No one yet knows exactly how Securities and Exchange Commission Rule 38a-1 affecting mutual fund compliance will be enforced in years to come. The SEC is bound to offer clarification and guidance as time goes on, but funds must take steps now to meet requirements and make compliance a pervasive aspect of their management and board culture.
A good deal of the responsibility for compliance falls to mutual fund boards, which will be under scrutiny from the SEC's office of compliance, inspections and examinations. Rule 38a-1 requires funds to designate a chief compliance officer (CCO) to manage the daily compliance responsibilities and report to the board. Boards are likely to find they cannot delegate these duties completely, however. The SEC will expect them to be more actively involved in supervising a wide range of issues, including market timing, late-day trading and fair valuation, to name a few.
Nevertheless, finding the right CCO is an important first step in establishing an effective compliance program. Fund boards have several options on how to structure the CCO role with no single approach emerging as an industry best practice. Fund firms generally have three choices: 1) appoint an independent person reporting solely to the board or a designated member; 2) appoint an employee of the investment advisor; or 3) appoint an employee of the service provider performing fund administration, fund accounting and transfer agency.
Appointing a CCO serving only the fund company represents an additional and significant staff expense. Thus, a board appointing its own CCO must justify its decision as being in the best interests of its funds' shareholders. One situation justifying such an approach is if the funds' operations are so bifurcated that no single firm has the necessary expertise to supply a "competent and knowledgeable" candidate.
Naming an employee of the investment advisor as the funds' CCO also has its drawbacks, including the inherent costs, potential conflicts of interest and possible lack of understanding of fund operations. However, an investment advisor solution appears to be most appropriate for funds where the advisor provides the majority of the funds' servicing or back-office operations.
A third choice is to turn to the service provider, particularly if they perform fund administration, fund accounting and transfer agency duties. This is a logical solution for small- to mid-size fund complexes that have already decided to appoint a non-advisor affiliated servicing agent to provide a significant portion of their back-office operations.
However, the third-party provider must demonstrate its ability to interact confidently, competently and directly with the funds' senior management, CCO and board, and understand the administrative processes across all funds in the complex. They must also be able to distinguish between the compliance role and the administrative function to assure independence on the compliance side, and monitor the role of all service providers. Finally, they must maintain well-documented compliance policies and procedures.
Since every fund complex is unique, there is no one-size-fits-all solution for the CCO position. However, there are some additional steps that all fund complexes can take to help ensure a culture of compliance.
First, they must evaluate senior management's commitment to compliance by looking at whether they have provided adequate resources and ensured that information is being transparently reported to the CCO. To properly gauge this commitment, the board may need to meet regularly with the CCO on a set schedule, especially in the early stages of the funds' program. They may also want to appoint a liaison director or committee as the prime point of contact.
Second, they need to formalize the compliance process. How are compliance concerns escalated to management and the board? Is everyone who comes in contact with fund operations familiar with the protocol? A fund complex must not leave room for gray areas or risk the chance that an issue remains buried through fear or ignorance of procedures.
Third, they must keep the team focused on the goal. Even with a CCO's guidance and coordination, compliance is everyone's job and responsibility. They can do this by, fourth, recognizing and rewarding compliance "wins."
Finally, fund companies must remain flexible. Many aspects of Rule 38a-1 began vaguely, but are bound to become more specific through subsequent interpretations and rulings. Meanwhile, if they are not sure, fund executives should turn to an expert at a law firm, auditors or fund administrator.
The mutual fund business has long been the subject of periodic regulatory scrutiny and heightened requirements. Rule 38a-1 is no more onerous than previous efforts by regulators to assure the protection of shareholder interests. In each of these previous instances, funds that rose to the challenges and turned them into opportunities were the ones that emerged the strongest. BISYS Fund Services wants to be sure its clients are among the winners in the current and future rounds.
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