February 3, 2004
Via Electronic Filing
Mr. Jonathan G. Katz
Re: Final Rule: Compliance Programs of Investment Companies and Investment Advisers, Release Nos. IA-2204, IC-26299; File No. S7-03-03
Dear Mr. Katz:
The Investment Counsel Association of America1 appreciates the opportunity to submit comments to the Commission on certain provisions of new Rule 38a-1 under the Investment Company Act of 1940 (fund compliance rule), which was adopted on December 3, 2003 together with Rule 206(4)-7 under the Investment Advisers Act of 1940 (adviser compliance rule).2 These rules require investment companies and investment advisers registered with the Commission to adopt formal compliance programs. Specifically, the rules require investment advisers and investment companies to: (1) adopt and implement written policies and procedures designed to prevent violations of the federal securities laws; (2) conduct an annual review of such policies and procedures; and (3) designate a chief compliance officer (CCO) responsible for administering the policies and procedures.
The Commission included in the adoption of the fund compliance rule certain changes from the proposed rule that are designed to enhance the independence of the fund's CCO, including: (1) a requirement that the fund's board approve the fund CCO's designation and compensation (and any changes to the CCO's compensation); (2) granting the fund board sole power to remove the CCO from his or her position; (3) a requirement that the fund CCO report directly to the board and meet with the independent directors in executive session at least annually; and (4) a prohibition against coercing or fraudulently influencing the CCO in the course of his or her responsibilities. Although the rule is final, the Commission requested comment on these provisions because they were not included in the proposal.3
The ICAA has consistently promoted the use of strong compliance systems as a best practice for investment advisers and therefore generally supported the proposed adviser compliance rule.4 The ICAA specifically supported the requirement to designate a CCO and strongly supported a requirement that the CCO either be a member of senior management or directly report to senior management to ensure that CCOs have sufficient authority to implement their compliance programs. We therefore applaud the Commission's statement in the adopting release that an adviser's chief compliance officer should be "empowered with full responsibility and authority to develop policies and procedures for the firm...and should have a position of sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures."5 We have significant concerns, however, regarding two elements of the final fund rule with respect to fund CCOs.
First, we do not agree that the fund board should be responsible for approving the fund CCO's compensation package or changes to that compensation package. Second, we do not agree that the fund board should have the sole power to remove the fund CCO from his or her position. While we understand the Commission's goal of enhancing compliance by facilitating interaction between the independent directors and the fund CCO, we believe these proposed aspects of the rule constitute an unwarranted regulatory intrusion into the business affairs of the investment adviser. Compensation issues and employment decisions are internal human resources issues and should not be the subject of command-and-control regulatory mandates. Further, eliminating these two aspects of the rule will not reduce its effectiveness in any manner because the independent directors retain full authority to make inquiries and to receive and evaluate information that may be relevant to the interests of the fund shareholders (such as actions taken by the adviser with respect to the fund CCO). Moreover, if the board is dissatisfied with any of the adviser's actions, it retains the ultimate leverage by virtue of its contract with the adviser.
While it may be appropriate for the fund board to approve the adviser's designation of the fund CCO, it is inappropriate to task the fund board with the approval of the fund CCO compensation package and any changes to that compensation package. This is an operational activity that logically falls within the responsibilities of the advisory firm as the employer of the fund CCO. Advisers, as operating businesses, have budgets, compensation pressures, and equity/ownership issues to address on an ongoing basis. A fund board demand to increase CCO compensation may create inequities within the adviser's compensation structure that have implications for all advisory employees. Significantly, there are no implications to the fund board in making compensation demands on behalf of the CCO because of the implicit expectation that increased compensation costs will be borne by the adviser. Further, the board presumably will be required to engage in the impractical task of compensation analysis among advisers of similar size and type, taking into consideration all of the adviser's clients, not merely fund clients, and varying CCO responsibilities among firms.
Similarly, the fund board should not have sole power to remove an employee of the investment adviser. This puts the adviser in the untenable position of having an employee who has little or no accountability to the adviser. There are many perfectly legitimate business reasons that an adviser's termination of an employee CCO may be appropriate, including reasons related to the employee's non-fund duties. Because the board does not have day-to-day contact with the CCO, the board will not be aware of potential issues of concern to the adviser, such as the CCO's work ethic, conduct with other advisory personnel, handling of matters related to non-fund clients, and internal team dynamics. The adviser should be permitted to terminate the employment of an employee who is a fund CCO, albeit with notice to the board. Providing the board notice of the adviser's intent to terminate the fund CCO would allow the members of the board to intervene or react in whatever manner they deem appropriate, while retaining the adviser's control over its own employees.
Permitting the adviser to control its own employment relationships is essential to maintaining an arms-length relationship between the adviser and the fund. The rule clearly contemplates that the fund CCO and the investment adviser's CCO may be the same person. In such cases, the fund CCO is not a fund employee, but an employee of the adviser, who most likely has duties and responsibilities for all of the adviser's clients, not just fund clients. As an advisory employee, a fund CCO fundamentally lacks "independence" from the adviser and inherently has the conflict posited by the Commission. The Commission's rule complicates the role of the CCO rather than clarifying it. Instead of attempting to make an advisory employee "independent" of the adviser, the Commission should encourage fund boards to require material information from the adviser regarding the CCO and the compliance program and to exercise active oversight. The fund board is responsible for overseeing the fund and protecting fund investors. It is the responsibility of the board and particularly the independent directors to evaluate information and make inquiries necessary to assure the protection of fund investors. Indeed, the Commission recently proposed several major rule amendments that are designed to increase investor protection by enhancing the independence of fund boards, including: (1) a requirement that funds have an independent chairman; (2) a requirement that 75 percent of each fund board be comprised of independent directors; (3) authorization for fund boards to retain staff; and (4) a requirement that boards annually evaluate their performance on shareholders' behalf.6
The other elements of the fund compliance rule fully empower the fund CCO in a meaningful and logical way. The rule requires the fund board to approve the designation of the fund CCO. The rule requires the fund CCO to meet directly with the fund board and to meet with the independent directors in private, executive session on at least an annual basis. Further, the fund rule prohibits the adviser or its employees from coercing or fraudulently influencing the fund CCO in the course of his or her responsibilities. These requirements will forge communication lines between the board and the CCO. They will also ensure that the CCO is empowered to share with the board any and all concerns related to compliance problems or issues at the management company or other fund service providers. These measures obviate the need for the board to perform human resources or operational activities that more appropriately fall within the responsibility of the investment adviser.
We commend the Commission's goal of enhancing compliance programs for investment advisers and investment companies and would be pleased to work with the Commission to implement these initiatives. We appreciate the opportunity to comment on the effects of the final fund compliance rule on investment advisers. Please do not hesitate to contact the undersigned or ICAA Associate General Counsel Caroline Schaefer to discuss any questions the Commission or its staff may have with respect to our comments.
Karen L. Barr
cc: The Honorable William H. Donaldson