On December 17, 2003, the Securities and Exchange Commission (the "SEC") adopted new Rule 206(4)-7 under the Investment Advisers Act of 1940, as amended (the "Investment Advisers Act") and new Rule 38a-1 under the Investment Company Act of 1940, as amended (the "Investment Company Act"). These new rules require investment advisers registered with the SEC ("Advisers") and investment companies ("funds"), respectively, to implement compliance policies and procedures designed to prevent the violation of federal securities laws and safeguard the interests of investors. (See SEC Release Nos. IA-2204; IC-26299 available at http://www.sec.gov/rules/final/ia-2204.htm). The new rules also mandate the appointment of a chief compliance officer to be responsible for the adherence to compliance policies and procedures.

New Rule 206(4)-7 and Amended Rule 204-2:
Regulations and Requirements Applicable to Investment Advisers

Compliance Policies and Procedures

Rule 206(4)-7 makes it unlawful for an Adviser to provide investment advice unless the Adviser has adopted and implemented written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act by the Adviser or any of its supervised persons. Acknowledging that a rule containing a uniform set of compliance criteria for all Advisers would be impracticable, the SEC is permitting each Adviser to adopt policies and procedures suitable to its operations. Rule 206(4)-7 does not stipulate any particular elements that Advisers must utilize in their compliance procedures but the following issues, to the degree applicable to the Adviser, should be addressed:

  • 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;
  • trading practices, including processes by which the Adviser meets its best execution obligation, uses client brokerage to obtain research and other services (i.e., "soft dollar arrangements") and allocates aggregated trades among clients;
  • proprietary trading of the Adviser and personal trading activities of supervised persons;
  • accuracy of disclosures made to investors, clients and regulators, including account statements and advertisements;
  • safeguarding of client assets from inappropriate use by advisory personnel;
  • accurate creation of required records and maintenance of such records that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • marketing advisory services, including the use of solicitors;
  • processes to value client holdings and assess fees based on those valuations;
  • safeguards to protect the privacy of client records and information; and
  • business continuity plans.

Under Rule 206(4)-7, Advisers are not required to consolidate all existing compliance policies into one document. In addition, Advisers are not required under this rule to memorialize every action that is taken in order to comply with the Investment Advisers Act; rather, it may be sufficient for the compliance policies and procedures to allocate responsibility within the Adviser’s organization for the timely performance of obligations such as the filing or updating of required forms. Furthermore, 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.

Annual Review

Under Rule 206(4)-7, Advisers are obligated to perform an annual review of their compliance policies and procedures to determine their continued adequacy and effectiveness of implementation. The scope of the review should include any compliance issues that arose during the year, any changes in the business of the Adviser or its affiliates and any changes in the Investment Advisers Act or other applicable regulations that might require a need to update the compliance policies and procedures. However, while the new rule calls only for an annual review, Advisers should utilize interim reviews in response to significant compliance events, changes in business arrangements and regulatory developments.

Chief Compliance Officer

Rule 206(4)-7 mandates that each Adviser must appoint a chief compliance officer to administer the Adviser’s compliance policies and procedures. Such chief compliance officer should be competent and knowledgeable regarding the Investment Advisers Act and should have a position of sufficient seniority and authority to require others to follow the Adviser’s compliance program.

Recordkeeping

In addition to adopting Rule 206(4)-7, the SEC has amended Rule 204-2 to require an Adviser to maintain, either in paper or electronic form, copies of all compliance policies and procedures currently in effect or that have been in effect in the last five years, in an easily accessible place. Moreover, amended Rule 204-2 requires an Adviser to keep all records documenting its annual review.

New Rule 38a-1:
Regulations and Requirements Applicable to Investment Companies

Compliance Policies and Procedures

Rule 38a-1 requires a fund’s board to adopt written policies and procedures designed to prevent the fund from violating Federal securities laws. Such written policies and procedures must provide for compliance oversight of the fund’s service providers including but not limited to its advisers, principal underwriters, administrators and transfer agents.

The board of directors of a fund, including a majority of its independent directors, must approve the policies and procedures of the fund and of each of its service providers. Such 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. In conducting a review of a fund’s or service provider’s policies and programs, the board may review summaries of the salient features of the programs (including programs of service providers) and the method by which such programs address significant compliance risks; such summaries must be prepared by the chief compliance officer, legal counsel or other persons familiar with the compliance programs.

The policies and procedures of a fund or service provider must address the issues discussed for Advisers, above. In addition to addressing such issues, funds are expected to take the following steps:

  • adopt pricing procedures pursuant to Rule 38a-1 that will ensure that fund shares are bought and redeemed at fair and accurate prices, and that shareholder interests are not affected by arbitrage opportunities created by the mispricing of shares;
  • facilitate the forward pricing of shares and preclude opportunity for "late trading" by requiring the segregation of investor orders received before the fund prices its shares from those received after shares are priced by the fund;
  • identify affiliated persons and implement effective policies and procedures aimed at stopping self-dealing or other unlawful transactions with affiliated persons;
  • protect nonpublic information and prevent insider trading by establishing, maintaining and enforcing written policies and procedures reasonably designed to prevent an advisor to the fund or any of its associated persons from misusing material, nonpublic information and also by addressing 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 any advisory personnel based on material nonpublic information about the fund’s portfolio;
  • ensure compliance by the fund with the Investment Company Act’s governance requirements and guard against, among other things, an improperly constituted board of directors, 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’s adviser and other service providers; and
  • implement compliance procedures reasonably designed to ensure compliance with the fund’s disclosed policies regarding market timing by providing for the effective monitoring of trading activity to detect market timing and reasonably preventing waivers of such market timing policies that would harm or subordinate the interests of the fund or its shareholders.

Annual Review

Similar to the annual review requirements applicable to Investment Advisers, a fund is required under Rule 38a-1 to conduct an annual review of its policies and procedures, as well as those of its service providers. The review is not required to be performed by the full board of directors, but by the designated compliance officer which will submit its report to the board.

Chief Compliance Officer

Like each Adviser, each fund must appoint a chief compliance officer who is responsible for administering the fund’s policies and procedures. However, in contrast to Rule 206(4)-7, Rule 38a-1 contains the following provisions intended to preserve the independence of the chief compliance officer from the management of the fund:

  • The compliance officer must be appointed, and its compensation must be approved, by the fund’s board (including a majority of independent directors). In addition, the board (including a majority of independent directors) can remove a chief compliance officer from responsibility at any time and can prevent the fund’s adviser or service providers from doing so;
  • The chief compliance officer must annually and whenever necessary provide the fund board with a written report on the adequacy of the fund’s compliance controls and those of its service providers;
  • The chief compliance officer is required to meet with the independent directors at least once a year outside the presence of fund management or interested directors; and
  • The fund’s officers, directors, employees, adviser, principal underwriter or any person acting under the direction of these persons are prohibited from exerting any undue influence on the chief compliance officer.

Recordkeeping and Private Sector Initiatives

Funds are bound by the same recordkeeping requirements under Rule 38a-1 as Advisers are under amended Rule 204-2. In addition, Rule 38a-1 requires 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, as well as the annual written reports by the fund’s chief compliance officer.

Effective Dates

New Rules 206(4)-7 and 38a-1, as well as the amendments to Rule 204-2, will become effective on February 5, 2004. The compliance date of such rules is October 5, 2004, at which time all funds and Advisers must have designated a chief compliance officer and fund boards must have approved a chief compliance officer. In addition, on or before the compliance date, all Advisors and funds must adopt compliance policies and procedures that satisfy the requirements in the new rules, which, in the case of funds, must be approved by the board on or before the compliance date. Advisers and funds must also complete their first annual review of the compliance policies and procedures no later than eighteen (18) months after the adoption or approval of the compliance policies and procedures. Furthermore, the chief compliance officer of a fund must submit the first annual report to the board within sixty (60) calendar days of the completion of the annual review.