SEC Sets Clear Expectations Regarding Registered Investment Companies’ Compliance Programs
Chief Compliance Officers, Trustees and Service Providers to registered investment companies (RICs) be fair warned … the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a Risk Alert identifying the most common deficiencies identified in examinations of RICs and providing observations with respect to money market funds and target date funds.
With respect to RICs, OCIE identified the most commonly cited deficiencies and weaknesses observed during 300 fund examinations over a two-year period. The most common deficiencies fell into the following categories: the compliance program rule for funds, fund disclosures, the 15(c) approval process, and the code of ethics rule.
But before we discuss the specifics of the Risk Alert, let’s consider that the real message isn’t just one or more deficiencies. The deficiencies cited by OCIE suggest one overarching theme: If you are going to sponsor, advise or act as a fiduciary to a RIC, you need to know the regulatory requirements for RICs and ensure that they are part of a fund’s compliance program and evaluated no less frequently than annually. Here, CSS provides these thoughts on avoiding such pitfalls.
OCIE’s Top Compliance Observations
Fund Compliance Rule (Rule 38a-1 of the Investment Company Act of 1940, as amended)
SEC Observation: Compliance programs did not address the nature of the funds’ business activities. Examples include valuation and pricing methods for all the instruments traded by the funds or procedures for investment guideline monitoring.
CSS Perspective: One size does not fit all. Funds’ policies and procedures should be customized to address the funds’ operations and activities. They should also be reviewed at least annually to assess whether they continue to address all of a fund’s operations and regulatory requirements.
SEC Observation: Policies and procedures not followed or enforced.
CSS Perspective: Do what you say and say what you do. This motto is as true for investment companies as it is for people. Funds either need to follow and/or enforce their written policies or revise them to reflect what a fund is actually doing related to a particular activity. Having a written policy that is not being followed can be worse than not having a policy.
SEC Observation: Inadequate service provider oversight.
CSS Perspective: Funds outsource nearly all of their activities to service providers. As such, the compliance program must include a comprehensive program for monitoring service providers’ activities and verifying that they are fulfilling their obligations to the funds. The oversight can be accomplished through any combination of attestations, certifications, requests for information, periodic status meetings and/or annual onsite reviews. It should also be documented. Issues that are identified should be escalated to the appropriate party, such as an audit committee or fund board. CCOs should utilize subject matter experts from a fund’s adviser or other resources in the oversight process to assist with evaluating a service provider’s controls.
SEC Observation: Annual reviews were not performed or did not address the adequacy of the fund’s policies and procedures.
CSS Perspective: Rule 38a-1 clearly defines the obligation of a fund’s CCO to provide a written report to the fund’s board no less frequently than annually that addresses:
-
- the operation of the policies and procedures of the fund and each investment adviser, principal underwriter, administrator and transfer agent;
- any materials changes made those policies and procedures since the date of the last report;
- any materials changes to the policies and procedures recommended as a result of the last review; and
- each material compliance matter.
It is the responsibility of a fund’s CCO to provide a written report to a fund’s board and a fund’s board responsibility to require that it is provided.
Disclosure to Investors
SEC Observation: Funds provided incomplete or potentially materially misleading information in the fund’s disclosure documents, such as the prospectus, SAI and shareholder reports.
CSS Perspective: Disclosure is at the heart of communicating to investors. The completeness and accuracy of a fund’s disclosure documents needs to be reviewed thoroughly by legal, compliance, operations and marketing personnel. The review must consider whether a fund’s operations have changed so as to require additional disclosure, particularly relating to fees, expenses and conflicts of interests, or deletion of outdated information.
The review of certain disclosure documents often requires numerous drafts and revisions. In order to allow time for meaningful reviews, the review dates should be included on a fund’s compliance calendar.
Section 15(c) Process
SEC Observation: Reasonably necessary information not requested or considered. The staff observed that certain fund boards did not request information relevant to the adviser while other boards received incomplete information.
CSS Perspective: Most RICs have fund legal counsel and often a board’s independent trustees have their own legal counsel. Fund boards should seek the advice of counsel respecting their 15(c) obligation and request that it is documented in a memorandum that is reviewed annually by the board in connection with a 15(c) review. Counsel should review the minutes of fund meetings at which the 15(c) review is conducted to verify that the minutes and related resolutions reflect that all 15(c) elements have been considered.
SEC Observation: Inadequate discussion forming the basis for board approval.
CSS Perspective: Counsel should review the minutes of fund meetings at which the 15(c) review is conducted to verify that the minutes and related resolutions reflect that all 15(c) elements have been considered.
Fund Code of Ethics
SEC Observation: Failure to implement code of ethics.
CSS Perspective: Rule 17j-1 requires every fund (other than a money market fund) and each investment adviser and principal underwriter to adopt a written code of ethics. A fund’s compliance program should include regulatory requirements; thus, the implementation of a fund’s code should be a component of its compliance program and reviewed no less frequently than annually.
SEC Observation: Failure to follow or enforce code of ethics.
CSS Perspective: As with any written policy, there must be a mechanism for administering the policy. Fund CCOs need to implement procedures for monitoring compliance with the Rule and process. The administration of the code of ethics should be documented to evidence that the policy has been implemented and is being followed.
SEC Observation: Code of ethics approval and reporting.
CSS Perspective: Similar to a Rule 15(c) process, a fund’s board needs to be aware of its responsibilities to a fund, including what items require review and approval. Fund or trustee counsel can assist a board with fulfilling its obligations by conducting board training and verifying that fund agendas include all the items required to be reviewed and approved by trustees. A fund’s CCO can also assist by incorporating such requirements into the 38a-1 compliance program review.
As noted, the Risk Alert also offered observations on money market funds (MMFs) and target date funds (TDFs). The Staff found MMFs to be in substantial compliance with the October 2016 amendments to MMF rules. Areas where deficiencies were observed included: eligible securities and minimal credit risk determinations; summary of significant stress testing assumptions; failure to adopt 2a-7 policies and procedures; and inaccurate or insufficient disclosure on websites and advertising materials. The Staff also observed the following deficiencies pertaining to TDFs: incomplete or misleading disclosure in prospectuses and advertisements; and incomplete or missing policies and procedures.
CSS Final Perspective: Be knowledgeable about the regulatory requirements for all types of RICs; develop and implement a compliance program that incorporates such requirements; and monitor and periodically assess that the requirements are being followed. Finally, never be afraid to reach out for assistance. If you need help, contact us.
SEC Proposes Amendments to Advertising Rules
In a proposal that would mark the first changes since 1961, the SEC has introduced amendments to modify the “Advertisements by Investment Advisers” Rule 206(4)-1 of the Investment Advisers Act. Changes to the rule would allow for testimonials and social media practices beyond that currently allowed, and performance marketing subject to new requirements. Some parts of the rule changes enshrine parts of no-action letters that have been used by the industry for decades. Other rule changes allow testimonials subject to disclosure of paid compensation. We note that the rule change expands the existing rule from 550 words and 2751 characters to 1830 words and 10,166 characters. Fifty-eight no-action letters covering applicable advertising topics are slated for review and withdrawal.
In addition to the rule changes, the SEC has proposed amendments to Form ADV Part 1, adding new Items 5.L.(1)-(5), which gather information about advisers’ Advertising Activities. Thirty-six additional no-action letters related to Rule 206(4)-3, the Cash Solicitation rule, are slated for review and withdrawal. Amendments include a name change of the rule to “Compensation for solicitations,” elimination of rules specific to affiliated persons, and adding private fund investor coverage. Thirty-five existing no-action letters covering Rule 206(4)-3 are slated for coverage.
Along with changing the rules, the SEC wants data to know what you are doing. Corresponding recordkeeping rule changes as well.
CSS continues to help advisers manage advertising rules. Our services will provide the new policies, the Sarasota 2020 Spring Conference agenda will cover the must knows, and a ComplianceCast webinar is being planned. We manage policies and procedures and conduct advertisement reviews for firms who want to know the answers. If you need help, contact us.
Roadmap to Conducting Annual Compliance Reviews
The “annual” in annual review is a misnomer! That was one of the key takeaways from a session conducted at the recent 2019 NSCP National Conference that featured practical and timely tips to consider when planning and undertaking an annual review for an investment adviser or mutual fund. Panelists Tracy Abbott, CCO of Seavest Investment Group and Allison Fraser, Director, Registered Investment Company Services for CSS, cautioned attendees not to wait until year end to cram a whole year’s worth of reviews into a few days. Instead, they highly recommended that firms outline a periodic (quarterly, monthly) compliance testing plan and perform the testing throughout the year.
To illustrate their original point, they highlighted the SEC’s enacting release, which states: “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.” Ms. Fraser stressed that the review should not only look backwards, but also forwards in terms of evaluating the effectiveness of the adviser’s compliance program with respect to identifying enhancements to the compliance program.
Another point that was stressed by the panel pertained to the documentation of the review testing; as many in the compliance world can attest to, if you don’t document a review, then regulators may take the view that it wasn’t really completed. Documents that reflect the testing results can also be used to outline any remedial measures called for by the testing results. In short, one of the key takeaways from this panel is that advisers should conduct reviews continuously throughout the year and then compile the results and recommendations annually.
Who should perform your annual reviews? To address this question, the panel outlined some hands-on steps to evaluate:
- Determine which business units or personnel will assist with conducting the review
- Establish to whom the annual review results will be reported
- Identify the focus areas or business functions that will be reviewed and tested
- In addition to the focus areas identified by the SEC, consider whether any firm specific topics should be included
- Establish a consistent process for memorializing the testing and results
Next, the panelists also tackled an often-asked question: “What issues should I include in my annual review?” They agreed it should include any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies and procedures.
If and when the SEC examines your firm, be ready to answer some questions regarding your annual review. In 2006, then-SEC OCIE Associate Director for Examinations Gene Gohlke enumerated the nine questions that SEC examiners consider. They are:
- Who conducted the review?
- What was reviewed?
- When was the review conducted?
- How was the review conducted?
- What were the findings from the review work?
- What recommendations were made?
- What is the current status of implementing recommendations?
- What documentation was created/retained to reflect the work done?
- What was the involvement of senior management in the review?
With the reviews and testing complete, the panelists tackled the question concerning the best method to present the review results. Regarding a format for the annual review report, the panel suggested the following:
- Executive Summary
- Introduction
- Description of Risk Inventory
- Summary of Review Methodology/Types of Testing
- Evaluation Methodology for Subject Matter Areas
- Reliance on Third Party Independent Assessments
Finally, Ms. Abbott pointed out that the Annual Review Report isn’t just about where your firm has been, it’s also about where it is going. She suggested spelling out, in addition to testing results, the following topics in the report: state of the union for compliance, strategic plans, future projects, new/pending regulations, and staffing and technology needs. The annual review is an ongoing process. Stay on top of it!
Need help with annual reviews or other compliance services? Check out our list of services and contact us.
Technology Advances Here and On the Way for Form CRS
CSS featured a strong presence at the recent 2019 BAM + Loring Ward Advisor National Conference in St. Louis, Mo. The conference, titled “In Our Element,” explored the chemistry of investment advisors’ relationships with their clients and the keys to successfully building those relationships.
Within that context, CSS’s compliance presentation outlining the purpose and implementation of Form CRS was a perfect match. The new Form CRS, a/k/a Form ADV Part 3, must be completed by SEC registered investment advisers and filed with the SEC by June 30, 2020. The new Form CRS is designed to highlight differences between the key characteristics of broker-dealers and investment advisers, i.e. the elements of the relationships between registered investment advisers (RIAs) and registered brokers-dealers (BDs), and their respective clients.
Form CRS is a continuation in the evolution of our U.S. regulatory thinking regarding the need to clarify the different obligations that RIAs and BDs owe to the investors they serve. It’s another new regulatory obligation requiring more time and energy from Chief Compliance Officers and all of the financial professionals at RIAs and BDs. CSS will soon announce more about its regulatory solutions for Form CRS and the related Regulation BI applicable to BDs.
The conference organizers tied it all together so well. Amidst numerous sessions about operating an independent advisory business, the most enjoyable was a sit down with Bill Nye, the Science Guy. He told us to realize and remember that changing people’s minds from engrained beliefs can take years. For example, he poignantly identified the changing understanding by the retail investor that stockbrokers do not by their very nature have market insight.
The Science Guy provided his own example. He explained that he had stubbornly been opposed to genetically modified foods but with new information, including the possibility of growing vegetables that produce vitamin B-12, he has changed his mind. He also noted that Burger King’s Impossible Whopper is so good because the makers genetically modified plants successfully to make the plants taste like meat.
The Science Guy concluded that we all should be optimistic to create great change. As an example, he told us that our grandchildren will wonder why we drove such inefficient vehicles.
CSS feels the same way about compliance and regulatory reporting solutions. When Form PF was introduced for private fund managers almost a decade ago, CSS was the leader in providing a solution to the market. Today, CSS provides shareholder threshold and position limit monitoring globally, transaction analysis and reporting solutions required by the latest European Union regulations. Same thing for Form CRS and Regulation BI. When you see our solution, you will be optimistic about change.
If you need more help on Form CRS, visit our Ultimate Guide to Form CRS page, with information about the regulation, as well as our solution.
How to Become a Compliance Influencer
Long gone are the days when compliance was grudgingly accepted as a necessary optic to largely allay the regulators and viewed, by many, negatively as an expense line item that needed to be kept to a minimum. At the recent CSS Fall 2019 Conference, a lively panel provided an informative timeline covering the evolution of the compliance function from these old-school days to where it stands today as a much needed and valued business partner.
As discussed by this panel, perhaps most importantly, compliance, and the Chief Compliance Officer specifically, plays a critical role in fostering integrity within their firms. One of a CCO’s key functions is to act in a consulting capacity by providing regulatory guidance and business advice internally to help keep the firm in compliance with applicable rules. As part of this mission, CCOs must work with senior management to instill a culture of compliance and advance an environment where all staff members understand the critical importance of maintaining high levels of integrity. Just as importantly, creating an environment where staff can feel free to speak up if they see the need to address a compliance concern adds a critical element to a firm’s compliance culture.
So, how can one become a compliance influencer?
The panel laid out a multi-pronged plan that focused on developing trust, character, building competence, compliance message consistency and, most importantly, listening to your peers. John Walsh, Partner at Eversheds Sutherland (US) LLP noted that studies have shown that one can build influence by closely listening to others. All panelists agreed that developing personal connections within your firm is a critical component to gaining influence, as well as gaining an understanding of your organization and the audience for your compliance program message. A little internal political savvy goes a long way as well in identifying key players that can advance compliance program interests.
The panel then discussed the critical difference between supervision and compliance and made the point that compliance should be more of a business partner or consultant, not a supervisor of business unit functions. CCOs don’t run the trade desk and are not responsible for deal due diligence – supervisory staff in the business units are. Compliance should serve to provide business and regulatory guidance to management and then serve in a surveillance role, bringing any exceptions to the attention of management for their consideration. Walsh noted that management must understand the supervisory role they play by actually reading the compliance manual and learning what functions they can be held responsible for.
Mark Happe, CCO of AIG Life and Retirement, encouraged attendees to develop an annual compliance plan that involves input from business unit management. Creating such plans for each business unit will aide in determining how and what compliance and supervisory issues must be tackled, by identifying goals, drafting a plan to achieve the goals and then monitoring progress towards reaching the goals.
Another key ingredient to developing and implementing the compliance plan focused on the importance of delivering a strong, consistent message on the role and importance of compliance, both in communicating to senior management and staff.
When delivering your message to senior leadership, Walsh and Matt Calabro, Director of Institutional Wealth Manager Services at CSS, stressed the importance of communicating the significance of maintaining a robust compliance program and highlighting the role compliance plays within the firm to protect clients and the firm’s reputation. The panel agreed that setting the right “tone at the top” firmwide is critical; given the vital role that CCOs play, they need to be supported by senior management. CCOs, of course, can never go solo. An effective compliance program must begin at the top of the organization. The need for senior management to support compliance is not just a good business practice, but also a business necessity. Calabro stressed that when communicating the importance of compliance to staff, employ the “KISS” strategy: use plain English, be concise, and lay out simple actionable steps.
Now, some panel takeaways for becoming a compliance influencer:
- Participate on executive or similar committees to reach out to senior management and ensure that your counsel is heard and understood;
- Have periodic independent reviews conducted by outside parties to help identify any overlooked issues and avoid an internal, silo group think culture (i.e. use consultants, law firms etc.)
- Build trust by being willing to listen to staff; an open-door policy is key to fostering an environment where staff believe that the CCO is approachable.
- Be strategic and holistic in developing your compliance plan, as compliance should never be a “check the box” exercise.
- Always keep an open mind to learn what you can do better.
- Pay close attention to due diligence questionnaires (“DDQs”) content, which are more detailed than Form ADV 2A disclosures. Ensure that the DDQs are in agreement with other disclosure documents.
- Learn to sell compliance to senior management by emphasizing the critical role it plays in protecting clients and the reputation of the organization.
Tips on monitoring the compliance function:
- Keep a log of all staff that call or meet with you to better learn who is seeking (and following) your advice
- Monitor internal traffic to sites such as the code of ethics or compliance policies, in particular, after training presentations to help determine if your training message has traction
- Monitor internal audit (or similar) findings and remediation
- Track SEC findings and remediation
In closing, in a speech on June 29, 2015, former SEC Commissioner Luis A. Aguilar, addressed the need for firms to support the role of chief compliance officers, when he noted: “A company’s senior leadership should be strong advocates for a robust and enduring culture of compliance; such a culture fosters an environment where everyone understands the firm’s core values of honesty and integrity.” Without a doubt, adhering to Mr. Aguilar’s views will start you off in the right direction to enhancing your role as a compliance influencer.
Tips From the Field to Enhance Your Compliance and Supervisory Programs
At the recent CSS Fall 2019 Conference, experienced professionals Jeff Blumberg of Faegre Baker Daniels and John Gentile of CSS provided practical solutions for in-house compliance pros. Regulators, in-house compliance personnel, and outside compliance and legal counsel understand all too well that compliance should not be a separate department from the rest of the advisory business—but how can compliance officers get that message across to their management and colleagues from other departments? As Gentile and Blumberg put it, “the challenge is getting everyone else to buy in that compliance is part of their job every day, not just when you call them.”
And how to meet that challenge? Here are some tips:
- Know the difference between supervision and compliance. Compliance officers do not supervise unless they have the authority to change/modify behavior with the authority to establish and implement repercussions.
- Utilize outside support, including third-party assessments, reviews, and mock exams. While an adviser is not likely to be able to rely on the attorney-client privilege for certain core compliance endeavors, such as an annual review per the Compliance Program Rule, there are plenty of analyses outside professionals can perform to support the in-house compliance function.
- Read the Adopting Releases for rules when your employer is doing something that does not directly fit within a rule; these Adopting Releases help one understand the purpose behind the rules, an understanding that regularly assists when dealing with “the gray areas.”
- Put together a risk inventory to share with other departments, supervisors, and management.
- Be organized. In other words, put together a compliance committee; utilize a compliance calendar; demand regular meetings with management; ask for appropriate staffing; and set internal deadlines that are in advance of the actual deadlines within a rule (to avoid a true violation of a rule).
Please feel free to contact us at Compliance Solutions Strategies to obtain additional support for your Compliance Program, or register for our next conference, to be held in Sarasota in April 2020.