Publications

Overview

The Board of Trustees plays a crucial role in the implementation and operation of a fund’s compliance policies and procedures (“Compliance Program”). Rule 38a-1 under the Investment Company Act of 1940 assigns to fund Boards very specific compliance responsibilities, including responsibility for approving a fund’s Compliance Program. However, the Securities and Exchange Commission (“SEC”) does not believe that an effective Compliance Program is built solely on policies, procedures and good intentions.¹ In the SEC’s view, a successful Compliance Program is imbedded in a fund’s culture. The Board can play an essential role in setting an ethical tone and fostering a culture of compliance. This memorandum discusses the Board’s specif ic responsibilities under Rule 38a-1, as well as steps the Board can take to foster a strong compliance culture.

Approve the Fund’s Compliance Programs

A fund’s Board of Trustees, including a majority of the independent Trustees, must approve the fund’s Compliance Program and the Compliance Programs of each investment adviser, principal underwriter, administrator and transfer agent of the fund (collectively, “Fund Service Providers”). The Board of Trustees must base its approval on a finding that the Compliance Programs are reasonably designed to prevent violations of the federal securities laws by the fund and by each Fund Service Provider.² In considering whether to approve the Compliance Programs of a fund or Fund Service Provider, the Board of Trustees should consider: (i) the nature of a fund’s exposure to compliance failures, (ii) the adequacy of the policies and procedures in light of recent compliance experiences, which may demonstrate weaknesses in a fund’s or Fund Service Provider’s Compliance Programs and (iii) best practices used by other fund complexes or recommended by fund counsel, compliance specialists and other experts familiar with compliance practices successfully used by similar funds or service providers. A list of specif ic questions the Trustees should consider regarding Compliance Programs is attached as Appendix A.

Trustees may satisfy their obligations under the rule by reviewing summaries of Compliance Programs prepared by the Chief Compliance Officer (“CCO”) , legal counsel or other persons familiar with the Compliance Programs. The summaries should familiarize Trustees with the salient features of the Compliance Programs and provide them with a good understanding of how the Compliance Programs address particularly significant compliance risks. With respect to approval of the policies and procedures of unaffiliated Fund Service Providers, the SEC will consider a fund’s Compliance Program to have satisfied the requirements of Rule 38a-1 if the Board of Trustees reviews a third-party report on the Fund Service Provider’s procedures, instead of the procedures themselves. However, the third-party report must (i) describe the service provider’s Compliance Program as it relates to the types of services provided to the fund, (ii) discuss the types of compliance risks material to the fund, and (iii) assess the adequacy of the service provider’s compliance controls. If a fund uses thirdparty reports for its approval of a service provider’s Compliance Program, the fund must also gather and take into account other relevant information, such as its experience with the Fund Service Provider.

Approve the Appointment, Removal and Compensation

Rule 38a-1 requires that a fund designate a CCO responsible for administering the fund’s Compliance Program. The CCO must report directly to the Board of Trustees. The rule provides that the fund’s Board of Trustees, including a majority of its independent Trustees, must approve the CCO’s appointment and compensation. The CCO serves at the pleasure of the Board of Trustees and may be removed from his or her responsibilities only through action by, and with the approval of, the Board of Trustees, including a majority of the independent Trustees.

Review the Chief Compliance Officer’s Annual Written Report

At least annually, the CCO must review the Compliance Programs of the fund and the Fund Service Providers and provide a written report to the Board of Trustees that, at a minimum, addresses: (i) the operation of the Compliance Programs of the fund and each Fund Service Provider, (ii) any material changes made to those Compliance Programs since the date of the last report, (iii) any material changes to the Compliance Programs recommended as a result of the annual review and (iv) each “material compliance matter” that occurred since the date of the last report. The term “Material Compliance Matter” is defined to mean any compliance matter about which the fund’s Board would reasonably need to know to oversee fund compliance. This includes (i) violations of the federal securities laws by the fund or the Fund Service Providers (or off icers, directors, employees or agents thereof), (ii) violations of the Compliance Programs of the fund or the Fund Service Providers, or (iii) weaknesses in the design or implementation of the Compliance Programs of the fund or the Fund Service Providers. The specific items to be covered in the annual review and written report are discussed in detail in Appendix B.

Regularly Meet with the Chief Compliance Officer

The CCO must hold a separate meeting with the fund’s independent Trustees at least annually. It is a good practice for a Board to invite the CCO to attend each quarterly board meeting and also to meet separately with the independent Trustees at that time. Regular and consistent participation by the CCO in board meetings demonstrates to fund management that compliance is important to the Board and that the Board considers the CCO to be a valued member of the fund management. In addition, participation in quarterly meetings helps to build a healthy working relationship between the Board and the CCO.

Establish Tone at the Top

The Board of Trustees is in a unique position to establish a culture of compliance and an expectation of high standards of ethical conduct. Setting the tone and expectations is important because an effective compliance program can help shield Trustees from personal liability in civil suits and from prosecution in civil and criminal actions. Court cases and amendments to the Organizational Sentencing Guidelines issued by the U.S. Sentencing Commission stress the importance of an effective compliance program, as well as Board and officer responsibility for the oversight and management of a company’s compliance program. The existence of an effective compliance program (i.e., an active, dynamic program that demonstrates a culture of compliance) may factor into a prosecutor’s decision whether to charge a company and will be a mitigating factor that reduces a company’s culpability and fines under the sentencing guidelines. In addition, in 2003 the SEC proposed examining companies that demonstrate a culture of compliance only every four years, while placing all other companies on a two to four year examination schedule.

Be Knowledgeable About the Program

The Board should be knowledgeable about the Compliance Program’s content and operation. In addition, the Board should exercise reasonable oversight of the implementation and effectiveness of the Compliance Program. The Board can do this by (i) requesting compliance reports on at least a quarterly basis, (ii) critically reviewing the CCO’s annual written report, (iii) requesting status reports from management on remedial actions undertaken to remedy compliance violations, (iv) focusing on recidivism and/or patterns of compliance violations that could indicate gaps or weaknesses in the Compliance Program or in the risk identif ication process and that reveal the existence of undetected compliance issues, and (v) monitoring the implementation of recommendations from the annual review of the Compliance Program that are designed to address compliance issues.

Provide Support to the CCO

A CCO is empowered by a Board that is committed to, and actively engaged in, the Compliance Program. The Board can provide support by, among other things, emphasizing ethical conduct by management, including compliance issues on each Board meeting agenda, revisiting compliance issues raised by the CCO on previous occasions, monitoring the implementation of the Compliance Programs by fund management, and supporting the CCO’s requests for resources.

Annually Evaluate the Effectiveness of the CCO

While Rule 38a-1 under the Investment Company Act requires a Board of Trustees to approve the appointment, removal and compensation of a fund’s CCO, the rule is silent as to any requirement to annually review his or her performance. However, as mentioned above, Rule 38a-1 does require that a fund annually review the adequacy and effectiveness of its Compliance Program, as well as the Compliance Program of each Fund Service Providers. Because the CCO is an integral part of any Compliance Program, it is reasonable to expect a board to evaluate the effectiveness of a CCO as part of, or in connection with, the annual review of the Compliance Programs.³

The following statement by the Securities and Exchange Commission (“SEC”) serves as a useful starting point for evaluating the effectiveness of a CCO:

“A fund’s chief compliance officer should be competent and knowledgeable regarding the federal securities laws and empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the fund.”⁴

Although this is a relatively vague standard, an SEC off icial has explained that this statement means that a CCO should possess a number of specific qualities and capabilities, including knowledge of the federal securities laws, an understanding of the compliance function and a pro-active disposition.⁵ These and other qualities and capabilities are discussed in Appendix C. In addition to analyzing these qualities and capabilities, a CCO’s effectiveness can be evaluated by reviewing the duties and functions actually performed by the CCO. This review should take into consideration the size, resources and business activities of the fund complex.

Engage in Small Gestures

A Board can emphasize the importance of compliance in subtle ways. These include providing sufficient time on the meeting agenda to fully discuss compliance issues, questioning fund management about compliance procedures, congratulating the CCO on compliance accomplishments, and emphasizing the importance of training and education.

Footnotes

1. See SPEECH BY SEC STAFF: NATIONAL ECONOMISTS CLUB: THE CULTURE OF COMPLIANCE, by Lori Richards, Director, Office of Compliance Inspection and Examinations, U.S. Securities and Exchange Commission, April 23, 2003
2. A fund that is approving the Compliance Programs of a Fund Service Provider is required to make findings only with respect to activities of the Fund Service Provider that could affect the fund.
3. Many fund CCOs also serve as employees of a fund’s adviser or administrator. These organizations generally evaluate employees and determine compensation (i.e., salary, bonuses, stock options, etc.) on an annual basis. Under Rule 38a-1, a board is required to approve any change in a CCO’s compensation, even when the compensation is paid by a third party. This process, which may not necessarily occur in connection with the annual review of the Compliance Programs, presents the board with an additional opportunity to evaluate the effectiveness of the CCO.
4. See Compliance Programs for Investment Companies and Investment Advisers, Release Nos. IA-2204; IC-26299 (February 2005) at p.11.
5. See Speech by SEC Staff: Managed Funds Association Educational Seminar Series 2005: Practical Guidance for Hedge Fund CCOs Under the SEC’s New Regulatory Framework – A Job Description For CCOs to Private Investment Funds, by Gene Gohlke, Associate Director, Office of Compliance Inspection and Examinations, U.S. Securities and Exchange Commission, May 5, 2005.

Appendix A

Questions for Consideration by Fund Trustees Regarding Policies and Procedures

In reviewing and approving Compliance Programs, fund Trustees should consider the following questions:

• Are they policies and procedures comprehensive, i.e., do they address all relevant compliance requirements under the federal securities laws, as well as other applicable requirements, e.g., ERISA, NASD, AML, commodities, blue sky, tax, etc.?
• Do they represent more than simple checklists of statutes and rules, i.e., do they describe how compliance with each regulatory requirement is ensured?
• Do they assign responsibility, i.e., do they indicate who is responsible within the organization for implementing each compliance policy or procedure?
• Do they provide for appropriate monitoring of compliance? (Note: the adopting release states that in some areas, such as best execution and allocation of investments, procedures for testing compliance to detect violations may be appropriate).
• Do they provide adequate procedures for reporting and correcting any violations that are detected?
• Are they tailored to the facts and circumstances of the particular fund organization, i.e., do they address the particular compliance risks and organizational structure of the fund organization in question?
• What provisions are made for oversight of the policies and procedures of Fund Service Providers, such as periodic reports, certif ications, diligence visits, etc.?

Appendix B

The Annual Review

Rule 38a-1 requires a fund to annually review the adequacy of its Compliance Program and the Compliance Program of each Fund Service Provider, as well as the effective-ness 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 Program continues to be effective in addressing those risks. This process requires a policy-bypolicy 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 in addressing risks identified in the GAP Analysis.
• An analysis of supervisory controls.

Testing of Policies and Procedures. The Annual Review should test the Compliance Program 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 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, (ii) 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 Annual Review of the operation of the Compliance Programs of the fund and the Fund Service Providers.

Material Changes. The Annual Report must review of 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 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 may contain a strategic plan designed to address compliance issues and strengthen the Compliance Programs in the coming year.

Appendex C

Qualities and Capabilities of a CCO and Their Use in Determining a CCO’s Effectiveness

Knowledge of Investment Company Regulation. A fund CCO should have a good understanding of the federal securities laws and related regulations, SEC no-action letters, SEC policy and interpretive statements, and any other laws and regulations impacting investment company operations and regulation. Consideration of these factors will assist a board in evaluating whether the CCO has the knowledge and background to effectively administer the fund’s Compliance Program.

Stays Abreast of Regulatory Developments. A fund CCO should keep abreast of changes in regulatory requirements applicable to investment companies and their activities. A board evaluating this factor should inquire as to whether the CCO:

• Attends industry conferences and stays abreast of regulatory developments.
• Is active in industry groups that promote the development and implementation of good compliance practices. Such groups include the Investment Company Institute and the National Society of Compliance Professionals, Inc.
• Updates the fund’s Compliance Program to take into account changes in regulatory requirements.
• Advises the Board regarding new or revised compliance requirements.

Understands the Compliance Function. A fund CCO should understand the compliance requirements applicable to investment companies and appreciate how effective Compliance Programs address and prevent violations of those requirements. This capability includes a familiarity with the steps required to create an effective compliance program, including the identification and assessment of risk, the creation of policies and procedures to address specific identif ied risks and the effective implementation of these policies and procedures. A CCO should be able to demonstrate that he or she:

• Has improved and strengthened the fund’s Compliance Program and/or made the Compliance Program more comprehensive, robust and effective.
• Is familiar with the Compliance Programs of the Fund Service Providers.
• Has established a compliance calendar to ensure that important regulatory, client reporting, tax and compliance deadlines are not missed.
• Has contributed to the overall compliance culture of the fund and the Fund Service Providers.
• Has established objectives for the coming year with respect to the fund’s Compliance Program and those of the Fund’s Service Providers.
• Has analyzed compliance failures and the effectiveness of corrective actions taken in response to such failures.

Makes Effective Use of Resources. A fund CCO should be able to determine the appropriate level of resources necessary to implement and maintain an effective Compliance Program and to request the resources necessary to carry out compliance activities. The board should determine whether the CCO:

• Has been an advocate for allocating appropriate resources to the Compliance Program.
• Has used available resources to administer the fund’s Compliance Program.
• Has requested additional resources when appropriate. Specific areas where additional resources have been requested should be identified.

Actively Monitors Compliance Implementation. A fund CCO should actively monitor the implementation of the Compliance Program by managers and others throughout the fund complex. An effective CCO will:

• Ensure that all personnel in the fund complex with compliance responsibilities are competently and fully performing their assigned functions.
• Establish a schedule to test the effectiveness of each of the policies and procedures comprising the fund’s Compliance Program.
• Provided adequate oversight of the Compliance Programs of the Fund Service Providers.
• Analyze recidivism and/or patterns of compliance violations. These patterns could indicate gaps or weaknesses in the Compliance Program or in the risk identification process and reveal the existence of undetected compliance issues.
• Ensure that the Compliance Programs of Fund Service Providers are effective so that the services provided by these f irms are consistent with the fund’s obligations to its shareholders.
• Provide to the Board a thorough written report on the annual review of the Compliance Programs that contains an articulate discussion of the operation of the Compliance Programs and well reasoned recommendations for material changes.
• Ensure that recommendations resulting from the annual review designed to address compliance issues and strengthen the Compliance Programs in the coming year are implemented.

Familiarity with the Fund’s Business Model. A fund CCO should be familiar with the fund’s business model, distribution channels, shareholder base, vendor relation-ships, and investment strategy. Knowledge of the fund’s business will help the CCO identify risks and gaps in the Compliance Program. An effective CCO will:

• Update policies and procedures to take into account changes in a fund’s business model or investment strategy.
• Be familiar with business operations of the Fund Service Providers.

Pro-Active. A fund CCO should be pro-active, inquisitive A board should attempt to determine whether the CCO:

• Has been pro-active and diligent.
• Has established working relationships with the Fund Service Providers.
• Frequently meets with, and provides substantive reports to, the board.
• Reports compliance violations on exception or management reports, promptly addresses the violations, and escalates issues to senior management when necessary.
• Has brought recurring or systemic violations to the attention of senior management and/or the board.
• Has implemented a compliance training and education program.

Possesses Sufficient Authority. A fund CCO should have sufficient authority within the fund complex to compel others to adhere to the f irm’s compliance policies and procedures. A fund CCO will, of course, report directly to the Board of Trustees. A fund CCO, however, also may be an employee of the fund’s adviser or administrator. These CCOs should be a member of senior management and generally should report to the Chief Executive Off icer (or an equivalent position) of the adviser or administrator. A board can determine whether a CCO has suff icient stature within an organization by evaluating:

• Whether the CCO is a member of senior management and the level of the person to whom the CCO reports.
• Whether the CCO confers with and advises senior management on significant compliance matters.
• Whether the CCO is considered the “go to person” on compliance matters.
• Whether CCO is involved in analyzing and resolving significant compliance issues.

For More Information

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

Disclosure

This advisory may be reproduced, in whole or in part, with the prior permission of Thompson Hine LLP and acknowledgement of its source and copyright. This publication is intended to inform clients about legal matters of current interest. It is not intended as legal advice. Readers should not act upon the information contained in it without professional counsel. This document may be considered attorney advertising in some jurisdictions. Some of the design images and photographs in this document may be of actors depicting fictional scenes.