SEC Holds National Outreach Seminar for CCOs of Investment Advisers, Investment Companies

Transcription

1 December 2005 / Issue 25 A legal upate from Dechert s Financial Services Group SEC Hols National Outreach Seminar for CCOs of Investment Avisers, Investment Companies On November 8, 2005, the Securities an Exchange Commission (the SEC ) sponsore the CCOutreach National Seminar for investment aviser an investment company Chief Compliance Officers ( CCOs ). 1 The purpose of the seminar was to allow the SEC an its staff to better communicate an coorinate with CCOs of avisers an mutual funs on topics CCOs wante to aress, following similar CCO outreach seminars conucte on a regional level. Registere investment avisers an registere investment companies are require to aopt a written compliance program pursuant to Rule 206(4)-7 uner the Investment Avisers Act of 1940, as amene (the Avisers Act ), an Rule 38a-1 uner the Investment Company Act of 1940, as amene (the Company Act ), respectively. 2 Moreover, Rule 206(4)-7 an Rule 38a-1 require that an aviser an investment company appoint a CCO to aminister the aviser s an fun s compliance policies an proceures. 3 Hege fun managers that are in the process of registering as investment avisers with the SEC pursuant to Rule 203(b)(3)-2 uner the Avisers Act will also be require to aopt a written compliance program an to appoint a CCO pursuant to Rule 206(4)-7. 4 Non-U.S.-base avis- 1 Panelists at the seminar inclue SEC officials an CCOs from mutual fun complexes an investment avisory firms. A webcast of the seminar can be accesse at 2 See Release No. IA-2204 (December 17, 2003) (the Compliance Rule Release ). 3 See Rule 206(4)-7(c) uner the Avisers Act an Rule 38a-1(a)(4) uner the Company Act. 4 See Release No. IA-2333 (December 2, 2004). ers that are registering with the SEC but are following the Regulation Lite regime are not require to aopt a written compliance program or to appoint a CCO. 5 Nevertheless, the topics iscusse at the seminar remain relevant because registere non-u.s.-base avisers are subject to the anti-frau provisions of the Avisers Act an to inspection by the SEC staff. Key Consierations for CCOs Base on the issues iscusse an the practices escribe, CCOs of registere investment avisers an registere investment companies shoul consier the following: 5 Be proactive. When a problem is ientifie internally, the CCO shoul unertake immeiate steps to correct the problem, an revise the compliance policies an proceures as appropriate. Aress the issue contemporaneously, as oppose to waiting to aress the problem at the time of the annual review of the compliance program. Review the compliance program an operations for potential conflicts of interest. The SEC has mae it clear that areas where conflicts of interest may exist will be closely examine. Conflicts of interest may likely arise in the following areas: The allocation of investments an sie-by-sie management Soft ollars See supra note 4.

2 Performance fees Valuation Agency an cross traes Principal traes Personal traing Proxy voting Document the CCO s review an what steps were unertaken to improve the organization s compliance program. Review of an organization s compliance program is a constant process. An aviser s or mutual fun s compliance policies an proceures manual is not a static ocument; it shoul reflect the ynamics of the market place an the organization s operations. As rules an regulations change, an an organization s business evolves, the compliance program shoul be revise accoringly. Pay particular attention to the firm s valuation policy. A CCO shoul work with the portfolio manager an others in the business unit in rafting the valuation policy. It will be important to have the valuation process be as transparent as possible. Documentation in support of valuation, especially illiqui securities an complex proucts such as erivatives, will likely be critical. The following is a more etaile summary of the key issues iscusse at the seminar. Panel I: The Role of the CCO an the Annual Review Role of the CCO In the Compliance Rule Release, the SEC staff state that the CCO shoul have sufficient seniority an authority to compel others to ahere to the compliance policies an proceures. The SEC staff also state that the esignation of a CCO shoul enhance the efficiency of funs an avisers operations by centralizing responsibility for the compliance function. Those themes were emphasize at the seminar. A recurring phrase share by the panelists is that the CCO be empowere to compel compliance an be the focal point for compliance. Accoring to Gene A. Gohlke, Office of Compliance Inspections an Examinations of the SEC, someboy has to be in charge an be a single point where compliance comes to rest. The CCO is to manage the compliance program an it is the business unit that executes compliance. In other wors, the CCO is to facilitate the ability of others to carry out their compliance responsibilities. Communication between the CCO an senior management an the boar of irectors of funs is critical. The CCO shoul have irect access to senior management an to irectors. Also, the CCO shoul keep senior management an irectors apprise on a real-time basis an not necessarily wait for the annual report with respect to compliance issues. The CCO shoul also have the full backing of senior management. Having senior management buy in to the compliance program sens a strong signal to all employees of the aviser or the fun that the organization is committe to compliance an therefore, everyone is expecte to ahere to the organization s policies an proceures. Hiring a Service Provier to Serve as the CCO The SEC recognizes that small avisers may hire a consultant to serve as the CCO. Robert Plaze, Division of Investment Management of the SEC, gave the example of a small hege fun run out of the office of a prime broker. In such a situation, the prime broker coul be in the position to provie the CCO. However, Mr. Gohlke expresse reservations about whether an employee of a service provier being a CCO on a part-time basis can truly be effective, an questione whether a part-time CCO coul be empowere to monitor an compel compliance. Some participants suggeste that a part-time CCO woul be ineffective, noting how important it is to be physically present at the office an on the traing floor. By being physically present, a CCO quite often hears or sees things that coul become a problem, but is there to aress them. SEC Staff Expectations of the CCO A concern of the inustry is whether being the CCO is tantamount to wearing a bull s-eye that the SEC then targets for an avisory firm s or fun s failures or viola- December 2005 / Issue 25 2

3 tions. Mr. Plaze note that the CCO oes not perform the activities that traitionally get people in trouble, such as traing. He note that in SEC enforcement actions where a CCO has been sanctione, the CCO was performing other uties, such as oing price reconciliations. Accoring to Mr. Plaze, what gets the CCO in trouble is when the CCO participates in the frau, facilitates the frau, or attempts to cover up the frau. Hallmarks of a Robust Program It is important to ientify a problem quickly after it occurs an to correct the problem as soon as possible. When the SEC staff conucts a routine exam, OCIE will ask for a list of material compliance issues. SEC examiners will look to see how each problem was resolve or is being resolve. Annual Review Avisers an mutual funs are require to review their policies an proceures annually to etermine the aequacy an effectiveness of their implementation. 6 The annual review is an opportunity to look back to check whether something was misse. The annual review can be characterize as a survey in which the CCO shoul aress the following: What has change? Shoul compliance policies change? What were the failures? What i the firm o to correct the failures? Panel II: Exams an Inspections The Examination The CCO is the point person uring the exam. The SEC oes not expect the CCO to know all the answers. However, the SEC expects the CCO to know where to go to get answers an obtain requeste ocuments. 6 See Rule 206(4)-7(b) uner the Avisers Act an Rule 38a- 1(a)(3) uner the Company Act. Mutual funs are subject to the aitional requirements that the fun review the policies an proceures of their service proviers. Also, the CCO of a mutual fun must submit its annual report to the fun boar for review. The SEC will likely interview the hea of traing, the hea portfolio manager, the CFO, the hea of marketing an the person responsible for fun pricing. The examination staff will focus its attention on compliance controls an management oversight. Areas of Focus When reviewing the compliance program, the SEC examiners will review the program as a whole from 40,000 feet an then assess the program for any risks. The SEC examiners will focus on certain areas where they see conflicts of interests arising. In aition, there are several core areas that are examine: anti-money launering; business continuity; traing, execution, an soft ollars; avertising an marketing; personal traing; an allocations of investment opportunities. Common eficiencies cite are performance avertising, soft ollars, an the allocation of investment opportunities. On soft ollars, avisers shoul pay more attention as to what they are paying out an tie it to the value of the research receive. On the allocation of investment opportunities, the SEC examiners will review the trae blotters, an the internal analysis in support of allocation ecisions. Tone at the Top When reviewing the compliance program, the SEC examiners will consier the tone at the top. With respect to a small aviser, this means assessing the key iniviuals of the aviser. When interviewing a key iniviual, the SEC staff will assess the following: What is the person s view regaring compliance? Does the person have respect for compliance? Is there an emphasis on ethical behavior? Is compliance something that is out of sight, out of min, or is it something that the person thinks about? Is this person forthcoming or obstinate uring the interview? December 2005 / Issue 25 3

4 Deficiency Letters With respect to response letters, the SEC prefers that a senior officer respon to the eficiency letter an sign the response letter. The SEC expects that the person writing the response letter is the one taking responsibility for the changes being implemente after eficiencies have been ientifie by the SEC staff. The SEC oes not like a response letter that is rafte in general terms stating that we will aress X, Y, an Z. The SEC prefers that the response letter escribe the actions that have alreay been unertaken in response to the eficiencies an any actions that the aviser is planning to take. Panel III: Traing an Market Issues Soft Dollars/Best Execution 7 The panelists gave a real worl account on how their respective firms assess soft ollars an best execution. One panelist state that his firm has a Brokerage Review Committee. The Brokerage Review Committee consists of the chief traer, the CCO, an representatives from operations, legal, an compliance. Detaile minutes are taken. The issues that the Brokerage Review Committee aresses inclue traes uring the past quarter, the costs of execution, the percentage of soft ollars allocate, the percentage of har ollars allocate, an the research receive. When the cost of an execution is higher than usual, the Committee reviews the reasons why was it because it was a ifficult trae or because creit was given by the broker? A secon panelist state that her firm also has a soft ollar/best execution committee. The committee consists of representatives from research, traing, compliance, an marketing. The committee rates each brokerealer use, incluing such factors as the research re- 7 Note that conventions governing the use of soft ollars may change in the near future. The SEC publishe for comment a propose interpretive release with respect to client commission practices uner Section 28(e) of the Securities Exchange Act of 1934, as amene. See Release No (October 19, 2005). The U.K. Financial Services Authority recently aopte new rules governing the use of soft commissions in July See U.K. Financial Services Authority, Policy Statement 05/9, Bunle Brokerage an Soft Commission Arrangements: Feeback on CP 05/5 an Final Rule (July 2005). See also Dechert Onpoint: SEC Releases Interpretation of Soft Dollar Usage by Money Managers (Nov 2005 / Issue 23). ceive, the availability of the analyst, the market strategy, the quantitative research, an the technical research. The committee also reviews the soft ollar buget. During an SEC examination, with respect to brokerage review committees, the staff reviews what topics are aresse an examines the minutes of the committee. Also, the SEC examiners check whether there are controls in place to monitor execution. Avisers an funs shoul consier an aress the following areas: Client irecte brokerage Use of commission funs to pay for fun istribution or client referrals Proucts an services receive from brokers in aition to trae execution Mixe use proucts Use of affiliate brokers Use of step out traes Use of introucing brokers an commission sharing arrangements With respect to mixe use proucts, the SEC examiners will review the allocation between research an nonresearch, as well as evience that the allocation was appropriate, accurate, an ocumente. Furthermore, they will examine the aequacy of isclosure an will look to see if there are soft ollar proucts an services that are not being isclose. Panel IV: Other Regulatory Issues The staff note that electronic ocuments are not treate ifferently from paper ocuments. Moreover, the SEC staff has access to all ocuments maintaine by an aviser pursuant to Section 204 of the Avisers Act. The SEC typically will not request that s be prouce at the beginning of an examination. Rather, after reviewing the aviser s or fun s compliance activities, an having ientifie areas that warrant a more in-epth review, the staff will submit a seconary request December 2005 / Issue 25 4

5 whereby the SEC will request the s of persons involve in key areas ientifie by the staff. Participants note that there is a cost to retain , an it is a business ecision to either sort out to etermine what to retain or to keep it all. The panelists conclue that it woul be reasonable for an aviser or fun to use a sampling process to review a batch of e- mails on a perioic basis to ensure that require recors that nee to be maintaine are not being estroye. It was note that a firm woul be at a heightene risk if it was not reviewing . A suggeste means to monitor is through sampling. For example, a firm woul ientify certain persons who are at a higher risk to abuse or to participate in a scheme that harms clients an then perioically review their . Another suggeste means of monitoring woul be to review a ranom sample of s of various employees. Coe of Ethics 8 The panelists gave real worl examples of provisions inclue in their firms coe of ethics. One panelist state that in aition to what is statutorily require in a coe of ethics, her firm also imposes restrictions on gifts, which is a best practice. As part of the restrictions on gifts, employees are require to complete a gifts log. A secon panelist escribe the blackout perio restrictions applicable to the personal traing of employees. A staggere tiere policy applies: non-traer employees are subject to a one ay blackout, an portfolio managers, traers, an analysts are subject to a seven ay blackout perio. Also, if a security is part of the portfolio or is uner consieration, then an employee may not trae that security. SEC staff members inicate that they preferre that personal securities transaction reports be maintaine in electronic format as oppose to paper format, especially if the aviser or fun is a large organization. Maintaining personal securities transaction reports in elec- 8 Registere investment avisers an registere investment companies are require to aopt a coe of ethics. See Release No. IA-2556 (July 2, 2004). Note that registere non- U.S.-base avisers that are complying with the Regulation Lite regime are require to retain their access persons personal securities reports that are require pursuant to Rule 204A-1 uner the Avisers Act. See supra note 4. tronic format facilitates the comparison of the holings of an access person s personal traing against a fun's portfolio or client s account. Form ADV CCOs shoul expect to receive reminers via that Part I of Form ADV is to be upate prior to the annual upate ealine. 9 The SEC will also communicate reminers, changes of law, an notices to CCOs via e- mail. In aition, the SEC staff will issue a perioic newsletter, the CCObserver, that will aress issues of interest to CCOs new rules, interpretive releases, recent examination finings, an relevant enforcement actions. The SEC staff also inicate that when the revise Part II is release, it will be entirely in narrative format. AML The SEC staff inicate that the U.S. Treasury may move forwar on final rules to require investment avisers an unregistere investment companies to aopt an anti-money launering program. 10 Valuation The SEC will assign a risk rating to an aviser s or fun s valuation policy. The rating is base on the composition of the fun s portfolio. A portfolio that is compose of exchange trae U.S. equity securities woul be consiere low risk. A portfolio that is compose of a broa range of securities publicly trae, thinly trae, U.S. securities, non-u.s. securities, futures woul be treate as high risk. If a portfolio is characterize as being high risk, even if the valuation controls are goo, the SEC examiners will closely scrutinize the valuation policy. 9 A registere investment aviser is require to amen Part I of Form ADV at least annually, within 90 ays of the aviser s fiscal year en. See Rule 204-1(a)(1) uner the Avisers Act. 10 See Financial Crimes Enforcement Network; Anti-Money Launering Programs for Investment Avisers ; propose rule. 68 Fe. Reg (May 5, 2003) an Financial Crimes Enforcement Network; Anti-Money Launering Programs for Unregistere Investment Companies ; propose rule 67 Fe. Reg (September 26, 2002). December 2005 / Issue 25 5

6 This upate was authore by George J. Mazin ( ; John V. O Hanlon ( ; john.ohanlon@echert.com), Keith T. Robinson ( ; keith.robinson@echert.com), an Roerick J. Cruz ( ; roerick.cruz@echert.com). Aitional practice group contacts For further information, please contact the authors, one of the attorneys liste, or any Dechert LLP attorney with whom you are in regular contact. Visit us at Saner M. Bieber saner.bieber@echert.com Robert W. Helm robert.helm@echert.com Keith T. Robinson keith.robinson@echert.com Timothy M. Clark timothy.clark@echert.com Jane A. Kanter jane.kanter@echert.com Alan Rosenblat alan.rosenblat@echert.com Douglas P. Dick Newport Beach ouglas.ick@echert.com Stuart J. Kaswell stuart.kaswell@echert.com Freerick H. Sherley Charlotte freerick.sherley@echert.com Ruth S. Epstein ruth.epstein@echert.com George J. Mazin george.mazin@echert.com Patrick W. D. Turley patrick.turley@echert.com Susan C. Ervin susan.ervin@echert.com Jack W. Murphy jack.murphy@echert.com Brian S. Vargo Philaelphia brian.vargo@echert.com Joseph R. Fleming Boston joseph.fleming@echert.com John V. O Hanlon Boston john.ohanlon@echert.com Davi A. Vaughan avi.vaughan@echert.com Brenan C. Fox brenan.fox@echert.com Jeffrey S. Puretz jeffrey.puretz@echert.com Davi J. Harris avi.harris@echert.com Jon S. Ran jon.ran@echert.com December 2005 / Issue 25 6

7 U.S. Boston Charlotte Harrisburg Hartfor Newport Beach Palo Alto Philaelphia Princeton San Francisco, D.C. U.K./Europe Brussels Frankfurt Lonon Luxembourg Munich Paris 2005 Dechert LLP. All rights reserve. Materials have been abrige from laws, court ecisions, an aministrative rulings an shoul not be consiere as legal opinions on specific facts or as a substitute for legal counsel. December 2005 / Issue 25 7