[Federal Register Volume 68, Number 247 (Wednesday, December 24, 2003)]
[Rules and Regulations]
[Pages 74714-74730]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-31544]



[[Page 74713]]

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Part II





Securities and Exchange Commission





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17 CFR Parts 270, 275, and 279



Compliance Programs of Investment Companies and Investment Advisers; 
Final Rule

  Federal Register / Vol. 68, No. 247 / Wednesday, December 24, 2003 / 
Rules and Regulations  

[[Page 74714]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 270, 275, and 279

[Release Nos. IA-2204; IC-26299; File No. S7-03-03]
RIN 3235-AI77


Compliance Programs of Investment Companies and Investment 
Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Final rule; request for comments.

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SUMMARY: The Securities and Exchange Commission is adopting new rules 
under the Investment Company Act of 1940 and the Investment Advisers 
Act of 1940 that require each investment company and investment adviser 
registered with the Commission to adopt and implement written 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 
designate a chief compliance officer to be responsible for 
administering the policies and procedures. In the case of an investment 
company, the chief compliance officer will report directly to the fund 
board. These rules are designed to protect investors by ensuring that 
all funds and advisers have internal programs to enhance compliance 
with the federal securities laws.

DATES: Effective Date: February 5, 2004.
    Comment Date: Comments requested in section II.F of this release 
should be received on or before February 5, 2004.
    Compliance Date: October 5, 2004. Section III of this release 
contains more information on the compliance date.

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 
Counsel, Office of Investment Adviser Regulation at (202) 942-0719, 
Division of Investment Management, Securities and Exchange Commission, 
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450 Fifth Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``SEC'' or ``Commission'') is adopting new rule 38a-1 (17 CFR 270.38a-
1) under the Investment Company Act of 1940 (15 U.S.C. 80a) 
(``Investment Company Act''), new 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 amendments to rule 204-2 (17 
CFR 275.204-2) under the Advisers Act, and to Part 1, Schedule A, Item 
2(a) of Form ADV (17 CFR 279.1).\2\
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    \2\ Unless otherwise noted, when we refer to rule 38a-1 or any 
paragraph of the rule, we are referring to 17 CFR 270.38a-1 of the 
Code of Federal Regulations in which the rule is published, as 
amended by this release; when we refer to rule 206(4)-7 or any 
paragraph of the rule, we are referring to 17 CFR 275.206(4)-7 of 
the Code of Federal Regulations in which the rule is published, as 
amended by this release; and when we refer to rule 204-2 or any 
paragraph of the rule, we are referring to 17 CFR 275.204-2 of the 
Code of Federal Regulations in which the rule is published, as 
amended by this release.
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Table of Contents

I. Background
II. Discussion
    A. Adoption and Implementation of Policies and Procedures
    1. Investment Advisers
    2. Investment Companies
    B. Annual Review
    1. Investment Advisers
    2. Investment Companies
    C. Chief Compliance Officer
    1. Investment Advisers
    2. Investment Companies
    D. Recordkeeping
    E. Private Sector Initiatives
    F. Additional Request for Comment
III. Effective Date
IV. Cost-Benefit Analysis
    A. Benefits
    B. Costs
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
VII. Summary of Final Regulatory Flexibility Analysis
VIII. Statutory Authority Text of Rules

I. Background

    Earlier this year the Commission proposed rules that would require 
investment companies (``funds'')\3\ and investment advisers to adopt 
written compliance procedures, review the adequacy of those procedures 
annually, and designate a chief compliance officer responsible for 
their administration.\4\ We proposed the rules because it is critically 
important for funds and advisers to have strong systems of controls in 
place to prevent violations of the Federal securities laws and to 
protect the interests of shareholders and clients. The proposed rules 
were designed to foster, among other things, improved compliance by 
clarifying the compliance obligations of fund management and to 
strengthen the hand of fund boards and compliance personnel when 
dealing with them.\5\
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    \3\ In this release, we use the term ``fund'' to mean a 
registered investment company or a business development company, 
which is an unregistered closed-end investment company. See section 
2(a)(48) of the Investment Company Act (15 U.S.C. 80a-2(a)(48)). We 
use 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)).
    \4\ Compliance Programs of Investment Companies and Investment 
Advisers, Investment Company Act Release No. 25925 (Feb. 5, 2003) 
(68 FR 7038 (Feb. 11, 2003)) (``Proposing Release'').
    \5\ Forty-eight commenters, most of which were investment 
advisers, fund management companies, and organizations representing 
those groups, submitted comments in response to the Proposing 
Release. Commenters generally supported the proposal to require 
funds and advisers to adopt and implement compliance programs, but 
many sought changes. The comment letters and a summary of comments 
prepared by our staff are available for public inspection and 
copying in the Commission's Public Reference Room, 450 5th Street, 
NW., Washington, DC (File No. S7-03-03). The comment summary is also 
available on the Commission's Internet Web site (http://www.sec.gov/rules/extra/s70303summary.pdf.)
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    In recent months, the Commission and State securities authorities 
have discovered unlawful conduct involving a number of fund advisers, 
broker-dealers, and other service providers that confirms the need for 
these rules. Fund advisory or distributor personnel have engaged in, or 
actively assisted others in engaging in, inappropriate market timing, 
late trading of fund shares, and the misuse of material, nonpublic 
information about fund portfolios.\6\

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These personnel, including in some cases senior executives of fund 
advisers, have placed their personal interests or the business 
interests of the fund adviser ahead of the interests of fund 
shareholders, thus breaching their fiduciary obligations to the funds 
involved and their shareholders. These individuals have harmed the 
funds, their management organizations, and the confidence of fund 
investors.
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    \6\ The Commission has already obtained settlements in a number 
of actions arising from such violations. See, e.g., In re Putnam 
Investment Management, Investment Advisers Act Release No. 2192 
(Nov. 13, 2003) (finding that an investment adviser failed to 
disclose potentially self-dealing securities trading by several of 
its employees, failed to have reasonable procedures to prevent 
misuse of material nonpublic information, and failed to reasonably 
supervise the employees who committed violations); In re Connelly, 
Securities Act Release No. 8304 (Oct. 16, 2003) (finding that a 
former executive of an investment adviser to a fund complex, in 
contravention of fund disclosures, approved agreements that 
permitted select investors to time certain funds in the complex); In 
re Markovitz, Securities Act Release No. 8298 (Oct. 2, 2003) 
(finding that a former hedge fund trader violated the Federal 
securities laws and defrauded investors by engaging in late trading 
of mutual fund shares).
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    Our response to these events is twofold. First, we are conducting 
an intensive investigation of funds, advisers, broker-dealers, and 
others.\7\ We will aggressively pursue and punish those who have 
violated the Federal securities laws and breached their fiduciary 
obligations to clients. When appropriate, we will actively work with 
other Federal law enforcement authorities and State authorities to see 
that the full weight of the law is brought to bear against those who 
have betrayed mutual funds and fund investors. Second, we will review 
all of our rules to determine what changes may be required to prevent 
this type of conduct.
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    \7\ To date, we have brought 10 enforcement actions. See SEC v. 
Mutuals.com, Inc., Civil Action No. 303 CV 2912D (N.D. Tex. Dec. 4, 
2003) (alleging that dually registered broker-dealer and investment 
adviser, three of its executives, and two affiliated broker-dealers 
assisted institutional brokerage customers and advisory clients in 
carrying out and concealing thousands of market timing trades and 
illegal late trades in shares of hundreds of mutual funds); SEC v. 
Invesco Funds Group, Civil Action No. 03-N-2421 (PAC) (D. Colo. Dec. 
2, 2003) (alleging that investment adviser, with approval of its 
president and chief executive officer, entered into market timing 
arrangements with more than 60 broker dealers, hedge funds, and 
advisers without disclosing these arrangements to the affected 
mutual funds' independent directors or shareholders); SEC v. 
Security Trust Company, Civil Action No. 03-2323 (D. Ariz. Nov. 24, 
2003) (alleging that unregistered financial intermediary and three 
of its senior executives facilitated and participated in late 
trading and market timing schemes by a group of related hedge 
funds); SEC v. Pilgrim, Civil Action No. 03-CV-6341 (E.D. Penn. 
filed Nov. 20, 2003) (alleging that investment adviser and two 
senior executives permitted a hedge fund, in which one of the 
executives had a substantial financial interest, to engage in 
repeated short-term trading of several mutual funds and that one of 
the executives provided nonpublic portfolio information to a broker-
dealer, which passed it on to its customers); SEC v. Druffner, Civil 
Action No. 03-12154-RCL (D. Mass. Nov. 4, 2003) (alleging that five 
brokers, with the assistance of their branch office manager, evaded 
attempts to restrict their trading and conducted thousands of market 
timing trades in numerous mutual funds); SEC v. Scott, Civil Action 
No. 03-12082-EFH (D. Mass. filed Oct. 28, 2003) (alleging that two 
senior investment executives of an investment adviser engaged in 
repeated short-term trading in their personal accounts of funds over 
which they had investment decision-making responsibility and about 
which they had access to nonpublic information); In re Sihpol, 
Administrative Proceeding No. 3-11261 (Sept. 16, 2003) (charging 
former broker with playing a key role in enabling certain hedge fund 
customers to engage in late trading in shares of funds). See also 
supra note . A number of State actions are also pending.
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    We are taking our first regulatory actions designed to curb the 
abusive practices recently uncovered and to prevent their recurrence. 
In companion releases, we are proposing to amend our rules regarding 
mutual fund share pricing and prospectus disclosure.\8\ In this 
release, we are adopting new rules requiring advisers and funds to 
adopt strong compliance controls administered by a chief compliance 
officer.
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    \8\ Amendments to Rules Governing Pricing of Mutual Fund Shares, 
Investment Company Act Release No. 26288 (Dec. 11, 2003) (68 FR 
70388 (Dec. 17, 2003)) (``Companion Late Trading Release''); 
Disclosure Regarding Market Timing and Selective Disclosure of 
Portfolio Holdings, Investment Company Act Release No. 26287 (Dec. 
11, 2003) (68 FR 70402 (Dec. 17, 2003)) (``Companion Disclosure 
Release'').
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II. Discussion

    The Commission is adopting new rule 206(4)-7 under the Advisers Act 
and new rule 38a-1 under the Investment Company Act.\9\ The new rules 
require each registered investment adviser and each fund to adopt and 
implement compliance programs that conform to the new rules. Failure of 
an adviser or fund to have adequate compliance policies and procedures 
in place will constitute a violation of our rules independent of any 
other securities law violation. The new rules will thus permit the 
Commission to address the failure of an adviser or fund to have in 
place adequate compliance controls, before that failure has a chance to 
harm clients or investors.
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    \9\ We also are adopting related amendments to rule 204-2 under 
the Advisers Act and a technical amendment to Form ADV.
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A. Adoption and Implementation of Policies and Procedures

1. Investment Advisers
    Under rule 206(4)-7, it is unlawful for an investment adviser 
registered with the Commission to provide investment advice unless the 
adviser has adopted and implemented written policies and procedures 
reasonably designed to prevent violation of the Advisers Act by the 
adviser or any of its supervised persons.\10\ The rule requires 
advisers to consider their fiduciary and regulatory obligations under 
the Advisers Act and to formalize policies and procedures to address 
them.\11\
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    \10\ Rule 206(4)-7(a). See also section 202(a)(25) of the 
Advisers Act (15 U.S.C. 80b-2(a)(25)) (defining ``supervised 
person'' as ``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'').
    \11\ In response to several comments, we revised the text of the 
rule so that a violation of the rule would be deemed to be 
``unlawful'' rather than ``a fraudulent, deceptive, or manipulative 
act, practice or course of business.'' This change, which responds 
to commenters' concerns regarding the optics of the rule, does not 
change its substance; failure to comply with its terms will result 
in a violation of section 206(4) of the Act.
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    Commenters generally supported these new requirements, but some 
expressed concerns for how they would be applied to smaller advisers. 
The Commission is sensitive to the burdens the rule may impose upon 
smaller advisory firms.\12\ The rule requires only that the policies 
and procedures be reasonably designed to prevent violation of the 
Advisers Act, and thus need only encompass compliance considerations 
relevant to the operations of the adviser. We would expect smaller 
advisory firms without conflicting business interests to require much 
simpler policies and procedures than larger firms that, for example, 
have multiple potential conflicts as a result of their other lines of 
business or their affiliations with other financial service firms.\13\ 
The preparation of these simpler policies and procedures and their 
administration should be much less burdensome.
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    \12\ In the Proposing Release, we requested comment on whether 
we should except a subset of investment advisers or funds from the 
requirements of the rules. Some commenters suggested that we except 
small advisers, but we believe that the flexibility of the rules 
obviates the need for this exception.
    \13\ Even small advisers may have arrangements, such as soft 
dollar agreements, that create conflicts. Advisers of all sizes, in 
designing and updating their compliance programs, must identify 
these arrangements and provide for the effective control of the 
resulting conflicts.
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    Rule 206(4)-7 does not enumerate specific elements that advisers 
must include in their policies and procedures.\14\ Commenters agreed 
with

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our assessment that funds and advisers are too varied in their 
operations for the rules to impose of a single set of universally 
applicable required elements. Each adviser should adopt policies and 
procedures that take into consideration the nature of that firm's 
operations. The policies and procedures should be designed to prevent 
violations from occurring, detect violations that have occurred,\15\ 
and correct promptly any violations that have occurred.\16\
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    \14\ Advisers already are subject to requirements to maintain 
written compliance policies and procedures in certain areas. The new 
rules do not alter those requirements. See, e.g., Investment Company 
Act rule 17j-1(c)(1) (17 CFR 270.17j-1(c)(1)) (requiring each 
investment adviser and principal underwriter of a 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); Advisers Act rule 206(4)-6 (17 CFR 275.206(4)-6) (requiring 
investment advisers to adopt and implement written policies and 
procedures reasonably designed to ensure that the adviser votes 
securities in the best interest of clients); Advisers Act section 
204A (15 U.S.C. 80b-4a) (requiring each adviser registered with us 
to have written policies and procedures reasonably designed to 
prevent the misuse of material nonpublic information by the adviser 
or persons associated with the adviser); Regulation S-P (``Privacy 
of Consumer Financial Information'') (17 CFR 248.30) (requiring 
investment advisers to ``adopt policies and procedures that address 
administrative, technical, and physical safeguards for the 
protection of customer records and information'').
    \15\ Where appropriate, advisers' policies and procedures should 
employ, among other methods of detection, compliance tests that 
analyze information over time in order to identify unusual patterns, 
including, for example, an analysis of the quality of brokerage 
executions (for the purpose of evaluating the adviser's fulfillment 
of its duty of best execution), or an analysis of the portfolio 
turnover rate (to determine whether portfolio managers are 
overtrading securities), or an analysis of the comparative 
performance of similarly managed accounts (to detect favoritism, 
misallocation of investment opportunities, or other breaches of 
fiduciary responsibilities).
    \16\ In the Proposing Release, we noted that the compliance 
policies and procedures should be designed to prevent, detect, and 
correct promptly any material violation of the federal securities 
laws (or in the case of advisers, the Advisers Act). A number of 
commenters suggested that these objectives were unrealistic and 
recommended that the rules be designed instead to promote compliance 
with the securities laws. While we understand that compliance 
policies and procedures will not prevent every violation of the 
securities laws, we believe that prevention should be a key 
objective of all firms' compliance policies and procedures.
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    Each adviser, in designing its policies and procedures, should 
first identify conflicts and other compliance factors creating risk 
exposure for the firm and its clients in light of the firm's particular 
operations, and then design policies and procedures that address those 
risks. We expect that an adviser's policies and procedures, at a 
minimum, should address the following issues to the extent that they 
are relevant to that adviser:
    [sbull] Portfolio management processes, including allocation of 
investment opportunities among clients and consistency of portfolios 
with clients' investment objectives, disclosures by the adviser, and 
applicable regulatory restrictions;\17\
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    \17\ Rule 206(4)-6 under the Advisers Act (17 CFR 275.206(4)-6) 
requires registered investment advisers to adopt and implement 
written policies and procedures that are reasonably designed to 
ensure that the adviser votes securities 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 aggregated trades among clients;
    [sbull] Proprietary trading of the adviser and personal trading 
activities of supervised persons;\18\
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    \18\ Section 204A of the Advisers Act (15 U.S.C. 80b-4a) 
requires registered investment advisers to have written policies and 
procedures reasonably designed to prevent the misuse of material 
nonpublic information by the advisers or persons associated with the 
advisers. Rule 17j-1(c)(1) under the Investment Company Act (17 CFR 
270.17j-1(c)(1)) requires funds and each investment adviser and 
principal underwriter of a 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, clients, and 
regulators, including account statements and 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;\19\
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    \19\ Rule 204-2(g)(3) under the Advisers Act (17 CFR 275.204-
2(g)(3)) and rule 31a-2(f)(3) under the Investment Company Act (17 
CFR 270.31a-2(f)(3)) require advisers and funds that maintain 
records in electronic formats to establish and maintain procedures 
to safeguard the records.
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    [sbull] Marketing advisory services, including the use of 
solicitors;\20\
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    \20\ Rule 206(4)-3 under the Advisers Act (17 CFR 275.206(4)-3) 
requires written agreements setting forth procedures to govern 
solicitation activities conducted by certain third parties on behalf 
of an adviser.
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    [sbull] Processes to value client holdings and assess fees based on 
those valuations;
    [sbull] Safeguards for the privacy protection of client records and 
information;\21\ and
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    \21\ Regulation S-P requires investment advisers to ``adopt 
policies and procedures that address administrative, technical, and 
physical safeguards for the protection of customer records and 
information.'' Regulation S-P (``Privacy of Consumer Financial 
Information'') (17 CFR 248.30). Regulation S-P also applies to 
funds.
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    [sbull] Business continuity plans.\22\
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    \22\ We believe that an adviser's fiduciary obligation to its 
clients includes the obligation to take steps to protect the 
clients' interests from being placed at risk as a result of the 
adviser's inability to provide advisory services after, for example, 
a natural disaster or, in the case of some smaller firms, the death 
of the owner or key personnel. The clients of an adviser that is 
engaged in the active management of their assets would ordinarily be 
placed at risk if the adviser ceased operations.
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    Rule 206(4)-7 does not require advisers to consolidate all 
compliance policies and procedures into a single document. Nor does it 
require advisers to memorialize every action that must be taken in 
order to remain in compliance with the Advisers Act. In some cases, it 
may be enough for the compliance policies and procedures to allocate 
responsibility within the organization for the timely performance of 
many obligations, such as the filing or updating of required forms.\23\
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    \23\ Advisers who are also registered as broker-dealers are not 
required to segregate their investment adviser compliance policies 
and procedures from their broker-dealer compliance policies and 
procedures.
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2. Investment Companies
    Rule 38a-1 requires fund boards to adopt written policies and 
procedures reasonably designed to prevent the fund from violating the 
Federal securities laws.\24\ The procedures must provide for the 
oversight of compliance by the fund's advisers, principal 
underwriters,\25\ administrators,\26\ and

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transfer agents \27\ (collectively, ``service providers'') through 
which the fund conducts its activities.\28\
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    \24\ Rule 38a-1(a)(1). For purposes of rule 38a-1, ``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, the Advisers Act, Title V of the Gramm-
Leach-Bliley Act (15 U.S.C. 6801) (governing disclosure of nonpublic 
personal information), any rules adopted by the Commission under any 
of these statutes, the Bank Secrecy Act (31 U.S.C. 5311-5314; 5316-
5332) (imposing restrictions designed to prevent financial 
intermediaries from being used in money laundering activities) as it 
applies to funds, and any rules adopted thereunder by the Commission 
or the Department of the Treasury. Rule 38a-1(e)(1).
    \25\ A ``principal underwriter'' of a fund (other than a closed-
end fund) is ``any underwriter who as principal purchases from such 
company, or pursuant to contract has the right (whether absolute or 
conditional) from time to time to purchase from such company, any 
such security for distribution, or who as agent for such company 
sells or has the right to sell any such security to a dealer or to 
the public or both, but does not include a dealer who purchases from 
such company through a principal underwriter acting as agent for 
such company.'' Section 2(a)(29) of the Investment Company Act (15 
U.S.C. 80a-2(a)(29)).
    \26\ An ``administrator'' is ``any person who provides 
significant administrative or business management services to an 
investment company.'' Investment Company Act rule 0-1(a)(5) (17 CFR 
270.0-1(a)(5)).
    \27\ Section 3(a)(25) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c-(3)(a)(25)) defines a ``transfer agent'' as ``any person 
who engages on behalf of an issuer of securities or on behalf of 
itself as an issuer of securities in (A) countersigning such 
securities upon issuance; (B) monitoring the issuance of such 
securities with a view to preventing unauthorized issuance, a 
function commonly performed by a person called a registrar; (C) 
registering the transfer of such securities; (D) exchanging or 
converting such securities; or (E) transferring record ownership of 
securities by bookkeeping entry without physical issuance of 
securities certificates.''
    \28\ In this release, we use the term ``service provider'' to 
refer only to a fund's advisers, principal underwriters, 
administrators, and transfer agents. By limiting the term in this 
manner, we are not lessening a fund's obligation to consider 
compliance as part of its decision to employ other entities, such as 
pricing services, auditors, and custodians.
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    a. Service Providers. Most of the operations of funds are carried 
out by service providers, which have their own compliance policies and 
procedures. Commenters pointed out that the proposed rule appeared to 
require a fund to adopt, as its own, the policies and procedures of its 
service providers.\29\ The final rule requires fund boards to approve 
the policies and procedures of fund service providers, and requires the 
fund's policies and procedures to include provisions for the fund to 
oversee compliance by its service providers.
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    \29\ Some commenters urged us to permit funds to simply rely on 
their service providers' policies and procedures. We have not 
adopted this suggestion because it would permit funds and their 
boards to absolve themselves of responsibility for compliance 
activities of the service providers through which funds conduct most 
of their activities.
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    Rule 38a-1 provides fund complexes with flexibility so that each 
complex may apply the rule in a manner best suited to its 
organization.\30\ A fund complex could, for example, adopt compliance 
policies and procedures that encompass the activities of the funds, the 
adviser and affiliated underwriters and transfer agents, while 
approving the policies and procedures of other service providers, such 
as subadvisers, over which it has oversight responsibility under the 
rule. Another fund complex could adopt policies and procedures that 
would cover solely activities of the funds, and could approve the 
policies and procedures of each of its service providers.
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    \30\ In this release, we use the term ``fund complex'' to mean a 
group of funds that share a compliance program and a common 
investment adviser and/or distributor.
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    b. Board Approval. Rule 38a-1 requires a fund's board, including a 
majority of its independent directors, to approve the policies and 
procedures of the fund and each of its service providers.\31\ The 
approval must be based on a finding by the board that the policies and 
procedures are reasonably designed to prevent violation of the Federal 
securities laws by the fund and its service providers.\32\
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    \31\ In this release, we refer to directors who are not 
``interested persons'' of the fund as ``independent directors.'' 
Section 2(a)(19) identifies persons who are ``interested persons'' 
of a fund. 15 U.S.C. 80a-2(a)(19).
    \32\ Rule 38a-1(a)(2). In response to comments seeking 
clarification of the board's responsibilities, we have added 
language to the rule text explicitly stating the basis for approval. 
If the policies and procedures of a service provider are included 
within the policies and procedures adopted by the fund, separate 
approval by the board is not required. A fund that is approving 
policies and procedures of service providers is required to make 
findings only with respect to activities of the service provider 
that could affect the fund.
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    Some commenters expressed concern that the rule would require 
directors to review lengthy compliance manuals and devote considerable 
time at each meeting to approving numerous amendments. Directors may 
satisfy their obligations under the rule by reviewing summaries of 
compliance programs prepared by the chief compliance officer, legal 
counsel or other persons familiar with the compliance programs. The 
summaries should familiarize directors with the salient features of the 
programs (including programs of service providers) and provide them 
with a good understanding of how the compliance programs address 
particularly significant compliance risks.\33\
    In considering whether to approve a fund's or service provider's 
compliance policies and procedures, boards should consider the nature 
of the fund's exposure to compliance failures. In the case of a money 
market fund, for example, the board should consider whether the 
policies and procedures sufficiently address the fund's compliance with 
rule 2a-7.\34\ Boards should also consider the adequacy of the policies 
and procedures in light of their recent compliance experiences, which 
may demonstrate weaknesses in the fund or service provider's compliance 
programs. We urge boards to also consider best practices used by other 
fund complexes, and to consult with fund counsel (and independent 
directors with their counsel), compliance specialists and other experts 
familiar with compliance practices successfully employed by similar 
funds or service providers.
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    \33\ Rule 38a-1 does not require fund boards to approve 
amendments to policies and procedures of the fund or its service 
providers. Such a requirement would, as commenters pointed out, 
inundate fund boards with review of minor changes and detract from 
their ability to address significant responsibilities committed to 
them by the Act and our rules. Moreover, such a requirement could 
delay funds and their service providers from making needed changes. 
Instead, the rule requires the fund's chief compliance officer to 
discuss material changes to the compliance policies and procedures 
in his or her annual report to the fund board. Rule 38(a)-
1(a)(4)(iii)(A). As we note below, however, serious compliance 
issues must be raised with the board immediately. See infra note 83.
    \34\ 17 CFR 270.2a-7.
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    The Commission understands that, in some cases, the fund may employ 
the services of a service provider that is not an affiliated person of 
the fund, such as a transfer agent or administrator, and that provides 
similar services to a large number of funds. In such cases, it may be 
impractical for the fund or its compliance officer to directly review 
all of the service provider's policies and procedures. In such cases, 
we will consider a fund's policies and procedures to have satisfied the 
requirements of this rule if the fund uses a third-party report on the 
service provider's procedures instead of the procedures themselves when 
the board is evaluating whether to approve the service provider's 
compliance program.\35\ The third-party report must describe the 
service provider's compliance program as it relates to the types of 
services provided to the fund, discuss the types of compliance risks 
material to the fund, and assess the adequacy of the service provider's 
compliance controls.\36\
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    \35\ In these limited circumstances, we would also consider the 
fund to have satisfied the rule's requirement with regard to annual 
review of service providers, as discussed in section II.B.2. of this 
release, supra, and with respect to the chief compliance officer's 
annual report with regard to service providers, as discussed in 
section II.C.2. of this release, supra, if such reviews and reports 
use such third-party reports provided to the fund no less than 
annually. If the fund uses such reports for its approval of a 
service provider's compliance program or the annual review or 
reporting on the program, the fund must also gather and take into 
account other relevant information, such as its experience with the 
service provider.
    \36\ See, e.g., Codification of Accounting Standards and 
Procedures, Statement on Auditing Standards No. 70, Reports on 
Processing of Transactions by Service Organizations (American Inst. 
of Certified Public Accountants).
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    c. Policies and Procedures. Funds' or their advisers' policies and 
procedures should address the issues we identified for investment 
advisers above.\37\ In

[[Page 74718]]

addition, we expect policies and procedures of funds (or fund service 
providers) to cover certain other critical areas. In light of our 
recent enforcement actions against a number of fund managers and 
service providers,\38\ we are taking this opportunity to review the 
application of these policies and procedures to several important areas 
of compliance with the Federal securities laws by funds and their 
service providers.
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    \37\ See supra text accompanying notes 17 through 22. Funds are 
also subject to requirements to maintain written compliance policies 
and procedures in certain of our rules. The new rules do not 
supplant these requirements. See, e.g., Investment Company Act rules 
2a-7(c)(7) (17 CFR 270.2a-7(c)(7)) (requiring boards of money market 
funds to establish written procedures ``reasonably designed * * * to 
stabilize the money market fund's net asset value per share'') and 
17j-1(c)(1) (17 CFR 270.17j-1(c)(1)) (requiring funds 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); Form N-1A, Item 13(f) (17 CFR 239.15A; 274.11A) (requiring 
funds to disclose the policies and procedures that they use to 
determine how to vote proxies relating to portfolio securities); 31 
CFR 103.130(c) (requiring funds to 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''); Regulation S-P (``Privacy of Consumer 
Financial Information'') (17 CFR 248.30) (requiring funds to ``adopt 
policies and procedures that address administrative, technical, and 
physical safeguards for the protection of customer records and 
information'').
    \38\ See supra notes 6 and 7 and accompanying text.
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    [sbull] Pricing of portfolio securities and fund shares. The 
Investment Company Act requires funds to sell and redeem their shares 
at prices based on their current net asset value, and to pay redemption 
proceeds promptly.\39\ The Investment Company Act requires funds to 
calculate their net asset values using the market value of their 
portfolio securities when market quotations for those securities are 
``readily available,'' and, when a market quotation for a portfolio 
security is not readily available, by using the fair value of that 
security, as determined in good faith by the fund's board.\40\ These 
pricing requirements are critical to ensuring fund shares are purchased 
and redeemed at fair prices and that shareholder interests are not 
diluted.
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    \39\ Section 22(e) of the Investment Company Act generally 
prohibits mutual funds from suspending the right of redemption and 
prohibits funds from postponing the payment of redemption proceeds 
for more than seven days. 15 U.S.C. 80a-22(e). Rule 22c-1(b) under 
the Act generally requires that a fund's net asset value be computed 
at least once daily, Monday through Friday, at a time or times 
specified by the fund's board of directors. 17 CFR 270.22c-1(b).
    \40\ Section 2(a)(41) of the Investment Company Act and rule 
2a41-1 (17 CFR 270.2a41-1).
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    When fund shares are mispriced, short-term traders have an 
arbitrage opportunity they can use to exploit a fund and disadvantage 
the fund's long-term investors by extracting value from the fund 
without assuming any significant investment risk. Mispricing may occur 
with respect to portfolio securities traded on a foreign market that 
closes before the time at which the fund prices its shares.\41\ If an 
event affecting the value of the portfolio securities occurs after the 
foreign market closes but before the fund prices its shares, the 
foreign market closing price for the portfolio security will not 
reflect the correct current value of those securities when the fund 
prices its shares. In 1984, we stated that, in these circumstances, a 
fund ``must, to the best of its ability, determine the fair value of 
the securities, as of the time'' that the fund prices its shares.\42\ 
We believe that funds that fail to fair value their portfolio 
securities under such circumstances may violate rule 22c-1 under the 
Investment Company Act.\43\ Fund directors who countenance such 
practices fail to comply with their statutory valuation obligations 
\44\ and fail to fulfill their fiduciary obligation to protect fund 
shareholders. Accordingly, rule 38a-1 requires funds to adopt policies 
and procedures that require the fund to monitor for circumstances that 
may necessitate the use of fair value prices; establish criteria for 
determining when market quotations are no longer reliable for a 
particular portfolio security;\45\ provide a methodology or 
methodologies by which the fund determines the current fair value of 
the portfolio security;\46\ and regularly review the appropriateness 
and accuracy of the method used in valuing securities, and make any 
necessary adjustments.\47\
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    \41\ Mispricing may also occur when a domestic trading market in 
a security closes before the time the fund prices its shares, or 
when market quotations for a security are not reliable because, 
e.g., sales have been infrequent or there is a thin market in the 
security. See Accounting Series Release No. 118 (Dec. 23, 1970) (35 
FR 19986 (Dec. 31, 1970)). Thus, in addition to monitoring for 
events that may necessitate fair value pricing, funds must pay 
attention to circumstances that would suggest the need for using 
fair value pricing.
    \42\ Pricing of Redeemable Securities for Distribution, 
Redemption, and Repurchase, Investment Company Act Release No. 14244 
(Nov. 21, 1984) (49 FR 46558 (Nov. 21, 1984)), at n. 7 (emphasis 
added) (proposing amendments to rule 22c-1). Subsequent to the 
issuance of this release, our staff has reminded funds of their fair 
valuation obligations. In 1999 and 2001, the Division of Investment 
Management issued interpretive letters elaborating on funds' 
obligations under sections 2(a)(41) of the Investment Company Act 
and rule 22c-1 (17 CFR 270.22c-1) thereunder. Letter from Douglas 
Scheidt, Associate Director and Chief Counsel, SEC Division of 
Investment Management, to Craig S. Tyle, General Counsel, Investment 
Company Institute (Dec. 8, 1999) (http://www.sec.gov/divisions/investment/guidance/tyle120899.htm); letter from Douglas Scheidt, 
Associate Director and Chief Counsel, SEC Division of Investment 
Management, to Craig S. Tyle, General Counsel, Investment Company 
Institute (Apr. 30, 2001) (http://www.sec.gov/divisions/investment/guidance/tyle043001.htm).
    \43\ 17 CFR 270.22c-1.
    \44\ Section 2(a)(41) (15 U.S.C. 80a-2(a)(41)) of the Investment 
Company Act.
    \45\ In some cases, funds have adopted policies and procedures 
requiring the use of fair value pricing in circumstances when prices 
may be affected by events subsequent to the close of trading, but 
have established criteria that result in infrequent use of fair 
value pricing, which provides an opportunity for price arbitrage. 
See, e.g., Susan Lee, The Dismal Science: The Feeling's Not Mutual, 
Wall St. J., Nov. 24, 2003, at A15. As we have stated previously, 
funds must fair value their portfolio securities whenever market 
quotations become unreliable. See supra note 42. The failure of a 
fund to establish sufficiently sensitive criteria for using fair 
value pricing should be recognizable in subsequent reviews of the 
accuracy of the prices used to compute the net asset value of the 
fund.
    \46\ In determining fair value, some funds use correlations 
between the exchange prices of foreign securities and other 
appropriate instruments or indicators, such as relevant indices, 
American Depository Receipts, and futures contracts. Software 
developed by vendors is today available to assist funds to determine 
the fair value of portfolio securities.
    \47\ In a companion release, we are proposing to amend funds' 
disclosure requirements with respect to the use and the effects of 
fair value pricing. See Section II.B of Companion Disclosure 
Release, supra note 8.
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    [sbull] Processing of fund shares. Our rules require forward 
pricing of fund shares.\48\ An investor submitting a purchase order or 
redemption request must receive the price next calculated after receipt 
of the purchase order or redemption request.\49\ Accordingly, rule 38a-
1 requires that a fund have in place procedures that segregate investor 
orders received before the fund prices its shares (which will receive 
that day's price) from those that were received after the fund prices 
its shares (which will receive the following day's price).\50\ Because 
fund purchase and redemption orders are ultimately transmitted to 
transfer agents engaged by the fund, we have expanded the service 
providers covered by the rule to include transfer agents.
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    \48\ Rule 22c-1(a) (17 CFR 270.22c-1(a)).
    \49\ Id. We adopted the forward pricing requirement in 1968 to 
eliminate so-called ``backward pricing'' that permitted sales and 
purchases of fund shares at a stated price. We concluded that 
backward pricing resulted in dilution of the value of fund shares, 
and that it disrupted fund management by encouraging short-term 
trading in funds by speculators seeking to take advantage of fund 
prices that did not reflect the current value of the fund portfolio. 
Adoption of Rule 22c-1 under the Investment Company Act of 1940 
Prescribing the Time Pricing of Redeemable Securities for 
Distribution, Redemption, and Repurchase, and Amendment of Rule 17a-
3(a)(7) under the Securities Exchange Act of 1934 Requiring Dealers 
to Time-Stamp Orders, Investment Company Act Release No. 5519 (Oct. 
16, 1968) (33 FR 16331 (Nov. 7, 1968)).
    \50\ Rule 38a-1(a)(1). In most cases, we expect these matters 
will be addressed by the policies and procedures of fund transfer 
agents. See Companion Late Trading Release, supra note 8, for a 
detailed discussion of how fund share transactions are processed by 
intermediaries.
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    Many funds today have contractual provisions with transfer agents 
and other intermediaries that obligate those

[[Page 74719]]

parties to segregate orders received by time of receipt in order to 
prevent ``late trading'' based on a previously determined price. 
Reliance on those contractual provisions alone would be insufficient to 
meet the requirements of the new rule.\51\ Funds should not only 
approve and periodically review the policies and procedures of transfer 
agents, as required by the rule, but should also take affirmative steps 
to protect themselves and their shareholders against late trading by 
obtaining assurances that those policies and procedures are effectively 
administered.\52\
---------------------------------------------------------------------------

    \51\ In a companion release, we are proposing amendments to rule 
22c-1 under the Investment Company Act that would eliminate the need 
for funds and their transfer agents to rely on the segregation of 
orders by fund intermediaries other than a registered transfer agent 
or clearing agency. See Companion Late Trading Release, supra note 
8.
    \52\ We discuss methods funds can use to oversee such policies 
and procedures later in this Adopting Release, in connection with 
the chief compliance officer's oversight of service providers. See 
infra text accompanying footnote 91.
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    [sbull] Identification of Affiliated Persons. To prevent self-
dealing and overreaching by persons in a position to take advantage of 
the fund, the Investment Company Act prohibits funds from entering into 
certain transactions with affiliated persons.\53\ Funds should have 
policies and procedures in place to identify these persons and to 
prevent unlawful transactions with them.
---------------------------------------------------------------------------

    \53\ See, e.g., section 17(a) (15 U.S.C. 80a-17(a)) (prohibiting 
first and second-tier affiliates of a fund from borrowing money or 
other property from, or selling or buying securities or other 
property to or from the fund, or any company that the fund 
controls); section 17(d) (15 U.S.C. 80a-17(d)) (making it unlawful 
for first- and second-tier affiliates of a fund, the fund's 
principal underwriters, and affiliated persons of the fund's 
principal underwriters, acting as principal, to effect any 
transaction in which the fund or a company controlled by the fund is 
a joint or a joint and several participant in contravention of 
Commission rules); rule 17d-1(a) (270 CFR 270.17d-1(a)) (prohibiting 
first- and second-tier affiliates of a fund, the fund's principal 
underwriter, and affiliated persons of the fund's principal 
underwriter, acting as principal, from participating in or effecting 
any transaction in connection with any joint enterprise or other 
joint arrangement or profit-sharing plan in which any such fund or 
company controlled by a fund is a participant unless an application 
regarding such enterprise, arrangement or plan has been filed with 
the Commission and has been granted); section 10(f) (15 U.S.C. 80a-
10(f)) (prohibiting a fund from purchasing securities in a primary 
offering if certain affiliated persons of the fund are members of 
the underwriting or selling syndicate); section 17(e) (15 U.S.C. 
80a-17(e)) (limiting the remuneration that first- and second-tier 
affiliates of a fund may receive in transactions involving the fund, 
and companies that the fund controls); and section 12(d)(3) (15 
U.S.C. 80a-12(d)(3)) and rule 12d3-1 (270 CFR 270.12d3-1) (together 
prohibiting a fund from acquiring securities issued by, among 
others, its own investment adviser).
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    [sbull] Protection of Nonpublic Information. The federal securities 
laws prohibit insider trading, and section 204A of the Advisers Act 
requires advisers (including advisers to funds) to establish, maintain, 
and enforce written policies and procedures reasonably designed to 
prevent the adviser or any of its associated persons from misusing 
material, nonpublic information. Fund advisers should incorporate their 
section 204A policies into the policies required by rule 38a-1. These 
policies typically include prohibitions against trading portfolio 
securities on the basis of information acquired by analysts or 
portfolio managers employed by the investment adviser. A fund's 
compliance policies and procedures should also address other potential 
misuses of nonpublic information, including the disclosure to third 
parties of material information about the fund's portfolio,\54\ its 
trading strategies,\55\ or pending transactions, and the purchase or 
sale of fund shares by advisory personnel based on material, nonpublic 
information about the fund's portfolio.\56\
---------------------------------------------------------------------------

    \54\ In a companion release, we are proposing to require funds 
to disclose their policies and procedures with respect to the 
disclosure of fund portfolio holdings. See Section II.C of Companion 
Disclosure Release, supra note 8.
    \55\ Thus, funds' and investment advisers' policies and 
procedures should preclude fund or advisory personnel from divulging 
a fund's portfolio schedule that has not been made generally 
available to the public. Divulging portfolio holdings to selected 
third parties is permissible only when the fund has legitimate 
business purposes for doing so and the recipients are subject to a 
duty of confidentiality. See, e.g., Selective Disclosure and Insider 
Trading, Securities Act Release No. 7881 at text accompanying n. 29 
(Aug. 15, 2000) (65 FR 51716 (Aug. 24, 2000)) (noting that ``issuers 
and their officials may properly share material nonpublic 
information with outsiders, for legitimate business purposes, when 
the outsiders are subject to duties of confidentiality''). See also 
Dirks v. SEC, 463 U.S. 646, 655 at n. 14 (1983) (``Under certain 
circumstances, such as where corporate information is revealed 
legitimately to an underwriter, accountant, lawyer, or consultant 
working for the corporation, these outsiders may become fiduciaries 
of the shareholders. The basis for recognizing this fiduciary duty 
is not simply that such persons acquired nonpublic corporate 
information, but rather that they have entered into a special 
confidential relationship in the conduct of the business of the 
enterprise and are given access to information solely for corporate 
purposes.'') (citations omitted). We understand that many funds 
provide portfolio information in response to requests by rating 
agencies and similar organizations only after receiving written 
assurances that the information will be kept confidential and that 
persons with access to the information will not use the information 
to trade securities.
    \56\ We urge funds and advisers to require persons who have 
access to nonpublic information to trade securities of the fund 
exclusively through identifiable accounts to enable the fund to 
monitor for excessive, short-term trading. Alternatively, although 
not required by section 17(j) of the Investment Company Act (15 
U.S.C. 80a-17(j)) or rule 17j-1 (17 CFR 270.17j-1), funds and 
advisers should consider amending their codes of ethics to cover, 
and thus require reporting of, trades by persons who have access to 
nonpublic information about the portfolio, including information 
about the accuracy of the prices of portfolio securities used to 
calculate net asset value.
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    [sbull] Compliance with Fund Governance Requirements. A fund's 
board plays an important role in overseeing fund activities to ensure 
that they are being conducted for the benefit of the fund and its 
shareholders. Fund boards, among other things, are tasked with 
approving the fund's advisory contracts,\57\ underwriting 
agreements,\58\ and distribution plans.\59\ The Investment Company Act 
requires that fund boards of directors be elected by fund 
shareholders,\60\ and that a certain percentage be ``independent 
directors.''\61\ To rely on many of our exemptive rules, independent 
directors must constitute a majority of the board, must be selected and 
nominated by other independent directors, and if they hire legal 
counsel, that counsel must be an independent legal counsel.\62\
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    \57\ Sections 15(a) and (c) of the Investment Company Act (15 
U.S.C. 80a-15(a) and (c)).
    \58\ Sections 15(b) and (c) of the Investment Company Act (15 
U.S.C. 80a-15(b) and (c)).
    \59\ Section 12(b) of the Investment Company Act (15 U.S.C. 80a-
12(b)) and rule 12b-1(b)(2) (17 CFR 270.12b-1(b)(2)).
    \60\ Section 16(a) of the Investment Company Act (15 U.S.C. 80a-
16(a)).
    \61\ Section 10(a) of the Investment Company Act (15 U.S.C. 80a-
10(a)) (prohibiting more than 60 percent of a fund's directors from 
being interested persons of the fund); section 10(b)(2) of the 
Investment Company Act (15 U.S.C. 80a-10(b)(2)) (requiring, in 
effect, that independent directors comprise a majority of a fund's 
board if the fund's principal underwriter is an affiliate of the 
fund's investment adviser); section 15(f)(1) of the Investment 
Company Act (15 U.S.C. 80a-15(f)(1)) (providing a safe harbor for 
the sale of an advisory business if directors who are not interested 
persons of the investment adviser constitute at least 75 percent of 
a fund's board for at least three years following the assignment of 
the advisory contract). See also rule 6e-3(T)(b)(15) (17 CFR 270.6e-
3(T)(b)(15)) (exempting certain funds underlying insurance products 
from various Investment Company Act provisions provided that 
independent directors constitute a majority of the boards of those 
funds).
    \62\ See rule 10f-3 (17 CFR 270.10f-3), rule 12b-1 (17 CFR 
270.12b-1), rule 15a-4 (17 CFR 270.15a-4), rule 17a-7 (17 CFR 
270.17a-7), rule 17d-1(d)(7) (17 CFR 270.17d-1(d)(7)), rule 17e-1 
(17 CFR 270.17e-1), rule 17g-1(j) (17 CFR 270.17g-1(j)), rule 18f-3 
(17 CFR 270.18f-3), and rule 23c-3 (17 CFR 270.23c-3). See also rule 
0-1(a)(6) (17 CFR 270.0-1(a)(6)) (defining ``independent legal 
counsel'').
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    The consequences of failing to meet the Investment Company Act's 
governance requirements are severe.\63\ Therefore, a fund's policies 
and procedures should be designed to guard against, among other things, 
an

[[Page 74720]]

improperly constituted board,\64\ the failure of the board to properly 
consider matters entrusted to it, and the failure of the board to 
request and consider information required by the Investment Company Act 
from the fund adviser and other service providers.\65\
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    \63\ See, e.g., In re Charles G. Dyer, Investment Company Act 
Release No. 25107 (Aug. 9, 2001) and SEC v. Centurion Growth Fund, 
No. 94-8199-CIV-UNGARO-BENAGES, (S.D. Fla. Apr. 22, 1994), 
Litigation Release No. 14063 (Apr. 28, 1994) (56 SEC Docket 1776).
    \64\ A board lacking a sufficient number of disinterested 
directors, for example, would be improperly constituted. To avoid 
this, fund procedures should provide for a process of determining 
that independent director candidates are not ``interested persons'' 
and, after their election, for a periodic reassessment that they 
continue not to be interested persons. See rule 31a-2 (17 CFR 
270.31a-2(a)(4)) under the Investment Company Act (requiring the 
maintenance of ``any record of the initial determination that a 
director is not an interested person of the investment company and 
each subsequent determination that the director is not an interested 
person * * * includ[ing] any questionnaire and any other document 
used to determine that a director is not an interested person of the 
company'').
    \65\ Section 15(c) requires fund directors ``to request and 
evaluate * * * such information as may reasonably be necessary to 
evaluate the terms of any contract whereby a person undertakes 
regularly to serve or act as investment adviser of such company.'' A 
board that fails to acquire sufficient information about the 
advisory fee and other fund expenses will be unable to negotiate 
effectively on behalf of the fund. As a result, the fund may pay a 
higher than necessary advisory fee, fail to benefit from economies 
of scale as a result of insufficient breakpoints in the advisory 
fee, or bear too many operating expenses.
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    [sbull] Market Timing. In a companion release today, we are 
proposing amendments to our mutual fund disclosure rules to require 
funds to disclose their policies on ``market timing,'' i.e., the 
excessive short-term trading of mutual fund shares that may be harmful 
to the fund.\66\ Many funds' prospectuses already disclose market 
timing policies, and failure to adhere to those disclosed policies 
violates the antifraud provisions of the Federal securities laws.\67\ 
Moreover, a fund adviser that waives or disregards those policies for 
the benefit of itself or a third party has breached its fiduciary 
responsibilities to the fund.\68\ Thus, under rule 38a-1 a fund must 
have procedures reasonably designed to ensure compliance with its 
disclosed policies regarding market timing. These procedures should 
provide for monitoring of shareholder trades or flows of money in and 
out of the funds in order to detect market timing activity, and for 
consistent enforcement of the fund's policies regarding market 
timing.\69\ If the fund permits any waivers of those policies, the 
procedures should be reasonably designed to prevent waivers that would 
harm the fund or its shareholders or subordinate the interests of the 
fund or its shareholders to those of the adviser or any other 
affiliated person or associated person of the adviser. In this regard, 
we strongly urge fund boards to require fund advisers, or other persons 
authorized to waive market timing policies, to report to the board at 
least quarterly all waivers granted, so that the board can determine 
whether the waivers were proper.
---------------------------------------------------------------------------

    \66\ See Section II.A. of the Companion Disclosure Release, 
supra note 8.
    \67\ Failure to adhere to statements made in the prospectus may 
render the prospectus disclosure materially misleading and thus 
violate provisions of the Federal securities laws that prohibit 
fraud. See, e.g., section 17(a) of the Securities Act (15 U.S.C. 
77q), section 10(b) of the Securities Exchange Act (15 U.S.C. 78j) 
and rule 10b-5 (17 CFR 240.10b-5) thereunder, and section 34(b) of 
the Investment Company Act (15 U.S.C. 80a-33(b)).
    \68\ An investment adviser has a fiduciary duty to act in the 
best interests of a fund it advises. Section 206 under the Advisers 
Act (15 U.S.C. 80b-6) and section 36(a) under the Investment Company 
Act (15 U.S.C. 80a-35(a)). See also Rosenfeld v. Black, 445 F.2d 
1337 (2d Cir. 1971); Brown v. Bullock, 194 F. Supp. 207, 229, 234 
(S.D.N.Y.), aff'd, 294 F.2d 415 (2d Cir. 1961); In re Provident 
Management Corp., Securities Act Release No. 5115 (Dec. 1, 1970) at 
text accompanying note 12.
    \69\ See, e.g., C. Meyrick Payne, Strengthening the Role of 
Mutual Fund Directors after the Canary Scandal, Management Practice 
Bulletin (Oct. 2003) (http://www.mfgovern.com/reports/2_canaryscandal.html) (explaining that ``periodic sales and redemption 
data'' are useful for detecting practices such as late trading and 
market timing).
---------------------------------------------------------------------------

B. Annual Review

1. Investment Advisers
    Rule 206(4)-7 requires each registered adviser to review its 
policies and procedures annually to determine their adequacy and the 
effectiveness of their implementation.\70\ The review should consider 
any compliance matters that arose during the previous year, any changes 
in the business activities of the adviser or its affiliates, and any 
changes in the Advisers Act or applicable regulations that might 
suggest a need to revise the policies or procedures. For example, an 
adviser that is acquired by a broker-dealer or by the corporate parent 
of a broker-dealer should assess whether its policies and procedures 
are adequate to guard against the conflicts that arise when the adviser 
uses that broker-dealer to execute client transactions, or invests 
client assets in funds or other securities distributed or underwritten 
by the broker-dealer.
---------------------------------------------------------------------------

    \70\ Rule 206(4)-7(b).
---------------------------------------------------------------------------

    Although the rule requires only annual reviews, advisers should 
consider the need for interim reviews in response to significant 
compliance events, changes in business arrangements, and regulatory 
developments. For example, we expect all registered advisers will begin 
reviewing their policies and procedures in light of our adoption of 
these rules.
2. Investment Companies
    Similarly, rule 38a-1 requires a fund to review its policies and 
procedures, as well as those of its service providers, annually.\71\ 
The rule does not require a fund board to conduct the review; the board 
would, however, have the benefit of the review in the report submitted 
by the compliance officer. We expect all funds will begin reviewing 
their compliance policies and procedures currently, not only in light 
of the adoption of these rules, but also in light of the recent 
revelations of unlawful practices involving fund market timing, late 
trading, and improper disclosures and use of nonpublic portfolio 
information.
---------------------------------------------------------------------------

    \71\ Rule 38a-1(a)(3).
---------------------------------------------------------------------------

C. Chief Compliance Officer

1. Investment Advisers
    Rule 206(4)-7 requires each adviser registered with the Commission 
to designate a chief compliance officer to administer its compliance 
policies and procedures.\72\ An adviser's chief compliance officer 
should be competent and knowledgeable regarding the Advisers Act and 
should be empowered with full responsibility and authority to develop 
and enforce appropriate policies and procedures for the firm.\73\ Thus, 
the compliance officer should have a position of sufficient seniority 
and authority within the organization to compel others to adhere to the 
compliance policies and procedures.\74\
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    \72\ Rule 206(4)-7(c). We are also making a technical amendment 
to the item related to chief compliance officers on Form ADV, the 
registration form that advisers use to register with us under the 
Advisers Act. Form ADV, Part 1, Schedule A, Item 2(a) (17 CFR 
279.1). The revision requires each registered adviser and each 
applicant for registration as an adviser to identify a single 
compliance officer.
    \73\ Having the title of chief compliance officer does not, in 
and of itself, carry supervisory responsibilities. Thus, a chief 
compliance officer appointed in accordance with rule 206(4)-7 (or 
rule 38a-1) would not necessarily be subject to a sanction by us for 
failure to supervise other advisory personnel. A compliance officer 
who does have supervisory responsibilities can continue to rely on 
the defense provided for in section 203(e)(6) of the Advisers Act 
(15 U.S.C. 80b-3(e)(6)). Section 203(e)(6) provides that a person 
shall not be deemed to have failed to reasonably supervise another 
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 supervising 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.
    \74\ The rule does not require advisers to hire an additional 
executive to serve as compliance officer, but rather to designate an 
individual as the adviser's chief compliance officer. Several 
commenters who complained of the burdens this proposed requirement 
would impose on them appeared to have assumed that they would be 
required to hire an additional person to fill the position of chief 
compliance officer.

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[[Page 74721]]

2. Investment Companies
    Rule 38a-1 requires each fund to appoint a chief compliance officer 
who is responsible for administering the fund's policies and procedures 
approved by the board under the rule.\75\ A fund's chief compliance 
officer should be competent and knowledgeable regarding the Federal 
securities laws and should be empowered with full responsibility and 
authority to develop and enforce appropriate policies and procedures 
for the fund. The chief compliance officer of a fund, like the chief 
compliance officer of an investment adviser, should have sufficient 
seniority and authority to compel others to adhere to the compliance 
policies and procedures.
---------------------------------------------------------------------------

    \75\ Rule 38a-1(a)(4).
---------------------------------------------------------------------------

    The rule contains several provisions, some of which were not 
included in our proposal, designed to promote the independence of the 
chief compliance officer from the management of the fund.\76\ First, 
the chief compliance officer will serve in her position at the pleasure 
of the fund's board of directors, which can remove her if it loses 
confidence in her effectiveness. The fund board (including a majority 
of independent directors) must approve the designation of the chief 
compliance officer, and must approve her compensation (or any changes 
in her compensation).\77\ The board (including a majority of the 
independent directors) can remove the chief compliance officer from her 
responsibilities at any time,\78\ and can prevent the adviser or 
another service provider from doing so.\79\
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    \76\ In the Proposing Release we requested comment on whether 
the chief compliance officer should be a senior manager of the fund 
because such a person would be in a better position to compel 
compliance with the fund's policies and procedures, and would less 
likely be intimidated in the performance of her duties. We are not 
adopting such a requirement because, as several commenters pointed 
out to us, it is very difficult to ascertain who is a ``senior 
manager'' in some organizations. Instead, we have described the 
authority we believe an individual must possess to be designated as 
a chief compliance officer, and have added a provision to the rule 
making it unlawful to exert undue influence on the chief compliance 
officer in the performance of her duties (see infra text 
accompanying note 86).
    \77\ Rule 38a-1(a)(4)(i). These requirements were not included 
in proposed rule 38a-1. Compensation would include any bonus. In 
approving a change in compensation, the board should assure itself 
that the chief compliance officer is not denied any customary cost 
of living increase or any full customary bonus and that fund 
managers are not otherwise retaliating against the chief compliance 
officer for having informed the board of a compliance failure or for 
having taken aggressive actions to ensure compliance with the 
federal securities laws by the fund or service provider.
    \78\ Rule 38a-1(a)(4)(ii).
    \79\ In a change from the proposed rule, the chief compliance 
officer can only be discharged from her responsibilities with the 
approval of the board. Rule 38a-1(a)(4)(ii).
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    Second, the chief compliance officer will report directly to the 
board of directors. She must annually furnish the board with a written 
report on the operation of the fund's policies and procedures and those 
of its service providers.\80\ The report must address, at a minimum: 
(i) The operation of the policies and procedures of the fund and each 
service provider since the last report, (ii) any material changes to 
the policies and procedures since the last report,\81\ (iii) any 
recommendations for material changes to the policies and procedures as 
a result of the annual review,\82\ and (iv) any material compliance 
matters since the date of the last report.\83\ We have added a 
definition of the term ``material compliance matter'' to the rule, to 
clarify that the report should inform the board of those compliance 
matters about which the fund's board reasonably needs to know in order 
to oversee fund compliance.\84\
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    \80\ If the fund is a unit investment trust, the fund's 
principal underwriter or depositor must approve the chief compliance 
officer, must receive all annual reports, and must approve the 
removal of the chief compliance officer from his or her 
responsibilities. Rule 38a-1(b).
    \81\ A change would be ``material'' in this context if it is a 
change that a fund director would reasonably need to know in order 
to oversee fund compliance.
    \82\ Id. The report should also discuss the fund's particular 
compliance risks and any changes that were made to the policies and 
procedures to address newly identified risks.
    \83\ Rule 38a-1(a)(4)(iii). Our proposal would have required the 
report to include only compliance matters that resulted in remedial 
action; our final rule contains no such limitation because we are 
concerned that a fund or its service providers might abuse the 
limitation and fail to impose remedial actions in order to avoid 
having to report a compliance failure to the board.
    \84\ Rule 38a-1(e)(2). Serious compliance issues must, of 
course, always be brought to the board's attention promptly, and 
cannot be delayed until an annual report. In addition, individual 
compliance matters that, taken in isolation, may not be material may 
collectively suggest a material compliance matter, such as a 
material weakness in the compliance programs of the fund or its 
service providers. See, e.g., Personal Investment Activities of 
Investment Company Personnel, Investment Company Act Release No. 
23958, at n. 25 (Aug. 20, 1999) (64 FR 46821 (Aug. 27, 1999)).
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    Third, we are requiring that the chief compliance officer meet in 
executive session with the independent directors at least once each 
year, without anyone else (such as fund management or interested 
directors) present.\85\ The executive session creates an opportunity 
for the chief compliance officer and the independent directors to speak 
freely about any sensitive compliance issues of concern to any of them, 
including any reservations about the cooperativeness or compliance 
practices of fund management.
---------------------------------------------------------------------------

    \85\ Rule 38a-1(a)(4)(iv). Independent counsel to the 
independent directors may be present.
---------------------------------------------------------------------------

    Fourth, we have added a provision to protect the chief compliance 
officer from undue influence by fund service providers seeking to 
conceal their or others' non-compliance with the federal securities 
laws. Rule 38a-1 prohibits the fund's officers, directors, employees or 
its adviser, principal underwriter, or any person acting under the 
direction of these persons, from directly or indirectly taking any 
action to coerce, manipulate, mislead or fraudulently influence the 
fund's chief compliance officer in the performance of her 
responsibilities under the rule.\86\
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    \86\ Rule 38a-1(c). This prohibition is similar to the 
prohibition on unduly influencing auditors found in section 303(a) 
of the Sarbanes-Oxley Act (Pub. L. 107-204, 116 Stat. 745 (2002)) 
and rule 13b2-2(b)(1) (17 CFR 240.13b2-2(b)(1)) under the Securities 
Exchange Act.
---------------------------------------------------------------------------

    The appointment of a chief compliance officer with overall 
responsibility for management of a fund complex's compliance program is 
a key element of the investor protections we are today adopting. Some 
commenters representing fund management companies urged us to permit 
funds to continue to use multiple compliance managers employed by 
different service providers, rely on the policies of the fund service 
providers, and omit the requirement that fund boards approve the 
compliance officer. These commenters would have us maintain funds' 
current approach to compliance management. Current practices, however, 
balkanize responsibility for fund compliance and isolate fund boards 
from compliance personnel, thus impeding boards' abilities to exercise 
their oversight responsibilities effectively. We decline to accept 
current practices, which we believe have contributed to the serious 
compliance lapses that are now the subject of our enforcement actions.
    We have observed that executives at service providers have 
overruled their own compliance personnel because of business 
considerations. For example, some fund advisers have continued to 
permit investors with whom they had other business relationships to 
engage in harmful market timing in fund shares after compliance 
personnel and portfolio managers brought the market timing activity to 
their attention. These compliance personnel may not have had access to 
fund directors or, having been overruled by their own management,

[[Page 74722]]

may have felt they were not in a position to approach the board.
    To address these concerns, rule 38a-1 provides fund boards with 
direct access to a single person with overall compliance responsibility 
for the fund who answers directly to the board. The rule provides the 
board with a powerful tool to exercise its oversight responsibilities 
over fund compliance matters. The new rule also strengthens the hand of 
compliance personnel by establishing a direct line of reporting to fund 
boards that is not controlled by management.\87\ We have observed that 
compliance failures have occurred when a fund service provider has 
denied information to the fund's board, or has been less than 
forthright, because the service provider viewed full disclosure as 
detrimental to its own interests. Under the new rule, the chief 
compliance officer will be responsible for keeping the board apprised 
of significant compliance events at the fund or its service providers 
and for advising the board of needed changes in the fund's compliance 
program.
---------------------------------------------------------------------------

    \87\ Rules 38a-1(a)(4)(ii) (providing that the board's approval 
is required to remove the chief compliance officer) and 38a-
1(a)(4)(iii) (requiring the chief compliance officer to provide a 
written compliance report to the board).
---------------------------------------------------------------------------

    We expect that a fund's chief compliance officer will often be 
employed by the fund's investment adviser or administrator.\88\ We are 
not adopting a requirement that the chief compliance officer be 
employed by only the fund because we believe that such a provision 
would actually weaken her effectiveness. Funds today typically have no 
employees, and delegate management and administrative functions, 
including the compliance function, to one or more service providers. If 
we were to preclude the chief compliance officer from being an employee 
of an adviser or any other service provider, she would be divorced from 
all fund operations.\89\ The adviser's chief compliance officer would 
continue to administer the adviser's compliance programs, and the role 
of the fund's chief compliance officer would be limited to oversight of 
the service providers' compliance policies and providing advice to the 
board on their operation. As a result, the fund's chief compliance 
officer would be almost entirely dependent on information filtered 
through the senior management of the fund's adviser rather than, for 
example, information received directly from a trading desk. Moreover, 
fund management would be unlikely to consult with an ``outside'' 
compliance officer on a prospective business decision to ascertain the 
compliance implications.
---------------------------------------------------------------------------

    \88\ Indeed, she is likely to be the chief compliance officer of 
that organization inasmuch as the duties of the positions will have 
significant overlap. Alternatively, the chief compliance officer of 
the fund may be another member of the adviser or administrator's 
legal or compliance departments.
    \89\ Internalizing the compliance function while retaining an 
externalized management function would also raise a number of 
practical issues, such as whether the chief compliance officer could 
use the adviser's office space and other resources, including 
support staff. In addition, it would be costly for funds, 
particularly small funds, to hire a chief compliance officer and pay 
her benefits. Those costs would be borne by investors.
---------------------------------------------------------------------------

    We recognize, however, that a chief compliance officer who is an 
employee of the fund's investment adviser might be conflicted in her 
duties, and that the investment adviser's business interests might 
discourage the adviser from making forthright disclosure to fund 
directors of its compliance failures. The rule, as adopted, is designed 
to address these concerns by requiring a fund's chief compliance 
officer to report directly to the board. The board, and the board 
alone, can discharge the officer if she fails to live up to the 
position. Thus, a chief compliance officer who fails to fully inform 
the board of a material compliance failure, or who fails to 
aggressively pursue non-compliance within the service provider, would 
risk her position. She would also risk her career, because it would be 
unlikely for another board of directors to approve such a person as 
chief compliance officer.\90\
---------------------------------------------------------------------------

    \90\ If such a person were approved by another fund, our staff 
would enhance its scrutiny of the fund accordingly.
---------------------------------------------------------------------------

    The chief compliance officer, in exercising her responsibilities 
under the rule, will oversee the fund's service providers, which will 
have their own compliance officials. A chief compliance officer should 
diligently administer this oversight responsibility by taking steps to 
assure herself that each service provider has implemented effective 
compliance policies and procedures administered by competent personnel. 
The chief compliance officer should be familiar with each service 
provider's operations and understand those aspects of their operations 
that expose the fund to compliance risks. She should maintain an active 
working relationship with each service provider's compliance personnel. 
Arrangements with the service provider should provide the fund's chief 
compliance officer with direct access to these personnel, and should 
provide the compliance officer with periodic reports and special 
reports in the event of compliance problems. In addition, the fund's 
contracts with its service providers might also require service 
providers to certify periodically that they are in compliance with 
applicable federal securities laws, or could provide for third-party 
audits arranged by the fund to evaluate the effectiveness of the 
service provider's compliance controls.\91\ The chief compliance 
officer could conduct (or hire third parties to conduct) statistical 
analyses of a service provider's performance of its duties to detect 
potential compliance failures.\92\
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    \91\ Mutual funds already rely on these types of measures in 
connection with their responsibility to ensure that their service 
providers carry out anti-money laundering compliance programs. Rules 
under the Uniting and Strengthening America by Providing Appropriate 
Tools Required to Intercept and Obstruct Terrorism Act of 2001, Pub. 
L. No. 107-56 (USA PATRIOT Act) require funds to maintain procedures 
reasonably designed to prevent them from being used for money 
laundering or the financing of terrorist activities. See, e.g., 
Anti-Money Laundering Programs for Mutual Funds, 67 FR 21117, 21119 
(Apr. 29, 2002) (mutual fund may contractually delegate functions 
under 31 CFR 103.130 to a service provider, but must take steps to 
ensure that the service provider's compliance program is reasonably 
designed, and to monitor its implementation and ensure its 
effectiveness).
    \92\ In the case of an insurance company separate account, the 
principal service providers typically will be the sponsoring 
insurance company. Therefore, the chief compliance officer must 
oversee the insurance company's compliance program with respect to 
the separate accounts, including the processing of new account 
applications, premium payments, and exchanges.
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D. Recordkeeping

    New rule 38a-1 (for funds) and amendments to rule 204-2 (for 
advisers) require firms to maintain copies of all policies and 
procedures that are in effect or were in effect at any time during the 
last five years.\93\ In addition, new rule 38a-1 will require funds to 
maintain materials provided to the board of directors in connection 
with their approval of the fund's and its service providers' policies 
and procedures and the annual written reports by the fund's chief 
compliance officer.\94\ New rule 38a-1 and amended

[[Page 74723]]

rule 204-2 will require funds and advisers to keep any records 
documenting their annual review.\95\ Our rules permit funds and 
advisers to maintain these records electronically.\96\ These new 
recordkeeping requirements will assist our examination staff in 
determining whether the adviser or fund is adhering to the new rules 
and in identifying weaknesses in the compliance program if violations 
do occur or are uncorrected.
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    \93\ Rules 38a-1(d)(1) and 204-2(a)(17)(i). As discussed above, 
the required policies and procedures do not all need to be contained 
in a single document. See supra text following note 22. We 
understand many firms issue policies and procedures in loose-leaf 
form, distributing revised sections periodically within their firms. 
These firms may comply with the recordkeeping requirements by 
keeping the current policies and procedures and retaining the 
superseded section(s) for the requisite period of time, so long as 
the firm can indicate to our examinating staff the version of 
compliance policies and procedures that were in effect as of a given 
date.
    \94\ Rule 38a-1(d)(2). In a change from proposed rule 38a-1, 
funds will have to maintain materials provided to the board of 
directors in connection with their approval of service providers' 
policies and procedures in addition to the annual compliance report. 
These records must be maintained for at least five years after the 
end of the fiscal year in which the documents were provided to the 
board, the first two years in an easily accessible place. Funds 
already are required to document in the fund board's minute books 
the 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. Board minute books must be 
maintained pursuant to rule 31a-1(b)(4) under the Investment Company 
Act (17 CFR 270.31a-1(b)(4)). All reports required by our rules are 
meant to be made available to the Commission and the Commission 
staff and, thus, they are not subject to the attorney-client 
privilege, the work-product doctrine, or other similar protections.
    \95\ Rules 38a-1(d)(3) and 204-2(a)(17)(ii). In a change from 
proposed rule 38a-1, funds will have to maintain any records 
documenting their annual review for at least five years after the 
end of the fiscal year in which the annual review was conducted, the 
first two years in an easily accessible place. Advisers will have 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. Rule 204-2(e)(1).
    \96\ See rules 31a-2(f) (17 CFR 270.31a-2(f)) and 204-2 (17 CFR 
275.204-2(g)). Funds and advisers that maintain records 
electronically must provide those records to our staff in electronic 
format upon request. Rule 31a-2(f)(2)(ii)(A) under the Investment 
Company Act (17 CFR 270.31a-2(f)(2)(ii)(A)) and rule 204-
2(g)(2)(ii)(A) under the Investment Advisers Act (17 CFR 275.204-
2(g)(2)(ii)(A)).
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E. Private Sector Initiatives

    In the Proposing Release, we requested that commenters consider 
four additional approaches that we might take to require the private 
sector to assume greater responsibility for compliance with the Federal 
securities laws. These possible approaches included: (i) A requirement 
that funds and advisers undergo third-party compliance reviews; (ii) an 
expansion of the role of independent public accountants to include the 
performance of certain compliance reviews; (iii) the formation of one 
or more self-regulatory organizations for advisers or funds; and (iv) 
the requirement that certain advisers obtain fidelity bonds from 
reputable insurance companies.
    We appreciate the many comments we received. Although we are not 
moving forward with any of these approaches at this time, we continue 
to regard them as viable options should the measures we are taking 
today fail to adequately strengthen the compliance programs of funds 
and advisers. In particular, we may reconsider whether to propose rules 
requiring funds and advisers to obtain compliance reviews from third-
party compliance experts. Such compliance audits could be a useful 
supplement to our examination program and would assure the frequent 
examination of advisers and funds.

F. Additional Request for Comment

    Rule 38a-1 includes provisions designed to promote the chief 
compliance officer's independence from fund management while still 
maintaining her effectiveness. The fund's board of directors must 
approve the chief compliance officer's designation and compensation, 
and has the sole power to remove her from her position.\97\ The chief 
compliance officer reports directly to the board, and must meet with 
the independent directors in executive session at least annually.\98\ 
The rule also protects the chief compliance officer by prohibiting 
persons from coercing or fraudulently influencing her in the course of 
her responsibilities.\99\ Today, in addition to adopting rule 38a-1, we 
request comment on these provisions. Are there other measures (or 
refinements to these provisions) that would further enhance the 
independence and effectiveness of chief compliance officers under the 
rule? We also request comment whether our definition of the ``material 
compliance matters'' that must be reported to fund boards by chief 
compliance officers adequately addresses our concern that fund boards 
receive compliance information they reasonably need to know in order to 
oversee fund compliance.\100\
---------------------------------------------------------------------------

    \97\ Rule 38a-1(a)(4)(i)-(ii). See supra notes 76-79 and 
accompanying text.
    \98\ Rule 38a-1(a)(4)(iii)-(iv). See supra notes 80-85 and 
accompanying text.
    \99\ Rule 38a-1(c) prohibits the fund's officers, directors, 
employees, or its adviser or principal underwriter or any person 
acting under the direction of these persons, from directly or 
indirectly taking any action to coerce, manipulate, mislead, or 
fraudulently influence the fund's chief compliance officer in the 
performance of compliance responsibilities under the rule. See supra 
note 86 and accompanying text, and note 76.
    \100\ Rule 38a-1(e)(2) defines the term ``material compliance 
matter'' to mean those compliance matters--including violations of 
the federal securities laws or compliance policies and procedures by 
the fund or its service providers, as well as weaknesses in the 
design or implementation of those policies and procedures--about 
which the fund's board reasonably needs to know in order to oversee 
fund compliance. See supra note 84 and accompanying text.
---------------------------------------------------------------------------

III. Effective Date

    New rules 38a-1 and 206(4)-7 and the amendments to rule 204-2 will 
be effective on February 5, 2004. The compliance date of the new rules 
and rule amendments is October 5, 2004. On or before the compliance 
date, all funds and advisers must have designated a chief compliance 
officer and fund boards must have approved the chief compliance 
officer. In addition, on or before the compliance date, funds and 
advisers must adopt compliance policies and procedures that satisfy the 
requirements in the new rules. In the case of funds, these policies and 
procedures must have been approved by the board on or before the 
compliance date. Funds and advisers must complete their first annual 
review of the compliance policies and procedures no later than 18 
months after the adoption or approval of the compliance policies and 
procedures. The chief compliance officer of a fund must submit the 
first annual report to the board within 60 calendar days of the 
completion of the annual review.
    Our allowance for a nine month transition period does not reduce 
the immediacy of the need for all funds, including those that already 
have compliance policies in place, to undertake a review of their 
policies and procedures, in light of recent revelations of unlawful 
practices involving market timing, late trading, and improper 
disclosures of nonpublic portfolio information.

IV. Cost-Benefit Analysis

    We are sensitive to the costs and benefits that result from our 
rules. The new rules 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. In the Proposing 
Release, we identified possible costs and benefits of the rules and 
requested comment on our analysis.

A. Benefits

    We expect that fund investors, advisory clients, funds, and 
advisers will benefit from the new rules. Commenters generally agreed 
that comprehensive compliance programs are beneficial. Although many 
funds and advisers already have such programs in place, the new rules 
will make this standard practice for all funds and advisers. One 
commenter, a compliance officer, noted that the benefits of the new 
measures in the form of increased investor protection would far exceed 
the costs.
    Requiring funds and investment advisers to design and implement a 
comprehensive internal compliance program will serve to reduce the risk

[[Page 74724]]

that fund investors and advisory clients (collectively, ``investors'') 
will be harmed by violations of the securities laws. With limited 
exception, commenters agreed that comprehensive written compliance 
programs are the first line of defense in investor protection. Recent 
allegations of violations related to market timing and late trading 
confirm the need for strong compliance programs that do not permit 
compliance objectives to be subordinated to the business objectives of 
fund advisers or their affiliated persons.
    The appointment of a chief compliance officer for each fund will 
also provide important investor protection benefits. Funds currently 
rely on multiple compliance personnel working for different service 
providers. Fund boards do not receive compliance information directly 
from these compliance officers; it is filtered through the management 
of the fund's investment adviser or other service providers. We believe 
these structures have contributed to serious compliance lapses that are 
now the subject of our enforcement actions. Rule 38a-1, by requiring 
each fund to have a compliance officer who serves at the pleasure of 
the fund's board and who is responsible for oversight of these service 
providers, and who cannot be unduly influenced will strengthen the hand 
of compliance personnel by giving them a direct line of reporting to 
the fund board that is not controlled by management.
    The rules will also benefit funds and investment 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. 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. Advisers may be denied eligibility to 
advise funds.\101\ In addition, advisers could be precluded from 
serving in other capacities.\102\
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    \101\ 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.
    \102\ 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)).
---------------------------------------------------------------------------

    The designation of a chief compliance officer also should enhance 
the efficiency of funds' and advisers' operations by centralizing 
responsibility for the compliance function. While many commenters 
agreed that fund and investment adviser compliance benefits from clear 
allocation of compliance responsibilities, they argued that large firms 
would benefit little from requiring a single person to be designated. 
We believe that the designation of a single officer will increase the 
coordination with which distributed compliance functions are executed.
    In addition, because the new rules complement our examination 
program for investment advisers and for fund complexes, they will 
enhance our ability to protect investors. The existence of a structured 
compliance program at funds and investment advisers, together with the 
designation of a chief compliance officer to serve as a point of 
contact, will 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. Most commenters 
noted that the proposed rules would enhance the effectiveness of the 
Commission's examination program and oversight of funds and advisers.

B. Costs

    The new rules will result in some additional costs for funds and 
investment advisers, which, in the case of funds, we expect would be 
passed on to investors. A number of commenters expressed concern about 
the costs that the new rules would impose.\103\ One commenter, noting 
that existing compliance mandates place a significant burden on 
investment advisers, expressed concern that the costs of new compliance 
obligations might outweigh the benefits. However, because all funds and 
most investment advisers currently have some written compliance 
policies and procedures in place, the costs of the new rules in many 
instances already are reflected in the fees investors currently pay.
---------------------------------------------------------------------------

    \103\ We believe that many of these concerns stemmed from the 
incorrect perception that the new rules would require the adoption 
and implementation of one-size-fits-all compliance programs. As 
discussed above, the new rules require each firm to adopt a 
compliance program that conforms with the scope and nature of its 
operations, thus eliminating concerns that the new rules will 
require duplicative or excessively detailed compliance programs.
---------------------------------------------------------------------------

    We would expect that funds and advisers with substantial 
commitments to compliance would incur only minimal costs in connection 
with the adoption of the new rules as they reviewed their internal 
compliance programs for adequacy. Funds and larger advisory firms 
typically have adopted and implemented comprehensive, written policies 
and procedures. Many of these funds and 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.
    A number of commenters expressed particular concern about the 
relative cost of the new rules for small investment advisers.\104\ This 
concern is consistent with our experience that investment advisers (as 
well as small funds) are less likely than their larger counterparts to 
have comprehensive, written internal compliance programs in place. 
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.
---------------------------------------------------------------------------

    \104\ The Investment Counsel Association of American (``ICAA''), 
for example, noted that in small firms with few employees, the 
responsibility for developing a compliance program, if done in-
house, would likely be borne by a highly-paid employee.
---------------------------------------------------------------------------

    However, we expect a number of factors will enable small investment 
advisers to control and minimize these costs. Because 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.\105\ 
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.\106\ If these firms need individualized 
outside assistance, we expect that the number of independent compliance 
experts will grow to fill this demand at competitive

[[Page 74725]]

prices, as has been the case in comparable situations. Estimates of the 
cost of developing compliance policies and procedures vary greatly 
depending on the type of help that an investment adviser seeks.\107\
---------------------------------------------------------------------------

    \105\ The ICAA estimated that, depending on an adviser's size 
and complexity, the adviser could purchase an off-the-shelf 
compliance manual for under $1,000, but would have to spend time 
adjusting the manual to correspond to its organizational structure. 
Alternatively, the ICAA also estimated that the adviser could enlist 
the assistance of a third-party compliance firm to draft a firm-
specific manual for a small to mid-size firm for between $2,500 and 
$3,500. The ICAA also estimated that a law firm would charge between 
$10,000 and $120,000 to draft procedures (and an accounting firm 
would charge between $50,000 and $200,000), depending on the size 
and complexity of the adviser's operations.
    \106\ Firms will incur a cost in tailoring these programs to 
their specific needs.
    \107\ One commenter stated that prohibitive costs may be the 
reason that some firms, particularly small firms, do not have 
compliance programs. The Financial Planning Association, however, 
estimated, based on discussions with a number of compliance vendors, 
a small adviser (with five employees) would spend $675 to purchase 
compliance software and customize it in-house. Alternatively, the 
FPA estimated that such an adviser could purchase a turn-key manual 
customized for the adviser for $1,500. Finally, the FPA estimated 
that the adviser could retain an outside consultant to develop a 
written compliance manual for $3,900.
---------------------------------------------------------------------------

    The requirement that each investment adviser designate a chief 
compliance officer likely will impose only a minimal cost. Many 
investment advisers already have large compliance staffs headed by an 
individual who officially or effectively serves as a chief compliance 
officer.\108\ For other investment advisers, costs associated with 
designating a chief compliance officer also would be minimized by the 
fact that the new rules would not require firms to hire an individual 
exclusively charged with serving in this capacity.\109\ One commenter 
characterized the chief compliance officer requirement as unduly 
burdensome because it would conflict with the complex and varied 
organizational structures of investment advisers. As noted above, we 
believe that it is important for each firm to have one person who 
coordinates compliance efforts on behalf of the firm, even though that 
individual may rely heavily on others within and outside the firm for 
assistance. The cost to funds of appointing a chief compliance officer 
also should not be significant. Like many investment advisers, many 
fund complexes already have large compliance staffs headed by an 
individual who officially or effectively serves as a chief compliance 
officer. We expect this individual will typically be qualified to serve 
the fund's board of directors as the fund's chief compliance 
officer.\110\
---------------------------------------------------------------------------

    \108\ The ICAA noted that most of its members have employees 
responsible for compliance and many of these have designated a chief 
compliance officer.
    \109\ Several commenters expressed concern about the cost to 
small firms of hiring a chief compliance officer. The rules that we 
are adopting do not require funds or investment advisers to hire a 
separate chief compliance officer, and we expect that many small 
investment advisers will designate a principal or employee of the 
firm to serve as chief compliance officer. However, a firm that does 
not currently have a person qualified to serve as chief compliance 
officer will incur costs associated with training someone in the 
firm.
    \110\ The requirement that fund boards approve the designation 
and compensation of the chief compliance officer, or take action to 
remove a chief compliance officer, will impose minimal costs, if 
any, beyond the current costs incurred to prepare briefing materials 
for directors and convene board meetings. With rare exception, fund 
boards should be able to take up these issues during their existing 
schedule of meetings.
---------------------------------------------------------------------------

    We anticipate that costs associated with the annual review 
requirement also will be limited. Many large funds and investment 
advisers with comprehensive compliance programs periodically review 
portions of their compliance programs. These firms may 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 will be less extensive and, 
therefore, less costly than for their larger counterparts. We have 
determined that requiring more frequent reviews would impose 
unnecessary costs on funds and advisers.
    Several commenters stated that there would be a substantial cost 
associated with the requirement that fund boards approve the compliance 
policies and procedures and review the annual report prepared by the 
chief compliance officer. We have clarified in this release that the 
new rules do not require the board of directors to read every policy 
and procedure. The board may make its decisions about the adequacy of 
the compliance policies and procedures based on summary reports. 
Similarly, the board's review of the chief compliance officer's annual 
report should focus on ensuring that the compliance programs of the 
fund and its service providers are reasonably designed and functioning 
effectively. In light of these clarifications, we do not believe that 
funds will incur excessive costs in connection with board oversight of 
compliance under the new rules.
    One commenter, a large fund complex, suggested that there would be 
substantial recordkeeping costs associated with the new rules, and 
suggested that firms be required to maintain for five years copies of 
only those policies and procedures that form the backbone of the firm's 
compliance program. Because records may be maintained electronically, 
the cost of maintaining copies of all compliance policies and 
procedures in place during the past five years will be contained.

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)) mandate that 
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.
    As discussed above, the new 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 new 
rules may indirectly increase efficiency in a number of ways. These 
compliance programs should increase efficiency by deterring Federal 
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 will 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 new rules apply equally to all funds and advisers, we do 
not anticipate that they will introduce any competitive disadvantages. 
To the contrary, the new 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. Several commenters 
cautioned, however, that the new rules could have anti-competitive 
effects on the advisory industry because they would disproportionately 
burden small advisers and could even force them to merge with their 
larger, more established counterparts or go out of business. While 
small advisers will incur the largest relative costs as a result

[[Page 74726]]

of the new rules, the rule's requirements are essential for the 
protection of small advisers' clients. Moreover, the existence of a 
strong compliance program may assist small advisers to attract client 
assets.
    We anticipate that the new rules will indirectly foster capital 
formation by bolstering investor confidence. It has been our experience 
that funds and advisers with effective compliance programs are less 
likely to violate the Federal 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.

VI. Paperwork Reduction Act

    As we discussed in the Proposing Release, the new rules and 
amendments would impose ``collection of information'' requirements 
within the meaning of the Paperwork Reduction Act of 1995.\111\ These 
collections of information are mandatory. Two of the collections of 
information are new. The titles of these new collections are ``Rule 
38a-1'' and ``Rule 206(4)-7.'' The Commission 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 other 
collection of information takes the form of amendments to a currently 
approved collection titled ``Rule 204-2,'' under OMB control number 
3235-0278. The Commission also 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.
---------------------------------------------------------------------------

    \111\ 44 U.S.C. 3501 to 3520.
---------------------------------------------------------------------------

    The collection of information under rule 38a-1 is necessary to 
ensure that investment companies maintain comprehensive internal 
programs that promote the companies' compliance with the federal 
securities laws. This collection of information is mandatory. The 
respondents are investment companies registered with us and business 
development companies. Our staff, conducting the Commission's 
examination and oversight program, will 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.\112\ Rule 38a-1 requires that certain 
records be retained for at least five years.\113\
---------------------------------------------------------------------------

    \112\ See section 31(c) of the Investment Company Act (15 U.S.C. 
80a-30(c).
    \113\ See rule 38a-1(c).
---------------------------------------------------------------------------

    The collection of information under rule 206(4)-7 is necessary to 
ensure that investment advisers maintain comprehensive internal 
programs that promote the advisers' compliance with the Advisers Act. 
This collection of information is mandatory. The respondents are 
investment advisers registered with us. Our staff, conducting the 
Commission's examination and oversight program, will 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.\114\
---------------------------------------------------------------------------

    \114\ 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. This 
collection of information is mandatory. 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.\115\ The records that an adviser must keep in accordance 
with the new rules must be retained for at least five years.\116\
---------------------------------------------------------------------------

    \115\ Id.
    \116\ See rules 204-2(a)(17)(i) and (ii) and rule 204-2(e)(1) 
(17 CFR 275.204-2(e)(1)).
---------------------------------------------------------------------------

A. Rule 38a-1

    We estimated in the Proposing Release that there are approximately 
5,030 registered investment companies and 53 business development 
companies (or a total of approximately 5,083 funds) that will be 
subject to rule 38a-1.\117\ We estimated that the average annual hour 
burden for a fund to document the policies and procedures that make up 
its compliance program as required by rule 38a-1 would be 60 
hours.\118\ We further estimated that each fund would spend five hours 
annually, on average, documenting the conclusions of its annual 
compliance review for its board of directors as required by rule 38a-1.
---------------------------------------------------------------------------

    \117\ These numbers are based on Commission filings as of 
January 2003.
    \118\ While each fund would be required to maintain written 
policies and procedures under rule 38a-1, this average estimate took 
into account that many fund complexes already have written policies 
and procedures documenting their compliance programs and can draw on 
a number of outlines and model programs available from a variety of 
industry representatives, commentators, and organizations to 
supplement these programs, if necessary. The estimate also took into 
account that most funds are located within a fund complex, and would 
be able to draw extensively from the fund complex's ``master'' 
compliance program.
---------------------------------------------------------------------------

    We also estimated that each fund would spend 0.5 hours annually, on 
average, maintaining copies of their compliance policies and procedures 
and chief compliance officer's annual reports for five years as 
required by rule 38a-1. In adopting rule 38a-1, we have expanded this 
recordkeeping requirement to also include copies of briefing materials 
provided to a fund's board of directors in connection with their 
approval of the fund and its service providers' compliance programs and 
board review of the chief compliance officer's annual reports, and to 
include copies of any records documenting a fund's annual review. Since 
these changes only require funds to retain copies of a limited number 
of records they have already created (rather than requiring funds to 
record any new information), we continue to estimate that the average 
annual hour burden for each adviser is 0.5 hours.
    Most commenters addressing the paperwork burden of rule 38a-1 
supported them as reasonable, though one large fund management firm 
predicted funds would find it burdensome to maintain copies of their 
compliance policies and procedures for five years as required by the 
rule. Because of the importance of these copies to our examination and 
oversight program, we are adopting rule 38a-1 without removing this 
requirement.
    Therefore, our total hour burden estimate for the collections of 
information under rule 38a-1 remains 332,936.5 burden hours, as we 
estimated in our proposal.\119\
---------------------------------------------------------------------------

    \119\ 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

    In the Proposing Release, we estimated the total annual average 
burden hours for advisers to document the policies and procedures that 
make up their compliance programs, as required by rule 206(4)-7, would 
be 623,200 hours, based on 7,790 investment advisers registered with us 
spending an annual average of 80 hours on such documentation.\120\
---------------------------------------------------------------------------

    \120\ 7,790 was the number of investment advisers registered 
with us on our Investment Adviser Registration Depository System as 
of January 14, 2003. 7,790 registered investment advisers x 80 
annual average burden hours = 623,200 hours.

---------------------------------------------------------------------------

[[Page 74727]]

    This 80 hour average estimate took into account that many advisers 
would be the primary drafters of compliance policies and procedures for 
funds under rule 38a-1, and would be able to draw extensively from 
their fund compliance programs to supplement, as necessary, compliance 
policies and procedures for the advisory firm. Our estimate also took 
into account 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.
    Our 80 hour estimate also took into account 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, but can 
draw on a number of outlines and model programs, and can develop less 
complex programs because they often do not participate in arranging or 
effectuating securities transactions that they recommend to their 
clients. Comments from a trade association representing many smaller 
advisers generally supported our underlying assessment in this regard. 
Comments from another investment adviser trade association noted that 
it would likely be the owner of (or senior person at) a smaller firm 
who tailors a model compliance program to suit the firm's particular 
business, and use of this person's time would be more costly to the 
firm than the compliance personnel used by larger firms.
    We are adopting rule 206(4)-7 without change to its paperwork 
collection requirements. Accordingly, our estimate of the annual 
aggregate burden of collection for the amended rule remains 623,200 
hours.

C. Rule 204-2

    In the Proposing Release, we estimated that the amendments to rule 
204-2 requiring investment advisers to maintain copies of their 
compliance policies and procedures and copies of any records 
documenting the adviser's annual review of those policies, as required 
by rule 206(4)-2, would increase each registered investment adviser's 
average annual collection burden under rule 204-2 by 0.5 hours to 
211.98 hours. We further estimated the amendments would increase the 
rule's annual aggregate burden by 3,895 hours.\121\ One commenter 
objected that it would be onerous for advisers to maintain copies of 
records generated by the adviser's annual compliance review. Because of 
the importance of these copies to our examination and oversight 
program, we are adopting the amendments to rule 204-2 without 
change.\122\
---------------------------------------------------------------------------

    \121\ 7,790 registered investment advisers x 0.5 hours = 3,895 
hours.
    \122\ Accordingly, our estimate in the Proposing Release of the 
annual aggregate burden of collection for the amended rule remains 
1,651,324.2 hours. This estimate was based on the OMB's approved 
burden of 1,625,638.5 hours before the amendments (shared by 7,687 
investment advisers at an annual average of 211.48 hours per 
adviser), plus an increase of 21,790.7 hours attributable to an 
increase in the number of investment advisers registered with us to 
7,790 as of January 2003, (each incurring an average annual burden 
of 211.48 hours) and an increase of 3,895 additional burden hours 
associated with the amendments to rule 204-2 (7,790 registered 
investment advisers x 0.5 hours).
---------------------------------------------------------------------------

VII. Summary of Final Regulatory Flexibility Analysis

    We have prepared a Final Regulatory Flexibility Analysis (``FRFA'') 
in accordance with 5 U.S.C. 604, related to the new rules and rule 
amendments that we are adopting today. A summary of the Initial 
Regulatory Flexibility Analysis (``IRFA''), which was prepared in 
accordance with 5 U.S.C. 603, was published in the Proposing Release. 
Copies of the FRFA and the IRFA may be obtained by contacting Hester 
Peirce, Senior Counsel, Securities and Exchange Commission, 450 5th 
Street, NW., Washington, DC 20549-0506.
    The FRFA summarizes the background of the new rules and rule 
amendments and discusses why these regulatory changes are needed to 
enhance compliance with the Federal securities laws by funds and 
advisers. These issues are addressed above. The FRFA also discusses 
comments received in response to the IRFA, the effect of the new rules 
and rule amendments on small entities, and the Commission's efforts at 
minimizing the effect on small entities. These issues are summarized 
below.
    The FRFA explains that the new rules and rule amendments will 
govern all registered investment companies, business development 
companies, and advisers registered with the Commission, including small 
entities. For purposes of the Regulatory Flexibility Act,\123\ 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.\124\ The staff estimates, based on 
Commission filings, that there are approximately 186 small open- and 
closed-end investment companies, 18 small unit investment trusts, and 
29 small business development companies.\125\
---------------------------------------------------------------------------

    \123\ 5 U.S.C. 601-612.
    \124\ 17 CFR 270.0-10.
    \125\ The number of small entities, which is current as of June 
2003, is derived from analyzing information from Form N-SAR and 
various databases including 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.
---------------------------------------------------------------------------

    For purposes of the Regulatory Flexibility Act, an investment 
adviser generally is a small entity if it: (i) Has assets under 
management having a total value of less than $25 million; (ii) did not 
have total assets of $5 million or more 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 
has assets under management of $25 million or more, or any person 
(other than a natural person) that had $5 million or more on the last 
day of its most recent fiscal year.\126\ The Commission estimates that, 
as of October 14, 2003, there were approximately 571 small investment 
advisers registered with us.\127\
    The FRFA discusses the comments that we received in response to 
issues raised in the IRFA.\128\ Several commenters, including one trade 
association for investment advisers, cautioned that the new rules would 
impose significant costs on small advisers. Another trade association 
for advisers acknowledged that small advisers would bear a higher 
relative cost than their larger counterparts, but anticipated that the 
cost to small advisers would be offset by the fact that compliance 
policies and procedures would not have to cover as broad a range of 
activities as the policies and procedures of their larger 
counterparts.\129\ A third commenter, however, noted that even though 
small firms might have less complex policies and procedures, the cost 
of drafting the basic policies and procedures would be the same as for 
larger firms and for some small firms the cost would be prohibitive.
---------------------------------------------------------------------------

    \126\ 17 CFR 275.0-7(a).
    \127\ The number of small investment advisers is derived from 
the Commission's Investment Adviser Registration Depository.
    \128\ The comment letters and a summary of comments prepared by 
our staff are available for public inspection and copying in the 
Commission's Public Reference Room, 450 5th Street, NW., Washington, 
DC (File No. S7-03-03). The comment summary is also available on the 
Commission's Internet Web site (http://www.sec.gov/rules/extra/s70303summary.pdf).
    \129\ The Financial Planning Association estimated that it would 
cost a small firm with five employees between $675 and $3,900 to 
develop a compliance program.
---------------------------------------------------------------------------

    Commenters recommended the following accommodations for small

[[Page 74728]]

entities: (i) Exempt small firms from the requirement to designate a 
chief compliance officer, (ii) exempt small advisers from all of the 
new requirements, (iii) identify procedures that are relevant to small 
firms, (iv) identify issues that do not apply to small advisers or 
advisers that do not manage assets and therefore would not have to be 
addressed in their compliance policies and procedures, (v) create a 
template that firms could adapt to fit their unique characteristics, or 
(vi) permit small advisers to maintain records outside their office 
space in an easily accessible location.
    The FRFA explains that the rules do not introduce new reporting 
requirements, but do introduce new compliance requirements, including 
new recordkeeping obligations. The FRFA sets forth the requirements of 
the rule (which are described above in detail) and explains that all 
funds and advisers, regardless of size, are subject to the compliance 
requirements. The FRFA also explains that while most firms already have 
instituted a compliance program and have designated someone charged 
with implementing it, small advisers are disproportionately represented 
among the firms that have not taken such steps. The FRFA notes that 
these firms will bear costs in developing and implementing policies and 
procedures.\130\ The FRFA explains that the new rules and rule 
amendments are designed to achieve their objectives without imposing 
undue costs on affected firms.
---------------------------------------------------------------------------

    \130\ The staff estimates that approximately half of these firms 
will develop these policies internally, while the remaining firms 
will seek outside assistance from compliance consultants, the number 
of which is expected to rise after the new rules are adopted.
---------------------------------------------------------------------------

    The FRFA discusses the alternatives considered by the Commission in 
adopting the new rules and rule amendments that might minimize adverse 
effects on small advisers, including: (i) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources available to small entities; (ii) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the rules for small entities; (iii) the 
use of performance rather than design standards; and (iv) an exemption 
from coverage of the rules, or any part thereof, for small entities.
    We do not presently believe that the establishment of special 
compliance requirements or timetables for small entities is feasible or 
necessary.\131\ Modifying these requirements for small funds or 
advisers would place their clients at unnecessary risk. The requirement 
that each fund or adviser implement written policies and procedures 
reasonably designed to prevent violation of the Federal securities 
laws, is essential to promote systematic and organized reviews by funds 
and advisers of their operations and activities. The requirement that 
funds obtain board approval of their programs and annually report about 
the programs to their boards is necessary to preserve the crucial 
oversight role of fund boards of directors.\132\ Annual reviews are 
integral to detecting and correcting any gaps in the program before 
irrevocable or widespread harm is inflicted upon investors. The 
required designation of a chief compliance officer is necessary to 
achieve centralized supervisory authority over all aspects of the 
compliance program and to reduce the likelihood of gaps in the 
compliance program. The requirement that funds and advisers keep file 
copies of their written policies, procedures, reports, and other 
records for five years, imposes an inconsequential burden on small 
funds and advisers. The establishment of a special compliance timetable 
to allow a transition period of more than six months would delay the 
rules' investor protection benefits without assisting small funds and 
advisers.
---------------------------------------------------------------------------

    \131\ As stated above, the rules impose no reporting 
requirements.
    \132\ In the case of investment advisers, for which such 
governance issues are not present, we have not included comparable 
requirements.
---------------------------------------------------------------------------

    The Commission does not presently believe that clarification, 
consolidation, or simplification of compliance requirements for small 
entities is feasible or necessary. The compliance requirements, which 
are integral to the effectiveness of the rules, are not technical or 
complex in any sense. The FRFA explains that some commenters requested 
more specific guidance about the type of compliance policies and 
procedures that would be required. In the Proposing Release and in this 
release, we have provided illustration and guidance to firms about the 
topics that should be addressed by their compliance policies and 
procedures. Because of the great variety across firms, any template 
that we could provide would be voluminous and would require extensive 
tailoring to the unique characteristics of each firm. Thus, it does not 
appear that Commission templates would effectuate significant burden 
reduction.
    The FRFA explains that the new rules, to the greatest extent 
possible, embody performance rather than design standards. The rules do 
not enumerate specific required elements of the policies and 
procedures, but will allow all firms, including small firms, to tailor 
their internal compliance programs to the nature and scope of their own 
business. The FRFA explains that the rules do not set forth a list of 
attributes that the chief compliance officer must possess and permit 
firms to designate an existing employee with other responsibilities to 
fill that role, which the staff anticipates that most small firms will 
do.
    The FRFA explains that we do not believe that the objectives of the 
rules could be achieved if small entities were exempted from coverage 
of any part of the proposals. It has been our experience that strong 
internal compliance programs are essential to investor protection in 
funds and advisers of all sizes.

VIII. Statutory Authority

    We are adopting 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)).\133\ We are adopting new rule 
206(4)-7 pursuant to the authority set forth in sections 206(4) and 
211(a) under the Advisers Act (15 U.S.C. 80b-6(4) and 80b-11(a)).\134\ 
We are adopting

[[Page 74729]]

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).
---------------------------------------------------------------------------

    \133\ 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 
adopting rule 38a-1 as necessary and appropriate to the exercise of 
the authority specifically conferred on us elsewhere in the Act, 
including sections 9(b) (authority to prohibit certain persons from 
serving in certain capacities with respect to investment companies), 
31(b) (authority to examine funds), 36(a) (authority to bring 
actions for the breach of fiduciary duty); and 42 (authority to 
enforce the provisions of the Investment Company Act) of the 
Investment Company Act (15 U.S.C. 80a-9(b), 80a-30(b), and 80a-41). 
Further, requiring the maintenance of internal compliance policies 
and procedures and an annual compliance report falls 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.
    \134\ Section 206(4) permits the Commission to define and 
prescribe rules to prevent conduct that is unlawful under section 
206. Rule 206(4)-7 defines an activity that is unlawful under 
section 206. 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 adopting rule 206(4)-7 as necessary and appropriate to the 
exercise of the authority specifically conferred on us elsewhere in 
the Act, including sections 203(e) (authority to censure, place 
limitations on, suspend, or revoke the registration of certain 
investment advisers), 204 (authority to examine advisers), and 209 
(authority to enforce the provisions of the Advisers Act) of the 
Advisers Act (15 U.S.C. 80b-3(e), 80b-4, and 80b-9).
---------------------------------------------------------------------------

    We are amending rule 279.1, Form ADV, under section 19(a) of the 
Securities Act of 1933 (15 U.S.C. 77s(a)), sections 23(a) and 28(e)(2) 
of the Securities Exchange Act of 1934 (15 U.S.C. 78w(a) and 
78bb(e)(2)), section 319(a) of the Trust Indenture Act of 1939 (15 
U.S.C. 77sss(a)), section 38(a) of the Investment Company Act of 1940 
(15 U.S.C. 78a-37(a)), and sections 203(c)(1), 204, and 211(a) of the 
Investment Advisers Act of 1940 (15 U.S.C. 80b-3(c)(1), 80b-4, and 80b-
11(a)).

List of Subjects

17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

17 CFR Parts 275 and 279

    Reporting and recordkeeping requirements, Securities.

Text of Rules

0
For reasons set forth in the preamble, title 17, chapter II of the Code 
of Federal Regulations is amended as follows:

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

0
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, and 80a-
39, unless otherwise noted.
* * * * *

0
2. Section 270.38a-1 is added to read as follows:


Sec.  270.38a-1  Compliance procedures and practices of certain 
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, including policies and procedures that 
provide for the oversight of compliance by each investment adviser, 
principal underwriter, administrator, and transfer agent of the fund;
    (2) Board approval. Obtain the approval of the fund's board of 
directors, including a majority of directors who are not interested 
persons of the fund, of the fund's policies and procedures and those of 
each investment adviser, principal underwriter, administrator, and 
transfer agent of the fund, which approval must be based on a finding 
by the board that the policies and procedures are reasonably designed 
to prevent violation of the Federal Securities Laws by the fund, and by 
each investment adviser, principal underwriter, administrator, and 
transfer agent of the fund;
    (3) Annual review. Review, no less frequently than annually, the 
adequacy of the policies and procedures of the fund and of each 
investment adviser, principal underwriter, administrator, and transfer 
agent and the effectiveness of their implementation;
    (4) Chief compliance officer. Designate one individual responsible 
for administering the fund's policies and procedures adopted under 
paragraph (a)(1) of this section:
    (i) Whose designation and compensation must be approved by the 
fund's board of directors, including a majority of the directors who 
are not interested persons of the fund;
    (ii) Who may be removed from his or her responsibilities by action 
of (and only with the approval of) the fund's board of directors, 
including a majority of the directors who are not interested persons of 
the fund;
    (iii) Who must, no less frequently than annually, provide a written 
report to the board that, at a minimum, addresses:
    (A) The operation of the policies and procedures of the fund and 
each investment adviser, principal underwriter, administrator, and 
transfer agent of the fund, any material changes made to those 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) Each Material Compliance Matter that occurred since the date of 
the last report; and
    (iv) Who must, no less frequently than annually, meet separately 
with the fund's independent directors.
    (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, must receive all 
annual reports, and must approve the removal of the chief compliance 
officer from his or her responsibilities.
    (c) Undue influence prohibited. No officer, director, or employee 
of the fund, its investment adviser, or principal underwriter, or any 
person acting under such person's direction may directly or indirectly 
take any action to coerce, manipulate, mislead, or fraudulently 
influence the fund's chief compliance officer in the performance of his 
or her duties under this section.
    (d) Recordkeeping. The fund must maintain:
    (1) A copy of the policies and procedures adopted by the fund under 
paragraph (a)(1) that are in effect, or at any time within the past 
five years were in effect, in an easily accessible place; and
    (2) Copies of materials provided to the board of directors in 
connection with their approval under paragraph (a)(2) of this section, 
and written reports provided to the board of directors pursuant to 
paragraph (a)(4)(iii) of this section (or, if the fund is a unit 
investment trust, to the fund's principal underwriter or depositor, 
pursuant to paragraph (b) of this section) for at least five years 
after the end of the fiscal year in which the documents were provided, 
the first two years in an easily accessible place; and
    (3) Any records documenting the fund's annual review pursuant to 
paragraph (a)(3) of this section for at least five years after the end 
of the fiscal year in which the annual review was conducted, the first 
two years in an easily accessible place.
    (e) Definitions. For purposes of this section:
    (1) Federal Securities Laws means the Securities Act of 1933 (15 
U.S.C. 77a-aa), the Securities Exchange Act of 1934 (15 U.S.C. 78a-mm), 
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 (Pub. L. No. 106-102, 113 Stat. 1338 (1999), any rules adopted by 
the Commission under any of these statutes, the Bank Secrecy Act (31 
U.S.C. 5311-5314; 5316-5332) as it applies to funds, and any rules 
adopted thereunder by the Commission or the Department of the Treasury.
    (2) A Material Compliance Matter means any compliance matter about 
which the fund's board of directors would reasonably need to know to 
oversee fund compliance, and that involves, without limitation:
    (i) A violation of the Federal securities laws by the fund, its 
investment adviser, principal underwriter, administrator or transfer 
agent (or officers, directors, employees or agents thereof),
    (ii) A violation of the policies and procedures of the fund, its 
investment

[[Page 74730]]

adviser, principal underwriter, administrator or transfer agent, or
    (iii) A weakness in the design or implementation of the policies 
and procedures of the fund, its investment adviser, principal 
underwriter, administrator or transfer agent.

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

0
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.
* * * * *

0
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)(i), inclusive, and (c)(2) 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.
* * * * *

0
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 shall be unlawful within the meaning of section 206 
of the Act (15 U.S.C. 80b-6) 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.

PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF 
1940

0
6. The authority citation for part 279 continues to read as follows:

    Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1, 
et seq.

0
7. Form ADV (referenced in 279.1) is amended by:
    In Part 1, Schedule A, revising Item 2(a), to read ``each Chief 
Executive Officer, Chief Financial Officer, Chief Operations Officer, 
Chief Legal Officer, Chief Compliance Officer (Chief Compliance Officer 
is required and cannot be more than one individual), director and any 
other individuals with similar status or functions;''

    Dated: December 17, 2003.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-31544 Filed 12-23-03; 8:45 am]
BILLING CODE 8010-01-P