Newly adopted rules will require each investment company and investment adviser registered with the Commission to implement policies and procedures designed to prevent violation of the federal securities laws, and designate a chief compliance officer ("CCO") to administer them. The policies and procedures and CCO must be in place by October 5, 2004.

Investment Companies

Policies and Procedures

New rule 38a-1 requires fund boards to adopt written policies and procedures reasonably designed to prevent the fund from violating the federal securities laws. The procedures must provide for the board and its designated CCO to oversee compliance by the fund and, in addition, by the fund’s advisers, principal underwriters, administrators, and transfer agents (collectively, "service providers").

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 those of each of its service providers and to review them annually. The initial 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. With respect to policies and procedures of service providers, a fund’s board is required to make findings only with respect to activities of the service providers that could affect the fund.

Directors may satisfy their obligations under the rule by reviewing summaries of compliance programs prepared by the CCO, legal counsel or other persons familiar with the compliance programs. In evaluating policies and procedures, boards are specifically urged 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.

Rule 38a-1 does not require fund boards to approve amendments to policies and procedures of the fund or its service providers or to reapprove them annually. Instead, the rule requires the fund’s CCO to discuss material changes to the compliance policies and procedures in an annual report to the fund board.

Polices and Procedures

Fund policies and procedures are expected to cover certain critical areas impacting the funds directly:

  • pricing of portfolio securities and fund shares;
  • processing of fund shares;
  • identification of affiliated persons;
  • protection of nonpublic information;
  • compliance with fund governance requirements; and
  • market timing.

For a more detailed description of these critical areas, please refer to Appendix A below. In addition, as relevant, fund policies and procedures should cover the items enumerated for the adviser’s policies and procedures, which are described later in this Alert.

Service Providers

The new rule requires fund boards to approve the policies and procedures of fund service providers, and requires the fund’s own policies and procedures to include provisions for the fund to oversee compliance by those service providers. Fund boards are expressly authorized to refer to third-party reports when evaluating the compliance program of a service provider that is not an affiliated person of the fund.

Chief Compliance Officer

Rule 38a-1 requires each fund board to appoint a CCO empowered with full responsibility and authority to develop, administer and enforce appropriate compliance policies and procedures for the fund. The CCO should have sufficient seniority and authority to compel others to adhere to the compliance policies and procedures. Also, the new rule contains four key requirements designed to promote the independence of the CCO from the management of the fund.

Employment and Compensation

First, the CCO must serve at the pleasure of the fund board, which can remove her for any reason. The fund board (including a majority of independent directors) must approve the designation of the CCO, and must approve her compensation, including any bonuses. In so doing, the board should assure itself that the CCO is not denied any customary cost of living increase or any customary bonus or otherwise suffering adversely for having informed the board of a compliance failure or for having taken aggressive compliance actions. The fund board (including a majority of the independent directors) can remove the CCO from her responsibilities at any time, and can prevent others from doing so.

Direct Report to Board

Second, the CCO must report directly to the fund board. 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. 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;
(iii) any recommendations for material changes to the policies and procedures as a result of the annual review; and
(iv) any material compliance matters since the date of the last report.

The added definition of the term "material compliance matter" to the rule clarifies that the report should inform the board of those compliance matters about which the board reasonably needs to know in order to oversee fund compliance. Serious compliance issues must be brought to the board’s attention promptly, and cannot be delayed until an annual report.

Executive Session

Third, the CCO is required to meet in executive session with the independent directors at least once each year, without anyone else (such as fund management or interested directors) present. Independent counsel to the independent directors may be present. This allows the CCO and 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.

Protection against Undue Influence

Fourth, 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 CCO.

Investment Advisers

Policies and Procedures

New rule 206(4)-7 requires registered advisers to formalize policies and procedures to address their fiduciary and regulatory obligations under the Advisers Act. The new rule does not enumerate specific elements that advisers must include in their policies and procedures. They should be designed to prevent violations from occurring, detect violations that have occurred, and correct promptly any violations that have occurred. Advisers should first identify conflicts and other compliance risk factors, and then design policies and procedures that address those risks. At a minimum, an adviser’s policies and procedures should address the following issues to the extent relevant to that adviser:

  • portfolio management processes, including adherence to strategies and restrictions;
  • trading practices, including soft-dollar arrangements;
  • proprietary trading by the adviser and personal trading by individuals;
  • accuracy of disclosures made to investors, clients, and regulators;
  • safeguarding of assets;
  • recordkeeping;
  • marketing;
  • valuations;
  • privacy; and
  • business continuity.

Annual Review

The adviser must conduct an annual review that considers 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. Advisers should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and regulatory developments.

Chief Compliance Officer

Each registered adviser is required to designate a single CCO empowered with full responsibility and authority to develop, administer and enforce appropriate policies and procedures for the firm. Thus, the CCO should have a position of sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures.

Conclusion

Development and implementation of the new policies and procedures will be a time-consuming process, demanding dedication of extensive resources. In addition to the fund’s implementation of policies and procedures for itself, oversight of service providers’ policies and procedures will present its own set of issues--unique to each fund complex. Also, a variety of factors must be assessed in selecting a CCO. Existing personnel may or may not be best suited for the task. Preservation of communication flows and nuances in the interpersonal dynamic created by the CCO’s special status, among other factors, must be considered. As implementing the requirements of the new rules will be a lengthy process, it is recommended that compliance efforts begin as early in 2004 as is practicable.

Appendix A

Investment Company--Polices and Procedures

  • Pricing of portfolio securities and fund shares -- Rule 38a-1 requires funds to adopt policies and procedures that require the fund to monitor for circumstances that may necessitate the use of fair value prices; establish criteria for determining when market quotations are no longer reliable for a particular portfolio security; provide methodologies to determine the current fair value of the portfolio security; and regularly review the appropriateness and accuracy of the method used in valuing securities, and make any necessary adjustments.
  • Processing of fund shares -- The rule 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). In most cases, these matters will be addressed by the policies and procedures of fund transfer agents (covered by the rule as a service provider). Funds should not simply rely on a transfer agent’s policies and procedures, or even on contractual provisions that require forward pricing of fund shares, 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.
  • Identification of affiliated persons -- Funds should have policies and procedures in place to identify affiliated persons and to prevent unlawful transactions with them.
  • Protection of nonpublic information -- Fund advisers should incorporate their section 204A policies into the policies required by rule 38a-1. 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, its trading strategies, or pending transactions, and the purchase or sale of fund shares by advisory personnel based on material, nonpublic information about the fund’s portfolio.
  • Compliance with fund governance requirements -- Fund boards, among other things, are tasked with approving the fund’s advisory contracts, underwriting agreements, and distribution plans. A fund’s policies and procedures should be designed to guard against, among other things, an improperly constituted board, 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.
  • Market timing -- 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. 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, fund boards are strongly urged 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

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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