\85\ Rule 38a-1(a)(4)(iv). Independent counsel to the
independent directors may be present.
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Fourth, we have added a provision to protect the chief compliance
officer from undue influence by fund service providers seeking to
conceal their or others' non-compliance with the federal securities
laws. Rule 38a-1 prohibits the fund's officers, directors, employees or
its adviser, principal underwriter, or any person acting under the
direction of these persons, from directly or indirectly taking any
action to coerce, manipulate, mislead or fraudulently influence the
fund's chief compliance officer in the performance of her
responsibilities under the rule.\86\
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\86\ Rule 38a-1(c). This prohibition is similar to the
prohibition on unduly influencing auditors found in section 303(a)
of the Sarbanes-Oxley Act (Pub. L. 107-204, 116 Stat. 745 (2002))
and rule 13b2-2(b)(1) (17 CFR 240.13b2-2(b)(1)) under the Securities
Exchange Act.
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The appointment of a chief compliance officer with overall
responsibility for management of a fund complex's compliance program is
a key element of the investor protections we are today adopting. Some
commenters representing fund management companies urged us to permit
funds to continue to use multiple compliance managers employed by
different service providers, rely on the policies of the fund service
providers, and omit the requirement that fund boards approve the
compliance officer. These commenters would have us maintain funds'
current approach to compliance management. Current practices, however,
balkanize responsibility for fund compliance and isolate fund boards
from compliance personnel, thus impeding boards' abilities to exercise
their oversight responsibilities effectively. We decline to accept
current practices, which we believe have contributed to the serious
compliance lapses that are now the subject of our enforcement actions.
We have observed that executives at service providers have
overruled their own compliance personnel because of business
considerations. For example, some fund advisers have continued to
permit investors with whom they had other business relationships to
engage in harmful market timing in fund shares after compliance
personnel and portfolio managers brought the market timing activity to
their attention. These compliance personnel may not have had access to
fund directors or, having been overruled by their own management,
[[Page 74722]]
may have felt they were not in a position to approach the board.
To address these concerns, rule 38a-1 provides fund boards with
direct access to a single person with overall compliance responsibility
for the fund who answers directly to the board. The rule provides the
board with a powerful tool to exercise its oversight responsibilities
over fund compliance matters. The new rule also strengthens the hand of
compliance personnel by establishing a direct line of reporting to fund
boards that is not controlled by management.\87\ We have observed that
compliance failures have occurred when a fund service provider has
denied information to the fund's board, or has been less than
forthright, because the service provider viewed full disclosure as
detrimental to its own interests. Under the new rule, the chief
compliance officer will be responsible for keeping the board apprised
of significant compliance events at the fund or its service providers
and for advising the board of needed changes in the fund's compliance
program.
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\87\ Rules 38a-1(a)(4)(ii) (providing that the board's approval
is required to remove the chief compliance officer) and 38a-
1(a)(4)(iii) (requiring the chief compliance officer to provide a
written compliance report to the board).
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We expect that a fund's chief compliance officer will often be
employed by the fund's investment adviser or administrator.\88\ We are
not adopting a requirement that the chief compliance officer be
employed by only the fund because we believe that such a provision
would actually weaken her effectiveness. Funds today typically have no
employees, and delegate management and administrative functions,
including the compliance function, to one or more service providers. If
we were to preclude the chief compliance officer from being an employee
of an adviser or any other service provider, she would be divorced from
all fund operations.\89\ The adviser's chief compliance officer would
continue to administer the adviser's compliance programs, and the role
of the fund's chief compliance officer would be limited to oversight of
the service providers' compliance policies and providing advice to the
board on their operation. As a result, the fund's chief compliance
officer would be almost entirely dependent on information filtered
through the senior management of the fund's adviser rather than, for
example, information received directly from a trading desk. Moreover,
fund management would be unlikely to consult with an ``outside''
compliance officer on a prospective business decision to ascertain the
compliance implications.
---------------------------------------------------------------------------
\88\ Indeed, she is likely to be the chief compliance officer of
that organization inasmuch as the duties of the positions will have
significant overlap. Alternatively, the chief compliance officer of
the fund may be another member of the adviser or administrator's
legal or compliance departments.
\89\ Internalizing the compliance function while retaining an
externalized management function would also raise a number of
practical issues, such as whether the chief compliance officer could
use the adviser's office space and other resources, including
support staff. In addition, it would be costly for funds,
particularly small funds, to hire a chief compliance officer and pay
her benefits. Those costs would be borne by investors.
---------------------------------------------------------------------------
We recognize, however, that a chief compliance officer who is an
employee of the fund's investment adviser might be conflicted in her
duties, and that the investment adviser's business interests might
discourage the adviser from making forthright disclosure to fund
directors of its compliance failures. The rule, as adopted, is designed
to address these concerns by requiring a fund's chief compliance
officer to report directly to the board. The board, and the board
alone, can discharge the officer if she fails to live up to the
position. Thus, a chief compliance officer who fails to fully inform
the board of a material compliance failure, or who fails to
aggressively pursue non-compliance within the service provider, would
risk her position. She would also risk her career, because it would be
unlikely for another board of directors to approve such a person as
chief compliance officer.\90\
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\90\ If such a person were approved by another fund, our staff
would enhance its scrutiny of the fund accordingly.
---------------------------------------------------------------------------
The chief compliance officer, in exercising her responsibilities
under the rule, will oversee the fund's service providers, which will
have their own compliance officials. A chief compliance officer should
diligently administer this oversight responsibility by taking steps to
assure herself that each service provider has implemented effective
compliance policies and procedures administered by competent personnel.
The chief compliance officer should be familiar with each service
provider's operations and understand those aspects of their operations
that expose the fund to compliance risks. She should maintain an active
working relationship with each service provider's compliance personnel.
Arrangements with the service provider should provide the fund's chief
compliance officer with direct access to these personnel, and should
provide the compliance officer with periodic reports and special
reports in the event of compliance problems. 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.\91\ 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.\92\
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\91\ Mutual funds already rely on these types of measures in
connection with their responsibility to ensure that their service
providers carry out anti-money laundering compliance programs. Rules
under the Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism Act of 2001, Pub.
L. No. 107-56 (USA PATRIOT Act) require funds to maintain procedures
reasonably designed to prevent them from being used for money
laundering or the financing of terrorist activities. See, e.g.,
Anti-Money Laundering Programs for Mutual Funds, 67 FR 21117, 21119
(Apr. 29, 2002) (mutual fund may contractually delegate functions
under 31 CFR 103.130 to a service provider, but must take steps to
ensure that the service provider's compliance program is reasonably
designed, and to monitor its implementation and ensure its
effectiveness).
\92\ In the case of an insurance company separate account, the
principal service providers typically will be the sponsoring
insurance company. Therefore, the chief compliance officer must
oversee the insurance company's compliance program with respect to
the separate accounts, including the processing of new account
applications, premium payments, and exchanges.
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D. Recordkeeping
New rule 38a-1 (for funds) and amendments to rule 204-2 (for
advisers) require firms to maintain copies of all policies and
procedures that are in effect or were in effect at any time during the
last five years.\93\ In addition, new rule 38a-1 will require funds to
maintain materials provided to the board of directors in connection
with their approval of the fund's and its service providers' policies
and procedures and the annual written reports by the fund's chief
compliance officer.\94\ New rule 38a-1 and amended
[[Page 74723]]
rule 204-2 will require funds and advisers to keep any records
documenting their annual review.\95\ Our rules permit funds and
advisers to maintain these records electronically.\96\ These new
recordkeeping requirements will assist our examination staff in
determining whether the adviser or fund is adhering to the new rules
and in identifying weaknesses in the compliance program if violations
do occur or are uncorrected.
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\93\ Rules 38a-1(d)(1) and 204-2(a)(17)(i). As discussed above,
the required policies and procedures do not all need to be contained
in a single document. See supra text following note 22. We
understand many firms issue policies and procedures in loose-leaf
form, distributing revised sections periodically within their firms.
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, so long as
the firm can indicate to our examinating staff the version of
compliance policies and procedures that were in effect as of a given
date.
\94\ Rule 38a-1(d)(2). In a change from proposed rule 38a-1,
funds will have to maintain materials provided to the board of
directors in connection with their approval of service providers'
policies and procedures in addition to the annual compliance report.
These records must be maintained for at least five years after the
end of the fiscal year in which the documents were provided to the
board, the first two years in an easily accessible place. Funds
already are required to document in the fund board's minute books
the board's deliberations in connection with the approval of the
compliance policies and procedures and their annual review of the
chief compliance officer's report. Board minute books must be
maintained pursuant to rule 31a-1(b)(4) under the Investment Company
Act (17 CFR 270.31a-1(b)(4)). All reports required by our rules are
meant to be made available to the Commission and the Commission
staff and, thus, they are not subject to the attorney-client
privilege, the work-product doctrine, or other similar protections.
\95\ Rules 38a-1(d)(3) and 204-2(a)(17)(ii). In a change from
proposed rule 38a-1, funds will have to maintain any records
documenting their annual review for at least five years after the
end of the fiscal year in which the annual review was conducted, the
first two years in an easily accessible place. Advisers will have to
maintain any records documenting their annual review in an easily
accessible place for at least five years after the end of the fiscal
year in which the review was conducted, the first two years in an
appropriate office of the investment adviser. Rule 204-2(e)(1).
\96\ See rules 31a-2(f) (17 CFR 270.31a-2(f)) and 204-2 (17 CFR
275.204-2(g)). Funds and advisers that maintain records
electronically must provide those records to our staff in electronic
format upon request. Rule 31a-2(f)(2)(ii)(A) under the Investment
Company Act (17 CFR 270.31a-2(f)(2)(ii)(A)) and rule 204-
2(g)(2)(ii)(A) under the Investment Advisers Act (17 CFR 275.204-
2(g)(2)(ii)(A)).
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E. Private Sector Initiatives
In the Proposing Release, we requested that commenters consider
four additional approaches that we might take to require the private
sector to assume greater responsibility for compliance with the Federal
securities laws. These possible approaches included: (i) A requirement
that funds and advisers undergo third-party compliance reviews; (ii) an
expansion of the role of independent public accountants to include the
performance of certain compliance reviews; (iii) the formation of one
or more self-regulatory organizations for advisers or funds; and (iv)
the requirement that certain advisers obtain fidelity bonds from
reputable insurance companies.
We appreciate the many comments we received. Although we are not
moving forward with any of these approaches at this time, we continue
to regard them as viable options should the measures we are taking
today fail to adequately strengthen the compliance programs of funds
and advisers. In particular, we 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 our examination program and would assure the frequent
examination of advisers and funds.
F. Additional Request for Comment
Rule 38a-1 includes provisions designed to promote the chief
compliance officer's independence from fund management while still
maintaining her effectiveness. The fund's board of directors must
approve the chief compliance officer's designation and compensation,
and has the sole power to remove her from her position.\97\ The chief
compliance officer reports directly to the board, and must meet with
the independent directors in executive session at least annually.\98\
The rule also protects the chief compliance officer by prohibiting
persons from coercing or fraudulently influencing her in the course of
her responsibilities.\99\ Today, in addition to adopting rule 38a-1, we
request comment on these provisions. Are there other measures (or
refinements to these provisions) that would further enhance the
independence and effectiveness of chief compliance officers under the
rule? We also request comment whether our definition of the ``material
compliance matters'' that must be reported to fund boards by chief
compliance officers adequately addresses our concern that fund boards
receive compliance information they reasonably need to know in order to
oversee fund compliance.\100\
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\97\ Rule 38a-1(a)(4)(i)-(ii). See supra notes 76-79 and
accompanying text.
\98\ Rule 38a-1(a)(4)(iii)-(iv). See supra notes 80-85 and
accompanying text.
\99\ Rule 38a-1(c) prohibits the fund's officers, directors,
employees, or its adviser or principal underwriter or any person
acting under the direction of these persons, from directly or
indirectly taking any action to coerce, manipulate, mislead, or
fraudulently influence the fund's chief compliance officer in the
performance of compliance responsibilities under the rule. See supra
note 86 and accompanying text, and note 76.
\100\ Rule 38a-1(e)(2) defines the term ``material compliance
matter'' to mean those compliance matters--including violations of
the federal securities laws or compliance policies and procedures by
the fund or its service providers, as well as weaknesses in the
design or implementation of those policies and procedures--about
which the fund's board reasonably needs to know in order to oversee
fund compliance. See supra note 84 and accompanying text.
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III. 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. On or before the compliance
date, all funds and advisers must have designated a chief compliance
officer and fund boards must have approved the chief compliance
officer. In addition, on or before the compliance date, funds and
advisers must adopt compliance policies and procedures that satisfy the
requirements in the new rules. In the case of funds, these policies and
procedures must have been approved by the board on or before the
compliance date. Funds and advisers must complete their first annual
review of the compliance policies and procedures no later than 18
months after the adoption or approval of the compliance policies and
procedures. The chief compliance officer of a fund must submit the
first annual report to the board within 60 calendar days of the
completion of the annual review.
Our allowance for a nine month transition period 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.
IV. Cost-Benefit Analysis
We are sensitive to the costs and benefits that result from our
rules. The new rules require each fund and adviser to adopt and
implement policies and procedures reasonably designed to prevent
violations of the securities laws, to review these annually, and to
designate an individual as chief compliance officer. In the Proposing
Release, we identified possible costs and benefits of the rules and
requested comment on our analysis.
A. Benefits
We expect that fund investors, advisory clients, funds, and
advisers will benefit from the new rules. Commenters generally agreed
that comprehensive compliance programs are beneficial. Although many
funds and advisers already have such programs in place, the new rules
will make this standard practice for all funds and advisers. One
commenter, a compliance officer, noted that the benefits of the new
measures in the form of increased investor protection would far exceed
the costs.
Requiring funds and investment advisers to design and implement a
comprehensive internal compliance program will serve to reduce the risk
[[Page 74724]]
that fund investors and advisory clients (collectively, ``investors'')
will be harmed by violations of the securities laws. With limited
exception, commenters agreed that comprehensive written compliance
programs are the first line of defense in investor protection. Recent
allegations of violations related to market timing and late trading
confirm the need for strong compliance programs that do not permit
compliance objectives to be subordinated to the business objectives of
fund advisers or their affiliated persons.
The appointment of a chief compliance officer for each fund will
also provide important investor protection benefits. Funds currently
rely on multiple compliance personnel working for different service
providers. Fund boards do not receive compliance information directly
from these compliance officers; it is filtered through the management
of the fund's investment adviser or other service providers. We believe
these structures have contributed to serious compliance lapses that are
now the subject of our enforcement actions. Rule 38a-1, by requiring
each fund to have a compliance officer who serves at the pleasure of
the fund's board and who is responsible for oversight of these service
providers, and who cannot be unduly influenced will strengthen the hand
of compliance personnel by giving them a direct line of reporting to
the fund board that is not controlled by management.
The rules will also benefit funds and investment advisers by
diminishing the likelihood of securities violations, Commission
enforcement actions, and private litigation. For a fund or adviser, the
potential costs associated with a securities law violation may consist
of much more than merely the fines or other penalties levied by the
Commission or civil liability. The reputation of a fund or adviser may
be significantly tarnished, resulting in redemptions (in the case of an
open-end fund) or lost clients. Advisers may be denied eligibility to
advise funds.\101\ In addition, advisers could be precluded from
serving in other capacities.\102\
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\101\ Section 9(a) of the Investment Company Act (15 U.S.C. 80a-
9(a)) prohibits a person from serving as an adviser to a fund if,
within the past 10 years, the person has been convicted of certain
crimes or is subject to an order, judgment, or decree of a court
prohibiting the person from serving in certain capacities with a
fund, or prohibiting the person from engaging in certain conduct or
practice.
\102\ See, e.g., 29 U.S.C. 1111(a) (prohibiting a person from
acting in various capacities for an employee benefit plan, if within
the past 13 years, the person has been convicted of, or has been
imprisoned as a result of, any crime described in section 9(a)(1) of
the Investment Company Act (15 U.S.C. 80a-9(a)(1)).
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The designation of a chief compliance officer also should enhance
the efficiency of funds' and advisers' operations by centralizing
responsibility for the compliance function. While many commenters
agreed that fund and investment adviser compliance benefits from clear
allocation of compliance responsibilities, they argued that large firms
would benefit little from requiring a single person to be designated.
We believe that the designation of a single officer will increase the
coordination with which distributed compliance functions are executed.
In addition, because the new rules complement our examination
program for investment advisers and for fund complexes, they will
enhance our ability to protect investors. The existence of a structured
compliance program at funds and investment advisers, together with the
designation of a chief compliance officer to serve as a point of
contact, will facilitate the examination staff's efforts to conduct
each examination in an organized and efficient manner and thus to
allocate resources to maximize investor protection. Most commenters
noted that the proposed rules would enhance the effectiveness of the
Commission's examination program and oversight of funds and advisers.
B. Costs
The new rules will result in some additional costs for funds and
investment advisers, which, in the case of funds, we expect would be
passed on to investors. A number of commenters expressed concern about
the costs that the new rules would impose.\103\ One commenter, noting
that existing compliance mandates place a significant burden on
investment advisers, expressed concern that the costs of new compliance
obligations might outweigh the benefits. However, because all funds and
most investment advisers currently have some written compliance
policies and procedures in place, the costs of the new rules in many
instances already are reflected in the fees investors currently pay.
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\103\ We believe that many of these concerns stemmed from the
incorrect perception that the new rules would require the adoption
and implementation of one-size-fits-all compliance programs. As
discussed above, the new rules require each firm to adopt a
compliance program that conforms with the scope and nature of its
operations, thus eliminating concerns that the new rules will
require duplicative or excessively detailed compliance programs.
---------------------------------------------------------------------------
We would expect that funds and advisers with substantial
commitments to compliance would incur only minimal costs in connection
with the adoption of the new rules as they reviewed their internal
compliance programs for adequacy. Funds and larger advisory firms
typically have adopted and implemented comprehensive, written policies
and procedures. Many of these funds and advisers also have well-staffed
compliance departments. Many conduct periodic reviews of their
compliance programs and some hire independent compliance experts to
review the adequacy of their compliance programs and the effectiveness
of their implementation.
A number of commenters expressed particular concern about the
relative cost of the new rules for small investment advisers.\104\ This
concern is consistent with our experience that investment advisers (as
well as small funds) are less likely than their larger counterparts to
have comprehensive, written internal compliance programs in place.
Based on our examination experience, we estimate that as many as one
half of SEC-registered investment advisers do not have comprehensive,
written internal compliance programs in place.
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\104\ The Investment Counsel Association of American (``ICAA''),
for example, noted that in small firms with few employees, the
responsibility for developing a compliance program, if done in-
house, would likely be borne by a highly-paid employee.
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However, we expect a number of factors will enable small investment
advisers to control and minimize these costs. Because small firms
typically engage in a limited number and range of transactions and have
one or two employees, their internal compliance programs would be
markedly less complex than those of their large firm counterparts.\105\
In addition, we anticipate that these firms will turn to a variety of
industry representatives, commentators, and organizations that have
developed outlines and model programs that these firms can tailor to
fit their own situations.\106\ If these firms need individualized
outside assistance, we expect that the number of independent compliance
experts will grow to fill this demand at competitive
[[Page 74725]]
prices, as has been the case in comparable situations. Estimates of the
cost of developing compliance policies and procedures vary greatly
depending on the type of help that an investment adviser seeks.\107\
---------------------------------------------------------------------------
\105\ The ICAA estimated that, depending on an adviser's size
and complexity, the adviser could purchase an off-the-shelf
compliance manual for under $1,000, but would have to spend time
adjusting the manual to correspond to its organizational structure.
Alternatively, the ICAA also estimated that the adviser could enlist
the assistance of a third-party compliance firm to draft a firm-
specific manual for a small to mid-size firm for between $2,500 and
$3,500. The ICAA also estimated that a law firm would charge between
$10,000 and $120,000 to draft procedures (and an accounting firm
would charge between $50,000 and $200,000), depending on the size
and complexity of the adviser's operations.
\106\ Firms will incur a cost in tailoring these programs to
their specific needs.
\107\ One commenter stated that prohibitive costs may be the
reason that some firms, particularly small firms, do not have
compliance programs. The Financial Planning Association, however,
estimated, based on discussions with a number of compliance vendors,
a small adviser (with five employees) would spend $675 to purchase
compliance software and customize it in-house. Alternatively, the
FPA estimated that such an adviser could purchase a turn-key manual
customized for the adviser for $1,500. Finally, the FPA estimated
that the adviser could retain an outside consultant to develop a
written compliance manual for $3,900.
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The requirement that each investment adviser designate a chief
compliance officer likely will impose only a minimal cost. Many
investment advisers already have large compliance staffs headed by an
individual who officially or effectively serves as a chief compliance
officer.\108\ For other investment advisers, costs associated with
designating a chief compliance officer also would be minimized by the
fact that the new rules would not require firms to hire an individual
exclusively charged with serving in this capacity.\109\ One commenter
characterized the chief compliance officer requirement as unduly
burdensome because it would conflict with the complex and varied
organizational structures of investment advisers. As noted above, we
believe that it is important for each firm to have one person who
coordinates compliance efforts on behalf of the firm, even though that
individual may rely heavily on others within and outside the firm for
assistance. The cost to funds of appointing a chief compliance officer
also should not be significant. Like many investment advisers, many
fund complexes already have large compliance staffs headed by an
individual who officially or effectively serves as a chief compliance
officer. We expect this individual will typically be qualified to serve
the fund's board of directors as the fund's chief compliance
officer.\110\
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\108\ The ICAA noted that most of its members have employees
responsible for compliance and many of these have designated a chief
compliance officer.
\109\ Several commenters expressed concern about the cost to
small firms of hiring a chief compliance officer. The rules that we
are adopting do not require funds or investment advisers to hire a
separate chief compliance officer, and we expect that many small
investment advisers will designate a principal or employee of the
firm to serve as chief compliance officer. However, a firm that does
not currently have a person qualified to serve as chief compliance
officer will incur costs associated with training someone in the
firm.
\110\ The requirement that fund boards approve the designation
and compensation of the chief compliance officer, or take action to
remove a chief compliance officer, will impose minimal costs, if
any, beyond the current costs incurred to prepare briefing materials
for directors and convene board meetings. With rare exception, fund
boards should be able to take up these issues during their existing
schedule of meetings.
---------------------------------------------------------------------------
We anticipate that costs associated with the annual review
requirement also will be limited. Many large funds and investment
advisers with comprehensive compliance programs periodically review
portions of their compliance programs. These firms may incur a cost
associated with transforming their periodic reviews into a more
systematic annual review, but this cost is difficult to quantify. Most
of the firms without any review mechanism in place are small. For these
firms, the annual review requirement likely will be less extensive and,
therefore, less costly than for their larger counterparts. We have
determined that requiring more frequent reviews would impose
unnecessary costs on funds and advisers.
Several commenters stated that there would be a substantial cost
associated with the requirement that fund boards approve the compliance
policies and procedures and review the annual report prepared by the
chief compliance officer. We have clarified in this release that the
new rules do not require the board of directors to read every policy
and procedure. The board may make its decisions about the adequacy of
the compliance policies and procedures based on summary reports.
Similarly, the board's review of the chief compliance officer's annual
report should focus on ensuring that the compliance programs of the
fund and its service providers are reasonably designed and functioning
effectively. In light of these clarifications, we do not believe that
funds will incur excessive costs in connection with board oversight of
compliance under the new rules.
One commenter, a large fund complex, suggested that there would be
substantial recordkeeping costs associated with the new rules, and
suggested that firms be required to maintain for five years copies of
only those policies and procedures that form the backbone of the firm's
compliance program. Because records may be maintained electronically,
the cost of maintaining copies of all compliance policies and
procedures in place during the past five years will be contained.
V. Consideration of Promotion of Efficiency, Competition and Capital
Formation
Section 2(c) of the Investment Company Act (15 U.S.C. 80a-2(c)) and
section 202(c) of the Advisers Act (15 U.S.C. 80b-2(c)) mandate that
the Commission, when engaging in rulemaking that requires it to
consider or determine whether an action is necessary or appropriate in
the public interest, to consider, in addition to the protection of
investors, whether the action will promote efficiency, competition, and
capital formation.
As discussed above, the new rules would require funds and
investment advisers to adopt and implement written policies and
procedures designed to prevent violations of the Federal securities
laws, and review those policies and procedures at least annually.
Although we recognize that a compliance program may divert resources
from funds' and advisers' primary businesses, we expect that the new
rules may indirectly increase efficiency in a number of ways. These
compliance programs should increase efficiency by deterring Federal
securities law violations, or by facilitating the fund's or adviser's
early intervention to decrease the severity of any violations that do
occur. In addition, funds and advisers will be required to carry out
their internal compliance functions in an organized and systematic
manner, which may be more efficient than their current approach to
these functions. The existence of an industry-wide compliance program
requirement may enhance efficiency further by encouraging third parties
to create new informational resources and guidance to which industry
participants can refer in establishing and improving their compliance
programs.
Since the new rules apply equally to all funds and advisers, we do
not anticipate that they will introduce any competitive disadvantages.
To the contrary, the new rules may encourage competition on a more
level basis than exists in the current environment, in which
compliance-oriented industry participants incur greater costs to
maintain compliance programs than other firms. Several commenters
cautioned, however, that the new rules could have anti-competitive
effects on the advisory industry because they would disproportionately
burden small advisers and could even force them to merge with their
larger, more established counterparts or go out of business. While
small advisers will incur the largest relative costs as a result
[[Page 74726]]
of the new rules, the rule's requirements are essential for the
protection of small advisers' clients. Moreover, the existence of a
strong compliance program may assist small advisers to attract client
assets.
We anticipate that the new rules will indirectly foster capital
formation by bolstering investor confidence. It has been our experience
that funds and advisers with effective compliance programs are less
likely to violate the Federal securities laws and harm to investors is
less likely to result. To the extent such an environment enhances
investor confidence in funds and client confidence in investment
advisers, investors and clients are more likely to make assets
available through these intermediaries for investment in the capital
markets.
VI. Paperwork Reduction Act
As we discussed in the Proposing Release, the new rules and
amendments would impose ``collection of information'' requirements
within the meaning of the Paperwork Reduction Act of 1995.\111\ These
collections of information are mandatory. Two of the collections of
information are new. The titles of these new collections are ``Rule
38a-1'' and ``Rule 206(4)-7.'' The Commission submitted these new
collections to the Office of Management and Budget (``OMB'') for review
in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The other
collection of information takes the form of amendments to a currently
approved collection titled ``Rule 204-2,'' under OMB control number
3235-0278. The Commission also submitted the amendments to this
collection to the OMB for review in accordance with 44 U.S.C. 3507(d)
and 5 CFR 1320.11. An agency may not conduct or sponsor, and a person
is not required to respond to, a collection of information unless it
displays a currently valid control number.
---------------------------------------------------------------------------
\111\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------
The collection of information under rule 38a-1 is necessary to
ensure that investment companies maintain comprehensive internal
programs that promote the companies' compliance with the federal
securities laws. This collection of information is mandatory. The
respondents are investment companies registered with us and business
development companies. Our staff, conducting the Commission's
examination and oversight program, will use the information collected
to assess funds' compliance programs. Responses provided to the
Commission in the context of its examination and oversight program are
generally kept confidential.\112\ Rule 38a-1 requires that certain
records be retained for at least five years.\113\
---------------------------------------------------------------------------
\112\ See section 31(c) of the Investment Company Act (15 U.S.C.
80a-30(c).
\113\ See rule 38a-1(c).
---------------------------------------------------------------------------
The collection of information under rule 206(4)-7 is necessary to
ensure that investment advisers maintain comprehensive internal
programs that promote the advisers' compliance with the Advisers Act.
This collection of information is mandatory. The respondents are
investment advisers registered with us. Our staff, conducting the
Commission's examination and oversight program, will use the
information collected to assess investment advisers' compliance
programs. Responses provided to the Commission in the context of its
examination and oversight program are generally kept confidential.\114\
---------------------------------------------------------------------------
\114\ See section 210(b) of the Advisers Act (15 U.S.C. 80b-
10(b)).
---------------------------------------------------------------------------
The collection of information under rule 204-2 is necessary for the
Commission staff to use in its examination and oversight program. This
collection of information is mandatory. The respondents are investment
advisers registered with us. Responses provided to the Commission in
the context of its examination and oversight program are generally kept
confidential.\115\ The records that an adviser must keep in accordance
with the new rules must be retained for at least five years.\116\
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\115\ Id.
\116\ See rules 204-2(a)(17)(i) and (ii) and rule 204-2(e)(1)
(17 CFR 275.204-2(e)(1)).
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A. Rule 38a-1
We estimated in the Proposing Release that there are approximately
5,030 registered investment companies and 53 business development
companies (or a total of approximately 5,083 funds) that will be
subject to rule 38a-1.\117\ We estimated that the average annual hour
burden for a fund to document the policies and procedures that make up
its compliance program as required by rule 38a-1 would be 60
hours.\118\ We further estimated that each fund would spend five hours
annually, on average, documenting the conclusions of its annual
compliance review for its board of directors as required by rule 38a-1.
---------------------------------------------------------------------------
\117\ These numbers are based on Commission filings as of
January 2003.
\118\ While each fund would be required to maintain written
policies and procedures under rule 38a-1, this average estimate took
into account that many fund complexes already have written policies
and procedures documenting their compliance programs and can draw on
a number of outlines and model programs available from a variety of
industry representatives, commentators, and organizations to
supplement these programs, if necessary. The estimate also took into
account that most funds are located within a fund complex, and would
be able to draw extensively from the fund complex's ``master''
compliance program.
---------------------------------------------------------------------------
We also estimated that each fund would spend 0.5 hours annually, on
average, maintaining copies of their compliance policies and procedures
and chief compliance officer's annual reports for five years as
required by rule 38a-1. In adopting rule 38a-1, we have expanded this
recordkeeping requirement to also include copies of briefing materials
provided to a fund's board of directors in connection with their
approval of the fund and its service providers' compliance programs and
board review of the chief compliance officer's annual reports, and to
include copies of any records documenting a fund's annual review. Since
these changes only require funds to retain copies of a limited number
of records they have already created (rather than requiring funds to
record any new information), we continue to estimate that the average
annual hour burden for each adviser is 0.5 hours.
Most commenters addressing the paperwork burden of rule 38a-1
supported them as reasonable, though one large fund management firm
predicted funds would find it burdensome to maintain copies of their
compliance policies and procedures for five years as required by the
rule. Because of the importance of these copies to our examination and
oversight program, we are adopting rule 38a-1 without removing this
requirement.
Therefore, our total hour burden estimate for the collections of
information under rule 38a-1 remains 332,936.5 burden hours, as we
estimated in our proposal.\119\
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\119\ 5,083 funds (5,030 registered investment companies + 53
business development companies) x (60 hours for documenting
compliance policies and procedures + 5 hours for documenting
conclusions of annual compliance review + 0.5 hours for maintaining
records) = 332,936.5 burden hours.
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B. Rule 206(4)-7
In the Proposing Release, we estimated the total annual average
burden hours for advisers to document the policies and procedures that
make up their compliance programs, as required by rule 206(4)-7, would
be 623,200 hours, based on 7,790 investment advisers registered with us
spending an annual average of 80 hours on such documentation.\120\
---------------------------------------------------------------------------
\120\ 7,790 was the number of investment advisers registered
with us on our Investment Adviser Registration Depository System as
of January 14, 2003. 7,790 registered investment advisers x 80
annual average burden hours = 623,200 hours.
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[[Page 74727]]
This 80 hour average estimate took into account that many advisers
would be the primary drafters of compliance policies and procedures for
funds under rule 38a-1, and would be able to draw extensively from
their fund compliance programs to supplement, as necessary, compliance
policies and procedures for the advisory firm. Our estimate also took
into account that approximately half of the investment advisers
registered with us already have drafted procedures addressing many
aspects of their compliance programs, and many investment advisers in
this group have drafted comprehensive procedures.
Our 80 hour estimate also took into account that a significant
number of smaller registered investment advisers--who typically employ
one or a few persons and have complete oversight of their business
operations--have not adopted written policies and procedures, but can
draw on a number of outlines and model programs, and can develop less
complex programs because they often do not participate in arranging or
effectuating securities transactions that they recommend to their
clients. Comments from a trade association representing many smaller
advisers generally supported our underlying assessment in this regard.
Comments from another investment adviser trade association noted that
it would likely be the owner of (or senior person at) a smaller firm
who tailors a model compliance program to suit the firm's particular
business, and use of this person's time would be more costly to the
firm than the compliance personnel used by larger firms.
We are adopting rule 206(4)-7 without change to its paperwork
collection requirements. Accordingly, our estimate of the annual
aggregate burden of collection for the amended rule remains 623,200
hours.
C. Rule 204-2
In the Proposing Release, we estimated that the amendments to rule
204-2 requiring investment advisers to maintain copies of their
compliance policies and procedures and copies of any records
documenting the adviser's annual review of those policies, as required
by rule 206(4)-2, would increase each registered investment adviser's
average annual collection burden under rule 204-2 by 0.5 hours to
211.98 hours. We further estimated the amendments would increase the
rule's annual aggregate burden by 3,895 hours.\121\ One commenter
objected that it would be onerous for advisers to maintain copies of
records generated by the adviser's annual compliance review. Because of
the importance of these copies to our examination and oversight
program, we are adopting the amendments to rule 204-2 without
change.\122\
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\121\ 7,790 registered investment advisers x 0.5 hours = 3,895
hours.
\122\ Accordingly, our estimate in the Proposing Release of the
annual aggregate burden of collection for the amended rule remains
1,651,324.2 hours. This estimate was based on the OMB's approved
burden of 1,625,638.5 hours before the amendments (shared by 7,687
investment advisers at an annual average of 211.48 hours per
adviser), plus an increase of 21,790.7 hours attributable to an
increase in the number of investment advisers registered with us to
7,790 as of January 2003, (each incurring an average annual burden
of 211.48 hours) and an increase of 3,895 additional burden hours
associated with the amendments to rule 204-2 (7,790 registered
investment advisers x 0.5 hours).
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VII. Summary of Final Regulatory Flexibility Analysis
We have prepared a Final Regulatory Flexibility Analysis (``FRFA'')
in accordance with 5 U.S.C. 604, related to the new rules and rule
amendments that we are adopting today. A summary of the Initial
Regulatory Flexibility Analysis (``IRFA''), which was prepared in
accordance with 5 U.S.C. 603, was published in the Proposing Release.
Copies of the FRFA and the IRFA may be obtained by contacting Hester
Peirce, Senior Counsel, Securities and Exchange Commission, 450 5th
Street, NW., Washington, DC 20549-0506.
The FRFA summarizes the background of the new rules and rule
amendments and discusses why these regulatory changes are needed to
enhance compliance with the Federal securities laws by funds and
advisers. These issues are addressed above. The FRFA also discusses
comments received in response to the IRFA, the effect of the new rules
and rule amendments on small entities, and the Commission's efforts at
minimizing the effect on small entities. These issues are summarized
below.
The FRFA explains that the new rules and rule amendments will
govern all registered investment companies, business development
companies, and advisers registered with the Commission, including small
entities. For purposes of the Regulatory Flexibility Act,\123\ a fund
is a small entity if the fund, together with other funds in the same
group of related funds, has net assets of $50 million or less as of the
end of its most recent fiscal year.\124\ The staff estimates, based on
Commission filings, that there are approximately 186 small open- and
closed-end investment companies, 18 small unit investment trusts, and
29 small business development companies.\125\
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\123\ 5 U.S.C. 601-612.
\124\ 17 CFR 270.0-10.
\125\ The number of small entities, which is current as of June
2003, is derived from analyzing information from Form N-SAR and
various databases including Lipper. Some or all of these entities
may contain multiple series or portfolios. If a registered
investment company is a small entity, the portfolios or series it
contains are also small entities.
---------------------------------------------------------------------------
For purposes of the Regulatory Flexibility Act, an investment
adviser generally is a small entity if it: (i) Has assets under
management having a total value of less than $25 million; (ii) did not
have total assets of $5 million or more on the last day of its most
recent fiscal year; and (iii) does not control, is not controlled by,
and is not under common control with another investment adviser that
has assets under management of $25 million or more, or any person
(other than a natural person) that had $5 million or more on the last
day of its most recent fiscal year.\126\ The Commission estimates that,
as of October 14, 2003, there were approximately 571 small investment
advisers registered with us.\127\
The FRFA discusses the comments that we received in response to
issues raised in the IRFA.\128\ Several commenters, including one trade
association for investment advisers, cautioned that the new rules would
impose significant costs on small advisers. Another trade association
for advisers acknowledged that small advisers would bear a higher
relative cost than their larger counterparts, but anticipated that the
cost to small advisers would be offset by the fact that compliance
policies and procedures would not have to cover as broad a range of
activities as the policies and procedures of their larger
counterparts.\129\ A third commenter, however, noted that even though
small firms might have less complex policies and procedures, the cost
of drafting the basic policies and procedures would be the same as for
larger firms and for some small firms the cost would be prohibitive.
---------------------------------------------------------------------------
\126\ 17 CFR 275.0-7(a).
\127\ The number of small investment advisers is derived from
the Commission's Investment Adviser Registration Depository.
\128\ The comment letters and a summary of comments prepared by
our staff are available for public inspection and copying in the
Commission's Public Reference Room, 450 5th Street, NW., Washington,
DC (File No. S7-03-03). The comment summary is also available on the
Commission's Internet Web site (http://www.sec.gov/rules/extra/s70303summary.pdf
).
\129\ The Financial Planning Association estimated that it would
cost a small firm with five employees between $675 and $3,900 to
develop a compliance program.
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Commenters recommended the following accommodations for small
[[Page 74728]]
entities: (i) Exempt small firms from the requirement to designate a
chief compliance officer, (ii) exempt small advisers from all of the
new requirements, (iii) identify procedures that are relevant to small
firms, (iv) identify issues that do not apply to small advisers or
advisers that do not manage assets and therefore would not have to be
addressed in their compliance policies and procedures, (v) create a
template that firms could adapt to fit their unique characteristics, or
(vi) permit small advisers to maintain records outside their office
space in an easily accessible location.
The FRFA explains that the rules do not introduce new reporting
requirements, but do introduce new compliance requirements, including
new recordkeeping obligations. The FRFA sets forth the requirements of
the rule (which are described above in detail) and explains that all
funds and advisers, regardless of size, are subject to the compliance
requirements. The FRFA also explains that while most firms already have
instituted a compliance program and have designated someone charged
with implementing it, small advisers are disproportionately represented
among the firms that have not taken such steps. The FRFA notes that
these firms will bear costs in developing and implementing policies and
procedures.\130\ The FRFA explains that the new rules and rule
amendments are designed to achieve their objectives without imposing
undue costs on affected firms.
---------------------------------------------------------------------------
\130\ The staff estimates that approximately half of these firms
will develop these policies internally, while the remaining firms
will seek outside assistance from compliance consultants, the number
of which is expected to rise after the new rules are adopted.
---------------------------------------------------------------------------
The FRFA discusses the alternatives considered by the Commission in
adopting the new rules and rule amendments that might minimize adverse
effects on small advisers, including: (i) The establishment of
differing compliance or reporting requirements or timetables that take
into account the resources available to small entities; (ii) the
clarification, consolidation, or simplification of compliance and
reporting requirements under the rules for small entities; (iii) the
use of performance rather than design standards; and (iv) an exemption
from coverage of the rules, or any part thereof, for small entities.
We do not presently believe that the establishment of special
compliance requirements or timetables for small entities is feasible or
necessary.\131\ Modifying these requirements for small funds or
advisers would place their clients at unnecessary risk. The requirement
that each fund or adviser implement written policies and procedures
reasonably designed to prevent violation of the Federal securities
laws, is essential to promote systematic and organized reviews by funds
and advisers of their operations and activities. The requirement that
funds obtain board approval of their programs and annually report about
the programs to their boards is necessary to preserve the crucial
oversight role of fund boards of directors.\132\ Annual reviews are
integral to detecting and correcting any gaps in the program before
irrevocable or widespread harm is inflicted upon investors. The
required designation of a chief compliance officer is necessary to
achieve centralized supervisory authority over all aspects of the
compliance program and to reduce the likelihood of gaps in the
compliance program. The requirement that funds and advisers keep file
copies of their written policies, procedures, reports, and other
records for five years, imposes an inconsequential burden on small
funds and advisers. The establishment of a special compliance timetable
to allow a transition period of more than six months would delay the
rules' investor protection benefits without assisting small funds and
advisers.
---------------------------------------------------------------------------
\131\ As stated above, the rules impose no reporting
requirements.
\132\ In the case of investment advisers, for which such
governance issues are not present, we have not included comparable
requirements.
---------------------------------------------------------------------------
The Commission does not presently believe that clarification,
consolidation, or simplification of compliance requirements for small
entities is feasible or necessary. The compliance requirements, which
are integral to the effectiveness of the rules, are not technical or
complex in any sense. The FRFA explains that some commenters requested
more specific guidance about the type of compliance policies and
procedures that would be required. In the Proposing Release and in this
release, we have provided illustration and guidance to firms about the
topics that should be addressed by their compliance policies and
procedures. Because of the great variety across firms, any template
that we could provide would be voluminous and would require extensive
tailoring to the unique characteristics of each firm. Thus, it does not
appear that Commission templates would effectuate significant burden
reduction.
The FRFA explains that the new rules, to the greatest extent
possible, embody performance rather than design standards. The rules do
not enumerate specific required elements of the policies and
procedures, but will allow all firms, including small firms, to tailor
their internal compliance programs to the nature and scope of their own
business. The FRFA explains that the rules do not set forth a list of
attributes that the chief compliance officer must possess and permit
firms to designate an existing employee with other responsibilities to
fill that role, which the staff anticipates that most small firms will
do.
The FRFA explains that we do not believe that the objectives of the
rules could be achieved if small entities were exempted from coverage
of any part of the proposals. It has been our experience that strong
internal compliance programs are essential to investor protection in
funds and advisers of all sizes.
VIII. Statutory Authority
We are adopting new rule 38a-1 under the Investment Company Act
pursuant to the authority set forth in sections 31(a) and 38(a) of the
Act (15 U.S.C. 80-30(a) and 80a-37(a)).\133\ We are adopting new rule
206(4)-7 pursuant to the authority set forth in sections 206(4) and
211(a) under the Advisers Act (15 U.S.C. 80b-6(4) and 80b-11(a)).\134\
We are adopting
[[Page 74729]]
amendments to rule 204-2 pursuant to the authority set forth in
sections 204 and 211 of the Advisers Act (15 U.S.C. 80b-4 and 80b-11).
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\133\ Section 38(a) authorizes the Commission to ``make * * *
such rules and regulations * * * as are necessary or appropriate to
the exercise of the functions and powers conferred upon the
Commission elsewhere in (the Investment Company Act).'' We are
adopting rule 38a-1 as necessary and appropriate to the exercise of
the authority specifically conferred on us elsewhere in the Act,
including sections 9(b) (authority to prohibit certain persons from
serving in certain capacities with respect to investment companies),
31(b) (authority to examine funds), 36(a) (authority to bring
actions for the breach of fiduciary duty); and 42 (authority to
enforce the provisions of the Investment Company Act) of the
Investment Company Act (15 U.S.C. 80a-9(b), 80a-30(b), and 80a-41).
Further, requiring the maintenance of internal compliance policies
and procedures and an annual compliance report falls under the
authority granted to us under section 31(a), which authorizes us to
require funds to maintain and preserve records, including memoranda,
books, and other documents.
\134\ Section 206(4) permits the Commission to define and
prescribe rules to prevent conduct that is unlawful under section
206. Rule 206(4)-7 defines an activity that is unlawful under
section 206. Further, section 211(a) of the Advisers Act authorizes
the Commission to ``make * * * such rules and regulations * * * as
are necessary or appropriate to the exercise of the functions and
powers conferred upon the Commission elsewhere in (the Act).'' We
are adopting rule 206(4)-7 as necessary and appropriate to the
exercise of the authority specifically conferred on us elsewhere in
the Act, including sections 203(e) (authority to censure, place
limitations on, suspend, or revoke the registration of certain
investment advisers), 204 (authority to examine advisers), and 209
(authority to enforce the provisions of the Advisers Act) of the
Advisers Act (15 U.S.C. 80b-3(e), 80b-4, and 80b-9).
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We are amending rule 279.1, Form ADV, under section 19(a) of the
Securities Act of 1933 (15 U.S.C. 77s(a)), sections 23(a) and 28(e)(2)
of the Securities Exchange Act of 1934 (15 U.S.C. 78w(a) and
78bb(e)(2)), section 319(a) of the Trust Indenture Act of 1939 (15
U.S.C. 77sss(a)), section 38(a) of the Investment Company Act of 1940
(15 U.S.C. 78a-37(a)), and sections 203(c)(1), 204, and 211(a) of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-3(c)(1), 80b-4, and 80b-
11(a)).
List of Subjects
17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
17 CFR Parts 275 and 279
Reporting and recordkeeping requirements, Securities.
Text of Rules
0
For reasons set forth in the preamble, title 17, chapter II of the Code
of Federal Regulations is amended as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
1. The authority citation for part 270 continues to read in part as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
0
2. Section 270.38a-1 is added to read as follows:
Sec. 270.38a-1 Compliance procedures and practices of certain
investment companies.
(a) Each registered investment company and business development
company (``fund'') must:
(1) Policies and procedures. Adopt and implement written policies
and procedures reasonably designed to prevent violation of the Federal
Securities Laws by the fund, including policies and procedures that
provide for the oversight of compliance by each investment adviser,
principal underwriter, administrator, and transfer agent of the fund;
(2) Board approval. Obtain the approval of the fund's board of
directors, including a majority of directors who are not interested
persons of the fund, of the fund's policies and procedures and those of
each investment adviser, principal underwriter, administrator, and
transfer agent of the fund, which approval must be based on a finding
by the board that the policies and procedures are reasonably designed
to prevent violation of the Federal Securities Laws by the fund, and by
each investment adviser, principal underwriter, administrator, and
transfer agent of the fund;
(3) Annual review. Review, no less frequently than annually, the
adequacy of the policies and procedures of the fund and of each
investment adviser, principal underwriter, administrator, and transfer
agent and the effectiveness of their implementation;
(4) Chief compliance officer. Designate one individual responsible
for administering the fund's policies and procedures adopted under
paragraph (a)(1) of this section:
(i) Whose designation and compensation must be approved by the
fund's board of directors, including a majority of the directors who
are not interested persons of the fund;
(ii) Who may be removed from his or her responsibilities by action
of (and only with the approval of) the fund's board of directors,
including a majority of the directors who are not interested persons of
the fund;
(iii) Who must, no less frequently than annually, provide a written
report to the board that, at a minimum, addresses:
(A) The operation of the policies and procedures of the fund and
each investment adviser, principal underwriter, administrator, and
transfer agent of the fund, any material changes made to those policies
and procedures since the date of the last report, and any material
changes to the policies and procedures recommended as a result of the
annual review conducted pursuant to paragraph (a)(3) of this section;
and
(B) Each Material Compliance Matter that occurred since the date of
the last report; and
(iv) Who must, no less frequently than annually, meet separately
with the fund's independent directors.
(b) Unit investment trusts. If the fund is a unit investment trust,
the fund's principal underwriter or depositor must approve the fund's
policies and procedures and chief compliance officer, must receive all
annual reports, and must approve the removal of the chief compliance
officer from his or her responsibilities.
(c) Undue influence prohibited. No officer, director, or employee
of the fund, its investment adviser, or principal underwriter, or any
person acting under such person's direction may directly or indirectly
take any action to coerce, manipulate, mislead, or fraudulently
influence the fund's chief compliance officer in the performance of his
or her duties under this section.
(d) Recordkeeping. The fund must maintain:
(1) A copy of the policies and procedures adopted by the fund under
paragraph (a)(1) that are in effect, or at any time within the past
five years were in effect, in an easily accessible place; and
(2) Copies of materials provided to the board of directors in
connection with their approval under paragraph (a)(2) of this section,
and written reports provided to the board of directors pursuant to
paragraph (a)(4)(iii) of this section (or, if the fund is a unit
investment trust, to the fund's principal underwriter or depositor,
pursuant to paragraph (b) of this section) for at least five years
after the end of the fiscal year in which the documents were provided,
the first two years in an easily accessible place; and
(3) Any records documenting the fund's annual review pursuant to
paragraph (a)(3) of this section for at least five years after the end
of the fiscal year in which the annual review was conducted, the first
two years in an easily accessible place.
(e) Definitions. For purposes of this section:
(1) Federal Securities Laws means the Securities Act of 1933 (15
U.S.C. 77a-aa), the Securities Exchange Act of 1934 (15 U.S.C. 78a-mm),
the Sarbanes-Oxley Act of 2002 (Pub. L. 107-204, 116 Stat. 745 (2002)),
the Investment Company Act of 1940 (15 U.S.C. 80a), the Investment
Advisers Act of 1940 (15 U.S.C. 80b), Title V of the Gramm-Leach-Bliley
Act (Pub. L. No. 106-102, 113 Stat. 1338 (1999), any rules adopted by
the Commission under any of these statutes, the Bank Secrecy Act (31
U.S.C. 5311-5314; 5316-5332) as it applies to funds, and any rules
adopted thereunder by the Commission or the Department of the Treasury.
(2) A Material Compliance Matter means any compliance matter about
which the fund's board of directors would reasonably need to know to
oversee fund compliance, and that involves, without limitation:
(i) A violation of the Federal securities laws by the fund, its
investment adviser, principal underwriter, administrator or transfer
agent (or officers, directors, employees or agents thereof),
(ii) A violation of the policies and procedures of the fund, its
investment
[[Page 74730]]
adviser, principal underwriter, administrator or transfer agent, or
(iii) A weakness in the design or implementation of the policies
and procedures of the fund, its investment adviser, principal
underwriter, administrator or transfer agent.
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
3. The authority citation for part 275 continues to read in part as
follows:
Authority: 15 U.S.C. 80b-2(a)(11)(F), 80b-2(a)(17), 80b-3, 80b-
4, 80b-6(4), 80b-6a, 80b-11, unless otherwise noted.
* * * * *
0
4. Section 275.204-2 is amended by adding new paragraph (a)(17) and by
revising paragraph (e)(1). The additions and revisions read as follows:
Sec. 275.204-2 Books and records to be maintained by investment
advisers.
(a) * * *
(17)(i) A copy of the investment adviser's policies and procedures
formulated pursuant to Sec. 275.206(4)-7(a) of this chapter that are
in effect, or at any time within the past five years were in effect,
and
(ii) Any records documenting the investment adviser's annual review
of those policies and procedures conducted pursuant to Sec.
275.206(4)-7(b) of this chapter.
* * * * *
(e)(1) All books and records required to be made under the
provisions of paragraphs (a) to (c)(1)(i), inclusive, and (c)(2) of
this section (except for books and records required to be made under
the provisions of paragraphs (a)(11), (a)(16), and (a)(17)(i) of this
section), shall be maintained and preserved in an easily accessible
place for a period of not less than five years from the end of the
fiscal year during which the last entry was made on such record, the
first two years in an appropriate office of the investment adviser.
* * * * *
0
5. Section 275.206(4)-7 is added to read as follows:
Sec. 275.206(4)-7 Compliance procedures and practices.
If you are an investment adviser registered or required to be
registered under section 203 of the Investment Advisers Act of 1940 (15
U.S.C. 80b-3), it shall be unlawful within the meaning of section 206
of the Act (15 U.S.C. 80b-6) for you to provide investment advice to
clients unless you:
(a) Policies and procedures. Adopt and implement written policies
and procedures reasonably designed to prevent violation, by you and
your supervised persons, of the Act and the rules that the Commission
has adopted under the Act;
(b) Annual review. Review, no less frequently than annually, the
adequacy of the policies and procedures established pursuant to this
section and the effectiveness of their implementation; and
(c) Chief compliance officer. Designate an individual (who is a
supervised person) responsible for administering the policies and
procedures that you adopt under paragraph (a) of this section.
PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF
1940
0
6. The authority citation for part 279 continues to read as follows:
Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1,
et seq.
0
7. Form ADV (referenced in 279.1) is amended by:
In Part 1, Schedule A, revising Item 2(a), to read ``each Chief
Executive Officer, Chief Financial Officer, Chief Operations Officer,
Chief Legal Officer, Chief Compliance Officer (Chief Compliance Officer
is required and cannot be more than one individual), director and any
other individuals with similar status or functions;''
Dated: December 17, 2003.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-31544 Filed 12-23-03; 8:45 am]
BILLING CODE 8010-01-P