CHARLES SCHWAB & CO., INC.
101 Montgomery Street
San Francisco, California 94104
April 23, 2003
Via U.S. Mail and Electronic Filing
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-03-03 -- Proposed Rule: Compliance Programs of Investment Companies and Investment Advisers
Dear Mr. Katz:
Charles Schwab & Co., Inc. ("CS&Co"), along with its affiliate Charles Schwab Investment Management, Inc. ("CSIM" and together with CS&Co, "Schwab")1 appreciates the opportunity to comment on the Securities and Exchange Commission's ("Commission" or "SEC") recent proposal to establish new rules (the "Proposed Rules") requiring each investment adviser ("adviser") and investment company ("fund") registered with the Commission to adopt, implement and periodically review compliance policies and procedures and appoint a chief compliance officer.2 The Proposing Release also seeks comment on possible private sector involvement in fostering adviser and fund compliance.
Schwab Supports the Commission's Goal of Assuring the Continued Effective Oversight of Advisers and Funds
Schwab commends the Commission for recognizing the importance of advisers and funds to the investing public and its goal of assuring the continued investor trust that has led to their tremendous growth. We agree that effective internal compliance programs are essential to achieving that goal. Therefore, with some comments below, we support the proposals to require advisers and funds to maintain written compliance policies and procedures, annually review them, and appoint a chief compliance officer. Schwab believes that given its time tested effectiveness, the SEC's inspection program for advisers and funds, should remain the primary tool to assure good external oversight of advisers and funds, and that the SEC should use some of its new resources in the wake of the Sarbanes-Oxley Act to increase the frequency of its inspections of advisers and funds (as it has announced it will do). Only after assessing the impact of increasing the frequency of its own reviews, and after more thorough economic analysis of possible new private sector involvement, should the SEC pursue the further private sector roles in compliance offered for comment in the release.
Schwab Supports Requiring Advisers and Funds to Maintain Compliance Programs
Schwab believes compliance programs with the components prescribed by the Proposed Rules are commonly followed as best practices among advisers and funds. The existing liability provisions of the Advisers Act and the Company Act for failure to supervise create substantial incentives for advisers and funds to maintain strong programs designed to promote compliance. Therefore, we believe that requiring all advisers and funds to have compliance programs is appropriate and not unduly burdensome. Similar requirements have proven useful in the broker-dealer industry. Our comments are intended to clarify the Proposed Rules to provide the needed flexibility, avoid imposing disproportionate costs on smaller advisers and funds, and account for various practical aspects of compliance.3
One way in which the Commission's proposal should provide needed flexibility is by refraining from specifying (in its rule or in its inspection procedures) a minimum set of compliance policies and procedures that all advisers or funds are expected to have. The diversity of firms' types and sizes and the variety of advisory services they offer makes any such list of minimum requirements unlikely to be well tailored and effective. Schwab supports the Proposed Rules' requirement for annual review of compliance procedures4.
The Commission requested comment on whether any subset of advisers or funds should be exempted from the Proposed Rules. Schwab recommends that so long as the final rules are sufficiently flexible, it is not necessary to exclude any subset of advisers. This flexibility will also address the cost of compliance issues that would otherwise arise, given that most advisers are small businesses.
The Compliance Policies and Procedures Requirement of the Proposed Rules Should Be Adopted Under the Commission's Authority to Regulate Supervision
Schwab questions whether adoption of the Proposed Rule for advisers under the anti-fraud provisions of the Advisers Act is appropriate given the proposed compliance program is primarily supervisory in nature. It concerns us that a breakdown in supervision (e.g., failing to include a procedure in a compliance manual) would be treated "a fraudulent, deceptive or manipulative practice" under the Proposed Rule. These consequences seem unduly harsh, and are inconsistent with a compliance program designed to achieve compliance both with antifraud and other rules such as record-keeping requirements. We note that the Commission has imposed analogous broker-dealer supervisory requirements under Section 15 of the Exchange Act, which provides general regulatory authority over broker-dealers, rather than imposing such rules under antifraud provisions such as Section 10. We believe full authority for the proposed rule exists under Section 203(e)(6) of the Advisers Act, which imposes a statutory duty on advisers to supervise and gives the Commission the ability to sanction an adviser for failure to supervise, and under Section 211, which grants general rulemaking authority to implement the Advisers Act. If the proposal is adopted under the anti-fraud provisions of the Advisers Act, we request that the Commission clarify that, absent a violation of some other rule or law, a violation of the compliance policies and procedures requirement (or other provisions of Proposed Rule) is not a per se fraudulent, deceptive or manipulative practice. Further, consistent with the Commission's practice in the broker-dealer area, we urge the Commission not to bring enforcement actions under the proposed compliance program rules absent an actual violation of an underlying law or rule - the Commission should not sanction an adviser or fund for an inadequate compliance program absent some actual substantive violation that occurred as a result of the inadequacy.
The Investment Company Act Rules Should Clarify that Fund Boards are not Required to Approve Each Specific Compliance Policy and Procedure
Schwab believes that the proposed rules should be revised to clarify that, consistent with the Commission's intent, fund boards are not required to approve each specific compliance policy and procedure, but rather to serve in an oversight role with a view toward reviewing and approving the compliance program as a whole on a periodic basis. Fund boards should oversee the overall effectiveness of compliance programs, rather than having to approve each specific change in policy or procedure - changes which often should not have to wait for the next fund board meeting. We recommend that the rule require that the fund and its service providers have adequate compliance systems in place, and that the board make a determination to this effect periodically. To facilitate the board's ability to make such a determination, the rule should require that each service provider report periodically, summarizing its compliance policies and procedures, and describing the results of its implementation programs. This approach is consistent with the approach the Commission has taken in a variety of contexts, such as Rule 10f-3, Rule 17a-7 and Rule 17e-1.
Funds Should Have the Flexibility to Rely on the Compliance Policies and Procedures of Their Service Providers
Since funds generally have no employees, they function through service providers. Schwab believes that compliance is best promoted by allowing that funds to rely on the compliance policies and procedures of their service providers. Allowing funds to rely on their service providers' compliance programs is consistent with current industry practice, which has worked well largely because it allows each service provider to develop compliance processes and procedures appropriate to its own operations. Requiring a fund to adopt its own detailed compliance policies and procedures could hamper the compliance process by increasing the complexity of the documentation and the coordination effort. If funds were required to maintain procedures that duplicate those of their service providers, staff time would have to be devoted to tasks such as revising the procedures every time a new service provider is retained, and establishing procedures to monitor whether the fund's policies and procedures are in conflict with those of its service providers. It would be more efficient and more effective to allow funds to rely directly on the compliance programs established by the service providers.
The Chief Compliance Officer Should Not Be Per Se Charged With Supervision
We urge the Commission to confirm in its Adopting Release the statement in footnote 38 of the Proposing Release that "designation of a person by an adviser as its chief compliance officer would, not in and of itself, impose upon the person a duty to supervise another person" and expand this statement to cover the chief compliance officer for funds. It is common industry best practice for the business unit of an organization to be charged with the development and enforcement of its supervisory policies and procedures. Compliance professionals in these cases serve as interpreters of applicable rules, regulation and laws for the business unit and not as supervisors. Compliance professionals typically do not possess supervisory powers such as the authority to unilaterally change business practices or the ability to hire or fire business personnel or affect compensation. Moreover, imposing per se supervisory liability on compliance personnel has the potential to undercut the accountability of line-level business managers for complying with applicable laws and rules.
The Commission has requested comment on whether: (a) the chief compliance officer should be required to certify an adviser's or fund's policies and procedures; (b) multiple compliance officers should be permitted; and (c) the chief compliance officer should be a member of senior management of the adviser or fund.
We do not believe compliance officers should certify an adviser's or fund's compliance policies and procedures. As discussed above, compliance officers typically do not have supervisory authority over an adviser's or fund's personnel, and it is not appropriate to require compliance officers to certify something they do not control. If such a certification is appropriate, it should be made by the board or executive management.
We urge the Commission to permit funds or advisers flexibility to have more than one compliance officer, so long as there is a compliance officer clearly responsible for each compliance function. Some firms may assign specific roles to individuals who specializes in a discrete area of regulation (e.g., Chief Privacy Officer or Anti-Money Laundering Officer), and firms should be able to recognize these areas of expertise. Advisers with multiple business units and/or a variety of advisory services may depend on the expertise of more than one individual to satisfy the compliance officer function. Likewise, funds and their services providers should be permitted to designate those individuals within their respective organizations primarily responsible for compliance.
We do not support an absolute requirement that the chief compliance officer be a member of the adviser's or fund's "senior management". The Proposing Release does not define the term "senior management", the application of which may vary substantially among different funds and advisers. As noted above, advisers and funds may rely on more than one compliance professional to satisfy the chief compliance officer function, each of whom may possess a different skill set and/or may support a specific business unit or advisory service. We believe funds and advisers should have flexibility to determine whether some or all of these individuals should be members of senior management.
The Investment Advisers Act Rule Should be Sensitive to Requirements Imposed by Other Regulators on Firms that Act in Multiple Capacities
Many broker-dealers are dually registered with the Commission as investment advisers. In addition to Commission oversight under the Advisers Act and the Securities Exchange Act of 1934 ("Exchange Act"), dual registrants are accountable to the self-regulatory organizations ("SROs") to which they are members. SRO rules generally require member firms to have written procedures relating to their business. Given existing SRO requirements, Schwab urges the Commission to clarify that a dual registrant's compliance with SRO rules governing compliance and supervision shall be deemed to satisfy compliance with the Proposed Rules. This position is consistent with Rule 204-2(h)(1) of the Advisers Act which deems a record made, kept, maintained and preserved under Rules 17a-3 and 17a-4 of the Exchange Act that is substantially the same as a record required under Rule 204-2(h)(1) as made, kept, maintained and preserved under Rule 204-2(h)(1).
The SEC Should Strengthen Its Direct Oversight of Advisers and Funds
Through its rulemaking, inspections and enforcement, the SEC has effectively overseen advisers and funds for over 60 years. During that time, the investment management industry has grown tremendously without major scandal or loss of investor trust. The Commission's direct oversight has been time tested and is clearly effective, and should continue to be the primary basis for outside oversight of the industry.
Schwab understands the Commission's concerns about the resources necessary to maintain an effective inspection program, and we concur that the Commission's recent cycle of inspecting funds and advisers once every five years is not sufficient. However, in the wake of the Sarbanes-Oxley Act, the Commission has seen its resources nearly double. We believe a proper allocation of these additional resources should give the Commission adequate staff to inspect every adviser and fund once every two to three years, in addition to more frequent "cause" examinations when warranted.5 (The Commission has already announced an intent to inspect all funds and advisers at least every two to four years.) We believe more frequent cycle and "cause" inspections, along with the compliance programs required by the Proposed Rules, would provide continued effective oversight of advisers and funds. Only after the Commission implements these proposed rules and a more frequent inspection program should the Commission consider whether additional private sector involvement is necessary to oversee advisers and funds. Should the Commission decide to conduct such an analysis, we urge the Commission to examine the costs and benefits of each of the different alternatives and provide that economic analysis for public notice and comment - something which it did not attempt in the Proposing Release.
Schwab Does Not Support the Establishment of a Self-Regulatory Organization for Advisers and Funds at this Time
Given the Commission's strong track record of effective regulation under the Advisers Act and Company Act, we are not convinced that an SRO for advisers and funds would be cost-effective. We concur with the comments of the ICAA, ICI and SIA that the interpositioning of an SRO in the adviser and fund regulatory landscape risks creating inconsistent and fragmented layers of regulation. We also believe that the adviser and fund industries are likely too varied to benefit from the SRO model (for example, financial planners, money managers, wealth managers, consultants, internet tool providers and research providers are all counted among the ranks of investment advisers registered with the SEC) and that the creation of one or more SROs to fulfill this challenging task likely would entail significant expense.
The Commission Should Study Further Whether Fidelity Bonding and/or Periodic Third Party or Independent Auditor Reviews Would Materially Enhance Compliance for Advisers and Funds
We believe the Commission should further analyze its concepts concerning fidelity bonds or periodic third party compliance reviews. For example, the Commission should review whether the types of problems historically uncovered at funds or advisers would be covered by a fidelity bond (which typically contain many exclusions, including for acts by the principals of a firm). Especially for smaller funds and advisers and in the current difficult insurance market, a bonding requirement could be costly. This cost may not be worthwhile if it does not in fact provide meaningful coverage for investors. If the Commission pursues an adviser fidelity bonding requirement, we suggest that the requirement apply only to those advisers that exercise investment discretion over their clients' accounts. We also suggest that the requirements for the bond (form, type, amount, etc.) be consistent with the bonding requirements of the Employee Retirement Income Security Act (ERISA) as well as Rule 17g-1 of the Company Act (which the Commission should consider conforming with ERISA).
There are challenges in requiring advisers and funds to undergo third party compliance reviews. The adviser and fund industries are diverse. The qualifications and competency of the third parties needed to conduct reviews of these varied industry participants are equally diverse. We share the ICI's concerns that creating standards for such exams which ensure uniformity of process, without requiring costly review of a laundry list of issues that are not relevant to a particular fund or adviser, may be difficult. We urge the Commission to provide more detail about this idea for public comment before formally proposing it. And we believe the Commission should assess the impact of adopting the Proposed Rules as well as that of enhancing the SEC inspection program before deciding to require fidelity bonding and/or third party reviews.6
Similarly, the Commission should consider further its concept of expanding external fund audits to include an examination of fund compliance controls. While fund auditors routinely test compliance with a variety of rules and regulations, their efforts are directed primarily toward evaluating internal controls necessary to produce accurate financial statements. A fund's auditor may not be the best resource for reviewing non-financial compliance issues. Moreover, the recently enacted rules under the Sarbanes-Oxley Act concerning the services that an auditor can provide strongly discourage audit firms from providing such non-financial compliance services to funds or other issuers. Schwab believes that it is appropriate to leave to the fund's board the decision about when a third party review of a fund's compliance processes and procedures is necessary, and to allow the board latitude to determine which reviewer and what type of review would be most effective in view of expertise and cost considerations. A board might well determine that an independent internal review, for example by the administrator's internal audit department, would be more appropriate in some cases than outsourcing this function to an external auditor. A "one size fits all" approach to compliance will not allow a board to oversee compliance in the most effective manner, i.e., one that is tailored to each fund's particular circumstances.
Schwab supports the Commission's goal to assure continued effective oversight of advisers and funds. With the comments above, we support the proposals to require advisers and funds to maintain effective compliance programs. We encourage the Commission to use its increased resources to strengthen its inspection program before requiring other private sector initiatives. If you have questions about this letter, please contact the undersigned at 415-636-5015 or at firstname.lastname@example.org.
CHARLES SCHWAB & CO., INC.
Vice President and
Associate General Counsel
cc: Paul F. Roye
Cynthia M. Fornelli
Robert E. Plaze
|1|| CS&Co and CSIM are wholly-owned subsidiaries of The Charles Schwab Corporation (NYSE: SCH) ("Schwab Corporation"). CS&Co is registered with the Commission as both a broker-dealer and as an investment adviser under the Investment Advisers Act of 1940 ("Advisers Act"). Through its Schwab Institutional division, CS&Co renders brokerage, custody, back office, and related services to over 5,900 independent investment advisers whose clients' accounts with Schwab total approximately $222 billion. CSIM is registered with the Commission as an investment adviser. CSIM is an investment adviser to the SchwabFunds, a family of over 40 mutual funds, with more than $144 billion in assets under management, which are also registered with the Commission under the Investment Company Act ("Company Act"). The Schwab Corporation, through its operating subsidiaries, serves approximately 8 million active accounts and is one of the nation's largest financial services firms.
|2|| Investment Company Act Release No. 25925 and Investment Advisers Act Release No. IA-2044 (February 5, 2003) (the "Proposing Release").
|3|| Schwab generally agrees with many of the comments on the proposal we understand are being submitted by securities industry groups, such as the SIA, ICI and ICAA. We believe that the thrust of these groups' comments is consistent with ours.
|4|| An annual review would complement and help facilitate an adviser's annual update of its Form ADV. Annual reviews also are consistent with broker-dealer requirements.
|5|| Schwab urges state securities regulators, who are responsible for inspections of advisers under the $25 million asset threshold for primary SEC jurisdiction, also to devote the resources necessary to inspect advisers on a two or three year cycle.
|6|| The Proposing Release does not suggest imposing supervisory responsibility on broker-dealers who do business with third-party independent advisers or funds (either as an executing broker or also as a custodian of assets). We agree with this decision. Advisers and funds typically do business with multiple broker-dealers and other financial services firms, no one of which may see all of the adviser's or fund's transactions. Funds and advisers are regulated separately from broker-dealers under different laws and rules, and broker-dealers are not privy to inspection findings for the advisers and funds with which they do business. While broker-dealers appropriately should review advisers and funds with which they do business, they are not in a position to supervise the activities of those funds and advisers.