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The Compliance Rule: One Year Later

Here we are, one full year after the Securities and Exchange Commission adopted a new compliance program through Rule 38a-1 under the Investment Company Act of 1940, requiring fund boards to adopt written compliance policies and procedures reasonably designed to prevent violations of the federal securities laws by fund complexes, including compliance oversight of certain service providers.

Even a full year later, the industry arguably is not any more knowledgeable about the SEC's expectations than when the rule was adopted. That is because, in many respects, Rule 32a-1 is a mere skeleton to which a mutual fund board and its chief compliance officer must add muscle and flesh to make it a living, breathing constitution of principals and standards of conduct for the fund and its service providers.

Unfortunately, this task is akin to giving a hospital resident a scalpel on his first day of residency and telling him to scrub in and perform surgery. One slip, and it is all over. And I am not talking just about the patient's livelihood.

Just like the resident, a fund CCO wants and needs more guidance before jumping into the assigned task of implementing the rule's directives. Fortunately, there is no dearth of unofficial guidance in the form of articles in publications, meetings of industry support groups, such as the Investment Company Institute is hosting this week, and others who make a livelihood out of this, such as myself and other professionals.

Following are trends I have seen regarding the rule's implementation, particularly the initial annual review and the CCO's interaction with service providers.

First, let's note that the rule's scope covers not just written policies and procedures of the fund, but also policies and procedures for compliance oversight of the investment advisor, distributor, administrator and transfer agent. However, many funds have deemed it prudent to expand their oversight beyond these required service providers to include custody and fund accounting functions, because these activities bear directly on the fund's ability to comply with federal securities laws. Thus, to the extent the compliance function extends to such functions, so must the annual report.

Second, the rule doesn't clearly identify who should be performing the review and how. One section of the rule requires the fund to annually review the adequacy of the compliance program and the effectiveness of its implemention. But complicating matters here even further, it doesn't clarify if it is the CCO, the board or both that is supposed to be reviewing the compliance program.

Then, the next section of the rule states that the CCO is responsible for implementing the compliance program and that they must deliver a written report to the board, at least once a year, that "addresses" the operations of the compliance program and any materials changes, including changes recommended as a result of the annual review of its adequacy.

So who really has the responsibility for performing the review?

I think the practical answer is that the CCO must perform the necessary due diligence and prepare their written report on the results, while the board must review the report.

Further complicating matters is that the rule does not specify that the CCO's written report must address each "material compliance matter," which means any compliance matter that the fund's board would reasonably need to know to oversee fund compliance. This would involve, without limitation, violations of federal securities laws or of the compliance program, or even weaknesses in the compliance program's design and implementation.

As far as the annual review and reporting process is concerned, many boards and CCOs are not waiting to complete the initial written report within the first 18-month deadline, and are planning to present subsequent reviews and reports more frequently than just once a year, for a number of good reasons.

First, the rule requires that the review of the compliance program, the delivery of the written report and the executive session meeting of the CCO and independent board members occur "no less frequently than annually." Footnote 84 of the rule's adopting release indicates that if there is a material compliance matter, then it should be important enough to communicate sooner rather than later. This allows the CCO and board to establish a relationship and understanding with each other on the form, material substance and frequency of ongoing communications.

Further, the SEC has also been conducting its CCO exams, in which it asks probing questions about compliance programs, the CCO's approach and their overall efficacy.

Thus, each written communication of a CCO's activities documents the steps taken to date toward completing the initial written report within the 18-month deadline.