MIAMI - Chief compliance officers at mutual fund shops are finding out that defining their responsibilities takes a lot of guesswork.
The very broad nature of the new compliance rule implemented last Oct. 5 has left newly appointed fund CCOs wondering where they need to focus their efforts and how they should allocate the necessary compliance resources to provide effective oversight. With the Securities and Exchange Commission already fixing to conduct compliance examinations, CCOs are scrambling to get up to speed.
"We must determine our role [and] do it quick. Otherwise it will be defined for us," said Danell Doty, fund chief compliance officer for Barclays Global Investors, speaking on a discussion panel at the National Investment Company Service Association's annual conference here.
The panel, focused on the role of CCOs, identified three areas that compliance officers bear responsibility for: risk assessment programs, the internal infrastructure of mutual funds and examining service providers. However, these compliance watchdogs have been given very little guidance from regulators as to what exactly is expected of them when conducting their due diligence tours.
As part of the risk assessment process, CCOs are asked to conduct annual reviews, but it is unclear what this really means. The SEC has yet to outline specific details for these reviews and whether there should be a comprehensive top-to-bottom evaluation or a broader review of a fund complex's compliance policies and procedures. "There isn't a lot of guidance from the Commission in that area," said Gene Gohlke, associate director of the SEC's office of compliance inspections & examinations.
Doty noted that the compliance rule identifies four entities that require oversight: the transfer agent, the principal underwriter, the fund advisor and the fund administrator. All other entities not listed in the text of the rule get lumped in with the fund, she said. Since the transfer agent is the only service provider specifically named in the rule and there is no uniform definition of a service provider, CCOs are unsure of how far their reach must be with respect to intermediaries.
"[CCOs] don't know what to look for. They are relying on the service provider to show them what they're doing on a due diligence tour," said Mike McVoy, chief compliance officer at U.S. Bancorp Fund Services, in a later panel. "We've gotten a lukewarm response from the intermediary community," he added.
Gohlke conceded that the new rule is "very general" about oversight of service providers, but he urged compliance personnel to use a "reasonable approach" to "reach out and touch every entity" that has an operating relationship with the funds.
Among the "wide range of processes" that will be expected of CCOs, Gohlke noted, are issuing monthly management reports, retrieving data from the operations side of the business, NAV accuracy, risk analysis, an evaluation of trading efficiency and statement on auditing standard (SAS) 70 audit reports. Gohlke told attendees that it is important for CCOs to work closely with an independent auditing firm to look for gaps in its compliance program.
In order to arrive at a consensus of what duties they will carry out, CCOs are encouraged to engage in discussions about exams and what information will be in their reports to the board of trustees. Doty noted that some of the questions that she and her peers should be asking include whether certain employees need to be fired as a result of compliance failures and if processes and procedures need to be retooled in order to prevent future transgressions.
Specifically, Doty identified NAV inaccuracies as a hot-button issue, one that she and her fellow CCOs agree must be addressed and their cause determined. She also cited market timing and frequent trading as an obvious area of risk, noting that compliance personnel should be looking at shareholder turnover rate, trading volume and activity in international funds. Another area of concern is directed brokerage, which has recently become a prohibited sales practice and the subject of a number of enforcement actions by the Commission.
Doty and other CCOs on the West Coast have monthly meetings in which they share their experiences and discuss how to attack these problems. It also affords them the opportunity to have the more veteran compliance personnel mentor the greener ones or those who work at smaller firms with fewer resources.
Recordkeeping has also become a more important issue in light of the adoption of Rule 38a-1, which has expanded the recordkeeping requirement to include copies of briefing materials provided to a fund's board related to the approval of the fund, its service providers' compliance programs and the chief compliance officer's annual reports.
By a show of hands, nearly all of the attendees in the room said they were aware of a 38a-1 implementation plan at their respective firms, but only half of them confirmed that it was actually being executed. When asked to provide a specific timetable for firms to complete its review of service providers, Gohlke declined to give a firm date but said that the SEC plans to continue to monitor compliance through sweep exams. In 2004, sweep exams consumed 40% of the Commission's resources.
Each exam is based on an inquiry sent to 40 or 50 firms regarding a narrow area of industry practices. In addition to these sweeps, the SEC has assigned an examiner to a number of the bigger fund complexes who will request a fair amount of documentation, Gohlke said. There will also be routine exams of some of the "higher-risk firms," he added.
The key to ensuring that compliance is effective is building a culture that fosters a commitment to best practices, which starts with the tone at the top, Barclays' Doty said. Gohlke warned that companies that do not report problems with their compliance program will be heavily scrutinized because every firm has compliance problems.
Given the spate of new rules put forth by the SEC, the cost of compliance for many firms has increased dramatically. That raises the question of whether the burden of that cost will be borne by the fund itself, its service providers or passed on to fund shareholders.
"There is a cost element that will be flowed back to our clients," said Don Gignac, senior vice president, fund administration at State Street. "And that will be reflected in the fees charged by the investment advisor." Ultimately, that is a determination the fund boards must make when evaluating the expense ratio of the fund and figuring out how to grapple with the increased cost of compliance.