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Overview

Rule 38a-1 under the Investment Company Act of 1940 requires a registered investment company to adopt and implement written policies and procedures ("Compliance Program") reasonably designed to prevent violations of the federal securities laws, including policies and procedures that provide for oversight of compliance by the fund’s investment adviser(s), principal underwriter, administrator and transfer agent ("Fund Service Providers"). A fund must review, at least annually, the adequacy of its Compliance Program and the Compliance Programs of the Fund Service Providers, and the effectiveness of their implementation. Rule 38a-1 also requires annual written reports to the fund’s Board of Directors or Trustees regarding the operation of the Compliance Program of the fund and the Fund Service Providers. Funds were required to design and implement Compliance Programs by October 5, 2004.

Now that the implementation deadline has past, Chief Compliance Officers ("CCO") must begin planning for the annual review and report on the operation and effective-ness of the Compliance Programs. Consequently, the following dates are significant:

April 5, 2006: Date by which each registered fund must complete the first annual review of its Compliance Program and the Compliance Programs of the Fund Service Providers.

June 5, 2006: Date by which each fund’s CCO must provide the first annual written report to the fund’s Board regarding the operation of the Compliance Programs of the fund and the Fund Service Providers.

The Annual Review

Rule 38a-1 requires a fund to annually review the adequacy of its Compliance Program and the Compliance Programs of each Fund Service Provider, as well as the effectiveness of their implementation. A fund CCO must provide a written report to the Board based on the Annual Review. During an examination, the SEC will request copies of these annual reports, as well as copies of all briefing materials presented to the fund’s Board in connection with the Board’s review of the Compliance Program. To comply with Rule 38a-1 and demonstrate the adequacy of the Compliance Program, the Annual Review should cover the following:

On-going GAP Analysis

The Annual Review should re-evaluate the fund’s compliance risks and assess whether the Compliance Programs continue to be effective in addressing those risks. This process requires a policy-by -policy review, which should involve:

• A consideration of changes in laws and regulations.
• A consideration of changes in the fund’s business model.
• Interviews with compliance, portfolio management and operations personnel to determine the effectiveness of policies and procedures that address risks identified in the GAP Analysis.
• An analysis of supervisory controls.

Testing of Policies and Procedures

The Annual Review should test the Compliance Programs on a policy-by-policy basis. This process should involve:

• An analysis of compliance failures and the effectiveness of corrective actions taken in response to such failures.
• A test of policies and procedures designed to address compliance failures identified in past SEC deficiency letters.
• An analysis of recidivism and/or patterns of compliance violations.
• An analysis of the reasons for, and frequency of, exceptions and overrides.
• An analysis of whether recurring or systemic violations are brought to the attention of senior management.

Education and Training Programs

The Annual Review also should evaluate the effectiveness of education and training programs to determine whether the programs need to be revised or updated. Education and training programs should be revised in light of:

• Repeated compliance failures.
• Changes in laws or regulations.
• Changes in the fund’s business model.
• SEC examination results.
• New technology.

The Chief Compliance Officer's Annual Report

A fund CCO must annually provide a written report to the fund’s Board addressing, at a minimum: (i) the operation of the Compliance Programs of the fund and the Fund Service Providers, (ii) material changes to the Compliance Programs since the date of the last report, (iii) material changes recommended as a result of the annual review, and (iv) each material compliance matter that occurred since the date of the last report. Of course, the SEC expects that serious compliance issues will be raised with the Board promptly and not be delayed until the Annual Report.

Operation of the Compliance Programs

The Annual Report must contain the results of the fund’s Annual Review of the operation of the Compliance Programs and the Fund Service Providers.

Material Changes

The Annual Report must review material changes made to the Compliance Programs since the last report, including any changes to the Compliance Programs made to address newly identified risks. A change is "material" if it is a change that a fund director or trustee would reasonably need to know in order to oversee the fund.

Recommended Changes

The Annual Report must review any material changes recommended to be made to the Compliance Programs as a result of the Annual Review.

Material Compliance Matters

The Annual Report must contain a report of material compliance matters that have arisen, including refusals to comply with the Compliance Programs. Individual compliance matters may not be material, but may collectively suggest a material weakness in the Compliance Programs.

Strategic Plan

Based on the Annual Review, the recognition of new compliance risks and the identification of compliance weakness, the Annual Report should contain a strategic plan designed to address compliance issues and strengthen Compliance Programs in the coming year.

For More Information

Please contact Michael V. Wible, Donald S. Mendelsohn, Richard S. Heller, JoAnn M. Strasser, or James P. Jalil or any member of our Corporate Transactions & Securities practice group for more information.

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