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Examining Your Fund's Internal Operations

If you want to ace your examinations by the U.S. Securities and Exchange Commission, remember these three phrases: fund governance, fraudulent activities and performance and advertising.

These are 2012's big exam focuses outlined by the SEC's Office of Compliance, Inspections and Examinations in a report released February. Attorney Paul Miller is making sure all of his mutual fund clients are cramming accordingly.

"You can't stress enough to compliance officers of mutual funds to pay attention to this report and those focus areas," says Miller, a partner in the investment management group at the Washington, D.C.-law firm Seward & Kissel. "The OCIE has informed funds of what it will focus on during exams, so it would be prudent for funds and their compliance officers to focus particularly on those points."

Acing these on-site exams though is harder than it sounds, for this year promises to be a rough ride for compliance officers everywhere.

Funds face uncertainty over a number of factors- regulators, Europe and illiquid assets to name a few- and that means compliance people must know their operations cold. Due diligence on steroids is the major theme of the season.

"It is important to understand how your business operates, who your employees are communicating with and what those communications are about," says D.J. Gorman, who is chief compliance officer of the Oakmark Funds and will serve as a panelist at the Mutual Fund Compliance Programs Conference hosted by the Investment Company Institute in May.

Fund Governance

Mutual funds need to answer one fundamental question: Are executives meeting their fiduciary duties?

This issue is a moving target due to uncertainty on a number of regulatory fronts, according to Matthew Vogel, a partner at the law firm of Quarles & Brady. There is uncertainty about implementation of the 2,000-plus page Dodd-Frank Wall Street Reform Act. Multiple regulatory agencies are trying to assert jurisdiction over mutual funds. Meanwhile, continuing court challenges to the SEC's rulemaking process makes industry insiders worry whether the regulator will get to enact any effective rules whatsoever.

"The Dodd-Frank Act mandated such a huge number of rules for the industry and in many instances did not provide rule-makers with a lot of the specifics that could have expedited their rulemaking process," says Vogel.

Turf wars between the SEC and the Commodity Futures Trading Commission aren't helping.

In February, CFTC commissioners approved major changes in Rule 4.5, governing how and when investment funds can exclude themselves from registering as Commodity Pool Operators. The amendment removed many of the permissible conditions from exclusion, and could cost commodity-trading funds a bundle by placing them under both agencies.

"The CFTC Rule 4.5 amendment basically requires funds that invest in futures to limit such investments substantially or comply with applicable CPO requirements, which could impose substantial costs on funds and their advisers," says Miller.

The rule faces a lawsuit, recently filed by the ICI and the U.S. Chamber of Commerce, alleging 4.5 violates both the Commodity Exchange Act and the Administrative Procedure Act.

Mutual funds, consequently, must drill down on all their operations.

For example, Oakmark's Gorman says that funds with sovereign debt need to make sure that they can price these securities the best way possible, and understand what could happen in the event of a Eurozone breakup. "Are your custodians adequately equipped so they can deal with the Eurozone?" he asks.

Miller echoes Gorman's views on valuations. Compliance officers need to be clear on how they calculate daily net asset values- scrutinizing fair value procedures and relevant service providers.

On the general governance front, Miller also advises funds to confirm that all advisory agreements are approved annually, and to bone up on Section 15(c) of the Investment Company Act of 1940, governing advisor contracts. All related letters, board meetings and public disclosures need to be reviewed according to that law.


Compliance people have to ask: "Do we have adequate policies and procedures to address all potential kinds of fraud?"

"Funds need to make certain that they have solid procedures and oversight in preventing insider trading," says Gorman.

These include policies related to cyber crimes, identity theft and insider trading, as well as related issues like conflict of interest.

The trick is making sure the policies cover not just every step of the financial chain, but every organization linked to it. Miller says that policies need to address expert networks.

If a firm engages an expert network, or a consultant, who may have worked for a particular company, does the firm's compliance policies address the information received about this company? Are contractors vetted? Are disclosure warnings provided?

Performance and Advertising

Regulators are going to scrutinize advertising and disclosures, especially with regards to performance that is "aberrational" or inconsistent with a fund's strategies or benchmarks.

Funds, according to Miller, need compliance processes for reviewing and approving marketing materials. Does the process include the portfolio managers responsible for the performance? Are compliance officers signing off on each such marketing piece, and are returns included in the marketing piece verified by the accounting or other similar department?

"If your firm plans to advertise a fund and its returns in a magazine, what is the review and approval process for the advertisement?" he asks.

Once these issues are addressed, compliance officers need to sell their compliance strengths to visiting regulators, according to Gorman. That includes outlines of the fund's unique risks, and risk controls.

"You want examiners to get a strong understanding as to how the fund handles risk," he says. "These are the units that oversee the risks and serve to mitigate them. These are the issues unique to our firm and this is how we deal with them."