• SEC Adopts New Rules Requiring The Adoption Of More Stringent Policies And Procedures By Registered Investment Companies And Investment Advisers
  • March 2, 2004
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • Effective February 5, 2004, the Securities and Exchange Commission ("SEC") adopted new rules applicable to all investment advisers and investment companies registered with the SEC which require such entities to review current compliance policies and procedures and to adopt more stringent policies and procedures (the "Compliance Program") designed to prevent violations of the Investment Advisers Act of 1940, as amended (the "Advisers Act") by registered investment advisers, and violations of the federal securities laws including, the Investment Company Act of 1940, as amended (the "Investment Company Act") by registered investment companies. Registered investment advisers and investment companies are required to comply with the new rules on or before October 5, 2004.

    Adoption of Policies and Procedures

    A. Investment Advisers. Rule 206(4)-7 makes it unlawful for a registered investment adviser to provide any investment advice to clients unless the adviser has adopted a written Compliance Program that is reasonably designed to prevent a violation of the Advisers Act by the adviser or by a person supervised by the adviser. In creating this Compliance Program, the adviser must consider its fiduciary obligations in light of its business operations, identify specific compliance risks that its business model is exposed to, and must design policies and procedures to address these issues. The Compliance Program must focus on the prevention and detection of a compliance violation and the prompt correction of any compliance violation.

    Some of the factors that, at a minimum, need to be addressed in the adviser's Compliance Program are:

    • portfolio management;
    • trading practices, including best execution and soft dollar arrangements;
    • accuracy of disclosures;
    • safeguarding of client assets from conversion or inappropriate use;
    • business continuity plans;
    • proprietary trading of the adviser and personal trading activities of its employees;
    • marketing advisory services, including the use of solicitors;
    • process of valuing client holdings and the assessment of fees based on those valuations;
    • privacy protection safeguards; and
    • creation and maintenance of required records.

    B. Investment Companies. Rule 38a-1 requires all investment companies to adopt written policies and procedures that are reasonably designed to prevent the investment company from violating the federal securities laws. This standard is more stringent because it encompasses all of the federal securities laws rather than just the Investment Company Act. In addition, the new rule requires the investment company's Compliance Program to provide policies for the oversight of third party service providers' compliance programs. The third party service providers include, but are not limited to, the investment adviser, principal underwriter, administrator and transfer agent.

    The following is a partial list of the requirements applicable to an investment company's Compliance Program:

    Annual Board Review and Approval of Compliance Programs. A majority of an investment company's Board, including a majority of the independent Directors/Trustees, must annually review and approve the Compliance Program and the compliance programs of its service providers. The Board must specifically find that the investment company and its service providers' compliance programs are reasonably designed to prevent a violation of federal securities laws by the investment company. The Board can meet its obligation by reviewing summaries of the investment company's and each service providers' compliance program prepared by the investment company's chief compliance officer, legal counsel or others. At the very least, the summaries must address the salient risks that the investment company faces.

    Policies and Procedures. In addition to the factors set forth above in the investment adviser section, an investment company must also address the following in its Compliance Program:

    1. Pricing of Portfolio Securities and the Investment Company's Shares

    An investment company must adopt policies that determine when market quotations are no longer reliable and provide a methodology for determining current fair value. The Compliance Program must, at minimum:

    • monitor the circumstances that necessitate the use of fair value pricing (i.e. unreliable market quotations);
    • establish criteria for determining when market quotes may not be reliable in valuing portfolio securities;
    • provide methodologies by which the investment company determines the current fair market value of a portfolio security; and
    • regularly review the appropriateness and accuracy of the method used in valuing portfolio securities.

    2. Processing of an Investment Company's Shares

    An investment company is required to develop procedures that segregate all orders received before the investment company prices its shares (which will receive that day's price) from those that are received after the investment company has priced its shares. Those orders received after the investment company has priced its shares will receive the next day's price. An investment company is not allowed to simply rely on its transfer agent's compliance program to ensure that the segregation properly takes place. Instead, the investment company must review and approve the transfer agent's policies and procedures, and must take the affirmative steps to protect the investment company and its shareholders from late trading by obtaining assurances that the transfer agent's compliance program is being effectively administered.

    3. Identification of Affiliated Persons

    Due to the prohibition on certain transactions between an investment company and an affiliated person, the investment company's Compliance Program must develop procedures for determining who its affiliated persons are. These procedures must be reviewed at least annually to determine which persons are prohibited from engaging in prohibited transactions with the investment company.

    4. Protection of Nonpublic Information

    The Compliance Program must include policies and procedures that are reasonably designed to prevent the misuse of material, nonpublic information. The policies must also prohibit:

    • trading on the basis of information acquired by analysts or managers employed by the adviser;
    • the disclosure to third parties of material information about the portfolio, its trading strategies or pending transactions; and
    • the purchase or sale of investment company shares by advisory personnel based on material, nonpublic information about the portfolio.

    5. Compliance with Fund Governance Requirements

    The Compliance Program must include policies that guard against an improperly constituted Board, the failure of the Board to properly consider matters entrusted to it, and the failure to request and consider information required by the Investment Company Act from an investment company's investment adviser and other service providers.

    6. Market Timing

    The Compliance Program must include policies that are reasonably designed to ensure compliance with the investment company's market timing policies and monitor shareholder trades in and out of the investment company. This aspect of the Compliance Program coincides with the SEC's new disclosure requirements concerning an investment company's policies regarding market timing.

    Annual Review of Adequacy of Compliance Program

    A. Investment Advisers. The new rule requires an adviser to annually determine the Compliance Program's adequacy and whether the program is being properly implemented. Interim reviews should be conducted as needed.

    B. Investment Companies.An investment company must review its Compliance Program and each of its service providers' compliance programs at least annually.

    Chief Compliance Officer

    A. Investment Advisers. The new rule requires investment advisers to designate a Chief Compliance Officer who is knowledgeable in the Advisers Act and has full authority to develop and enforce the investment adviser's Compliance Program.

    B. Investment Companies. An investment company must appoint a Chief Compliance Officer who is knowledgeable about the federal securities laws. The Chief Compliance Officer will serve at the pleasure of the Board, can only be removed by the Board and will be compensated in an amount set by the Board. The Chief Compliance Officer is required to meet with the Independent Directors in executive session at least annually and annually furnish the Board with a written report on the investment company's Compliance Program and the service providers' compliance program. In addition, the Chief Compliance Officer is responsible for overseeing the service providers and for taking all necessary steps to insure that the service providers are adhering to their compliance procedures. Thus, a Chief Compliance Officer must be familiar with the operations of each service provider and must be aware of the compliance risks that a service provider's business exposes the investment company to.

    Record Keeping

    The new rules require investment advisers and investment companies to maintain copies of all compliance policies and procedures that have been in effect over the past five years. In addition, investment companies must maintain all of the materials that are presented to the Board in connection with the Board's approval of the investment company's and each of its service providers' compliance programs.