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Fifteen Years Later – Funds Struggle to Comply With Rule 38a-1

Introduction

In 20041, the SEC adopted Rule 38a-1 (the “Rule”) under The Investment Company Act of 1940 (the “40 Act”). Under the Rule, an investment company (“fund”) must adopt and implement written policies and procedures reasonably designed to prevent the fund from violating federal securities laws. The policies and procedures must provide for the oversight of compliance for each of the fund’s investment advisers, principal underwriters, administrators, and transfer agents (collectively, “service providers”) through which the fund conducts its activities2. The Rule also requires that the: (i) fund’s board approve them for the fund’s service providers3; (ii) fund annually review the adequacy and effectiveness of the procedures of both the Fund and its service providers4; and, (iii) fund’s chief compliance office (“CCO”) annually provide the fund’s board with a written report concerning, among other things, the operations of the written policies and procedures and any material changes thereto5.

Most Commonly Observed Deficiencies and/or Weaknesses

Fifteen years after enactment, the SEC continues to find that many funds fail to comply with the plainly worded Rule. As described in the Risk Alert issued on November 7, 20196, the Office of Compliance Inspections and Examinations (“OCIE”) noted that there are commonly occurring deficiencies and weaknesses involving written policies and procedures. The most often cited deficiencies and/or weaknesses observed by the OCIE include:

  • Imprecise written policies and procedures. The OCIE has observed written policies and procedures that were too general, did not address business activities or risks specific to the fund, and were not reasonably designed to prevent violations of the fund’s investment limitations or guidelines. The OCIE also observed that certain funds lacked procedures to: (i) review the appropriateness and accuracy of the fund’s pricing of securities; and (ii) confirm the accuracy of disclosures contained in advertisement and/or sales literature.
  • Failure to abide by or enforce written policies and procedures. The OCIE noted that some funds failed to follow and/or enforce adequately written policies and procedures. The OCIE found that some funds did not follow their own written policies concerning requirements: (i) that the fund’s board approve the valuations committee’s determinations of fair valuations; and (ii) to obtain multiple broker quotes in connection with cross trades (which would provide the fund’s board with the information it needs to allow it to determine if the trades comply with the exemptions under the affiliated transaction rule).
  • Failure to oversee compliance by service providers. The OCIE discovered that certain funds either failed to include or failed to enforce written policies and procedures reasonably designed to oversee the compliance by the fund’s service providers. The OCIE noted instances where: (i) the funds’ written policies and procedures did not provide for ongoing monitoring or due diligence of services relating to pricing of portfolio securities and fund shares; and (ii) the fund’s board had not approved the written policies and procedures of the fund’s subadvisor.
  • Unperformed or inadequately performed annual reviews. The OCIE observed that certain funds failed to perform annual reviews of their written policies and procedures. Moreover, the OCIE noted that it was unable to ascertain whether a fund had conducted an annual review due to the fund’s lack of supporting documentation. The OCIE also noted instances where certain funds did conduct annual reviews, but the reviews failed to address the adequacy and/or implementation of the funds’ written policies and procedures.

Conclusions

By following some simple guidelines, a CCO can help ensure that the fund complies with the Rule’s requirements. The deficiencies and weaknesses observed by the OCIE in its Risk Alert can largely be addressed if the: (i) written policies and procedures are specifically tailored for the fund’s business activities and risks; (ii) written policies and procedures are followed and enforced; (iii) fund oversees compliance by its service providers; and (iv) written policies and procedures are subject to a properly performed annual review.

If you have questions about the information provided in this announcement, or for information about our investment company compliance services, please email us at info@alariccompliance.com, call Alaric at 888-243-2448, or visit our website, at www.alariccompliance.com.


1 The Rule’s effective date was February 5, 2004 and implementation date was October 5, 2004.
2 The 40 Act Rule 38a-1(a)(1).
3 The 40 Act Rule 38a-1(a)(2).
4 The 40 Act Rule 38a-1(a)(3).
5 The 40 Act Rule 38a-1(a)(4).
6 The Risk Alert listed the most common deficiencies and weaknesses observed in approximately 300 fund examinations conducted by the OCIE over a two-year period.

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