Financial Engines Advisors LLC
1804 Embarcadero Road
Palo Alto, CA 94303
April 18, 2003
Securities and Exchange Commission
RE: File No. S7-03-03/Compliance Programs of Investment Companies
Ladies and Gentlemen:
Financial Engines Advisors LLC is pleased to submit this comment letter to the Commission on the importance of internal compliance programs maintained by investment companies and investment advisers.1 With respect to investment advisers, new Rule 206(4)-7 will require advisers to adopt and implement policies and procedures reasonably designed to prevent violation of the federal securities laws, review those policies annually for adequacy and effectiveness, and appoint a chief compliance officer to be responsible for administering the policies and procedures. In addition, Rule 204-2 would be amended to require such policies and annual reviews to be documented and maintained for a period of not less than five (5) years (collectively, the "Compliance Programs" rule proposal).
We are also providing comment on the four "private sector" compliance concepts the Commission is considering to augment its resources and administration which include: (i) third party compliance reviews by private consulting firms, (ii) expanded financial audit reviews by private accounting firms, (iii) formation of one or more self-regulatory organizations ("SROs") and (iv) fidelity bonding by private insurance companies (collectively, the "Concepts").
We Support the Internal Compliance Programs Rule Proposal
Financial Engines agrees with the Commission that compliance programs are important to protect fund investors and advisory clients and to facilitate the Commission's administration of its examination process. We support best practices that include the establishment of written policies and procedures and periodic review and updates to reflect evolving needs and requirements of the business. As currently proposed, however, we do not believe that the Compliance Programs rule proposal should specify a minimum checklist of practices and procedures. We agree with the Commission's observation that the operations of funds and advisers are diverse and varied in contrast to a "one size fits all" approach. Nor do we believe that mandating review of Compliance Programs more frequently than annually is necessary to further the objectives of protecting investors. In contrast to the quarterly financial reporting concerns of the Sarbanes-Oxley standards, it is far less likely that significant changes will need to be made to Compliance Programs on a quarterly basis. In sum, we support the proposed rules with respect to establishing written procedures and reviewing them no less than annually. We view this development as part of the natural evolution of best practices that have been championed by practitioners and industry leaders.
We do have some questions and concerns, however, as to how the rule might negatively impact smaller firms and new market entrants. In particular, the proposed requirement of the specific designation of a chief compliance officer could impose significant costs to such firms compared to larger or more established firms. The unintended effect of this requirement may be to inadvertently favor large firms over smaller firms, and to favor established incumbents over new market entrants. The question is whether this additional requirement might discourage the overall availability of services to investors and the benefits of competition and market innovations.
Should the designation of a chief compliance officer remain a requirement under the new rules, we would urge the Commission to allow maximum flexibility in how different firms are able to organize, operate and serve investors. The rules should avoid prescribing that compliance personnel must be members of senior management and that all authority must reside in one individual. Multiple compliance officers also may be needed in different organizations, particularly those firms that engage in multiple lines of business (e.g. dual registrants). Moreover, the skills and expertise of different firms' personnel may reside in different parts of their respective organizations. Some firms may seek flexibility by outsourcing certain compliance programs under the supervision of a designated officer. Invariably, different firms will organize and operate differently.
Finally, we do have some concern that, as currently drafted, failure to satisfy the requirements of proposed Rule 206(4)-7 could in and of itself result in violations of the Investment Advisers Act of 1940 (the "Advisers Act"). Indeed, it appears that it might be considered a fraudulent practice where written policies and procedures are found lacking, and yet the investment adviser has not otherwise violated any applicable laws and regulations. This aspect of the new rule is particularly troubling if enforcement proceedings can and will be brought solely on allegations that a particular policy or procedure is considered deficient. Conceivably, diligent investment advisers who proactively try to develop new policies and procedures but come up short, might put their firms at greater enforcement risk than other advisers who might overlook, defer or otherwise not bring attention to a particular aspect of their business.
The Concept of One or More Quasi-Governmental SRO(s) May Merit Additional Study, Yet We Oppose the Delegation or Transfer of the Commission's Examination and Oversight Responsibilities to Private Parties
Of the four (4) Concepts identified by the Commission, Financial Engines believes that the feasibility of the establishment of one or more quasi-governmental SRO(s) for the examination and oversight of funds or investment advisers, or both, may merit additional study. We oppose, however, the delegation or transfer of the Commission's jurisdiction and examination and oversight responsibilities of investment advisers to private sector firms as proposed in the Concepts. The legal basis under the Advisers Act for such delegation and transfer to private companies is unclear. In particular, we oppose more delegation or transfer to accounting firms and insurance companies, either directly or indirectly, by expanding the current scope of audit or fidelity bonding requirements. We would expect that the Commission might take great comfort in the fact that most investment advisory firms do not take custody of client assets. Rather, the assets of advisory clients typically are held in the custody of other institutions (e.g. banks, trust companies, broker-dealers) that are subject to stringent bonding and net capital requirements.
The establishment of additional regulatory audit or fidelity bonding requirements could also create the real prospect of fueling artificial demand for goods and services that are not inexpensive in the first instance and that are supplied from a relatively limited pool of vendors. Expanded audits and additional fidelity bonds also can be expected to become more expensive over time. The continued availability of such services is also open to question as claims and actions inevitably will arise. An example of this possibility is reflected in the relatively limited availability, and high premiums, of directors and officers insurance policies. At a minimum, it appears that more market research would need to be done concerning the availability and costs of audits and fidelity bonds before expanding these requirements.
It is also worth noting that many accounting firms and insurance firms compete directly with investment advisers. Many accounting and insurance firms or their affiliates offer tax planning, financial planning, investment advice, variable annuities, insurance, mutual funds and other advisory products and services.
With respect to private consultants and organizations that might conduct mandatory annual compliance audits, we question an assertion in the proposing release that "[t]here are many organizations that provide compliance reviews" [emphasis supplied] at affordable prices that would advance the investor protections sought. We believe that the number of private firms that might be capable of performing such compliance audits is limited to only a handful of consulting firms and law firms that specialize in investment adviser and investment company regulatory matters. Moreover, these firms are not inexpensive to either small or large advisory firms. Although the Commission has had some good experience with private compliance consultants as "a condition to the settlement of an enforcement action," we would assume that this is a relatively small number of wrongdoers on an annual basis. Accordingly, this experience may not be a good proxy to establish a requirement that all investment advisory firms in the industry must obtain privately-generated compliance audits on an annual basis.
A related concern is that "mock audits" would no longer remain voluntary or "mock" in nature. Thus, cost, quality and availability assumptions emanating from the limited use to date of "mock audits" may be of limited value. As we read the proposing release, mandatory audit reports issued by private consultants might be elevated to levels comparable to formal examinations conducted by a government authority. Consequently, the stakes of a mandatory audit process conducted by private parties would be dramatically increased under the Concepts being considered, particularly with respect to the consequences of any findings, scope, records and disclosure issues. For these reasons, we oppose a new mandatory requirement that investment advisors must obtain annual compliance audits conducted by private third parties. Still, we strongly support the continued industry practice of obtaining "mock" compliance audits by private law firms or industry consultants either on a voluntary basis or as part of remedial measures required in the context of the settlement of an enforcement action.
We understand that the Commission has made great strides in its examination program through division of labor with the states under the National Securities Markets Improvements Act of 1996. In addition, the Staff has developed "smart" audits and other innovations to increase the reach and effectiveness of it programs. We believe that the codification of more uniform best practices reflected in the Compliance Programs rule proposal represents yet another step forward that will enhance investor protections. If the Commission believes at this time that more resources and improvements are needed, we would offer that the Staff could undertake additional study of whether one or more quasi-governmental SRO(s) could materially improve the Commission's oversight and examination responsibilities of investment funds and investment advisers. We urge the Commission not to cede or transfer its jurisdictional authority to private accounting firms, private insurance companies or private consultants.
In conclusion, Financial Engines is supportive of requiring written compliance procedures and policies of investment advisers and requiring an annual review of the same. In this regard, however, we do ask that the Commission give special consideration to the impact that requiring the designation of a chief compliance officer may have on the organizational flexibility and operations of all investment advisers, particularly smaller firms and new market entrants. Beyond simply identifying the SRO issue as a possible Concept, the feasibility and effectiveness of quasi-governmental SRO(s) dedicated to investment funds or investment advisers, may warrant further study. Financial Engines opposes, however, more delegation or transfer of the Commission's examination and oversight jurisdiction and responsibilities to the private sector.
We appreciate this opportunity to comment on the proposals and concepts. We hope the Commission finds these comments helpful. If you have any questions, please feel free to contact the undersigned at (650) 565-4938 at your convenience.
cc: Mr. Paul Roye - Director, Division of Investment Management