[Federal Register Volume 68, Number 28 (Tuesday, February 11, 2003)]
[Proposed Rules]
[Pages 7038-7050]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-3315]



[[Page 7037]]

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Part III





Securities and Exchange Commission





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17 CFR Parts 270 and 275



Compliance Programs of Investment Companies and Investment Advisers; 
Proposed Rule

  Federal Register / Vol. 68, No. 28 / Tuesday, February 11, 2003 / 
Proposed Rules  

[[Page 7038]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270 and 275

[Release Nos. IC-25925, IA-2107; File No. S7-03-03]
RIN 3235-AI77


Compliance Programs of Investment Companies and Investment 
Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission is publishing for 
comment new rules under the Investment Company Act of 1940 and the 
Investment Advisers Act of 1940 that would require each investment 
company and investment adviser registered with the Commission to adopt 
and implement policies and procedures reasonably designed to prevent 
violation of the federal securities laws, review those policies and 
procedures annually for their adequacy and the effectiveness of their 
implementation, and appoint a chief compliance officer to be 
responsible for administering the policies and procedures. The 
Commission also seeks comment on other ways to involve the private 
sector in fostering compliance by investment companies and investment 
advisers with the federal securities laws. The proposed rules are 
designed to protect investors by being the first step towards enhanced 
compliance achieved through private initiative.

DATES: Comments must be received on or before April 18, 2003.

ADDRESSES: To help us process and review your comments more 
efficiently, comments may be sent to us in either paper or electronic 
format. Comments should not be sent by both methods.
    Comments in paper format should be submitted in triplicate to 
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 
Fifth Street, NW., Washington, DC 20549-0609. Comments in electronic 
format may be submitted at the following e-mail address: [email protected]. All comment letters should refer to File No. S7-03-
03; if e-mail is used, this file number should be included on the 
subject line. Comment letters will be available for public inspection 
and copying in the Commission's Public Reference Room, 450 Fifth 
Street, NW., Washington, DC 20549. Electronically submitted comment 
letters will also be posted on the Commission's Internet Web site 
(http://www.sec.gov).\1\
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    \1\ We do not edit personal or identifying information, such as 
names or e-mail addresses, from electronic submissions. Submit only 
information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Hester Peirce, Senior Counsel, Office 
of Regulatory Policy at (202) 942-0690, or Jamey Basham, Special 
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Counsel, Office of Investment Adviser Regulation at (202) 942-0719.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``SEC'' or ``Commission'') is requesting public comment on proposed 
rule 38a-1 [17 CFR 270.38a-1] under the Investment Company Act of 1940 
[15 U.S.C. 80a] (``Investment Company Act''), proposed rule 206(4)-7 
[17 CFR 275.206(4)-7] under the Investment Advisers Act of 1940 [15 
U.S.C. 80b] (``Investment Advisers Act'' or ``Advisers Act''), and 
proposed amendments to rule 204-2 under the Advisers Act [17 CFR 
275.204-2].

Table of Contents

I. Background
II. Discussion
    A. Adoption and Implementation of Policies and Procedures
    B. Annual Review
    C. Chief Compliance Officer
    D. Recordkeeping
    E. Request for Comment on Further Private Sector Involvement
    1. Compliance Reviews
    2. Expanded Audit Requirement
    3. Self-Regulatory Organization
    4. Fidelity Bonding Requirement for Advisers
III. General Request for Comment
IV. Cost-Benefit Analysis
    A. Benefits
    B. Costs

C. Request for Comment

V. Consideration of Promotion of Efficiency, Competition, and 
Capital Formation
VI. Paperwork Reduction Act
    A. Rule 38a-1
    B. Rule 206(4)-7
    C. Rule 204-2
    D. Request for Comment
VII. Summary of Initial Regulatory Flexibility Analysis
VIII. Statutory Authority
Text of Proposed Rules

I. Background

    Mutual funds and other types of investment companies provide access 
to the capital markets for millions of small and large investors.\2\ 
The tremendous growth of funds reflects the confidence investors have 
in funds and the regulatory protections provided by the federal 
securities laws.
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    \2\ In this release, we use the term ``fund'' to mean a 
registered investment company or a business development company 
defined in section 2(a)(48) of the Investment Company Act [15 U.S.C. 
80a-2(a)(48)], and the term ``mutual fund'' to mean a registered 
investment company that is an open-end management company defined in 
section 5(a) of the Investment Company Act [15 U.S.C. 80a-5(a)].
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    The Commission regulates mutual funds and other investment 
companies under the Investment Company Act, and regulates the 
investment advisers that provide investment management services to 
those funds and to other clients under the Advisers Act.\3\ The 
Investment Company Act provides a comprehensive regulatory structure 
designed to protect largely passive investors in funds, while the 
Advisers Act, which contains a less detailed regulatory scheme, imposes 
a broad fiduciary duty on advisers, requiring them to act in the best 
interest of their clients.\4\ These statutes contain common elements: 
they require registration with us;\5\ proscribe certain types of 
harmful conduct;\6\ and give us the authority to require the disclosure 
of certain information \7\ and the maintenance of certain records.\8\ 
They give us authority to examine the records of funds and advisers.\9\ 
During fiscal year 2002, our staff conducted examinations of 278 fund 
complexes \10\ and 1,570 investment advisers.
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    \3\ Funds and advisers are also subject to other federal 
securities laws, including the Securities Act of 1933 [15 U.S.C. 77] 
and the Securities Exchange Act of 1934 [15 U.S.C 78] (``Exchange 
Act'').
    \4\ Transamerica Mortgage Advisors v. Lewis, 444 U.S. 11, 17 
(1979).
    \5\ See Section 8(a) of the Investment Company Act [15 U.S.C. 
80a-8(a)] and section 203 of the Advisers Act [15 U.S.C. 80b-3].
    \6\ See, e.g., sections 10(f) [15 U.S.C. 80a-10(f)] (prohibiting 
funds from acquiring securities during the existence of an 
underwriting syndicate in which an affiliate participates), 12(d) 
[15 U.S.C. 80a-12(d)] (prohibiting funds from acquiring securities 
of other funds above certain limits), and 17(a) [15 U.S.C. 80a-
17(a)] (prohibiting certain persons from engaging in certain 
purchase, sale, and loan transactions with an affiliated fund) of 
the Investment Company Act; and section 206 of the Advisers Act [15 
U.S.C. 80b-6] (prohibiting fraud).
    \7\ See, e.g., section 30(e) of the Investment Company Act [15 
U.S.C. 80a-29(e)] (authorizing Commission to require funds to 
transmit certain information to stockholders) and section 204 of the 
Advisers Act [15 U.S.C. 80b-4] (authorizing Commission to require 
advisers to disseminate certain information).
    \8\ See Section 31(a) of the Investment Company Act [15 U.S.C. 
80a-30(a)] (authorizing Commission to require funds to maintain 
records) and section 204 of the Advisers Act (authorizing Commission 
to require advisers to maintain records).
    \9\ See Section 31(b) of the Investment Company Act [15 U.S.C. 
80a-30(b)] (authorizing Commission to examine fund records) and 
section 204 of the Advisers Act (authorizing Commission to examine 
adviser records).
    \10\ In this release, we use the term ``fund complex'' to 
indicate a group of funds that share a compliance program and often 
also have a common investment adviser or distributor.
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    The Commission's examination of funds and advisers is a key element 
of our investor protection program. During

[[Page 7039]]

a compliance examination, our staff visits the offices of the fund or 
adviser, reviews business records and interviews personnel to determine 
whether the fund or adviser is acting in compliance with the federal 
securities laws. Our examinations permit us to identify compliance 
problems at an early stage, identify practices that may be harmful to 
investors, and provide a deterrent to unlawful conduct. In many 
respects, our examiners are like ``cops on the beat'' watching for 
unlawful conduct in a neighborhood.
    Like police officers, our examiners cannot be everywhere at all 
times. Approximately 5,030 funds and 7,790 advisers are currently 
registered with us.\11\ Collectively, these funds and advisers control 
over $21 trillion of assets, and engage in tens of millions of 
transactions each year. Our current resources permit us to conduct 
routine examinations of each of the 966 fund complexes and each adviser 
only once every five years, and during these examinations we are unable 
to review every transaction. Instead, our compliance examinations focus 
on the effectiveness of the internal controls that the fund or adviser 
has established to prevent and detect violations of the federal 
securities laws.
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    \11\ As of November 2002, these registered investment companies 
were organized into 966 fund complexes and comprised nearly 33,000 
fund series and portfolios.
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    Our experience is that funds and advisers with effective internal 
compliance programs administered by competent compliance personnel are 
much less likely to violate the federal securities laws. If violations 
do occur, they are much less likely to result in harm to investors. In 
contrast, we have learned to regard weak controls as an indicator that 
undetected (and uncorrected) violations may have occurred, and we have 
assumed that, until improved controls are implemented, investors are at 
risk. Accordingly, our staff focuses its examination efforts on testing 
the effectiveness of controls and related compliance procedures, and 
requests that management correct any weaknesses that the staff 
discovers. This focus allows us to leverage our limited examination 
resources; we are able to direct additional resources to firms with 
weaker compliance controls, and may examine them more closely and more 
frequently.\12\
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    \12\ See Lori A. Richards, Director, SEC Office of Compliance 
Inspections and Examinations, The Evolution of the SEC's Inspection 
Program for Advisers and Funds: Keeping Apace of a Changing 
Industry, Remarks at Conference on Compliance and Inspection Issues 
for Investment Advisers and Investment Companies (Oct. 30, 2002) 
(transcript available at: http://www.sec.gov/news/speech/spch597.htm) (``[E]xaminers will ask about your compliance and 
control policies and procedures, and evaluate their implementation 
and effectiveness. If we can conclude that your controls are working 
effectively, we will adjust the depth and amount of test-checking we 
do to reflect that fact. If we find weaknesses in controls, however, 
our test-checking will be greater, inasmuch as the likelihood of 
violations will be greater.''). See also H.R. Rep. No. 104-622 
(1996) (``[T]he goal of examinations effected by the Commission 
staff should not be simply to duplicate the role played by a fund's 
internal compliance staff. If a fund has a well-functioning system 
of internal controls, the Commission's limited resources could be 
directed to other areas of fund operations, or to other funds.'').
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    Our ability to protect fund investors and advisory clients has in 
many respects come to rely upon the effectiveness of these compliance 
programs. They provide the first line of investor protection. Many 
funds and advisers have established effective programs staffed with 
competent and trained professionals.\13\ However, neither the federal 
securities laws nor our rules require funds and advisers to adopt and 
implement comprehensive compliance programs, and not all firms 
registered with us have adopted and implemented adequate compliance 
programs. The consequences of inadequate compliance programs are well 
documented in our releases through which we publicize our enforcement 
actions.\14\
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    \13\ One reason that funds and advisers may have adopted and 
implemented comprehensive compliance procedures is to defend 
themselves against a charge by us that they (or their officers or 
supervisory personnel) failed to supervise their employees (or other 
supervised persons). Section 203(e)(6) of the Advisers Act [15 
U.S.C. 80b-3(e)(6)] provides that a person shall not be deemed to 
have failed to supervise any person if: (i) The adviser had adopted 
procedures reasonably designed to prevent and detect violations of 
the federal securities laws; (ii) the adviser had a system in place 
for applying the procedures; and (iii) the person had reasonably 
discharged his supervisory responsibilities in accordance with the 
procedures and had no reason to believe the supervised person was 
not complying with the procedures.
    \14\ See, e.g., Millennium Capital Advisors, Investment Advisers 
Act Release No. 2092 (Dec. 13, 2002) (unauthorized trading in client 
account and concealment of this trading were facilitated by 
adviser's vague and insufficient compliance procedures and absence 
of independent monitoring of portfolio manager); Gintel Asset 
Management, Investment Advisers Act Release No. 2079 (Nov. 8, 2002) 
(repeated improper cross trades, principal transactions, and 
personal trading resulted in part from inadequate procedures to 
prevent violation of the adviser's code of ethics); Back Bay 
Advisors, Investment Advisers Act Release No. 2070 (Oct. 25, 2002) 
(excessive reliance on self-reporting and self-monitoring by 
portfolio managers to determine whether the firm was in compliance 
with the federal securities laws resulted in improper cross-trades); 
Western Asset Management, Investment Advisers Act Release No. 1980 
(Sept. 28, 2001) (subadviser had not established adequate procedures 
to detect portfolio manager's fraudulent activities with respect to 
the purchase and pricing of private placement securities); Scudder 
Kemper Investments, Investment Advisers Act Release No. 1848 (Dec. 
22, 1999) (adviser did not have in place procedures that could have 
prevented and detected trader's unauthorized trading for investment 
company accounts); Rhumbline Advisers, Investment Advisers Act 
Release No. 1765 (Sept. 29, 1998) (absence of procedures enabled 
chief investment officer to engage in unauthorized trading and to 
misrepresent resultant losses); Kemper Financial Services, 
Investment Advisers Act Release No. 1494 (June 6, 1995) (adviser had 
no guidelines or procedures in place to address conflicts of 
interest and funds' portfolio manager misappropriated funds' 
investment opportunity on behalf of private profit-sharing plan he 
also managed).
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    Because of the importance of these compliance programs to investors 
and to the administration of our examination authority under the 
Investment Company Act and Advisers Act, we are proposing two new rules 
(one for funds and one for advisers) that would require funds and 
advisers to (i) adopt and implement policies and procedures designed to 
prevent violations of the securities laws, (ii) review these policies 
and procedures at least annually for their adequacy and the 
effectiveness of their implementation, and (iii) designate a chief 
compliance officer responsible for administering the policies and 
procedures.\15\ We discuss each of the rules in more detail below.
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    \15\ The Investment Company Institute (ICI) submitted a 
rulemaking proposal to the Commission in November 1994 that 
recommended we adopt rules similar to the ones that we are proposing 
today (``ICI Proposal''). A copy of that proposal is available in 
the Commission's Public Reference Room, 450 Fifth Street, NW., 
Washington, DC 20549 (File No. S7-03-03).
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    We also are asking for comment on other possible roles for the 
private sector in overseeing compliance by funds and advisers with the 
federal securities laws. Specifically, we ask comment on the following 
possible avenues towards enhanced private sector involvement: (i) 
Periodic third-party compliance reviews of funds and advisers, (ii) an 
expansion of the scope of the fund audits performed by independent 
public accountants, (iii) the formation of one or more self-regulatory 
organizations, and (iv) a fidelity bonding requirement for advisers.

II. Discussion

    The Commission is proposing new rule 38a-1 under the Investment 
Company Act and new rule 206(4)-7 under the Advisers Act. In this 
release, we will refer to the rules collectively as the ``Proposed 
Rules.''\16\ Together the Proposed Rules would require all investment 
companies and advisers registered with us to adopt and

[[Page 7040]]

implement internal compliance programs containing elements described in 
the rules.\17\
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    \16\ We also are proposing related amendments to rule 204-2 
under the Advisers Act. See infra section II.D. These proposed 
amendments also will be included in the term ``Proposed Rules.''
    \17\ The rules also would require business development 
companies, which are unregistered closed-end investment companies, 
to adopt and implement such programs.
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    [sbull] We request comment on whether we should provide for one or 
more exceptions. Is there a subset of funds or investment advisers with 
operations so limited or staffs so small that the adoption of an 
internal compliance program would not be beneficial? If so, are there 
alternative measures that these funds and advisers could take to 
promote their compliance with the federal securities laws?

A. Adoption and Implementation of Policies and Procedures

    The Proposed Rules would require funds and advisers to adopt and 
implement policies and procedures reasonably designed to prevent 
violation of the federal securities laws.\18\ They must be written and, 
in the case of a fund, must be approved by the fund's board of 
directors, including a majority of the fund's independent 
directors.\19\ A fund's policies and procedures must be designed to 
prevent violation of the federal securities laws by the fund, its 
investment adviser, principal underwriter, and administrator in 
connection with their provision of services to the fund.\20\ An 
adviser's policies and procedures must be designed to prevent violation 
of the Advisers Act by the adviser and its supervised persons.\21\
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    \18\ Proposed rules 38a-1(a)(1) and 206(4)-7(a). Under proposed 
rule 206(4)-7(a), the policies and procedures would need to address 
only compliance with the Advisers Act.
    \19\ Proposed rule 38a-1(a)(2). Fund directors are commonly 
referred to as ``independent directors'' if they are not 
``interested persons'' of the fund. The term ``interested person'' 
is defined in section 2(a)(19) of the Investment Company Act [15 
U.S.C. 80a-2(a)(19)]. If the fund is a unit investment trust, the 
fund's principal underwriter or depositor must approve the policies 
and procedures. Proposed rule 38a-1(b).
    \20\ The ICI, in its submission to us suggesting a similar 
rulemaking, favored requiring the policies and procedures to cover 
the fund, but not the fund's service providers, such as its adviser. 
See ICI Proposal, supra note 15, at 20. Typically, however, a fund 
has no employees; personnel of its adviser, principal underwriter 
and/or administrator conduct all of its activities. It is unclear to 
us whether the ICI's proposal, limited in this manner, would require 
a fund to adopt sufficiently comprehensive policies and procedures. 
Therefore, proposed rule 38a-1 would require a fund's procedures to 
cover the fund's adviser, principal underwriter and administrator, 
but only with respect to their activities in connection with the 
operations of the fund.
    \21\ A ``supervised person'' is ``any partner, officer, director 
(or other person occupying a similar status or performing similar 
functions), or employee of an investment adviser, or other person 
who provides investment advice on behalf of the investment adviser 
and is subject to the supervision and control of the investment 
adviser.'' Section 202(a)(25) of the Advisers Act [15 U.S.C. 80b-
2(a)(25)].
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    The Proposed Rules would require funds and advisers to adopt a 
system of controls that promotes compliance with the securities laws. 
Internal control systems have long been used to assure the integrity of 
financial reporting. Congress recently recognized the importance of 
internal control systems in the Sarbanes-Oxley Act of 2002, which 
effectively requires public companies to adopt and periodically review 
the effectiveness of a system of internal controls.\22\ Broker-dealers 
have long been required to adopt compliance procedures.\23\ Banks are 
required to maintain internal controls that include compliance 
procedures.\24\ Several foreign regulators already require funds or 
advisers registered with them to adopt compliance policies and 
procedures.\25\ The Proposed Rules do not enumerate specific elements 
that funds and advisers must include in their required policies and 
procedures.\26\ Funds and advisers are too varied in their operations 
for the Commission to impose a single list of required elements. The 
policies and procedures required by the Proposed Rules should take into 
consideration the nature of each organization's operations.\27\ They 
should be designed to prevent violations

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(by, for example, separating operational functions such as trading and 
reporting), detect violations of securities laws (by, for example, 
requiring a supervisor to review employees' personal securities 
transactions), and correct promptly any material violations.
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    \22\ See Sarbanes-Oxley Act of 2002 [Pub. L. No. 107-204, 116 
Stat. 745 (2002)] (``Sarbanes-Oxley Act''). Section 404 of the 
Sarbanes-Oxley Act requires us to prescribe rules requiring each 
annual report required by section 13(a) or 15(d) of the Securities 
Exchange Act of 1934 [15 U.S.C. 78m(a) and 78o(d)] to include 
internal control reports containing an assessment of the 
effectiveness of those controls, and further requires that the 
auditors for an issuer attest to the assessment made by the 
management of the issuer. In October 2002, we proposed rules to 
implement the provisions of Section 404. Disclosure Required by 
Sections 404, 406, and 407 of the Sarbanes-Oxley Act of 2002, 
Investment Company Act Release No. 25775 (Oct. 22, 2002) [67 FR 
66208 (Oct. 30, 2002)]. Section 302 of the Sarbanes-Oxley Act 
required us to adopt rules under which the principal executives and 
financial officers of public issuers must certify the information 
contained in the issuer's quarterly and annual reports. These rules 
also were to require these officers to certify that: they are 
responsible for establishing, maintaining, and regularly evaluating 
the effectiveness of the issuer's internal controls; they have made 
certain disclosures to the issuer's auditors and the audit committee 
of the board of directors about the issuer's internal controls; and 
they have included information in the issuer's quarterly and annual 
reports about their evaluation and whether there have been 
significant changes in the issuer's internal controls or in other 
factors that could significantly affect internal controls subsequent 
to the evaluation. On August 29, 2002, we adopted rules implementing 
Section 302. Certification of Disclosure in Companies' Quarterly and 
Annual Reports, Investment Company Act Release No. 25722 (Aug. 29, 
2002) [67 FR 57276 (Sept. 9, 2002)].
    \23\ Broker-dealers are required by the National Association of 
Securities Dealers (``NASD'') to establish and maintain written 
procedures ``that are reasonably designed to achieve compliance with 
applicable securities laws and regulations, and the applicable Rules 
of [the NASD].'' NASD Conduct Rule 3010(b). See also New York Stock 
Exchange (``NYSE'') Rule 342. Both the NASD and the NYSE recently 
have proposed to enhance these procedures by, among other things, 
requiring the annual testing and verification of broker-dealers' 
internal controls by persons independent of the supervision of the 
underlying activities. NASD Rulemaking: Supervisory Control 
Amendments, Exchange Act Release No. 46859 (Nov. 20, 2002) [67 FR 
70990 (Nov. 27, 2002)] and NYSE Rulemaking: Amendments to Exchange 
Rule 342 (``Offices--Approval, Supervision and Control'') and its 
Interpretation, Rule 401 (``Business Conduct''), Rule 408 
(``Discretionary Power in Customers' Accounts''), and Rule 410 
(``Records of Orders''), Exchange Act Release No. 46858 (Nov. 20, 
2002) [67 FR 70994 (Nov. 27, 2002)].
    \24\ Under section 39 of the Federal Deposit Insurance Act [12 
U.S.C. 1831p-1], banks and thrifts are required by their regulators 
(the Office of the Comptroller of the Currency, the Board of 
Governors of the Federal Reserve System, the Federal Deposit 
Insurance Corporation and the Office of Thrift Supervision 
(collectively, ``Banking Regulators'')) to adopt internal controls 
that are ``appropriate to the size of the institution and the 
nature, scope and risk of its activities and that provide for: (1) 
An organizational structure that establishes clear lines of 
authority and responsibility for monitoring adherence to established 
polices; (2) effective risk assessment; (3) timely and accurate 
financial, operational and regulatory reports; (4) adequate 
procedures to safeguard and manage assets; and (5) compliance with 
applicable laws and regulations.'' Standards for Safety and 
Soundness, 60 FR 35674 (July 10, 1995) (``Interagency Guidelines''), 
codified at 12 CFR part 30 (Office of the Comptroller of the 
Currency), 12 CFR part 208, appendix D-1 and part 263, subpart I 
(Board of Governors of the Federal Reserve System), 12 CFR part 364 
(Federal Deposit Insurance Corporation), and 12 CFR part 570 (Office 
of Thrift Supervision).
    \25\ See, e.g., Financial Services Authority (FSA), FSA Handbook 
of Rules and Guidance, Systems and Controls Sec.  3.2.6 (``Areas 
covered by systems and controls: Compliance'') (United Kingdom); 
Commission des Operations de Bourse, L'Instruction du 15 Decembre 
1998 Relative aux [Organisme de Placement Collective en Valeurs 
Mobilieres] Prise en Application du Reglement, L'Annexe IV No. 89-
02, Bulletin Mensuel COB 369 (June 2002) (France); Securities and 
Futures Commission, Fund Manager Code of Conduct Sec.  1.6.3 (1997) 
(Hong Kong).
    \26\ The required polices and procedures should incorporate the 
policies and procedures funds have adopted pursuant to other 
requirements in the federal securities laws, a number of which we 
identify in succeeding notes. These policies and procedures need not 
be contained in the same document.
    \27\ The NASD directs its broker-dealer members to ``implement a 
supervisory system that is tailored specifically to the member's 
business.'' See NASD Notice to Members 99-45, at 294 (June 1999). 
The Banking Regulators have taken a similar approach with respect to 
compliance programs for banks and thrifts. See Interagency 
Guidelines, supra note 24, at 35676. See also Office of Comptroller 
of the Currency, Comptroller's Handbook: Compliance Management 
System (Consumer Compliance Examination), at 2 (Aug. 1996); Federal 
Deposit Insurance Corporation, Compliance Examination Manual, at B-2 
(July 1999); Board of Governors of the Federal Reserve System, 
Examination Manual for U.S. Branches and Agencies of Foreign Banking 
Organizations Sec.  5000.1 (Compliance), at 1 (Sept. 1997); Office 
of Thrift Supervision, Compliance Self-Assessment Guide: Components 
of an Effective Compliance Program, at 2 (Dec. 2002).
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    We would expect that policies and procedures of funds and (to the 
extent relevant) advisers would, at a minimum, address:
    [sbull] Portfolio management processes, including allocation of 
investment opportunities among clients and consistency of portfolios 
with guidelines established by clients, disclosures, and regulatory 
requirements; \28\
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    \28\ Rule 206(4)-6 under the Advisers Act [17 CFR 275.206(4)-6] 
requires investment advisers to adopt and implement written policies 
and procedures that are reasonably designed to ensure that the 
adviser votes proxies in the best interest of clients. Similarly, 
funds must disclose the policies and procedures that they use to 
determine how to vote proxies relating to portfolio securities. Form 
N-1A, Item 13(f) [17 CFR 239.15A; 274.11A]; Form N-2, Item 18.16 [17 
CFR 239.14; 274.11a-1]; Form N-3, Item 20(o) [17 CFR 239.17a; 17 CFR 
274.11b]; and Form N-CSR, Item 7 [17 CFR 249.331; 17 CFR 274.128].
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    [sbull] Trading practices, including procedures by which the 
adviser satisfies its best execution obligation, uses client brokerage 
to obtain research and other services (``soft dollar arrangements''), 
and allocates aggregate trades among clients;
    [sbull] Proprietary trading of the adviser and personal trading 
activities of supervised persons;\29\
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    \29\ Section 204A of the Advisers Act [15 U.S.C. 80b-4a] 
requires each adviser registered with us to have written policies 
and procedures reasonably designed to prevent the misuse of material 
non-public information by the adviser or persons associated with the 
adviser. Rule 17j-1(c)(1) under the Investment Company Act [17 CFR 
270.17j-1(c)(1)] requires a fund and each investment adviser and 
principal underwriter of the fund to ``adopt a written code of 
ethics containing provisions reasonably necessary to prevent'' 
certain persons affiliated with the fund, its investment adviser or 
its principal underwriter from engaging in certain fraudulent, 
manipulative, and deceptive actions with respect to the fund.
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    [sbull] The accuracy of disclosures made to investors, including 
information in advertisements;
    [sbull] Safeguarding of client assets from conversion or 
inappropriate use by advisory personnel;
    [sbull] The accurate creation of required records and their 
maintenance in a manner that secures them from unauthorized alteration 
or use and protects them from untimely destruction;\30\
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    \30\ Rule 31a-2(f)(3) under the Investment Company Act [17 CFR 
270.31a-2(f)(3)] and rule 204-2(g)(3) under the Advisers Act [17 CFR 
275.204-2(g)(3)] require funds and advisers that maintain records in 
electronic formats to establish and maintain procedures to safeguard 
the records.
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    [sbull] Processes to value client holdings and assess fees based on 
those valuations;
    [sbull] Safeguards for the protection of client records and 
information; \31\ and
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    \31\ Regulation S-P (``Privacy of Consumer Financial 
Information'') [17 CFR Part 248.30] requires funds and investment 
advisers to ``adopt policies and procedures that address 
administrative, technical, and physical safeguards for the 
protection of customer records and information.''
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    [sbull] Business continuity plans.
    Fund procedures would ordinarily cover a number of additional 
areas, including:
    [sbull] Pricing of portfolio securities and fund shares; \32\
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    \32\ Rule 2a-7(c)(7) under the Investment Company Act [17 CFR 
270.2a-7(c)(7)] requires boards of money market funds to establish 
written procedures ``reasonably designed * * * to stabilize the 
money market fund's net asset value per share.''
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    [sbull] Processing of fund shares;
    [sbull] Identification of affiliated persons with whom the fund 
cannot enter into certain transactions, and compliance with exemptive 
rules and orders that permit such transactions;\33\
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    \33\ Rule 10f-3(b)(10) under the Investment Company Act [17 CFR 
270.10f-3(b)(10)] requires boards of funds that purchase securities 
in an underwriting in which certain persons serve as principal 
underwriters to adopt certain procedures to govern those purchases. 
Rule 17a-7(e) under the Investment Company Act [17 CFR 270.17a-7(e)] 
requires boards of funds that engage in purchase or sale 
transactions with certain affiliated persons to adopt procedures 
``reasonably designed'' to achieve compliance with the conditions on 
such transactions set forth in the rule.
---------------------------------------------------------------------------

    [sbull] Compliance with fund governance requirements; and
    [sbull] Prevention of money laundering.\34\
---------------------------------------------------------------------------

    \34\ Under 31 CFR 103.130(c), funds must develop an anti-money 
laundering program, which includes the establishment and 
implementation of ``policies, procedures, and internal controls 
reasonably designed to prevent the mutual fund from being used for 
money laundering or the financing of terrorist activities and to 
achieve compliance with the applicable provisions of the Bank 
Secrecy Act and the implementing regulations thereunder.''
---------------------------------------------------------------------------

    While funds and advisers could delegate compliance functions to 
service providers, their policies and procedures should provide for 
effective oversight of these service providers. We request comment on 
our proposed requirement that advisers and funds adopt compliance 
policies and procedures.
    [sbull] Should either rule specify certain minimum policies and 
procedures? If so, what specific required policies and procedures 
should we include, and in which rule should we include them?
    [sbull] We anticipate that if we adopt the Proposed Rules, we will 
provide guidance to funds and advisers in our adopting release similar 
to what we have provided above (regardless of whether the rules, as 
adopted, include specific minimum requirements). We request comment on 
the guidance that we have provided and urge commenters to provide 
suggestions as to additional areas our guidance should cover.
    [sbull] Should the policies and procedures of funds or advisers be 
designed to prevent violations by persons other than those listed in 
the Proposed Rules?

B. Annual Review

    Under the Proposed Rules, each fund and adviser must review its 
policies and procedures at least annually to determine their adequacy 
and the effectiveness of their implementation.\35\ These provisions are 
designed to require advisers and funds to evaluate periodically whether 
their policies and procedures continue to work as designed and whether 
changes are needed to assure their continued effectiveness.
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    \35\ Proposed rules 38a-1(a)(3) and 206(4)-7(b). The NASD and 
the NYSE recently have proposed annual reviews of the internal 
controls, and reports to senior management. See supra note 23.
---------------------------------------------------------------------------

    [sbull] Should we require more frequent review of the policies and 
procedures? Our proposed rules implementing Section 404 of the 
Sarbanes-Oxley Act would require that executives of issuers evaluate 
the company's internal controls for financial reporting quarterly.\36\
---------------------------------------------------------------------------

    \36\ Investment Company Act Release No. 25775, supra note 22.
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C. Chief Compliance Officer

    The policies and procedures of a firm, no matter how well-crafted, 
will be ineffective unless well-trained, competent personnel administer 
them. Therefore, we are proposing to require that each fund and adviser 
designate an individual responsible for administering the compliance 
policies and procedures.\37\ The chief compliance officer should be 
competent and knowledgeable regarding the applicable federal securities 
laws and should be empowered with full responsibility and authority to 
develop and enforce appropriate policies and procedures for the adviser 
or the fund complex.\38\
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    \37\ Proposed rules 38a-1(a)(4) and 206(4)-7(c). In the case of 
an adviser, the individual would have to be a supervised person of 
the adviser. See supra note 21, regarding the definition of 
``supervised person.'' Although the NASD does not require its member 
broker-dealers to appoint a chief compliance officer, NASD Conduct 
Rule 3010(a)(2) does direct them to designate principals responsible 
for supervision, which ``ensure[s] that there is an identifiable 
individual who has ultimate responsibility for implementing the 
member's supervisory system and written procedures for each type of 
business the member conducts.'' NASD Notice to Members 99-45, at 
295-96 (June 1999).
    \38\ Designation of a person by an adviser as its chief 
compliance officer would not, in and of itself, impose upon the 
person a duty to supervise another person. Thus, a chief compliance 
officer appointed in compliance with the Proposed Rules would not 
necessarily be subject to a sanction by us for failure to supervise. 
A compliance officer that does have supervisory responsibilities 
will have available the defense discussed above. See supra note 13.

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[[Page 7042]]

    We understand that many funds and advisers have designated a person 
to serve as the chief compliance officer.\39\ Not all firms have taken 
this step, which we believe is critical to an effective compliance 
program. We expect that the primary effect of the rule on funds and 
larger advisory firms would be to require the compliance personnel to 
report to one individual with overall responsibility to coordinate the 
fund's (or firm's) compliance efforts and to establish procedures for 
annual review of its compliance programs.\40\
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    \39\ Form ADV, the registration form that advisers use to 
register with us under the Advisers Act, requires each adviser to 
report the name of its chief compliance officer, but does not 
require the adviser to have a chief compliance officer. Form ADV, 
Part 1, Schedule A, Item 2(a) [17 CFR 279.1].
    \40\ The ICI, in its 1994 submission to us, urged that multiple 
individuals be permitted to perform this role because the knowledge 
about compliance in specific areas may not be concentrated in any 
one individual. See ICI Proposal, supra note 15, at 23. Our 
proposal, which would require appointment of a single individual, 
would accommodate a large and diverse compliance organization, but 
would require the many compliance officers to report ultimately to 
one individual. The Hong Kong Securities and Futures Commission has 
taken a similar approach. See Fund Manager Code of Conduct at Sec.  
1.6.1 (1997) (Hong Kong registered fund managers must have a 
``designated compliance officer'').
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    In the case of a fund, the fund's board of directors, including a 
majority of the independent directors, would have to approve the chief 
compliance officer, who would have additional duties that reflect the 
important role of fund boards in overseeing fund compliance with the 
federal securities laws.\41\ Proposed rule 38a-1 would require the 
chief compliance officer to furnish the fund's board of directors 
annually with a written report on the operation of the fund's policies 
and procedures, including (i) any material changes to the policies and 
procedures since the last report, (ii) any recommendations for material 
changes to the policies and procedures as a result of the annual 
review, and (iii) any material compliance matters requiring remedial 
action that occurred since the date of the last report.\42\ The rule 
would thus require board oversight of the fund's compliance program, 
but would not require directors to become involved in the day-to-day 
administration of the program. We designed the proposed rule to reflect 
the way many fund complexes' compliance personnel currently administer 
fund codes of ethics under rule 17j-1 of the Investment Company Act.
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    \41\ Proposed rule 38a-1(a)(4)(i). If the fund is a unit 
investment trust, the fund's principal underwriter or depositor must 
approve the chief compliance officer. Proposed rule 38a-1(b).
    \42\ Proposed rule 38a-1(a)(4)(ii).
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    [sbull] Rule 17j-1 requires that funds, their investment advisers, 
and principal underwriters certify annually that they have adopted 
procedures reasonably necessary to prevent violations of their codes of 
ethics adopted under the rule.\43\ Should we similarly require each 
chief compliance officer to certify the fund's compliance policies and 
procedures?
---------------------------------------------------------------------------

    \43\ Rule 17j-1(c)(1)(2).
---------------------------------------------------------------------------

    [sbull] The USA PATRIOT Act requires funds to establish anti-money 
laundering programs that designate an anti-money laundering compliance 
officer,\44\ but the implementing rules permit multiple persons to 
serve in this role.\45\ Should our rule permit multiple compliance 
officers?
---------------------------------------------------------------------------

    \44\ See section 352 of the Uniting and Strengthening America by 
Providing Appropriate Tools Required to Intercept and Obstruct 
Terrorism Act of 2001, Pub. L. No. 107-56, 115 Stat. 272 (``USA 
PATRIOT Act''), amending 31 U.S.C 5318(h).
    \45\ 31 CFR 103.130(c)(3).
---------------------------------------------------------------------------

    [sbull] Should we require that the chief compliance officer be a 
member of senior management of the fund or the adviser? \46\
---------------------------------------------------------------------------

    \46\ In the United Kingdom, the FSA requires that firms allocate 
to a ``director'' or ``senior manager'' responsibility for oversight 
of the firm's compliance and reporting. FSA Handbook of Rules and 
Guidance, Systems and Controls Sec.  3.2.8 (``Areas covered by 
systems and controls: Compliance'') (United Kingdom).
---------------------------------------------------------------------------

D. Recordkeeping

    We are proposing to require that funds and advisers maintain a copy 
of their policies and procedures.\47\ Funds would have to keep the 
annual written report by the fund's chief compliance officer.\48\ 
Advisers would have to keep records documenting their annual 
review.\49\ Funds and advisers would have to keep the required 
documents for five years.\50\ These records are designed to provide our 
examination staff with a basis to determine whether the adviser or fund 
has complied with the rules.
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    \47\ Proposed rules 38a-1(c)(1) and 204-2(a)(17)(i).
    \48\ Proposed rule 38a-1(c)(2). A fund's board's deliberations 
in connection with the approval of the compliance policies and 
procedures and their annual review of the chief compliance officer's 
report would be documented in the minute books of the fund board, 
which must be maintained pursuant to rule 31a-1(b)(4) under the 
Investment Company Act [17 CFR 270.31a-1(b)(4)].
    \49\ Proposed rule 204-2(a)(17)(ii).
    \50\ Funds and advisers would be required to maintain copies of 
all policies and procedures that are in effect or were in effect at 
any time during the last five years. Proposed rules 38a-1(c)(1) and 
204-2(a)(17)(i). Funds would be required to maintain the annual 
compliance reports to the board for at least five years after the 
end of the fiscal year in which the report was provided to the 
board, the first two years in an easily accessible place. Proposed 
rule 38a-1(c)(2). Advisers would be required to maintain any records 
documenting their annual review in an easily accessible place for at 
least five years after the end of the fiscal year in which the 
review was conducted, the first two years in an appropriate office 
of the investment adviser. Proposed rule 204-2(e)(1).
---------------------------------------------------------------------------

    We request comment on the recordkeeping requirements. Specifically, 
as required by section 31(a)(2) of the Investment Company Act [15 
U.S.C. 80a-30(a)(2)], we request commenters to address whether there 
are feasible alternatives to the Proposed Rules that would minimize the 
recordkeeping burdens, the necessity of these records in facilitating 
the examinations carried out by our staff, the costs of maintaining the 
required records, and any effects that the proposed recordkeeping 
requirements would have on the nature of firms' internal compliance 
policies and procedures.

E. Request for Comment on Further Private Sector Involvement

    As we note above, the number of funds and advisers (and the amount 
of assets they control) has grown significantly.\51\ This growth has 
substantially exceeded the growth in our resources \52\ as well as 
those resources we have been able to allocate to our investment company 
and investment adviser programs.\53\ Although the Commission's 
resources may increase substantially in the future,\54\ other program 
areas will have competing needs for those resources.\55\

[[Page 7043]]

Moreover, even if we are able to substantially expand our 
examinationstaff, it is unlikely that future growth in our resources 
will ever keep pace with future growth of investment advisers and 
investment companies. We therefore are exploring ways in which we may 
make the best use of limited government resources to protect the 
interests of the millions of investors who invest in funds, participate 
in pension funds managed by investment advisers, or use the services of 
a personal financial planner or money manager.
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    \51\ The number of registered investment companies has increased 
approximately 44% in the past 10 years, from approximately 3,500 in 
1991 to approximately 5,030 currently. Investment company assets 
have grown over 400%, from $1.2 trillion to $6.4 trillion over the 
same period. Although the number of advisers registered with us 
decreased during the period (as a result of the enactment of the 
National Securities Markets Improvement Act, Pub. L. No. 104-290, 
110 Stat. 3416 (1996) (codified in Section 203A of the Advisers Act 
[15 U.S.C 80b-3a] and other scattered sections of the United States 
Code)), which prohibited most smaller state-registered advisers from 
registering with us, the amount of assets under the management of 
registered advisers has grown from $10.7 trillion in 1997 to over 
$21 trillion currently, an increase of nearly 100%.
    \52\ See United States General Accounting Office, SEC 
Operations: Increased Workload Creates Challenges, at 11 (Mar. 2002) 
(``GAO Study'') (during the past decade, ``the increases in SEC's 
workload substantially outpaced the increases in SEC's staff'').
    \53\ See GAO Study, supra note 52, at 13 (``total assets under 
management by investment companies (IC) and investment advisers (IA) 
increased by about 264 percent over 10 years, while the number of IC 
and IA examination staff increased by 166 percent'').
    \54\ Section 601 of the Sarbanes-Oxley Act, supra note 22, 
authorized us to spend $776 million in fiscal year 2003, which, if 
appropriated, would be a substantial increase over our appropriation 
of $487.2 million in fiscal year 2002.
    \55\ Section 408 of the Sarbanes-Oxley Act, supra note 22, for 
example, requires us, based upon consideration of certain enumerated 
criteria, to review the disclosures, including the financial 
statements made by issuers reporting under the Securities Exchange 
Act of 1934, at least once every three years.
---------------------------------------------------------------------------

    One promising way of leveraging government resources would be for 
the Commission to rely more heavily on the private sector, i.e., on the 
advisers and funds that are the indirect beneficiaries of our 
compliance program and the federal tax dollars that today support our 
regulatory efforts. The rules we are proposing today are one step in 
this direction. Others may also be appropriate to consider, including 
those we describe briefly below. We invite interested persons to submit 
comments as to the advisability of pursuing any or all of them, as well 
as other approaches for involving the private sector in enhancing 
compliance with the federal securities laws. We request that commenters 
address the Commission's authority to effect through rulemaking each of 
the approaches.
1. Compliance Reviews
    One approach might be to require each fund and adviser to undergo 
periodic compliance reviews by a third party that would produce a 
report of its findings and recommendations. Our examination staff could 
use these reports to identify quickly areas that required attention, 
permitting us to allocate examination resources better and, as a 
result, to increase the frequency with which our staff could examine 
funds and advisers. Funds and advisers with reports indicating that 
they have effective compliance programs could be examined less 
frequently, which would reduce the burdens on them of undergoing more 
frequent examination by our staff.
    There are many organizations that provide compliance reviews, 
including ``mock audits'' for investment advisers and funds, and have 
personnel that have experience in designing, implementing, and 
assessing the effectiveness of compliance programs.\56\ As a condition 
to the settlement of an enforcement action, we frequently require an 
adviser or fund to engage a compliance consultant.\57\ The USA PATRIOT 
Act requires financial institutions (including mutual funds), as part 
of their anti-money laundering programs, to have an independent audit 
function to test their programs.\58\
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    \56\ See, e.g., Jeremy Kahn, Practice Audits Pay Off, Fortune, 
June 24, 2002, at 40 (discussing mock audits of investment 
advisers); Nancy Opiela, ``They're Here * * *,'', 15 Journal of 
Financial Planning 52 (2002) (discussing use of mock auditors by 
financial planners preparing for audits by our staff).
    \57\ See, e.g., Gintel Asset Management, Investment Advisers Act 
Release No. 2079 (Nov. 8, 2002); Performance Analytics, Investment 
Advisers Act Release No. 2036 (June 17, 2002); ND Money Management, 
Investment Advisers Act Release No. 2027 (Apr. 12, 2002); Stan D. 
Kiefer & Associates, Investment Advisers Act Release No. 2023 (Mar. 
22, 2002).
    \58\ Section 352 of the USA PATRIOT Act, supra note 44. See also 
31 CFR 103.130(c)(2) (requiring mutual funds, as a part of their 
written anti-money laundering programs, to provide for ``independent 
testing for compliance to be conducted by the mutual fund's 
personnel or by a qualified outside party'').
---------------------------------------------------------------------------

    We request comment on the advantages and disadvantages of requiring 
advisers and funds to undergo compliance reviews. If we adopt such a 
requirement, should we exclude certain types of funds or advisers? 
Would the cost of these reviews be prohibitive for smaller advisers? 
Would some fund groups or advisers hire the least expensive compliance 
consultant regardless of the quality of the consultant's work? If so, 
how could we ensure that a high quality compliance review is conducted? 
If we adopt such a requirement, should we require the third parties who 
conduct such reviews to satisfy certain minimum standards for education 
and experience? What criteria should be included in the rule to 
determine whether a third party compliance expert is independent? How 
frequently should we require such reviews to be conducted? What is the 
proper scope for third party reviews? Should we require the third party 
consultant to file its report with us? If so, what should the scope of 
the report be?
2. Expanded Audit Requirement
    Another approach might be to expand the role of independent public 
accountants that audit fund financial statements to include an 
examination of fund compliance controls. Such an approach would involve 
the performance by fund auditors of certain of the compliance review 
procedures currently performed by our staff in a compliance 
examination.\59\
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    \59\ We first raised this idea in a concept release we issued in 
1983. Concept of Utilizing Private Entities in Investment Company 
Examinations and Imposing Examination Fees, Investment Company Act 
Release No. 13044 (Feb. 23, 1983) [48 FR 8485 (Mar. 1, 1983)].
---------------------------------------------------------------------------

    Our rules today require fund auditors to submit internal control 
reports to fund boards.\60\ In these reports, the auditor must identify 
any material weaknesses in the accounting system, the system of 
internal accounting controls, and the procedures for safeguarding 
securities of which they become aware while planning and performing the 
audit on the fund's financial statements.\61\ The auditor's 
responsibilities could be augmented to require the identification of 
material weaknesses in the internal controls or a report on other 
aspects of the internal controls that are not required to be reviewed 
in planning and performing an audit of the financial statements. 
Expanding the auditor's responsibilities could, to some extent, serve 
as a substitute for staff examination or reduce the frequency of staff 
examination of funds with strong internal compliance programs, which 
would free Commission resources to focus on other areas of fund 
operations and permit us to examine funds with weaker internal 
compliance programs more often.
---------------------------------------------------------------------------

    \60\ Rule 30a-1 [17 CFR 270.30a-1]; Item 77B of Form N-SAR [17 
CFR 249.330; 17 CFR 274.101].
    \61\ Item 77B, supra, note 60.
---------------------------------------------------------------------------

    We request comment on this approach. Should we expand the 
responsibilities of the fund auditor? If so, what specific areas would 
it be appropriate for auditors to review? What type of assurance report 
should be provided?\62\
---------------------------------------------------------------------------

    \62\ See, e.g., American Institute of Certified Public 
Accountants (AICPA), Statement on Auditing Standards No. 70 Service 
Auditor's Report; AICPA, Statement on Standards for Attestation 
Engagements, AT Sec. Sec.  500.54-61 (``Compliance Attestation 
Reporting'')).
---------------------------------------------------------------------------

3. Self-Regulatory Organization
    The formation of one or more self-regulatory organizations (SROs) 
for funds and/or advisers also would be a means to involve the private 
sector in support of our regulatory program. An SRO would function in a 
manner analogous to the national securities exchanges and registered 
securities associations under the Securities Exchange Act of 1934 by 
(i) establishing business practice rules and ethical standards, (ii) 
conducting routine examinations, (iii) requiring minimum education or 
experience standards, and (iv) bringing its own actions to

[[Page 7044]]

discipline members for violating its rules and the federal securities 
laws.
    SROs play an increasingly important role in the regulation of 
financial services in the United States. SROs participate with us in 
overseeing the public securities markets, including broker-dealers.\63\ 
They also oversee the municipal bond market,\64\ and the system of 
clearance and settlement of securities trades.\65\ An SRO also plays an 
important part in the oversight of the futures markets, including 
futures commissions merchants, commodity pool operators, and commodity 
trading advisers.\66\ In the Sarbanes-Oxley Act, Congress affirmed the 
role of private sector regulatory organizations by establishing the 
Public Company Accounting Oversight Board, which is charged with 
overseeing the audit of public companies.\67\
---------------------------------------------------------------------------

    \63\ National Securities Exchanges register with us as SROs 
pursuant to Section 6 of the Exchange Act [15 U.S.C. 78f]. 
Currently, there are nine active securities exchanges. Section 15A 
of the Exchange Act [15 U.S.C. 78o-3] authorizes us to register one 
or more national securities associations to regulate the activities 
of member broker-dealers. NASD is the only national securities 
association currently registered under this section. Section 15A was 
added in 1938 to regulate the activities of brokers who traded 
securities of issuers that were not listed on the exchanges. Maloney 
Act, Pub. L. No. 75-719, 52 Stat. 1070 (1938).
    \64\ The Securities Amendments Act of 1975 [Pub. L. No. 94-29, 
87 Stat. 97 (1975)] added section 15B to the Exchange Act [15 U.S.C. 
78o-4], which directed the Commission to establish the Municipal 
Securities Rulemaking Board (``MSRB''). Unlike the other SROs, the 
MSRB was created by Congress solely to write rules governing the 
municipal securities market; it is not a membership organization and 
does not have authority to discipline its members.
    \65\ Clearing agencies register with us pursuant to Section 
17A(b) of the Exchange Act [15 U.S.C. 78q-1(b)]. Currently, there 
are 13 clearing agencies registered with us.
    \66\ See Commodity Futures Trading Commission (``CFTC'') Rule 
170.15 [17 CFR 170.15] (membership in a registered futures 
association mandatory) and National Futures Association (``NFA'') 
Bylaw 1101 (membership in the NFA mandatory for any registered party 
that transacts futures business with the public). The NFA performs 
various functions for the CFTC, including processing of applications 
for registration and conducting proceedings to deny, condition, 
suspend, restrict or revoke the registration of persons registered 
with the CFTC.
    \67\ Section 101 of the Sarbanes-Oxley Act, supra note 22.
---------------------------------------------------------------------------

    United States Supreme Court Justice Stewart stated that the purpose 
of the provisions of the Exchange Act creating SROs was ``to delegate 
governmental power to working institutions which would undertake, at 
their own initiative, to enforce compliance with ethical as well as 
legal standards in a complex and changing industry.''\68\ Our 
experience with SROs suggests that this delegation of authority can 
have many advantages: SROs can marshal resources not available to the 
Commission and can have greater access to industry expertise. They can 
act more nimbly than a government agency, which is subject to 
significant personnel, contracting, and procedural requirements. An SRO 
can require its members to adhere to higher standards of ethical 
behavior than we can require under the securities laws. Moreover, 
industry leaders who participate in the regulatory process acquire a 
greater sense of their stake in the process.\69\
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    \68\ Silver v. New York Stock Exchange, 373 U.S. 341, 371 (1963) 
(Stewart, J., dissenting).
    \69\ See Report of Special Study of Securities Markets of the 
Securities and Exchange Commission, H.R. Doc. No. 88-95, pt. 4, at 
722 (1963) (``Special Study'').
---------------------------------------------------------------------------

    Proposals to create SROs for funds or investment advisers have been 
considered by Congress, the Commission, and members of the investment 
management industry in past years. In 1983, we requested comment on the 
concept of designating an ``inspection-only'' SRO for funds.\70\ And in 
1989, we submitted legislation to Congress requesting authority to 
designate one or more SROs for investment advisers.\71\ Both 
initiatives reflected the concern of the Commission that our resources 
were inadequate to address the growth of investment advisers and 
funds.\72\ Any SRO would be subject to the pervasive oversight of the 
Commission. We would examine its activities, require it to keep 
records, and approve its rules only if we conclude that they further 
the goals of the federal securities laws. Disciplinary actions could be 
appealed to the Commission. We would expect to be vigilant in 
preventing SRO rules that impose a burden on competition not necessary 
to further a regulatory purpose. Our staff would continue to examine 
the activities of funds and advisers, both to ensure adequate 
examination coverage and to provide oversight of the SRO examination 
program.
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    \70\ Investment Company Act Release No. 13044, supra note 59.
    \71\ The legislation was introduced as S. 1410 and H.R. 3054, 
101st Cong. (1989). Consideration by the Commission of an SRO for 
investment advisers appears to have first begun in 1963 when our 
Special Study of the Securities Markets recommended that membership 
in an SRO should be required of all registered investment advisers. 
Special Study, supra note 69, pt. 1, at 158-59. In 1976, the 
Commission asked Congress for the authority to conduct a formal 
study of the feasibility of establishing one or more SROs for 
investment advisers. S. Rep. No. 94-910, at 10 (1976).
    In 1986, the NASD conducted a pilot program to determine the 
feasibility of examining the investment advisory activities of its 
members who were also registered as investment advisers. See Staff 
of the Securities and Exchange Commission, Report on Financial 
Planners to House Comm. on Energy and Commerce, Subcomm. on 
Telecommunications and Finance, at 118-23 (Feb. 1988). In 1993, the 
House of Representatives passed a bill that, among other things, 
would have amended the Advisers Act to authorize the creation of an 
``inspection-only'' SRO for investment advisers. H.R. 578, 103rd 
Cong. (1993).
    Industry organizations and their members and commenters have, 
from time-to-time, also called for the creation of an SRO for 
investment advisers. See Note, Financial Planning: Is It Time for a 
Self-Regulatory Organization?, 53 Brook. L. Rev. 143 (1987); Charles 
Lefkowitz, The World of Financial Planning: Why an SRO Makes Sense, 
87 Best's Review, Dec. 1986, at 32. In 1985, the International 
Association of Financial Planners proposed the creation of an SRO 
for financial planners based on the NASD model. See Letter from 
Hubert L. Harris, Executive Director of the International 
Association for Financial Planning, to Kathryn B. McGrath, Director 
of the Commission's Division of Investment Management (June 19, 
1985) (transmitting summary of proposal for financial planner SRO 
adopted by the Association's board of directors) (available in File 
No. S7-03-03). Not all industry participants have supported the 
creation of an SRO. See David Tittsworth, Executive Director, 
Investment Counsel Association of America, Statement for our 
Roundtable on Investment Adviser Regulatory Issues (May 23, 2000) 
(``We continue to oppose the creation of a self-regulatory 
organization for the advisory profession * * * [which] is 
unwarranted and would impose a new layer of cost and bureaucracy on 
the profession.'') (available at: http://www.sec.gov/rules/other/f4-433/tittswo1.htm). Others object to being regulated by a particular 
SRO. See Aaron Luccetti, NASD's Push to Extend Its Reach Spurs Anger 
of Investment Advisers, Wall St. J., Nov. 12, 1998, at C1.
    \72\ We issued the 1983 concept release out of a concern, in 
part, that the growth in money market funds (which were then a novel 
type of fund) would outstrip our examination resources. In 1983, 
money market funds had $179 million of assets under management. 
Today, they have nearly $2.3 trillion of assets. Investment Company 
Institute, 2002 Mutual Fund Fact Book 86.
---------------------------------------------------------------------------

    We request comment on whether one or more SROs should be 
established for funds and/or investment advisers. Should the SROs be 
limited in their authority? For example, should they be limited to 
conducting examinations? How should the activities of an SRO be 
financed? \73\
---------------------------------------------------------------------------

    \73\ Other financial SROs, for example, are financed by fees 
imposed on members and users of their services rather than by public 
funds.
---------------------------------------------------------------------------

4. Fidelity Bonding Requirement for Advisers
    Another means to privatize some of the compliance function would be 
to require investment advisers to obtain fidelity bonds from insurance 
companies. Fidelity bonds provide a source of compensation for advisory 
clients who are victims of fraud or embezzlement by advisory personnel. 
They result in additional oversight of advisers by insurance companies, 
which are unwilling to issue bonds to advisers that place their assets 
at risk by having poor controls or that hire employees with criminal or 
poor disciplinary records. The cost of that oversight is reflected in 
the premiums charged for the bond. High-risk advisers would be denied 
bonds or would be charged

[[Page 7045]]

higher amounts to compensate the insurance company for assuming greater 
risk.
    Investment advisers are among the only financial service providers 
handling client assets that are not required to obtain fidelity 
bonds.\74\ The Advisers Act does not require advisory firms to have a 
minimum amount of capital invested, and many have few assets.\75\ When 
we discover a serious fraud by an adviser, often the assets of the 
adviser are insufficient to compensate clients. The losses are borne by 
clients who may lose their life's savings, or be unable to afford a 
college education for their children or a comfortable retirement.
---------------------------------------------------------------------------

    \74\ Fidelity bonds are required to be obtained by: broker-
dealers (NASD Conduct Rule 3020; NYSE Rule 319; American Stock 
Exchange Rule 330); transfer agents (NYSE Listed Company Manual 
Sec.  906.01); investment companies (17 CFR 270.17g-1); national 
banks (12 CFR 7.2013); and federal savings associations (12 CFR 
563.190). Section 412 of the Employee Retirement Income Security Act 
(ERISA) [29 U.S.C. 1112] requires investment advisers to obtain a 
fidelity bond with respect to any employee benefit plan assets the 
adviser manages, and many state laws require state-registered 
advisers to obtain fidelity bonds. See, e.g., Ala. Admin. Code r. 
830-x-3-.06(4) (2002) (requiring $50,000 bond for advisers that have 
custody of or discretionary authority over customer assets); Mass. 
Regs. Code tit. 950, Sec.  12.205(5)(b) (2002) (requiring $10,000 
bond for advisers that have custody of or discretionary authority 
over client assets or receive prepayments); Minn. R. 2875.1930, 
Subpart 1 (2002) (requiring $25,000 bond for advisers that have 
custody of or discretionary authority over client assets); N.J. 
Admin. Code tit. 13, Sec.  47.A-2.2 (2002) (requiring $25,000 bond 
or $25,000 minimum capital for advisers that have custody of client 
assets); 21 Va. Admin. Code 5-80-180(B) (requiring $25,000 bond or 
$25,000 minimum capital for advisers). Similarly, independent 
financial advisers registered with the FSA in the United Kingdom 
must maintain professional indemnity insurance. Prudential Rules for 
Independent Financial Advisers Sec.  13.13R (Nov. 2001).
    \75\ In 1992, both the Senate and House of Representatives 
passed bills that would have given us authority to require advisers 
to obtain fidelity bonds. S. 2266, Sec.  5, 102nd Cong. (1992), and 
H.R. 5726, Sec.  107, 102nd Cong. (1992). Because differences in the 
two bills were never reconciled, neither became law.
---------------------------------------------------------------------------

    Should advisers be required to obtain a fidelity bond from a 
reputable insurance company? If so, should some advisers be excluded? 
\76\ Alternatively, should advisers be required to maintain a certain 
amount of capital that could be the source of compensation for clients? 
\77\ What amount of capital would be adequate? \78\
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    \76\ The 1992 legislation would have given us authority to 
require bonding of advisers that have custody of client assets or 
that have discretionary authority over client assets. Section 412 of 
ERISA requires plan fiduciaries to obtain a bond with respect to 
plan assets ``handled'' by the plan fiduciary. Department of Labor 
rules clarify that handling plan assets includes having 
discretionary authority over them. 29 CFR 2580.412-6.
    \77\ In 1973, a Commission advisory committee recommended that 
Congress authorize us to adopt minimum financial responsibility 
requirements for investment advisers, including minimum capital 
requirements. Advisory Committee on Investment Management Services 
for Individual Investors, Small Account Investment Management 
Services: Recommendations for Clearer Guidelines and Policies 64-66 
(Jan. 1973). Three years later, in 1976, the Senate Committee on 
Banking, Housing, and Urban Affairs reported a bill that, among 
other things, authorized the Commission to adopt rules requiring 
advisers (i) with discretionary authority over client assets, (ii) 
with access to client funds or securities, or (iii) that advise 
registered investment companies, to meet financial responsibility 
standards. S. Rep. No. 94-910, at 14-15 (1976) (reporting favorably 
S. 2849). S. 2849 was never enacted.
    \78\ Section 412 of ERISA requires that the bond required under 
that section be no less than 10% of the amount of funds handled.
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III. General Request for Comment

    The Commission requests comment on the Proposed Rules, suggestions 
for additions to the Proposed Rules, and comment on other matters that 
might have an effect on the proposals contained in this release. We 
note that the comments that are of greatest assistance are those that 
are accompanied by supporting data and analysis of the issues addressed 
in those comments.

IV. Cost-Benefit Analysis

    We are sensitive to the costs and benefits that result from our 
rules. The Proposed Rules would require each fund and adviser to adopt 
and implement policies and procedures reasonably designed to prevent 
violations of the securities laws, to review these annually, and to 
designate an individual as chief compliance officer. We have identified 
certain costs and benefits, which are discussed below, that may result 
from the proposals. We request comment on the costs and benefits of the 
Proposed Rules. We encourage commenters to identify, discuss, analyze, 
and supply relevant data regarding these or any additional costs and 
benefits.

A. Benefits

    We anticipate that fund investors, advisory clients, funds, and 
advisers will benefit from the Proposed Rules. The Proposed Rules would 
benefit fund investors and advisory clients (collectively, 
``investors'') by requiring funds and advisers to design and implement 
a comprehensive internal compliance program. Although many funds and 
advisers already have such programs in place, the Proposed Rules would 
make this standard practice for all firms. Investors would be less 
likely to be harmed by violations of the securities laws because 
experience has shown that strong internal compliance programs lower the 
likelihood of securities laws violations occurring and enhance the 
likelihood that any violations that do occur will be detected and 
corrected. In addition, because the Proposed Rules are designed to 
complement the Commission's examination program, the Commission's 
ability to protect investors would be enhanced. The existence of a 
structured compliance program, together with the designation of a chief 
compliance officer to serve as a point of contact, would facilitate the 
examination staff's efforts to conduct each examination in an organized 
and efficient manner and thus to allocate resources to maximize 
investor protection.
    Although the Proposed Rules would impose additional compliance 
costs on many funds and advisers, they would benefit funds and advisers 
by diminishing the likelihood of securities violations, Commission 
enforcement actions, and private litigation. For a fund or adviser, the 
potential costs associated with a securities law violation may consist 
of much more than merely the fines or other penalties levied by the 
Commission or civil liability. Advisers may be denied eligibility to 
advise funds.\79\ In addition, advisers could be precluded from serving 
in other capacities.\80\ The reputation of a fund or adviser may be 
significantly tarnished, resulting in redemptions (in the case of an 
open-end fund) or lost clients.
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    \79\ Section 9(a) of the Investment Company Act [15 U.S.C. 80a-
9(a)] prohibits a person from serving as an adviser to a fund if, 
within the past 10 years, the person has been convicted of certain 
crimes or is subject to an order, judgment, or decree of a court 
prohibiting the person from serving in certain capacities with a 
fund, or prohibiting the person from engaging in certain conduct or 
practice.
    \80\ See, e.g., 29 U.S.C. 1111(a) (prohibiting a person from 
acting in various capacities for an employee benefit plan, if within 
the past 13 years, the person has been convicted of, or has been 
imprisoned as a result of, any crime described in section 9(a)(1) of 
the Investment Company Act [15 U.S.C. 80a-9(a)(1)].
---------------------------------------------------------------------------

B. Costs

    The Proposed Rules would result in some additional costs for funds 
and advisers, which, in the case of funds, we expect would be passed on 
to investors. However, since all funds and most advisers currently have 
some written compliance policies and procedures in place, the costs in 
many instances already are reflected in the fees investors currently 
pay. Funds and larger advisory firms typically have adopted and 
implemented comprehensive, written policies and

[[Page 7046]]

procedures. Many of these advisers also have well-staffed compliance 
departments. Many conduct periodic reviews of their compliance programs 
and some hire independent compliance experts to review the adequacy of 
their compliance programs and the effectiveness of their 
implementation. We would expect that funds and advisers with 
substantial commitments to compliance would incur only minimal costs in 
connection with the adoption of the Proposed Rules as they reviewed 
their internal compliance programs for adequacy.
    It is our experience that small funds and advisers are less likely 
than their larger counterparts to have comprehensive, written internal 
compliance programs in place. The Proposed Rules would impose larger 
relative costs on these firms. Based on our examination experience, we 
estimate that as many as one half of SEC-registered investment advisers 
do not have comprehensive, written internal compliance programs in 
place. These firms would incur costs in order to develop a compliance 
program or to convert their current compliance activities into a 
systematic program. However, we expect a number of factors will enable 
these firms to control and minimize these costs. Because these small 
firms typically engage in a limited number and range of transactions 
and have one or two employees, their internal compliance programs would 
be markedly less complex than those of their large firm counterparts. 
In addition, we anticipate that these firms will turn to a variety of 
industry representatives, commentators, and organizations that have 
developed outlines and model programs that these firms can tailor to 
fit their own situations. If these firms need individualized outside 
assistance, we expect that the number of independent compliance experts 
will grow to fill this demand at competitive prices, as has been the 
case in comparable situations.
    The requirement that each firm designate a chief compliance officer 
likely would impose only a minimal cost. Many firms already have large 
compliance staffs headed by an individual who effectively serves as a 
chief compliance officer. For other firms, costs associated with 
designating a chief compliance officer also would be minimized by the 
fact that the Proposed Rules would not require firms to hire an 
individual exclusively charged with serving in this capacity.
    We anticipate that costs associated with the annual review 
requirement also would be limited. Many large firms with comprehensive 
compliance programs periodically review portions of their compliance 
programs. These firms would incur a cost associated with transforming 
their periodic reviews into a more systematic annual review, but this 
cost is difficult to quantify. Most of the firms without any review 
mechanism in place are small. For these firms, the annual review 
requirement likely would be less extensive and, therefore, less costly 
than for their larger counterparts.

C. Request for Comment

    We request comment on the potential costs and benefits identified 
in the proposal and any other costs or benefits that may result from 
the Proposed Rules. For purposes of the Small Business Regulatory 
Enforcement Fairness Act of 1996,\81\ the Commission also requests 
information regarding the impact of the proposed rule on the economy on 
an annual basis. Commenters are requested to provide data to support 
their views.
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    \81\ Pub. L. No. 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

V. Consideration of Promotion of Efficiency, Competition and Capital 
Formation

    Section 2(c) of the Investment Company Act [15 U.S.C. 80a-2(c)] and 
section 202(c) of the Advisers Act [15 U.S.C. 80b-2(c)] require the 
Commission, when engaging in rulemaking that requires it to consider or 
determine whether an action is necessary or appropriate in the public 
interest, to consider, in addition to the protection of investors, 
whether the action will promote efficiency, competition, and capital 
formation.\82\
---------------------------------------------------------------------------

    \82\ Although proposed rule 206(4)-7 is not based on a 
statutorily-mandated public interest determination, in the interest 
of comprehensiveness, we include it in this analysis.
---------------------------------------------------------------------------

    As discussed above, the Proposed Rules would require funds and 
investment advisers to adopt and implement written policies and 
procedures designed to prevent violations of the federal securities 
laws, and review those policies and procedures at least annually. 
Although we recognize that a compliance program may divert resources 
from funds' and advisers' primary businesses, we expect that the 
Proposed Rules may indirectly increase efficiency in a number of ways. 
These compliance programs would increase efficiency by deterring 
securities law violations, or by facilitating the fund's or adviser's 
early intervention to decrease the severity of any violations that do 
occur. In addition, funds and advisers would be required to carry out 
their internal compliance functions in an organized and systematic 
manner, which may be more efficient than their current approach to 
these functions. The existence of an industry-wide compliance program 
requirement may enhance efficiency further by encouraging third parties 
to create new informational resources and guidance to which industry 
participants can refer in establishing and improving their compliance 
programs.
    Since the Proposed Rules would apply equally to all funds and 
advisers, we do not anticipate that any competitive disadvantages would 
be created. To the contrary, the Proposed Rules may encourage 
competition on a more level basis than exists in the current 
environment, in which compliance-oriented industry participants incur 
greater costs to maintain compliance programs than other firms.
    We anticipate the Proposed Rules would indirectly foster capital 
formation. It has been our experience that funds and advisers with 
effective compliance programs are less likely to violate the securities 
laws and harm to investors is less likely to result. To the extent such 
an environment enhances investor confidence in funds and client 
confidence in investment advisers, investors and clients are more 
likely to make assets available through these intermediaries for 
investment in the capital markets.
    We request comment on whether the Proposed Rules, if adopted, would 
impose a burden on competition. We also request comment on whether the 
Proposed Rules, if adopted, would promote efficiency, competition, and 
capital formation. Commenters are requested to provide empirical data 
and other factual support for their views, if possible.

VI. Paperwork Reduction Act

    The Proposed Rules would impose ``collection of information'' 
requirements within the meaning of the Paperwork Reduction Act of 
1995.\83\ If adopted, these collections of information would be 
mandatory. Two of the collections of information are new. The 
Commission has submitted these new collections to the Office of 
Management and Budget (``OMB'') for review in accordance with 44 U.S.C. 
3507(d) and 5 CFR 1320.11. The titles of these new collections are 
``Rule 38a-1'' and ``Rule 206(4)-7.'' The OMB has not yet assigned 
these collections control numbers. The other collection of information 
takes the form of

[[Page 7047]]

amendments to a currently approved collection titled ``Rule 204-2,'' 
under OMB control number 3235-0278. The Commission also has submitted 
the amendments to this collection to the OMB for review in accordance 
with 44 U.S.C. 3507(d) and 5 CFR 1320.11. An agency may not conduct or 
sponsor, and a person is not required to respond to, a collection of 
information unless it displays a currently valid control number.
---------------------------------------------------------------------------

    \83\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    The collection of information under rule 38a-1 is necessary to 
assure that investment companies maintain comprehensive internal 
programs that promote the companies' compliance with the federal 
securities laws. The respondents are investment companies registered 
with us and business development companies. Our staff, conducting the 
Commission's examination and oversight program, would use the 
information collected to assess funds' compliance programs. Responses 
provided to the Commission in the context of its examination and 
oversight program are generally kept confidential.\84\ Rule 38a-1 
requires that certain records be retained for at least five years.\85\
---------------------------------------------------------------------------

    \84\ See section 31(c) of the Investment Company Act [15 U.S.C. 
80a-30(c)].
    \85\ See Proposed rule 38a-1(c).
---------------------------------------------------------------------------

    The collection of information under rule 206(4)-7 is necessary to 
assure that investment advisers maintain comprehensive internal 
programs that promote the advisers' compliance with the Advisers Act. 
The respondents are investment advisers registered with us. Our staff, 
conducting the Commission's examination and oversight program, would 
use the information collected to assess investment advisers' compliance 
programs. Responses provided to the Commission in the context of its 
examination and oversight program are generally kept confidential.\86\
---------------------------------------------------------------------------

    \86\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
---------------------------------------------------------------------------

    The collection of information under rule 204-2 is necessary for the 
Commission staff to use in its examination and oversight program. The 
respondents are investment advisers registered with us. Responses 
provided to the Commission in the context of its examination and 
oversight program are generally kept confidential.\87\ The records that 
an adviser must keep in accordance with the Proposed Rules must be 
retained for at least five years.\88\
---------------------------------------------------------------------------

    \87\ Id.
    \88\ See proposed rule 204-2(a)(17)(i) and rule 204-2(e)(1) [17 
CFR 275.204-2(e)(1)].
---------------------------------------------------------------------------

A. Rule 38a-1

    There are currently approximately 5,030 registered investment 
companies and 53 business development companies.\89\ Thus, 
approximately 5,083 funds would be subject to proposed rule 38a-1. We 
estimate that the average annual hour burden for a fund to document the 
policies and procedures that make up its compliance program would be 60 
hours. While each fund would be required to maintain written policies 
and procedures under rule 38a-1, this average estimate takes into 
account that most funds are located within a fund complex. Based on our 
staff's experience in connection with our examination and oversight 
program, we expect that each fund in a complex would be able to draw 
extensively from the fund complex's ``master'' compliance program to 
assemble appropriate compliance policies and procedures. It also has 
been our experience that many fund complexes already have written 
policies and procedures documenting their compliance programs. Further, 
a fund needing to develop policies and procedures on one or more topics 
in order to achieve a comprehensive compliance program can draw on a 
number of outlines and model programs available from a variety of 
industry representatives, commentators, and organizations.
---------------------------------------------------------------------------

    \89\ These numbers are based on Commission filings and are 
current as of January 2003.
---------------------------------------------------------------------------

    We also estimate that each fund would spend five hours annually, on 
average, documenting the conclusions of its annual compliance review 
for its board of directors. Finally, we estimate that each fund would 
spend 0.5 hours annually, on average, maintaining the records required 
by proposed rule 38a-1. In total, the collections of information under 
rule 38a-1 would entail 332,936.5 burden hours.\90\
---------------------------------------------------------------------------

    \90\ (5,083 funds (5,030 registered investment companies + 53 
business development companies)) x (60 hours for documenting 
compliance policies and procedures + 5 hours for documenting 
conclusions of annual compliance review + 0.5 hours for maintaining 
records) = 332,936.5 burden hours.
---------------------------------------------------------------------------

B. Rule 206(4)-7

    There are currently approximately 7,790 investment advisers 
registered with us.\91\ We estimate that the average annual hour burden 
for each adviser to document the policies and procedures that make up 
its compliance program would be 80 hours, for a total burden of 623,200 
hours.\92\ While each adviser registered with us would be subject to 
the requirement to maintain written policies and procedures under 
proposed rule 206(4)-7, this average estimate takes into account that 
many advisers would be the primary drafters of compliance policies and 
procedures for funds under proposed rule 38a-1. We expect that these 
advisers would be able to draw extensively from their fund compliance 
programs to supplement, as necessary, compliance policies and 
procedures for the advisory firm.
---------------------------------------------------------------------------

    \91\ This is the number of investment advisers registered with 
us on our Investment Adviser Registration Depository System as of 
January 14, 2003.
    \92\ 7,790 registered investment advisers x 80 annual average 
burden hours = 623,200 hours.
---------------------------------------------------------------------------

    It also has been our staff's experience in connection with our 
examination and oversight program that approximately half of the 
investment advisers registered with us already have drafted procedures 
addressing many aspects of their compliance programs, and many 
investment advisers in this group have drafted comprehensive 
procedures. Further, while it has been our experience that a 
significant number of smaller registered investment advisers--who 
typically employ one or a few persons and have complete oversight of 
their business operations--have not adopted written policies and 
procedures, these advisers can draw on a number of outlines and model 
programs available from a variety of industry representatives, 
commentators, and organizations. Based on our experience, these smaller 
advisers are less likely to participate in arranging or effectuating 
securities transactions that they recommend to their clients, thereby 
greatly simplifying the scope of the policies and procedures they would 
be required to document under the proposed rule.

C. Rule 204-2

    The currently-approved annual aggregate information collection 
burden under rule 204-2 is 1,625,638.5 hours. This approved annual 
aggregate burden was based on estimates that 7,687 advisers were 
subject to the rule, and each of these advisers spends an average of 
211.48 hours preparing and preserving records in accordance with the 
rule. Based upon the most recently available data, there are 7,790 
registered investment advisers. The increase in the number of 
registered investment advisers increases the total burden hours of 
current rule 204-2 from 1,625,638.5 to 1,647,429.2,\93\ an increase of 
21,790.7 hours.\94\
---------------------------------------------------------------------------

    \93\ 7,790 registered investment advisers x 211.48 hours = 
1,647,429,2 hours.
    \94\ 1,647,429.2 hours--1,625,638.5 hours = 21,790.7 hours.

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[[Page 7048]]

    The proposed amendments to rule 204-2 would require a registered 
investment adviser to maintain copies of the written policies and 
procedures drafted under proposed rule 206(4)-7. In addition, the 
proposed amendments would require a registered investment adviser to 
retain copies of any records documenting the adviser's annual review of 
its policies and procedures under proposed rule 206(4)-7. The 
collection of information under rule 204-2 is necessary for the 
Commission staff to carry out its examination and oversight program. 
The adviser would be required to maintain these records for five 
years.\95\
---------------------------------------------------------------------------

    \95\ Proposed rule 204-2(a)(17)(i) would require advisers to 
maintain a copy of any policies and procedures in effect during the 
past five years. Pursuant to proposed rule 204-2(e)(1), the records 
documenting the adviser's annual review of those policies and 
procedures would have to be maintained and preserved in an easily 
accessible place for five years, the first two in an office of the 
investment adviser.
---------------------------------------------------------------------------

    We estimate that these proposed amendments would increase each 
registered investment adviser's average annual collection burden under 
rule 204-2 by 0.5 hours to 211.98 hours,\96\ and would increase the 
rule's annual aggregate burden by 3,895 hours.\97\ If the proposed 
amendments to rule 204-2 are adopted, the rule's aggregate annual 
burden would be 1,651,324.2 hours.\98\
---------------------------------------------------------------------------

    \96\ 211.48 hours + 0.5 hours = 211.98 hours.
    \97\ 7,790 registered investment advisers x 0.5 hours = 3,895 
hours.
    \98\ 1,625,638.5 (currently-approved burden) + 21,790.7 
(adjustment attributable to increase in number of investment 
advisers registered with us) + 3,895 (additional burden hours 
associated with the proposed amendments to rule 204-2) = 1,651,324.2 
hours.
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D. Request for Comment

    We request comment on whether these estimates are reasonable. 
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments 
to: (i) Evaluate whether the proposed collections of information are 
necessary for the proper performance of the functions of the 
Commission, including whether the information will have practical 
utility; (ii) evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collections of information; (iii) determine 
whether there are ways to enhance the quality, utility, and clarity of 
the information to be collected; and (iv) determine whether there are 
ways to minimize the burden of the collections of information on those 
who are to respond, including through the use of automated collection 
techniques or other forms of information technology.
    Persons wishing to submit comments on the collection of information 
requirements should direct them to the Office of Management and Budget, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Room 3208, New Executive 
Office Building, Washington, DC 20503, and also should send a copy to 
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 
Fifth Street, NW, Washington, DC 20549-0609 with reference to File No. 
S7-03-03.
    OMB is required to make a decision concerning the collections of 
information between 30 and 60 days after publication, so a comment to 
OMB is best assured of having its full effect if OMB receives the 
comment within 30 days after publication of this release. Requests for 
materials submitted to OMB by the Commission with regard to these 
collections of information should be in writing, refer to File No. S7-
03-03, and be submitted to the Securities and Exchange Commission, 
Records Management, Office of Filings and Information Services, 450 
Fifth Street, NW, Washington, DC 20549.

VII. Summary of Initial Regulatory Flexibility Analysis

    We have prepared an Initial Regulatory Flexibility Analysis 
(``IRFA'') in accordance with 5 U.S.C. 603 regarding the proposed rule 
38a-1 under the Investment Company Act, and proposed rule 206(4)-7 and 
proposed amendments to rule 204-2 under the Advisers Act. The following 
summarizes the IRFA.
    The IRFA summarizes the background of the proposals. The IRFA also 
discusses the reasons for the proposals and the objectives of, and 
legal basis for, the proposals. Those items are discussed above.
    The IRFA discusses the effect of the Proposed Rules on small 
entities. For purposes of the Regulatory Flexibility Act, a fund is a 
small entity if the fund, together with other funds in the same group 
of related funds, has net assets of $50 million or less as of the end 
of its most recent fiscal year.\99\ An investment adviser is a small 
entity if it (i) manages less than $25 million in assets, (ii) has 
total assets of less than $5 million on the last day of its most recent 
fiscal year, and (iii) does not control, is not controlled by, and is 
not under common control with another investment adviser that manages 
$25 million or more in assets, or any person (other than a natural 
person) that had total assets of $5 million or more on the last day of 
the most recent fiscal year.\100\ The staff estimates, based on 
Commission filings, that there are 200 small open- and closed-end 
investment companies and 29 small business development companies.\101\ 
The staff further estimates that there are approximately 7,790 
registered investment advisers, of which approximately 172 are small 
entities.\102\
---------------------------------------------------------------------------

    \99\ 17 CFR 270.0-10.
    \100\ 17 CFR 275.0-7.
    \101\ These numbers, which are current as of June 2002, are 
derived from analyzing information from databases such as 
Morningstar and Lipper. Some or all of these entities may contain 
multiple series or portfolios. If a registered investment company is 
a small entity, the portfolios or series it contains are also small 
entities.
    \102\ The number of small investment advisers is derived from 
information submitted by investment advisers registered with us on 
Form ADV, or amendments thereto, through January 14, 2003.
---------------------------------------------------------------------------

    The IRFA explains that the Proposed Rules would impose no new 
reporting requirements, but would impose compliance requirements on 
funds and advisers, including small funds and advisers. A fund would be 
required to adopt and implement written policies and procedures 
reasonably designed to prevent violation of the federal securities 
laws, obtain approval of the policies and procedures from its board of 
directors, review the policies and procedures at least annually, and 
provide a written report on the review to its board of directors. A 
fund also would be required to designate a chief compliance officer, 
and to maintain copies of the policies and procedures and reports to 
the board for at least five years. An adviser would be required to 
adopt and implement written policies and procedures reasonably designed 
to prevent violation of the Advisers Act and review the policies and 
procedures at least annually. An adviser would be required to designate 
a chief compliance officer, and to maintain copies of the policies and 
procedures and any records documenting the annual review for at least 
five years.
    The IRFA states that we have not identified any federal rules that 
conflict with the Proposed Rules. The IRFA explains that the written 
policies and procedures that would be required by the Proposed Rules 
would include some policies and procedures required by other rules 
under the federal securities laws, but the Proposed Rules would not 
require them to be duplicated.\103\ The IRFA further explains that some 
of the records a fund would be required to maintain under the Proposed 
Rules also may be required records under the general recordkeeping 
provisions of rule 31a-1 of the Investment Company Act, but that the 
overlap would be limited

[[Page 7049]]

and the Commission would not require the fund to maintain duplicate 
copies.
---------------------------------------------------------------------------

    \103\ See supra notes 26, and 29 through 34.
---------------------------------------------------------------------------

    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objectives, 
while minimizing any significant economic impact on small entities. The 
IRFA explains that we currently believe that different compliance 
requirements for small entities could not be established, because the 
compliance requirements are integral to achieving the objectives of the 
Proposed Rules. The IRFA also states that we currently believe it would 
not be necessary to establish different recordkeeping requirements, 
because the recordkeeping requirements of the Proposed Rules impose an 
inconsequential burden on small entities. The IRFA also describes our 
current view that these compliance and recordkeeping provisions could 
not be consolidated, and that there would be no reason to simplify or 
clarify them because they are not technical or complex.
    As the IRFA explains, the Proposed Rules would rely on performance 
standards rather than design standards. Each small entity would be 
afforded the flexibility to implement policies and procedures, and to 
determine qualifications for its chief compliance officer that are 
appropriate in light of its business operations.
    The IRFA also explains our present view that the objectives of the 
Proposed Rules could not be achieved if small entities were exempted 
from coverage of any part of the Proposed Rules, because it has been 
our experience that small funds and advisers are less likely to have 
comprehensive, written compliance programs and are more likely to have 
the kinds of compliance deficiencies that could be remedied by such 
programs.
    We encourage comment with respect to any aspect of the IRFA. We 
specifically request comment on the number of small entities that would 
be affected by the Proposed Rules, and the likely impact of the 
Proposed Rules on small entities. Commenters are asked to describe the 
nature of any impact and provide empirical data supporting the extent 
of the impact. These comments will be considered in connection with the 
adoption of the Proposed Rules, and will be placed in the same public 
file as comments on the Proposed Rules themselves. A copy of the IRFA 
may be obtained by contacting Hester Peirce, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0506.

VIII. Statutory Authority

    The Commission is proposing new rule 38a-1 under the Investment 
Company Act pursuant to the authority set forth in sections 31(a) and 
38(a) of the Act [15 U.S.C. 80-30(a) and 80a-37(a)].\104\ The 
Commission is proposing new rule 206(4)-7 pursuant to the authority set 
forth in sections 206 and 211(a) under the Advisers Act [15 U.S.C. 80b-
6 and 80b-11(a)].\105\ The Commission is proposing amendments to rule 
204-2 pursuant to the authority set forth in sections 204 and 211 of 
the Advisers Act [15 U.S.C. 80b-4 and 80b-11].
---------------------------------------------------------------------------

    \104\ Section 38(a) authorizes the Commission to ``make * * * 
such rules and regulations * * * as are necessary or appropriate to 
the exercise of the functions and powers conferred upon the 
Commission elsewhere in [the Investment Company Act].'' We are 
proposing rule 38a-1 as necessary and appropriate to the exercise of 
the authority specifically conferred on us elsewhere in the Act, 
including section 31(b) of the Investment Company Act [15 U.S.C. 
80a-30(b)] (authority to examine funds) and section 42 of the 
Investment Company Act [15 U.S.C. 80a-41] (authority to enforce the 
provisions of the Investment Company Act). Further, requiring the 
maintenance of internal compliance policies and procedures and an 
annual compliance report would fall under the authority granted to 
us under section 31(a), which authorizes us to require funds to 
maintain and preserve records, including memoranda, books, and other 
documents.
    \105\ Section 206(4) permits the Commission to define conduct as 
fraudulent under the Advisers Act, and to adopt rules reasonably 
designed to prevent fraud. We are proposing rule 206(4)-7 as a means 
reasonably necessary to prevent fraud by investment advisers. 
Further, section 211(a) of the Advisers Act authorizes the 
Commission to ``make * * * such rules and regulations * * * as are 
necessary or appropriate to the exercise of the functions and powers 
conferred upon the Commission elsewhere in [the Act].'' We are 
proposing rule 206(4)-7 as necessary and appropriate to the exercise 
of the authority specifically conferred on us elsewhere in the Act, 
including section 204 of the Advisers Act (authority to examine 
advisers) and section 209 of the Advisers Act [15 U.S.C. 80b-9] 
(authority to enforce the provisions of the Advisers Act).
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List of Subjects

17 CFR 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

17 CFR 275

    Reporting and recordkeeping requirements, Securities.

Text of Proposed Rules

    For reasons set forth in the preamble, Title 17, Chapter II of the 
Code of Federal Regulations is proposed to be amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

    1. The authority citation for Part 270 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39, 
unless otherwise noted;
* * * * *
    2. Section 270.38a-1 is added to read as follows:


Sec.  270.38a-1  Compliance procedures and practices of registered 
investment companies.

    (a) Each registered investment company and business development 
company (``fund'') must:
    (1) Policies and procedures. Adopt and implement written policies 
and procedures reasonably designed to prevent violation of the Federal 
Securities Laws by the fund, or by its investment adviser, principal 
underwriter or administrator in connection with their provision of 
services to the fund;
    (2) Board approval. Obtain the approval of the policies and 
procedures of the fund by the board of directors of the fund, including 
a majority of directors who are not interested persons of the fund;
    (3) Annual review. Review, no less frequently than annually, the 
adequacy of the policies and procedures established pursuant to this 
section and the effectiveness of their implementation;
    (4) Chief compliance officer. Designate an individual responsible 
for administering the policies and procedures adopted under paragraph 
(a)(1) of this section who must:
    (i) Be approved by the board of directors of the fund, including a 
majority of directors who are not interested persons of the fund; and
    (ii) No less frequently than annually, provide a written report to 
the board on:
    (A) Existing policies and procedures, any material changes made to 
the policies and procedures since the date of the last report, and any 
material changes to the policies and procedures recommended as a result 
of the annual review conducted pursuant to paragraph (a)(3) of this 
section; and
    (B) Any material compliance matters requiring remedial action that 
occurred since the date of the last report.
    (b) Unit investment trusts. If the fund is a unit investment trust, 
the fund's principal underwriter or depositor must approve the fund's 
policies and procedures and chief compliance officer, and receive all 
annual reports.
    (c) Recordkeeping. The fund must maintain:
    (1) A copy of the fund's policies and procedures that are in 
effect, or at any time within the past five years were in effect, in an 
easily accessible place; and
    (2) Written reports provided to the board of directors pursuant to 
paragraph

[[Page 7050]]

(a)(4)(ii) of this section for at least five years after the end of the 
fiscal year in which the report is provided to the board, the first two 
years in an easily accessible place.
    (d) For purposes of this section, Federal Securities Laws means the 
Securities Act of 1933 (15 U.S.C. 77a), the Securities Exchange Act of 
1934 (15 U.S.C. 78a), the Sarbanes-Oxley Act of 2002 (Pub. L. 107-204, 
116 Stat. 745 (2002)), the Investment Company Act of 1940 (15 U.S.C. 
80a), the Investment Advisers Act of 1940 (15 U.S.C. 80b), Title V of 
the Gramm-Leach-Bliley Act (15 U.S.C. 6801), any rules adopted by the 
Commission under any of these statutes, the Bank Secrecy Act (31 U.S.C. 
5311) as it applies to funds, and any rules adopted thereunder by the 
Commission or the Department of the Treasury.

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

    3. The authority citation for Part 275 continues to read in part as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(F), 80b-2(a)(17), 80b-3, 80b-
4, 80b-6(4), 80b-6a, 80b-11, unless otherwise noted.
* * * * *
    4. Section 275.204-2 is amended by adding new paragraph (a)(17) and 
by revising paragraph (e)(1). The additions and revisions read as 
follows:


Sec.  275.204-2  Books and records to be maintained by investment 
advisers.

    (a) * * *
    (17)(i) A copy of the investment adviser's policies and procedures 
formulated pursuant to Sec.  275.206(4)-7(a) of this chapter that are 
in effect, or at any time within the past five years were in effect, 
and
    (ii) Any records documenting the investment adviser's annual review 
of those policies and procedures conducted pursuant to Sec.  
275.206(4)-7(b) of this chapter.
* * * * *
    (e)(1) All books and records required to be made under the 
provisions of paragraphs (a) to (c)(1), inclusive, of this section 
(except for books and records required to be made under the provisions 
of paragraphs (a)(11), (a)(16), and (a)(17)(i) of this section), shall 
be maintained and preserved in an easily accessible place for a period 
of not less than five years, from the end of the fiscal year during 
which the last entry was made on such record, the first two years in an 
appropriate office of the investment adviser.
* * * * *
    5. Section 275.206(4)-7 is added to read as follows:


Sec.  275.206(4)-7  Compliance procedures and practices.

    If you are an investment adviser registered or required to be 
registered under section 203 of the Investment Advisers Act of 1940 (15 
U.S.C. 80b-3), it is a fraudulent, deceptive or manipulative act, 
practice or course of business within the meaning of section 206(4) of 
the Act (15 U.S.C. 80b-6(4)) for you to provide investment advice to 
clients unless you:
    (a) Policies and procedures. Adopt and implement written policies 
and procedures reasonably designed to prevent violation, by you and 
your supervised persons, of the Act and the rules that the Commission 
has adopted under the Act;
    (b) Annual review. Review, no less frequently than annually, the 
adequacy of the policies and procedures established pursuant to this 
section and the effectiveness of their implementation; and
    (c) Chief compliance officer. Designate an individual (who is a 
supervised person) responsible for administering the policies and 
procedures that you adopt under paragraph (a) of this section.

By the Commission.

    Dated: February 5, 2003.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 03-3315 Filed 2-10-03; 8:45 am]
BILLING CODE 8010-01-P