Investment Management Commentary
FEBRUARY 2003
SEC Proposes Rules for Mandatory Compliance Programs
for Investment Companies and Investment Advisers
and Seeks Comment on Further Private Sector
Involvement in Compliance
by Michael S. Caccese (mcaccese@kl.com), George J. Zornada (gzornada@kl.com)
and XinXin Guo (xguo@kl.com)*
On February 5, 2003, the Securities and Exchange
Commission (the “Commission”) issued proposals
that would require each investment company
(including business development companies) and
investment adviser registered with the Commission
to adopt and implement compliance policies and
procedures designed to prevent violations of the
federal securities laws, annually review the
effectiveness of those policies and procedures and
appoint a chief compliance officer responsible for
administering the compliance program. In addition,
the Commission sought comment regarding any
additional means of involving the private sector in
fostering compliance with the federal securities laws
by investment companies and investment advisers.
The Commission will accept comments on the
proposals until April 18, 2003.
The Commission’s proposals would leverage its
inspection program by requiring the adoption of
compliance programs by registered investment
companies (“funds”) and investment advisers
(“advisers”). The Commission noted that many
funds and advisers have established effective
programs staffed with competent and trained
professionals, but that neither the federal securities
laws nor Commission rules currently require funds
and advisers to adopt and implement comprehensive
compliance programs, and that not all funds and
advisers have adopted and implemented adequate
compliance programs. The proposals would not
impose a “one size fits all” requirement for
compliance programs, but would require funds and
advisers to establish compliance programs based on
broad common elements.
ADOPTION AND IMPLEMENTATION OF
COMPLIANCE PROGRAMS
Specifically, the Commission proposed new rule
38a-1 under the Investment Company Act of 1940
and new rule 206(4)-7 under the Investment Advisers
Act of 1940 (along with amendments to the
* Michael Caccese is a partner in the Boston Office of Kirkpatrick & Lockhart LLP. He works extensively with the
investment advisers and investment companies on registration and compliance issues. He was previously the General
Counsel to AIMR and was responsible for overseeing and implementing industry-wide standards of best practice for
investment firms and investment professionals. He can be reached at 617.261.3133 and mcaccese@kl.com. George
Zornada and XinXin Guo both are associates with K&L and practice in the firm’s Washington D.C. and San Francisco
offices, respectively.
Kirkpatrick & Lockhart LLP
– safeguarding of assets;
recordkeeping requirements of rule 204-2) that
would require funds and advisers registered with the
Commission to adopt and implement internal
compliance programs that contain common elements:
n
Policies and Procedures. Funds and advisers
would be required to adopt and implement
written policies and procedures reasonably
designed to prevent violation of the Federal
Securities Laws, as defined in the rules. In the
case of a fund, the written policies and
procedures must address the fund, and its
investment adviser, principal underwriter or
administrator in connection with their
provision of services to the fund. In addition,
in the case of a fund, the policies and
procedures must be approved by the board of
directors of the fund, including a majority of
the independent directors.
The proposals do not set forth any specific
policies or procedures. The Commission stated
in the release that the proposed rules are
intended to allow funds and advisers to
develop compliance programs specifically
based on the nature of their operations, and
could delegate functions to service providers if
effective oversight is maintained. The
Commission stated that policies and
procedures of funds and advisers (to the extent
applicable to each) would, at a minimum,
address:
– portfolio management processes,
including allocation of investment
opportunities, consistency with
guidelines established by clients, and
compliance with disclosure and
regulatory requirements;
– trading and brokerage practices,
including best execution, use of “soft
dollars,” and allocation of aggregate
trades among clients;
– proprietary trading and employee
personal trading;
– accuracy of disclosures to investors,
including advertising;
– creation, maintenance and accuracy of
books and records;
– business continuity plans;
– portfolio pricing and valuation of assets;
– processing of fund shares;
– affiliated transactions and compliance
with exemptive rules;
– fund governance requirements; and
– prevention of money laundering.
n
n
Annual Review. Funds and advisers would be
required to review their policies and
procedures no less frequently than annually to
determine their adequacy and the effectiveness
of their implementation.
Chief Compliance Officer. Each fund and
adviser would be required to designate an
individual responsible for administering the
compliance program. The Commission stated
that the chief compliance officer should be
empowered with full responsibility and
authority to develop and enforce appropriate
policies and procedures for the adviser or fund
complex.
– For funds, the chief compliance officer
would have to be approved by the fund’s
board of directors, including a majority
of the independent directors. Proposed
rule 38a-1 would also require the chief
compliance officer to report to the fund’s
board of directors annually in writing on
the operations of the fund’s policies and
procedures, including (i) any
recommendations for material changes to
the policies and procedures since the last
report, (ii) any recommendations for
material changes to the policies and
procedures as a result of the annual
review, and (iii) any material compliance
matters requiring remedial action that
occurred since the last report. In the case
of unit investment trusts, the principal
underwriter or depositor must approve
Kirkpatrick & Lockhart LLP
2
the policies and procedures and the chief
compliance officer, and receive all
annual reports. The Commission
requested comment on whether the chief
compliance officer should be an officer
of a fund.
– For advisers, the designated chief
compliance officer would have to be a
supervised person (i.e., any partner,
officer, director or other person with a
similar status or function, or employee of
the 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 Commission requested comment on
whether the chief compliance officer
should be a member of senior
management of an adviser.
n
n
Recordkeeping. The policies and procedures
and related reports required under the
proposed rules would be subject to funds’ and
advisers’ recordkeeping requirements
regarding accessibility and maintenance.
Definition of Federal Securities Laws. Each
fund’s and adviser’s compliance program must
be designed to comply with the following
federal securities laws: the Securities Act of
1933; the Securities Exchange Act of 1934; the
Investment Company Act of 1940; the
Investment Advisers Act of 1940; the
Sarbanes-Oxley Act of 2002; Title V of the
Gramm-Leach-Bliley Act and rules adopted by
the Commission under any of those statutes;
and the Bank Secrecy Act as it applies to
funds, and any rules adopted thereunder by the
Commission or the Department of the
Treasury.
Although the final version of the rules is yet to be
determined pending public comments, statements by
various Commissioners indicate that it is likely that
many provisions of the proposed rules will be
adopted substantially as proposed. Importantly,
while many funds may already have compliance
programs in place, including regular reporting to the
board, if adopted as proposed, the chief compliance
officer reporting and record maintenance
requirements would require that the board receive an
internal written record of any material compliance
matter that requires remedial action (that is, any
material violation of a policy), which report must be
made available to the Commission. For funds and
advisers, especially many smaller advisers and funds
not affiliated with larger fund complexes, the rules
also may impose significant costs when establishing
written policies and procedures.
PRIVATE SECTOR INVOLVEMENT
As an additional matter, in exploring other ways of
leveraging limited government resources, the
Commission published for public comment what
amounts to a concept release on possible ways of
increasing private sector involvement in compliance
issues. The release seeks comment on several
specific ideas: (i) periodic third party compliance
reviews of funds and advisers; (ii) an expansion of
the scope of the fund audits performed by
independent public accountants; (iii) the formation of
one or more self-regulatory organizations; and (iv) a
fidelity bonding requirement for advisers.
The first approach would involve mandatory periodic
compliance reviews by a third party that would
produce a report of its findings and
recommendations. These reports could in turn be
used by Commission examination staff to identify
quickly areas for Commission staff attention. The
second approach involves the expanded role of
independent public accountants to include an
examination of fund compliance controls. The third
approach involves the formation of one or more selfregulatory organizations (“SROs”) for funds and/or
advisers. An SRO for funds and/or advisers could
function in a manner analogous to the SROs for
registered broker-dealers by (i) establishing business
practice rules and ethical standards, (ii) conducting
routine examinations, (iii) requiring minimum
education or experience standards, and (iv) bringing
its own actions to discipline members for violating
its rules and the federal securities laws. The fourth
approach involves additional discipline exerted on
the activities of advisers by requiring advisers to
obtain fidelity bonds from insurance companies, with
those advisers engaging in riskier activities incurring
Kirkpatrick & Lockhart LLP
3
higher insurance costs.
The Commission’s stated purpose in seeking
comment on these ideas is to explore through the
comment process the further involvement of the
private sector to enhance compliance with federal
securities laws. The basis for the Commission’s
focus, given the lack of generalized compliance
problems or other financial scandal in the fund
industry, is curious, especially in light of the very
significant costs involved with any of the four
suggestions. Indeed, the legal basis on which the
Commission could establish an SRO is itself unclear.
We expect that all of the approaches likely will draw
extensive comment, and possibly encounter
opposition from various Commissioners. In this
regard, several Commissioners voiced strong
skepticism regarding an industry SRO, and voiced
concern regarding the potential costs of the matters
put out for comment. The Commission indicated that
the private sector involvement proposals represent its
continuing efforts to address investor protection
issues and that the Commission has not concluded
that any one of the proposed approaches would be
implemented.
Kirkpatrick & Lockhart LLP
4
Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with over 60 lawyers devoting all or a substantial portion of their practice to this area. According to the April 2002
American Lawyer, K&L is a mutual funds “powerhouse” that represents more of the largest 25 investment company
complexes and their affiliates than any other law firm.
We represent mutual funds, insurance companies, broker-dealers, investment advisers, retirement plans, banks and
trust companies, private funds, offshore funds and other financial institutions. We also regularly represent mutual
fund distributors, independent directors of investment companies, retirement plans and service providers to the
investment management industry. In addition, we frequently serve as outside counsel to industry associations on a
variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the
investment company business: from organizing and registering open-end and closed-end funds, both as series and
individual portfolios, to providing ongoing advice and representation to the funds and their advisers, directors and
distributors.
We invite you to contact one of the members of our investment management practice, listed below, for additional
assistance. You may also visit our website at www.kl.com for more information, or send general inquiries via email
to investmentmanagement@kl.com.
BOSTON
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas Hickey III
Nicholas Hodge
617.261.3133
617.261.3156
617.261.3163
617.261.3208
617.261.3210
mcaccese@kl.com
pfina@kl.com
mgoshko@kl.com
thickey@kl.com
nhodge@kl.com
LOS ANGELES
William P. Wade
310.552.5071
wwade@kl.com
NEW YORK
Beth R. Kramer
Richard D. Marshall
Robert M. McLaughlin
Loren Schechter
212.536.4024
212.536.3941
212.536.3924
212.536.4008
bkramer@kl.com
rmarshall@kl.com
rmclaughlin@kl.com
lschechter@kl.com
SAN FRANCISCO
Eilleen M. Clavere
David Mishel
Mark D. Perlow
Richard M. Phillips
415.249.1047
415.249.1015
415.249.1070
415.249.1010
eclavere@kl.com
dmishel@kl.com
mperlow@kl.com
rphillips@kl.com
WASHINGTON
Clifford J. Alexander
Diane E. Ambler
Catherine S. Bardsley
Arthur J. Brown
Arthur C. Delibert
Robert C. Hacker
Benjamin J. Haskin
Kathy Kresch Ingber
Rebecca H. Laird
Thomas M. Leahey
Cary J. Meer
R. Charles Miller
Dean E. Miller
R. Darrell Mounts
C. Dirk Peterson
Alan C. Porter
Theodore L. Press
Robert H. Rosenblum
William A. Schmidt
Lynn A. Schweinfurth
Donald W. Smith
Robert A. Wittie
Robert J. Zutz
202.778.9068
202.778.9886
202.778.9289
202.778.9046
202.778.9042
202.778.9016
202.778.9369
202.778.9015
202.778.9038
202.778.9082
202.778.9107
202.778.9372
202.778.9371
202.778.9298
202.778.9324
202.778.9186
202.778.9025
202.778.9464
202.778.9373
202.778.9876
202.778.9079
202.778.9066
202.778.9059
calexander@kl.com
dambler@kl.com
cbardsley@kl.com
abrown@kl.com
adelibert@kl.com
rhacker@kl.com
bhaskin@kl.com
kingber@kl.com
rlaird@kl.com
tleahey@kl.com
cmeer@kl.com
cmiller@kl.com
dmiller@kl.com
dmounts@kl.com
dpeterson@kl.com
aporter@kl.com
tpress@kl.com
rrosenblum@kl.com
william.schmidt@kl.com
lschweinfurth@kl.com
dsmith@kl.com
rwittie@kl.com
rzutz@kl.com
®
Kirkpatrick & Lockhart LLP
®
Challenge us.
www.kl.com
BOSTON
n
DALLAS
n
HARRISBURG
n
LOS ANGELES
n
MIAMI
n
NEWARK
n
NEW YORK
n
PITTSBURGH
n
SAN FRANCISCO
n
WASHINGTON
............................................................................................................................................................
This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2003 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.