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ICI Guidelines Seek to Calm CCO Nerves: Provide Road Map to Implementation of Rule 38a-1

The Investment Company Institute of Washington has released a paper that serves as a road map of sorts for chief compliance officers who might be wrestling with their mutual fund's annual review, which is due to fund boards this spring.

The 34-page document, titled "Assessing the Adequacy and Effectiveness of a Fund's Compliance Policies and Procedures," is designed to help fund complexes comply with Rule 38a-1 under the Investment Act of 1940. Adopted by the Securities and Exchange Commission two years ago in the wake of the fund scandal, the rule requires funds to adopt and implement written policies and procedures reasonably designed to prevent Federal securities laws violations.

The rule also requires funds to review the regulatory checks and balances of their third-party service providers and to designate a CCO to administer the fund's compliance policies and procedures.

But the rule was met with much hand wringing by the money management industry, as it never offered any concrete guidance on exactly what sort of policies and procedures a fund should implement; nor did it provide a hint of how a CCO might conduct an annual review, or how much information should be included in a report to fund boards. It also appeared to place all compliance accountability squarely on the shoulders of the newly created CCO position, which in today's heightened regulatory environment, seemed a responsibility no executive would embrace enthusiastically.

Two years later, despite a spate of industry conferences that examined the rule and a number of CCO outreach seminars hosted by the SEC, some fund executives are still experiencing high anxiety, said Margaret Sheehan, a partner in the financial services and product group at the law firm Alston Bird in Washington.

"On the one hand is the CCO that's waiting for a sign that this heightened regulatory environment is lightening, but they're not seeing it," she said. "They're also still experiencing anxiety over what might be their personal liability.

"And then there are other CCOs that see that there's a lot of power and autonomy built into this rule, and they're flexing their muscles," Sheehan said.

Ultimately, she said, a CCO's comfort level depends largely on the size of the fund. Full-time CCOs are far out in front of Rule 38a-1, but those executives who have been saddled with the title in addition to their previous responsibilities could benefit greatly from the ICI paper.

"If the 40 Act isn't something they deal with on a daily basis, they might need a road map, but most of my larger clients already have this thing nailed," she said.

Shareholder activist Mercer Bullard, founder of Fund Democracy of Oxford, Miss., agrees.

"Most large fund complexes already have many of these [policies and procedures] in place," said Bullard, a former assistant chief counsel in the SEC's division of investment management. "But many CCOs continue to struggle with how to manage communication with the fund board and how to keep this from becoming an exercise in micromanagement."

Nonetheless, he said, the ICI paper comes as good news to investors.

"It will provide a benchmark that the average CCO would find difficult not to meet," he said.

Elizabeth Krentzman, general counsel at the ICI, admits that there isn't a lot of new material in the paper, but she said it puts everything a CCO might encounter during the review process and board presentation into one place and in plain English.

"The SEC put forth the legal framework, and we've put together the how,'" Krentzman said. "A lot of it isn't necessarily new - we all know what an exception report is and what a reconciliation report is, for instance - but this puts in one place all the options available to a CCO and the pros and cons to each," she said.

"All of these things are evolving, too," Krentzman added. "We very well could be updating this paper in another couple of years."

One early suggestion in the paper is that a CCO develop an annual review game plan, or a checklist that identifies the areas to be reviewed. A key part of that planning process, the paper indicates, is to consider which areas of the business pose the highest compliance risks. For example, a CCO might want to focus on areas where potential conflicts of interest exist, or areas where there have been significant policy or procedural changes in the last year. Places where managerial changes have recently occurred, or those areas where an inexperienced manager might be in charge, also demand attention.

It further suggests that in their fund board reports, which are due 60 days after the initial review is conducted, CCOs should avoid delivering a "data dump." Instead, the paper offers, reports "should provide fund boards with meaningful and concise information in understandable language," and "reflect the CCO's attempt to synthesize and analyze the fund's compliance program."

A CCO might also want to consider sitting down with a board member to briefly discuss the report's content prior to the official presentation, the paper suggests. While the paper doesn't improve on the SEC's guidance on how egregious a compliance violation must be before a CCO should make the board aware, the paper seems to suggest that a CCO would be wise to err on the side of caution.

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