Prudential Financial, Inc.
April 18, 2003
VIA E-MAIL - firstname.lastname@example.org
Jonathan G. Katz, Secretary
Re: Compliance Programs of Investment Companies and Investment Advisers (File No. S7-03-03)
Dear Mr. Katz:
Prudential Financial, Inc. is pleased to offer comments on the SEC's proposal (the "Proposal") concerning compliance programs of investment companies and investment advisers, published at 68 Fed. Reg. 7038 (February 11, 2003).
Prudential Financial, Inc. ("Prudential Financial") (NYSE:PRU)1, through its asset management business, Prudential Investment Management, Inc. ("PIM"), offers a range of investment management services to institutional and retail clients around the world, through specialized investment managers with strong market positions in each asset class -- equity, fixed income, private fixed income, real estate and commercial mortgages. As of December 31, 2002, PIM managed approximately $288 billion in assets under management, including $80 billion for more than 650 institutional clients that include corporations, public funds, Taft-Hartley plans, insurance companies, foundations and endowments. PIM's advised investment products include U.S. mutual funds, offshore retail funds, hedge funds, collateralized debt obligations and private funds investing in real estate, private equity, commercial mortgages and private debt securities.
As of December 31, 2002, the Prudential Financial mutual fund complex included 46 investment companies comprising 144 portfolios and total assets of $81.2 billion. These investment companies are advised by Prudential Investments LLC and are sub-advised by PIM or its subsidiary Jennison Associates LLC and 29 third party sub-advisers. Upon Prudential Financial's pending acquisition of American Skandia, Inc., the complex will increase to include an additional three investment companies, 72 portfolios and 16 sub-advisers, with $22.5 billion total assets as of December 31, 2002.
Prudential Financial, through its subsidiaries, is also a major issuer of variable annuities and variable life insurance products. These products are issued by the insurance company's separate accounts that are generally registered as investment companies.
The first part of our letter offers comments with respect to mutual funds and investment advisers. The second part of our letter deals with variable products. We then briefly discuss issues related to transition and private sector involvement. Our comments on the proposed rules can be summarized as follows:
I. Mutual Funds and Investment Advisers
1. Policies and Procedures
We support the proposed requirement that investment advisers adopt and implement compliance procedures, but question whether it is necessary or practicable to impose the requirement on mutual funds.
With respect to investment advisers, we believe the Proposal largely would codify what is in effect an existing practical requirement. General fiduciary standards as well as the substance of the Investment Advisers Act of 1940 and numerous other laws (e.g. ERISA, laws relating to anti-money laundering) dictate that an investment adviser cannot operate in compliance with laws and regulations and meet its obligations to its clients without written compliance policies and procedures, a supporting infrastructure and the necessary commitment of management to ensure that the compliance policies and procedures are implemented and observed.
With respect to the standard for compliance policies and procedures, we believe that Rule 206(4)-7 should state that compliance programs should be intended to promote compliance with applicable laws and regulations, rather than to prevent violations of law. We are concerned that the proposed standard could be interpreted as requiring an objective of preventing all violations, even if minor or inadvertent, which is not feasible. Also, there is a value to stating an affirmative standard to guide behavior and reflect a firm's aspirations. While prevention of violations is a key by-product of good compliance policies and systems, we believe that the overall objective should be to comply with the letter and spirit of the law in all aspects of doing business. This is an express element of Prudential Financial's philosophy of doing business and serving our clients.2
We respectfully submit that imposing on investment companies the same compliance program requirement as for advisers is unjustified and would not provide additional protection to investors. Mutual funds do not have employees and are able to act only through their advisers, distributors and transfer agents, and the investment company's board of directors oversees the services provided to the fund. Each fund's service providers must have their own compliance policies and procedures to address their respective functions, in order to comply with numerous laws and regulations that apply to the many different aspects of mutual fund organization, securities offering and distribution, management of assets and shareholder administration. This structure and allocation of duties have served the industry and investors well for many years. The Proposal does not suggest what will be the benefit of creating an additional duplicative layer of compliance policies and procedures, where funds have no staff to implement them but are wholly reliant on service providers.
Under the Proposal, in order to comply with proposed Rule 38a-1, the board of directors of a mutual fund would seem to have two options3. For example, the board of directors could adopt the fund's own compliance policies and procedures, which would have to be reviewed carefully and in detail by or on behalf of the board to make sure they were identical to, or at least fully consistent with, the corresponding policies of each of the fund's service providers. Alternatively, the board of directors could adopt or incorporate by reference, in gross, the policies of the service providers as its own.
However, neither alternative is necessary or desirable. Enormous time and effort would be needed to prepare policies and procedures, using as models all of the policies and procedures of the service providers and involving wholesale creation of a compliance manual of hundreds of pages. If a fund board instead determines to adopt or incorporate by reference the manuals of its service providers, it will have to thereby incorporate all of their provisions relating to matters other than mutual fund compliance. Having done so, presumably fund boards would have to approve any changes to providers' policies, or incorporate them in its own, as and when adopted.
These problems are exacerbated in the case of a multi-manager fund complex faced with having to create a uniform and consistent set of compliance policies and procedures.4 While a fund arguably could adopt the policies of a single adviser, if multiple advisers -- some or all of which may be unaffiliated -- each manage a portion of the fund's assets, the fund cannot simply adopt their policies as its own, because they have different policies adapted to their own particular circumstances and needs. Even within a firm like Prudential Financial, an adviser like PIM, which manages inter alia fixed income and passive or enhanced index equity portfolios, has certain compliance policies that are different than those of its subsidiary adviser, Jennison Associates LLC, which is an active equity manager.
On crucial subjects such as allocation, best execution, trade errors and proxy voting, different advisers invariably and necessarily have customized compliance policies adapted to the asset classes they manage, their style of investing and their systems capabilities.5 On any subject where unaffiliated sub-advisers have different policies, it is not apparent how a fund complex or even a fund can create or impose a single uniform policy. The Proposal does not address or offer guidance on implementation of the rule in the multi-manager context.
The difficulty of implementing the rule will be especially acute for Prudential Financial upon completion of its pending acquisition of American Skandia, Inc. The Prudential Financial mutual fund complex (using 2002 year-end data) will then have 49 investment companies comprising 204 portfolios, advised by two affiliated advisers and 45 unaffiliated advisers.
We believe that the burden of compliance properly rests with the service providers, and that it should be the responsibility of mutual fund boards to perform due diligence initially and periodically with respect to the compliance policies and practices of providers, just as boards perform such due diligence with respect to the investment performance and processes of the advisers they engage. Accordingly, we would endorse the idea of annual reports to fund boards by service providers concerning their compliance policies and procedures as a measure to enhance the ability of fund boards to oversee the activity being conducted on the fund's behalf.
We also would endorse the idea of fund boards determining, initially and periodically, that service providers have compliance policies and procedures that appear reasonably designed to ensure that the activities conducted on the fund's behalf are in compliance with applicable laws and regulations. That determination should not need to be based on the directors having to read hundreds of pages of service providers' compliance manuals, but should be able to be made by the directors based on such reports and presentations as they would rely on for other matters of similar import in the due exercise of their fiduciary responsibilities.6
2. Annual Review
Under the proposed rules, mutual funds and investment advisers must review their policies and procedures at least annually to determine their adequacy and the effectiveness of their implementation. The Proposal requests comment on whether the Commission should require more frequent review. We do not believe so. The frequency of the review should be dictated by the unique structure and operation of each fund and adviser, or factors such as identified deficiencies. In some cases, an annual review will be appropriate. In other circumstances, a more frequent review may be necessary. This flexibility should be afforded by the rules.
Also, as discussed above, we believe that it is appropriate that a fund's annual review focus on the compliance policies and procedures of its service providers. Specifically, based on review of materials presented by the service providers, a fund's board would affirm that the service providers' compliance procedures appear reasonably designed to ensure that the activities conducted on the fund's behalf are in compliance with applicable laws and regulations. In making this determination, a fund's board should be able to rely on the review conducted by the service provider.
3. Chief Compliance Officer
Here, again, we would draw a distinction between investment advisers and funds. We believe that most advisers - and certainly all large advisers -- should have chief compliance officers who are full-time professionals. But because investment companies have no employees and rely on service providers, it would be awkward to single out the chief compliance officer function as one calling for appointment as a fund officer. In practice this would often mean that the chief compliance officer of the adviser to a fund family would be designated as chief compliance officer for all funds in the fund complex. However, he would have no staff as such, and would have to rely on compliance staff some of whom may be employed by the adviser and therefore report to him, but others who may be employed by the underwriter, the transfer agent or other affiliates. Creation of new, inconsistent reporting lines across business unit lines within a large financial enterprise could create friction and accountability without authority, particularly if affiliated advisers are managed independently.
This structural problem is compounded for multi-manager fund complexes, where the chief compliance officer would be charged with accountability for staff, activities and compliance policies and procedures of unaffiliated advisers, over whom he or she has no authority and no possibility of exercising authority. His or her lot would seem to be both unenviable and unworkable.
We believe that the current investment company construct is sound and has served the public well. Mutual funds are wholly reliant on their service providers, which creates accountability for the service providers and ensures that they devote the necessary resources and management attention to their obligations to funds and their shareholders. This applies as fully to regulatory and legal compliance as to portfolio management, shareholder service and other business matters. Everyone in the industry is accustomed to thinking about their personal responsibilities to the entity that employs them, and, at the same time, the obligations of that entity to funds and their shareholders. This framework and clarity of roles and responsibilities is valuable. With respect to fund boards of directors, it is safe to say that at no time in the history of the industry have their roles and responsibilities been more clear and highly evolved. It is not clear how departing from this model will improve the effectiveness of fund governance and compliance.
II. Variable Products
In addition to the comments that we offer above with respect to mutual funds and which generally apply to variable products, we offer these additional comments concerning the application of the proposed rules to variable products. Specifically, we request that Rule 38a-1 clarify that a separate account be able to satisfy the requirements of the rule through a combination of policies and procedures from the functional areas supporting the separate account and variable product lines.
Generally speaking, variable products are issued by separate accounts that are registered as unit investment trusts under the Investment Company Act. These separate accounts invest in underlying funds that are also registered under the Investment Company Act. Under this structure, the separate account is a passive vehicle: it has no board of directors, officers, or employees.
The proposed rule contemplates some flexibility given the passive nature of the separate account by allowing the compliance oversight function to be conducted by the contract's principal underwriter or depositor. We believe that the rule needs to provide additional flexibility to account for the variable product structure.
As a practical matter, insurers typically integrate their variable contract product lines into multiple functional areas that broadly support their insurance businesses. Examples of these functional areas may include premium acceptance and processing, customer call centers, claims and disbursements, marketing and distribution, and operations and systems. Thus, registered separate accounts are part of a product line supported by a variety of functional areas within an insurance company, and each of these functional areas may maintain its own standard operating and compliance policies and procedures.
Allowing separate accounts to satisfy the requirements through the compliance policies and procedures of the functional areas supporting the business will not compromise the objectives of the Proposal. For example, with respect to the requirement to maintain written procedures, each functional area will operate under written compliance procedures designed and maintained to address the specific needs of the activities it performs. The separate account -- or more appropriately its depositor -- would be responsible for ensuring that the functional area has implemented the necessary procedures.
III. Transition Period
As a final comment relating to proposed Rule 38a-1 in general, in whatever form it may ultimately be adopted, we would respectfully suggest that its implementation should be required only after a one-year transition period. This would permit considered review by fund boards and allow sufficient time to implement potential systems and operations changes. The investment industry is still engaged in fully implementing the unprecedented series of new regulatory requirements that have been adopted in recent years pursuant to the USA PATRIOT Act and the Sarbanes-Oxley Act, as well as Commission initiatives such as the new proxy voting rules.
IV. Private Sector Involvement
In addition to proposing new compliance requirements, the Commission has requested comments on four potential initiatives for involving the private sector in efforts to promote compliance with the securities laws by funds and advisers. These initiatives include: mandatory compliance reviews by third parties; expansion of fund audits; fidelity bonding for advisers; and the formation of a self-regulatory organization.
We do not here provide specific comment on this aspect of the Proposal. We note that we are participating in the Investment Company Institute's discussions concerning private sector involvement and fully endorse the comments that they will be submitting. We also would offer the suggestion that because they represent a significant departure from existing regulatory approaches, it would be reasonable to defer consideration of them at present and revisit them after a period of time sufficient to determine the effect of adoption of the new rules coupled with the Commission's imminent increase in resources.
We appreciate the opportunity to comment on the Proposal. If you have any questions or would like any further information, please call the undersigned at 973-802-7333 (Clifford E. Kirsch) or 973-367-3949 (John L. Bronson).