Another fund complex could adopt policies and procedures that would cover solely activities of the funds, and could approve the policies and procedures of each of its 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 each of its service providers.
Some commenters expressed concern that the rule would require directors to review lengthy compliance manuals and devote considerable time at each meeting to approving numerous amendments. Directors may satisfy their obligations under the rule by reviewing summaries of compliance programs prepared by the chief compliance officer, legal counsel or other persons familiar with the compliance programs.
The summaries should familiarize directors with the salient features of the programs including programs of service providers and provide them with a good understanding of how the compliance programs address particularly significant compliance risks.
In considering whether to approve a fund's or service provider's compliance policies and procedures, boards should consider the nature of the fund's exposure to compliance failures. In the case of a money market fund, for example, the board should consider whether the policies and procedures sufficiently address the fund's compliance with rule 2a We urge boards to also consider best practices used by other fund complexes, and 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.
The Commission understands that, in some cases, the fund may employ the services of a service provider that is not an affiliated person of the fund, such as a transfer agent or administrator, and that provides similar services to a large number of funds. In such cases, it may be impractical for the fund or its compliance officer to directly review all of the service provider's policies and procedures. In such cases, we will consider a fund's policies and procedures to have satisfied the requirements of this rule if the fund uses a third-party report on the service provider's procedures instead of the procedures themselves when the board is evaluating whether to approve the service provider's compliance program.
Policies and Procedures. Funds' or their advisers' policies and procedures should address the issues we identified for investment advisers above. In light of our recent enforcement actions against a number of fund managers and service providers, 38 we are taking this opportunity to review the application of these policies and procedures to several important areas of compliance with the federal securities laws by funds and their service providers.
Rule 4 -7 requires each registered adviser to review its policies and procedures annually to determine their adequacy and the effectiveness of their implementation. For example, an adviser that is acquired by a broker-dealer or by the corporate parent of a broker-dealer should assess whether its policies and procedures are adequate to guard against the conflicts that arise when the adviser uses that broker-dealer to execute client transactions, or invests client assets in funds or other securities distributed or underwritten by the broker-dealer.
Although the rule requires only annual reviews, advisers should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and regulatory developments.
For example, we expect all registered advisers will begin reviewing their policies and procedures in light of our adoption of these rules. Similarly, rule 38a-1 requires a fund to review its policies and procedures, as well as those of its service providers, annually.
We expect all funds will begin reviewing their compliance policies and procedures currently, not only in light of the adoption of these rules, but also in light of the recent revelations of unlawful practices involving fund market timing, late trading, and improper disclosures and use of nonpublic portfolio information.
Rule 4 -7 requires each adviser registered with the Commission to designate a chief compliance officer to administer its compliance policies and procedures. Rule 38a-1 requires each fund to appoint a chief compliance officer who is responsible for administering the fund's policies and procedures approved by the board under the rule.
The chief compliance officer of a fund, like the chief compliance officer of an investment adviser, should have sufficient seniority and authority to compel others to adhere to the compliance policies and procedures. The rule contains several provisions, some of which were not included in our proposal, designed to promote the independence of the chief compliance officer from the management of the fund.
The fund board including a majority of independent directors must approve the designation of the chief compliance officer, and must approve her compensation or any changes in her compensation. Second, the chief compliance officer will report directly to the board of directors.
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. Third, we are requiring that the chief compliance officer meet in executive session with the independent directors at least once each year, without anyone else such as fund management or interested directors present.
Fourth, we have added a provision to protect the chief compliance officer from undue influence by fund service providers seeking to conceal their or others' non-compliance with the federal securities laws.
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 chief compliance officer in the performance of her responsibilities under the rule.
The appointment of a chief compliance officer with overall responsibility for management of a fund complex's compliance program is a key element of the investor protections we are today adopting. Some commenters representing fund management companies urged us to permit funds to continue to use multiple compliance managers employed by different service providers, rely on the policies of the fund service providers, and omit the requirement that fund boards approve the compliance officer.
These commenters would have us maintain funds' current approach to compliance management. Current practices, however, balkanize responsibility for fund compliance and isolate fund boards from compliance personnel, thus impeding boards' abilities to exercise their oversight responsibilities effectively. We decline to accept current practices, which we believe have contributed to the serious compliance lapses that are now the subject of our enforcement actions.
We have observed that executives at service providers have overruled their own compliance personnel because of business considerations. For example, some fund advisers have continued to permit investors with whom they had other business relationships to engage in harmful market timing in fund shares after compliance personnel and portfolio managers brought the market timing activity to their attention.
These compliance personnel may not have had access to fund directors or, having been overruled by their own management, may have felt they were not in a position to approach the board. To address these concerns, rule 38a-1 provides fund boards with direct access to a single person with overall compliance responsibility for the fund who answers directly to the board.
The rule provides the board with a powerful tool to exercise its oversight responsibilities over fund compliance matters. The new rule also strengthens the hand of compliance personnel by establishing a direct line of reporting to fund boards that is not controlled by management.
Under the new rule, the chief compliance officer will be responsible for keeping the board apprised of significant compliance events at the fund or its service providers and for advising the board of needed changes in the fund's compliance program.
We expect that a fund's chief compliance officer will often be employed by the fund's investment adviser or administrator. Funds today typically have no employees, and delegate management and administrative functions, including the compliance function, to one or more service providers. If we were to preclude the chief compliance officer from being an employee of an adviser or any other service provider, she would be divorced from all fund operations. As a result, the fund's chief compliance officer would be almost entirely dependent on information filtered through the senior management of the fund's adviser rather than, for example, information received directly from a trading desk.
Moreover, fund management would be unlikely to consult with an "outside" compliance officer on a prospective business decision to ascertain the compliance implications. We recognize, however, that a chief compliance officer who is an employee of the fund's investment adviser might be conflicted in her duties, and that the investment adviser's business interests might discourage the adviser from making forthright disclosure to fund directors of its compliance failures.
The rule, as adopted, is designed to address these concerns by requiring a fund's chief compliance officer to report directly to the board. The board, and the board alone, can discharge the officer if she fails to live up to the position.
Thus, a chief compliance officer who fails to fully inform the board of a material compliance failure, or who fails to aggressively pursue non-compliance within the service provider, would risk her position. She would also risk her career, because it would be unlikely for another board of directors to approve such a person as chief compliance officer. The chief compliance officer, in exercising her responsibilities under the rule, will oversee the fund's service providers, which will have their own compliance officials.
A chief compliance officer should diligently administer this oversight responsibility by taking steps to assure herself that each service provider has implemented effective compliance policies and procedures administered by competent personnel.
The chief compliance officer should be familiar with each service provider's operations and understand those aspects of their operations that expose the fund to compliance risks. She should maintain an active working relationship with each service provider's compliance personnel. Arrangements with the service provider should provide the fund's chief compliance officer with direct access to these personnel, and should provide the compliance officer with periodic reports and special reports in the event of compliance problems.
In addition, the fund's contracts with its service providers might also require service providers to certify periodically that they are in compliance with applicable federal securities laws, or could provide for third-party audits arranged by the fund to evaluate the effectiveness of the service provider's compliance controls.
New rule 38a-1 for funds and amendments to rule for advisers require firms to maintain copies of all policies and procedures that are in effect or were in effect at any time during the last five years. In the Proposing Release, we requested that commenters consider four additional approaches that we might take to require the private sector to assume greater responsibility for compliance with the federal securities laws.
These possible approaches included: i a requirement that funds and advisers undergo third-party compliance reviews; ii an expansion of the role of independent public accountants to include the performance of certain compliance reviews; iii the formation of one or more self-regulatory organizations for advisers or funds; and iv the requirement that certain advisers obtain fidelity bonds from reputable insurance companies.
We appreciate the many comments we received. Although we are not moving forward with any of these approaches at this time, we continue to regard them as viable options should the measures we are taking today fail to adequately strengthen the compliance programs of funds and advisers. In particular, we may reconsider whether to propose rules requiring funds and advisers to obtain compliance reviews from third-party compliance experts. Such compliance audits could be a useful supplement to our examination program and would assure the frequent examination of advisers and funds.
Rule 38a-1 includes provisions designed to promote the chief compliance officer's independence from fund management while still maintaining her effectiveness. The fund's board of directors must approve the chief compliance officer's designation and compensation, and has the sole power to remove her from her position.
Are there other measures or refinements to these provisions that would further enhance the independence and effectiveness of chief compliance officers under the rule? We also request comment whether our definition of the "material compliance matters" that must be reported to fund boards by chief compliance officers adequately addresses our concern that fund boards receive compliance information they reasonably need to know in order to oversee fund compliance.
New rules 38a-1 and 4 -7 and the amendments to rule will be effective on February 5, The compliance date of the new rules and rule amendments is October 5, On or before the compliance date, all funds and advisers must have designated a chief compliance officer and fund boards must have approved the chief compliance officer.
In addition, on or before the compliance date, funds and advisers must adopt compliance policies and procedures that satisfy the requirements in the new rules. In the case of funds, these policies and procedures must have been approved by the board on or before the compliance date.
Funds and advisers must complete their first annual review of the compliance policies and procedures no later than eighteen months after the adoption or approval of the compliance policies and procedures.
The chief compliance officer of a fund must submit the first annual report to the board within sixty calendar days of the completion of the annual review. Our allowance for a nine month transition period does not reduce the immediacy of the need for all funds, including those that already have compliance policies in place, to undertake a review of their policies and procedures, in light of recent revelations of unlawful practices involving market timing, late trading, and improper disclosures of nonpublic portfolio information.
We are sensitive to the costs and benefits that result from our rules. The new rules require each fund and adviser to adopt and implement policies and procedures reasonably designed to prevent violations of the securities laws, to review these annually, and to designate an individual as chief compliance officer. In the Proposing Release, we identified possible costs and benefits of the rules and requested comment on our analysis. We expect that fund investors, advisory clients, funds, and advisers will benefit from the new rules.
Commenters generally agreed that comprehensive compliance programs are beneficial. Although many funds and advisers already have such programs in place, the new rules will make this standard practice for all funds and advisers. One commenter, a compliance officer, noted that the benefits of the new measures in the form of increased investor protection would far exceed the costs.
Requiring funds and investment advisers to design and implement a comprehensive internal compliance program will serve to reduce the risk that fund investors and advisory clients collectively, "investors" will be harmed by violations of the securities laws.
With limited exception, commenters agreed that comprehensive written compliance programs are the first line of defense in investor protection.
Recent allegations of violations related to market timing and late trading confirm the need for strong compliance programs that do not permit compliance objectives to be subordinated to the business objectives of fund advisers or their affiliated persons.
The appointment of a chief compliance officer for each fund will also provide important investor protection benefits. Funds currently rely on multiple compliance personnel working for different service providers. Fund boards do not receive compliance information directly from these compliance officers; it is filtered through the management of the fund's investment adviser or other service providers.
We believe these structures have contributed to serious compliance lapses that are now the subject of our enforcement actions. Rule 38a-1, by requiring each fund to have a compliance officer who serves at the pleasure of the fund's board and who is responsible for oversight of these service providers, and who cannot be unduly influenced will strengthen the hand of compliance personnel by giving them a direct line of reporting to the fund board that is not controlled by management.
The rules will also benefit funds and investment advisers by diminishing the likelihood of securities violations, Commission enforcement actions, and private litigation. For a fund or adviser, the potential costs associated with a securities law violation may consist of much more than merely the fines or other penalties levied by the Commission or civil liability. The reputation of a fund or adviser may be significantly tarnished, resulting in redemptions in the case of an open-end fund or lost clients.
Advisers may be denied eligibility to advise funds. The designation of a chief compliance officer also should enhance the efficiency of funds' and advisers' operations by centralizing responsibility for the compliance function.
While many commenters agreed that fund and investment adviser compliance benefits from clear allocation of compliance responsibilities, they argued that large firms would benefit little from requiring a single person to be designated.
We believe that the designation of a single officer will increase the coordination with which distributed compliance functions are executed. In addition, because the new rules complement our examination program for investment advisers and for fund complexes, they will enhance our ability to protect investors. The existence of a structured compliance program at funds and investment advisers, together with the designation of a chief compliance officer to serve as a point of contact, will facilitate the examination staff's efforts to conduct each examination in an organized and efficient manner and thus to allocate resources to maximize investor protection.
Most commenters noted that the proposed rules would enhance the effectiveness of the Commission's examination program and oversight of funds and advisers. The new rules will result in some additional costs for funds and investment advisers, which, in the case of funds, we expect would be passed on to investors. A number of commenters expressed concern about the costs that the new rules would impose. However, because all funds and most investment advisers currently have some written compliance policies and procedures in place, the costs of the new rules in many instances already are reflected in the fees investors currently pay.
We would expect that funds and advisers with substantial commitments to compliance would incur only minimal costs in connection with the adoption of the new rules as they reviewed their internal compliance programs for adequacy. Funds and larger advisory firms typically have adopted and implemented comprehensive, written policies and procedures. Many of these funds and advisers also have well-staffed compliance departments.
Many conduct periodic reviews of their compliance programs and some hire independent compliance experts to review the adequacy of their compliance programs and the effectiveness of their implementation. A number of commenters expressed particular concern about the relative cost of the new rules for small investment advisers. Based on our examination experience, we estimate that as many as one half of SEC-registered investment advisers do not have comprehensive, written internal compliance programs in place.
However, we expect a number of factors will enable small investment advisers to control and minimize these costs. Because small firms typically engage in a limited number and range of transactions and have one or two employees, their internal compliance programs would be markedly less complex than those of their large firm counterparts. Estimates of the cost of developing compliance policies and procedures vary greatly depending on the type of help that an investment adviser seeks.
The requirement that each investment adviser designate a chief compliance officer likely will impose only a minimal cost. Many investment advisers already have large compliance staffs headed by an individual who officially or effectively serves as a chief compliance officer.
As noted above, we believe that it is important for each firm to have one person who coordinates compliance efforts on behalf of the firm, even though that individual may rely heavily on others within and outside the firm for assistance.
The cost to funds of appointing a chief compliance officer also should not be significant. Like many investment advisers, many fund complexes already have large compliance staffs headed by an individual who officially or effectively serves as a chief compliance officer.
We expect this individual will typically be qualified to serve the fund's board of directors as the fund's chief compliance officer. We anticipate that costs associated with the annual review requirement also will be limited. Many large funds and investment advisers with comprehensive compliance programs periodically review portions of their compliance programs.
These firms may incur a cost associated with transforming their periodic reviews into a more systematic annual review, but this cost is difficult to quantify. Most of the firms without any review mechanism in place are small. For these firms, the annual review requirement likely will be less extensive and, therefore, less costly than for their larger counterparts.
We have determined that requiring more frequent reviews would impose unnecessary costs on funds and advisers. Several commenters stated that there would be a substantial cost associated with the requirement that fund boards approve the compliance policies and procedures and review the annual report prepared by the chief compliance officer.
We have clarified in this release that the new rules do not require the board of directors to read every policy and procedure. The board may make its decisions about the adequacy of the compliance policies and procedures based on summary reports.
Similarly, the board's review of the chief compliance officer's annual report should focus on ensuring that the compliance programs of the fund and its service providers are reasonably designed and functioning effectively. In light of these clarifications, we do not believe that funds will incur excessive costs in connection with board oversight of compliance under the new rules.
One commenter, a large fund complex, suggested that there would be substantial recordkeeping costs associated with the new rules, and suggested that firms be required to maintain for five years copies of only those policies and procedures that form the backbone of the firm's compliance program.
Because records may be maintained electronically, the cost of maintaining copies of all compliance policies and procedures in place during the past five years will be contained. Section 2 c of the Investment Company Act [15 U. As discussed above, the new rules would require funds and investment advisers to adopt and implement written policies and procedures designed to prevent violations of the federal securities laws, and review those policies and procedures at least annually.
Although we recognize that a compliance program may divert resources from funds' and advisers' primary businesses, we expect that the new rules may indirectly increase efficiency in a number of ways. These compliance programs should increase efficiency by deterring federal securities law violations, or by facilitating the fund's or adviser's early intervention to decrease the severity of any violations that do occur. In addition, funds and advisers will be required to carry out their internal compliance functions in an organized and systematic manner, which may be more efficient than their current approach to these functions.
The existence of an industry-wide compliance program requirement may enhance efficiency further by encouraging third parties to create new informational resources and guidance to which industry participants can refer in establishing and improving their compliance programs. Since the new rules apply equally to all funds and advisers, we do not anticipate that they will introduce any competitive disadvantages. To the contrary, the new rules may encourage competition on a more level basis than exists in the current environment, in which compliance-oriented industry participants incur greater costs to maintain compliance programs than other firms.
Several commenters cautioned, however, that the new rules could have anti-competitive effects on the advisory industry because they would disproportionately burden small advisers and could even force them to merge with their larger, more established counterparts or go out of business. While small advisers will incur the largest relative costs as a result of the new rules, the rule's requirements are essential for the protection of small advisers' clients.
Moreover, the existence of a strong compliance program may assist small advisers to attract client assets. We anticipate that the new rules will indirectly foster capital formation by bolstering investor confidence.
It has been our experience that funds and advisers with effective compliance programs are less likely to violate the federal securities laws and harm to investors is less likely to result. To the extent such an environment enhances investor confidence in funds and client confidence in investment advisers, investors and clients are more likely to make assets available through these intermediaries for investment in the capital markets.
As we discussed in the Proposing Release, the new rules and amendments would impose "collection of information" requirements within the meaning of the Paperwork Reduction Act of Two of the collections of information are new.
The titles of these new collections are "Rule 38a-1" and "Rule 4 The other collection of information takes the form of amendments to a currently approved collection titled "Rule ," under OMB control number The General Provisions Part Part contains regulatory requirements that apply to more than one type of financial institution, and in some cases, individuals. The financial-institution-specific parts contain regulatory requirements specific to a particular type of financial institution.
Part pertains to mutual funds 31 C. For the testing to be independent, it must not be done by the same employees involved in the operation or oversight of the AML program; and risk-based procedures for conducting ongoing customer due diligence.
These should include, but not be limited to, procedures to: 1 identify and verify the identity of customers, 2 understand the nature and purpose of customer relationships so customer risk profiles can be developed, and 3 conduct ongoing monitoring to identify and report suspicious transactions as well as to maintain and update customer information, including beneficial ownership information.
Adopting Release: 67 Fed. Adopting Release: 68 Fed. The letters provide staff no-action statements regarding broker-dealers relying on investment advisers to conduct the required elements of the CIP rule. Beneficial Ownership Covered financial institutions are required to establish and maintain written procedures that are reasonably designed to identify and verify beneficial owners of legal entity customers and to include such procedures in their anti-money laundering compliance program required under 31 U.
Beneficial owner means each of the following: Each individual, if any, who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, owns 25 percent or more of the equity interests of a legal entity customer; and A single individual with significant responsibility to control, manage, or direct a legal entity customer, including: An executive officer or senior manager e.
If a trust owns directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, 25 percent or more of the equity interests of a legal entity customer, the beneficial owner shall mean the trustee.
Adopting Release: 81 Fed. See also 31 C. Adopting Release : 71 Fed. Extension of Applicability Date: 71 Fed. Proposed Rule: 67 Fed. Interim Final Rule: 67 Fed. Adopting Release: 71 Fed. Confidentiality of Suspicious Activity Reports, 75 Fed.
Affiliates Nov. FBAR: 31 C. Adopting Release: 76 Fed. CMIR: 31 C. Recordkeeping and Travel Rule : 31 C. Adopting Release: 75 Fed. Proposing Release: 74 Fed. Source Documents: Section a Rule: 31 C. Proposed Rule Release: 74 Fed. Broadening Access to the a program: 75 Fed. Changing your Point of Contact for a Nov. Source Documents: Section b Rule: 31 C. FinCEN b Webpage provides information on section b and an online registration system.
Source Documents: Section Special Measures If the fund is a unit investment trust, the fund 's principal underwriter or depositor must approve the fund 's policies and procedures and chief compliance officer, must receive all annual reports, and must approve the removal of the chief compliance officer from his or her responsibilities.
No officer, director, or employee of the fund , its investment adviser, or principal underwriter , or any person acting under such person 's direction may directly or indirectly take any action to coerce, manipulate, mislead, or fraudulently influence the fund 's chief compliance officer in the performance of his or her duties under this section.
The fund must maintain:. For purposes of this section:.
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