Proposed Rule 206(4)-7: Investment Adviser Compliance Program

Article by Susan Krawczyk, Holly Smith, Eric Arnold

Overview. On February 4, 2003, the Securities and Exchange Commission ("SEC") proposed sweeping changes for investment advisers registered with the agency ("Advisers") that would require such firms to:

• Adopt and implement policies and procedures reasonably designed to prevent violation of the Investment Advisers Act of 1940, as amended (the "Advisers Act");
• Review those policies and procedures annually for their adequacy and the effectiveness of their implementation; and
• Appoint a chief compliance officer to be responsible for administering the policies and procedures.

These requirements are proposed to be codified in a new rule 206(4)-7 (the "Proposed Rule") under the Advisers Act, which is discussed in a release available at http://www.sec.gov/rules/proposed/ic-25925.htm (the "Release").¹ The Release also seeks comment on ways to involve the private sector in fostering compliance by Advisers, including the creation of a self-regulatory organization for Advisers and/or investment companies. The Proposed Rule is designed in large part to make more effective use of the SEC's limited resources by relying on compliance programs designed by Advisers to provide the first line of investor protection.

The Proposed Rule will affect Advisers differently, depending on whether they manage a registered investment company. This memo summarizes the Proposed Rule and its impact on "retail" Advisers that do not manage the assets of a mutual fund or any other investment company.

Adoption and Implementation of Policies and Procedures. The Proposed Rule would require Advisers to adopt and implement policies and procedures reasonably designed to prevent violation of the Advisers Act.² Such policies and procedures must be written and designed to prevent violation of the Advisers Act by the Adviser and its supervised persons (which includes any partner, officer, director, or employee of an Adviser, or other person who provides investment advice on behalf of the Adviser and is subject to the supervision and control of the Adviser). The Release explains that a firm's policies and procedures should take into consideration the nature of its operations and be designed to prevent, detect and promptly correct material violations of the Advisers Act. While the Proposed Rule does not enumerate specific elements that must be included in an Adviser's policies and procedures, the Release states that the SEC would expect such policies and procedures (to the extent relevant) to address, at a minimum:³

• Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with guidelines established by clients, disclosures, and regulatory requirements;
• Trading practices, including procedures by which the Adviser satisfies its best execution obligation, establishes soft dollar arrangements, and allocates aggregate trades among clients;
• Proprietary trading of the Adviser and personal trading activities of supervised persons;
• The accuracy of disclosures made to investors, including information in advertisements;
• Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
• The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
• Processes to value client holdings and assess fees based on those valuations;
• Safeguards for the protection of client records and information; and
• Business continuity plans.

Annual Review. The Proposed Rule would require each Adviser to review its policies and procedures at least annually to determine their adequacy and the effectiveness of their implementation. According to the Release, this would require Advisers to periodically evaluate "whether their policies and procedures continue to work as designed and whether changes are needed to assure their continued effectiveness."

Chief Compliance Officer. The Proposed Rule would require each Adviser to designate an individual responsible for administering the compliance policies and procedures. The Release affirms that the chief compliance officer must be knowledgeable regarding the applicable federal securities laws and be empowered with full authority to develop and enforce appropriate policies and procedures for the Adviser. Importantly, the SEC recognizes in the Release that designation of a person as a chief compliance officer would not, in and of itself, impose upon the person a duty to supervise another person. Thus, a chief compliance officer appointed in compliance with the Proposed Rule would not necessarily be subject to sanction by the SEC for failure to supervise.

Proposed changes to Rule 204-2 under the Advisers Act would require Advisers to maintain a copy of their policies and procedures, as well as records relating to compliance with the Proposed Rule, for five years. The Release explains that these records are designed to provide the SEC's examination staff with a basis to determine whether the Adviser has complied with the Proposed Rule.

The Release explains that the growth in the number of Advisers (and the amount of assets they control) has substantially exceeded the growth in the SEC's resources over the past few years. To address this challenge, the SEC is exploring ways it can leverage its resources by relying more heavily on the private sector. The Release requests comment on (but does not propose any rules with regard to) several possible approaches, discussed below, by which the private sector would play a role in Adviser compliance.

Compliance Reviews. The first approach presented in the Release would require each Adviser to undergo periodic compliance reviews by a third party that would produce a written report of its findings and recommendations. The SEC's examination staff would use these reports to identify quickly areas that required attention. Advisers with reports indicating they have effective compliance programs would be examined less frequently.⁴

Self-Regulatory Organization. The Release also discusses the possibility of forming a self-regulatory organization ("SRO") for Advisers as another way to involve the private sector in support of the SEC's regulatory program. As envisioned in the Release the SRO would function in a manner analogous to NASD, Inc. and in particular would (i) establish business practice rules and ethical standards, (ii) conduct routine examinations, (iii) require minimum education or experience standards, and (iv) bring its own actions to discipline members for violating its rules and the federal securities laws. In discussing the SRO option, the SEC makes clear in the Release that any SRO would be subject to pervasive oversight by the SEC; the SEC would examine its activities, require it to keep records, and approve its rules only if the SEC concluded that they further the goals of the federal securities laws. In addition, disciplinary actions could be appealed to the SEC. Even if the SRO option were selected, the SEC staff would continue to examine the activities of Advisers, to ensure adequate examination coverage and to provide oversight of the SRO examination program.

Fidelity Bonding Requirements. The final approach presented in the Release is to impose a fidelity bonding requirement on Advisers. The Release notes that Advisers currently are among the only financial service providers handling client assets that are not required to obtain fidelity bonds. In addition, the Advisers Act does not require advisory firms to have a minimum amount of capital invested. The stated purpose for a fidelity bonding requirement is to provide a source of compensation for advisory clients who are victims of fraud or embezzlement by advisory personnel. The Release also asserts that a fidelity bonding requirement would result in additional oversight of Advisers by insurance companies because such companies would be unwilling to issue bonds - or would charge higher premiums - to Advisers with poor controls or employees with criminal or poor disciplinary records. As an alternative to the fidelity bonding requirement, the Release also seeks comment on a minimum capital requirement for Advisers.

The SEC requests comment on the Proposed Rule, suggestions for additions to the Proposed Rule, and comment on other matters that might have an effect on the proposals contained in the Release. Comments must be received on or before April 18, 2003. There are a number of different aspects of the Proposed Rule you may wish to comment on. The SEC specifically seeks comment on whether:

• There should be an exception to the Proposed Rule for certain Advisers (e.g. small Advisers or Advisers with limited operations). If so, the SEC inquires whether there are alternative measures that such Advisers could take to promote their compliance with the Advisers Act.
• The Proposed Rule should specify certain minimum policies and procedures (and if yes, which specific required policies and procedures should be included).
• Additional guidance is needed with respect to the areas that should be covered by an Adviser's compliance policies and procedures.
• The chief compliance officer should be a member of senior management of the Adviser.
• There are alternatives to the Proposed Rules that would minimize recordkeeping burdens.
• It is advisable to have the private sector play an increased role in Adviser compliance, and if so, whether there are other approaches for involving the private sector that should be considered.
• The SEC has authority to effect, through rulemaking, the private sector approaches.
• The SEC should require Advisers to undergo compliance reviews. If the SEC were to adopt such a requirement, the agency wants to know whether it should exclude certain types of Advisers (such as small Advisers). In addition, the SEC wants to know how it can prevent Advisers from simply hiring the least expensive compliance consultant regardless of the quality of the consultant's work. The SEC also requests comment on whether it should require the third parties who conduct the reviews to satisfy certain minimum standards for education and experience. It also seeks comment on what criteria should be included in the rule to determine whether a third party compliance expert is independent. Finally, the SEC requests comment about the frequency of the reviews, the proper scope of the reviews and whether the third party consultant should be required to file its report with the SEC.
• The SEC should establish an SRO for Advisers and if so, whether its activities should be limited (e.g. to conducting examinations). In addition, the SEC wants feedback about how the SRO should be financed.
• Whether Advisers should be required to obtain a fidelity bond. If so, the SEC asks whether some Advisers should be excluded from the requirement.
• Whether Advisers should be required to maintain a certain level of capital, and if so, how much.