AUSTIN, Texas - The mutual fund industry has its first full year of the new compliance era under its belt, but a host of questions remain unanswered.
Rule 38a-1 of the Investment Company Act of 1940, for example, requires that a mutual fund's chief compliance officer provide a written report on a fund's compliance program, but many firms are struggling to determine the document's minimum requirements.
The rule also calls for funds to annually review their compliance programs, but it's unclear whether that it is to be conducted by the board or by the newly required chief compliance officer. Exactly who would be responsible for compliance at the intermediary level is also unclear. How often the two parties should meet and how detailed those gatherings should be isn't entirely known, either. And how the cost of compliance might be divvied up along the fund food chain is also in question.
Fund boards, as well as their service providers, are also instructed to report any material breach of their compliance program found in their required annual review, but many firms are reporting that it's not always clear if a violation has occurred.
"I guess it's a bit like the old definition of pornography," observed Victor R. Siclari, a partner with the Pittsburgh-based law firm Reed Smith. "I can't tell you what it is, but I know it when I see it."
Siclari's cheeky response was typical of many of the answers to the compliance riddles that industry experts arrived at during the Investment Company Institute's 2005 Operations and Technology Conference, held here last week.
Others, however, were slightly more concrete.
For instance, Siclari indicated that the written compliance report, which funds were ordered to adopt a year ago and is due to the Securities and Exchange Commission by next spring at the very latest, must include any changes made by the fund or its service providers over the last year that improved upon its current compliance program. It must also include, he said during a panel discussion on rule 38a-1, each "material compliance matter," or those things the board would need to know to oversee fund compliance. That might include any violations that may have occurred over the course of the year, or any weakness in the compliance program's design that the chief compliance officer has discovered.
Siclari said it's on the fund CCO's shoulders to determine what constitutes a compliance violation or program weakness, but he warned that in this initial year of exams, the SEC would likely have every aspect of the report under the microscope.
"Next year," Siclari added, "the focus will be much more holistic, on issues like improving risk analysis, back testing and reinforcing compliance through education and training. Although more new rules are also coming next year, such as Rule 22c-2."
It would also be prudent, Siclari said, for a fund's compliance program to cover functions of fund accountants and custodians, in addition to the required service providers, although the SEC excluded those entities in writing the rule. It's unclear why - perhaps the regulator believes fund administrators are sufficiently guided by banking rules, Siclari offered - but since accountants and custodians bear directly on the ability of the fund and its service providers to operate in compliance with federal securities laws, it would be smart to include them in the program.
Fund boards and CCOs should also consider reviewing their compliance quarterly, rather than just annually, as minimally required by the rule. In fact, he said, the trend is for episodic, informal communications between quarterly meets, particularly if there's an issue the CCO feels they should elevate. E-mails and telephone calls are the usual method there, Siclari said, but quarterly updates to the board should be written, if for no other reason than to provide a convenient paper trail for SEC examiners.
Siclari also reported that many fund boards and their CCOs aren't waiting an entire year before they compile their annual written reports, as required under the rule. Compiling the report earlier than mandated allows the fund board and CCO to establish a comfortable rapport with each other over the substance and the frequency of their communications.
Besides, he said, the SEC has already begun its CCO exams, so many funds are thinking it might be wise to have their houses in order before the regulator comes knocking.
Karen Becker, senior vice president and CCO at Calvert Funds, agreed that the more inclusive a compliance program, the better. Becker's Bethesda, Md.-based firm enjoyed its first SEC site visit earlier this year and noted that the SEC left no stone unturned.
"They asked a zillion questions," said Becker, who meets with her fund board regularly and is asked at the conclusion of each session whether she has enough resources to perform her job effectively. "And my answer is always, yes."
But during the SEC site visit, Becker said the examiners were particularly interested in her company's e-mails. Since these electronic communications are so useful in an SEC investigation, Siclari added, it's alarming how cavalier the attitudes of many executives are when it comes to electronic messages.
"It's amazing what people will say in an e-mail," Siclari said, shaking his head. "It's important that employees are told that whatever is contained in an e-mail can and will be used against them in a court of law. Whenever I write an e-mail now, I ask myself how it might be interpreted if it were taken out of context."
In her observations over the last year, Joan Dowd, vice president and chief compliance officer at the Boston-based transfer agent BFDS, said she's found that most mutual fund CCOs are overwhelmed with responsibilities. Fund CCOs might be ultimately accountable by the SEC for ensuring compliance at all tiers, but it's hardly possible to expect them to be intimately familiar with every corner of the business.
"We've found that the CCO is presented with a great deal of challenges," said Dowd, whose company services multiple funds. "They need to understand federal securities laws for every one of their services providers and how the SEC governs them. We found that what the CCO really needs is a comprehensive package from the transfer agent detailing its processes for compliance."
Thus, Dowd's firm has compiled a list and description of TA rules, associated those rules with business processes, and demonstrated the controls that are in place to ensure compliance with the rules.
"But the key was putting together a means for the fund boards and CCOs to statistically measure their effectiveness," she said.
In regards to the due-diligence meetings required by the rule, Dowd said her firm determined through client focus groups that larger, full-scale meetings allow CCOs to better evaluate the TA's compliance function. Those meetings can be supplemented by quarterly get-togethers, where the two parties might focus on a specific area of the business. It also helps to know the particular fund compliance officer's background prior to the meeting, she added, as her firm has encountered CCOs with very little knowledge of the industry, others that know the fund business well but aren't entirely familiar with the compliance aspect, and some that are seasoned industry professionals who are very knowledgeable about the TA function.
But, at the end of the day, who ends up covering the compliance bill is still anyone's guess. Most third-party transfer agents are bearing the cost of their programs, as well as the cost for external auditors to evaluate their policies and procedures. As for the funds, the advisor is absorbing most of the costs. If the advisor is separate from the fund, the cost is generally shared.
As for the pay scale for a typical CCO, that can vary widely between $100,000 and $500,000 annually, Becker said, depending on the firm. Or, as Siclari again said cheekily, "usually the fund wants to pay less and the CCO wants more."
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