The Vanguard Group
April 16, 2003
Jonathan G. Katz, Secretary
RE: Proposed Rule: Compliance Programs of Investment Companies and Investment Advisers. File No. S7-03-03
Dear Mr. Katz:
The Vanguard Group1 appreciates the opportunity to comment on recent proposals by the Securities and Exchange Commission to require investment companies and investment advisers to adopt certain compliance programs. The Proposing Release2 also requests comment on additional methods to involve the private sector in mutual fund and investment adviser compliance and on requiring insurance coverage for advisers.
We note at the outset that, as a practical matter, comprehensive compliance programs are in place at most mutual fund companies given the detailed substantive regulation of funds and advisers under the securities laws. It is simply not possible to manage mutual funds effectively without a substantial compliance program, although programs vary widely throughout the industry. We also note that the proposed rules are not designed to address a particular compliance problem that the Commission has identified, but rather to generally guide existing compliance efforts at fund companies and assist the Commission with its oversight function. We strongly support the Commission's objective to enhance the effectiveness of fund and adviser compliance programs, and we share the Commission's goal to increase investor confidence. To that end, we support the proposed rules, with cerain modifications suggested below. On the other hand, we believe that only one of the four private sector proposals described in the Release - the one that would require fidelity bond insurance coverage for investment advisers - should be pursued.
I. Compliance Policies and Procedures for Investment Companies and Investment Advisers
In the Release, the Commission proposes new rules under the Investment Company Act and the Investment Advisers Act that would require each registered investment company and registered investment adviser to adopt and implement policies and procedures reasonably designed to prevent violation of the federal securities laws, to review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and to appoint a chief compliance officer responsible for administering the policies and procedures.3
Vanguard believes that good business practices and prudent management as a practical matter virtually require funds and advisers to have compliance procedures such as these. The need for such procedures has increased as the number and complexity of regulations has grown over the years. A culture of compliance within investment company and investment adviser firms serves to protect the interests of those firms' clients and to promote investor confidence. We therefore strongly support the Commission's proposal.
A. Elements of an effective compliance program
Vanguard greatly appreciates the Commission's effort to take a flexible approach in the proposed rules, recognizing that fund companies and advisers have varied structures and approaches to performing their compliance responsibilities. However, we find parts of the proposed rule text and the proposing release to be at odds with the Commission's stated interest in preserving flexibility in meeting the rules' objectives. To ensure that the rules, as adopted and applied, provide funds and advisers with the necessary flexibility, and also provide funds, fund boards, advisers, and SEC examination staff with clear guidance as to the appropriate elements of an effective compliance program, we urge the Commission to include in the adopting release guidelines similar to the following:
Applying these seven elements helps to identify important suggestions regarding implementation of the proposed rules, which we discuss below. Proposed modifications to the rule text are attached as an exhibit to this letter.
B. The proposed rules should relate to a compliance "program" and not to every detailed compliance policy adopted by the fund or the adviser
The proposed rules should require funds and advisers to adopt and implement a "program" to foster "compliance" with the federal securities laws rather than "policies and procedures" designed to "prevent" violation of those laws.4 Undoubtedly, any compliance program would consist in large part of policies and procedures. However, the emphasis should be on developing and maintaining a compliance program that meets the elements noted above.
Funds and advisers may have policies and procedures at several levels. For example, an adviser to a mutual fund may have detailed soft dollar, directed brokerage, and best execution policies. These policies might deal with such issues as how brokers are selected, how the reasonableness of brokerage commissions is evaluated, what percentage of brokerage may be directed to any one broker, what services or products may be acquired in return for brokerage commissions, how research and other services and products should be allocated among funds (and other accounts), and what disclosures should be made about these policies. Although the fund's compliance program may involve a board review of how the adviser addresses these issues, it should not be necessary for the board to formally approve each and every policy that the adviser has adopted. Rather, the board should satisfy itself that the adviser has procedures in place to address relevant issues, identify exceptions, elevate important issues, and otherwise meet the seven elements outlined above.
We believe that this approach is consistent with the Commission's approach, based on the following provisions of the Proposed Rules:
Without clear guidance from the Commission, however, there is a danger that funds and advisers, in an attempt to comply with the new rules, may in an abundance of caution interpret the rules broadly to apply to all policies and procedures related to the compliance function. This would significantly increase the amount of time and costs those firms would expend in complying with the rules. Consequently, the adopting release should state expressly that the proposed rules are not intended to cover every compliance policy or procedure, but only those that outline a company's basic program for compliance with the federal securities laws and serve as a management-level blueprint to set the company's compliance "culture."
C. Issues related to the chief compliance officer
The proposed rules require funds and advisers to designate a chief compliance officer. As written, that provision appears to require designation of one person only.6 We believe that the rules, as adopted, should allow the appointment of different persons to oversee different compliance areas.
The Commission in the Release has acknowledged the need for firms to have flexibility in writing their policies and procedures.7 We believe the same logic applies to the designation of a chief compliance officer. Particularly in large firms, like Vanguard, different people may oversee, and have expertise regarding, different areas. It may not be possible for one person to knowledgeably oversee such disparate issues as recordkeeping, pricing, disclosure, investment operations, privacy, advertising, anti-money laundering, transfer agency functions, soft dollars, etc. The most important feature of an effective compliance program is the assignment of responsibility to individuals who have the appropriate level of expertise to do the job. Requirements regarding the number of compliance officers, their titles, or level within the organization are largely irrelevant if the compliance program contains the elements listed above in Part I.A. It is far more important that the compliance officers have the appropriate expertise, know how to elevate issues, and have a reporting line to the board than whether they have a "senior management" title or are specifically approved by the board. Accordingly, we recommend that the proposed rules be revised to eliminate these types of requirements and therefore permit multiple compliance officers.
Along these lines, the adopting release should make clear that compliance reporting and an annual assessment of the fund's compliance program may be two different things. Since there may be many individuals fulfilling compliance functions, there may be multiple reports to the board on compliance matters throughout the year. These reports are most effective when they are presented to the board in their appropriate context rather than on some predetermined annual basis. Again, the more important feature of an effective compliance program is that information is elevated to a level of management that is authorized to take appropriate corrective action and that significant compliance matters are brought to the attention of the board. The time and scope of those reports are best determined by the managers responsible for those functions and should not be dictated by rule. Distinct from the frequent compliance reports routinely provided to the board is an annual report concerning the effectiveness of the fund's compliance program. We agree that fund boards should receive such a report, as required by proposed rule 38a-1. However, the rule should not dictate the contents of the report or who prepares it. In particular, the annual report to the board should not necessarily have to be prepared by the "chief compliance officer" or any other designated person.
We do not support certification of the fund's policies and procedures by a chief compliance officer or other officers. As a practical matter, we are unconvinced anything would be gained by such a requirement. Moreover, we believe a certification requirement is superfluous in light of the requirement that (a) each fund and adviser review its policies and procedures at least annually to determine their adequacy and the effectiveness of their implementation; and (b) each fund provide a written report to its board at least once a year describing, among other things, any material changes or proposed changes to the policies and procedures.
D. Advisers Act compliance rule as anti-fraud provision
Unlike the rule proposed for investment companies, the rule proposed for investment advisers would be an anti-fraud provision. According to proposed rule 206(4)-7, advisers who give advice without adopting and implementing written policies and procedures, conducting an annual review of those policies and procedures, or appointing a compliance officer would be committing a "fraudulent, deceptive or manipulative act." We strongly disagree that the basis for implementing compliance functions should lie in anti-fraud regulation. We do not believe that the giving of advice should be considered per se fraudulent simply because the adviser had an inadequate compliance program or failed to conduct an annual review of the program. Although we support the Commission's goal to strengthen industry commitment to compliance programs, we believe it is inappropriate to characterize a substandard compliance program as somehow perpetrating a fraud on the firm's clients. That characterization seems disproportionate to the offense. We believe that this compliance rule more appropriately belongs under the recordkeeping requirements adopted pursuant to Section 204 of the Advisers Act or as a "stand alone" rule adopted pursuant to Section 211(a) of the Act.
II. Use of the Private Sector to Promote Industry Compliance
The Commission has requested comment on additional methods to involve the private sector in promoting compliance with the federal securities laws. The Commission has suggested four possible approaches:
For the reasons set forth below, Vanguard believes that only the last item would be in the public interest.
We question the need for private sector initiatives at all given the excellent track record of the Commission's oversight of investment companies and investment advisers, as well as the demonstrated effectiveness of the Commission's examination program. Indeed, the Commission recently has undertaken a new examination approach that will result in more frequent reviews for large firms and firms with higher risk.8 As one of the nation's largest fund companies, Vanguard has been examined under this new approach and we have found it to be effective and well-suited to gathering the appropriate information about business procedures and controls. We believe the examination staff's focus on risk management and internal controls reaffirms the need for a strong compliance culture for funds and advisers. The proposed rules will further enhance this compliance culture. In addition, the large budget increase for the Commission anticipated for the next fiscal year should allow the hiring of additional examination staff. At a minimum, the Commission should assess the effectiveness of the new examination approach, additional examination staff, and the proposed rules before considering the necessity for private sector initiatives.
More generally, we believe that additional layers of regulation should be imposed only when the benefits outweigh the costs. The Commission has not made the case for the private sector initiatives, and we believe there is none. Nor has the Commission indicated that compliance problems have increased at funds and advisers. There is no suggestion of a problem that would justify the costs, duplication of effort, and resource reallocation associated with these private sector initiatives. Finally, we note that, with the exception of the fidelity bond proposal, each of the private sector initiatives faces staffing challenges attributable to the limited pool of capable experts qualified to undertake fund and adviser examinations.
A. Compliance reviews by independent third parties
In addition to cost, there are other problems with mandating compliance reviews by third parties. Requiring third party reviews undoubtedly would lead to the creation of many new firms to satisfy the increased demand for examination services. Given the limited pool of qualified examiners, there would be no way to ensure that fund and advisers would be able to secure examination services of a uniformly high quality. Because different standards would be applied to different funds and advisers, SEC examination staff would be able to rely to only a limited degree on the results of third party exams, obviating one of the primary benefits of the proposal.
B. Expanded audits by independent public accountants
The Release suggests expanding the role of independent public accountants to include an examination of fund compliance controls. If accounting firms are charged with monitoring mutual fund compliance, they would be asked, and expected, to review systems and controls that, in most cases, are not within their areas of expertise. In addition, we question whether this proposal is consistent with the Sarbanes-Oxley approach of limiting the scope of non-audit services provided by accountants to audit clients.
C. Establishment of an SRO
The proposal to establish an SRO to oversee funds and/or advisers would add an additional, and unnecessary, layer of oversight that ultimately would be detrimental to fund shareholders and adviser clients.
According to the Release, any SRO would "be subject to the pervasive oversight of the Commission," and the Commission staff "would continue to examine the activities of funds and advisers, both to ensure adequate examination coverage and to provide oversight of the SRO examination program."9 Under such a regime, the Commission would be adding to its oversight duties, not alleviating them. Requiring Commission staff to continue to examine funds and advisers, with the additional burden of overseeing an SRO, ultimately would weaken rather than strengthen the Commission's ability to effectively oversee funds and advisers.
We are seriously concerned that an added compliance layer would not provide fund shareholders with sufficient benefits to outweigh the anticipated costs to them of funding an SRO. As the Release notes, other SROs are financed by their members, and there is every indication that a mutual fund SRO would be expected to be paid for by mutual funds and their advisers. We are concerned such an SRO would add another significant industry expense, one that ultimately would be borne entirely by fund shareholders through higher expenses and a related reduction in investor returns, without commensurate benefits. Given the scrutiny that Congress and the Commission recently have given to fund costs, we question the need for such a costly "reform." We note that mutual funds already pay significant fees to the Commission (far more than the Commission uses for mutual fund oversight), which are used, in part, to regulate the industry and help pay for examinations.10 An SRO would require funds to pay twice, once to the Commission and once to an SRO, for essentially the same amount of oversight they receive today.
Finally, we are concerned that an SRO would add a layer of bureaucracy that would distance those conducting fund and adviser examinations from the Commission staff charged with developing regulatory policy and interpreting the federal securities laws. We see no benefit to be gained from separating those functions. Indeed, separating those functions would likely weaken the regulatory oversight of mutual funds and advisers by making it harder for the overseers and policy makers to have a good understanding of the practical application of the rules and current business practices. Similarly, the separation of functions resulting from the establishment of an SRO will make it harder for the examination teams to interpret the law and the rules as they try to apply them effectively in the field.
D. Fidelity bond coverage for investment advisers
Vanguard would support a Commission proposal to require investment advisers to obtain fidelity bonds. We have long believed this to be a sound business practice. In fact, Vanguard, which is a registered investment adviser, is covered by a fidelity bond today. Moreover, many Vanguard funds are managed by external advisers who also currently have fidelity bond coverage. We believe that fidelity insurance protects investors by providing coverage against fraudulent or criminal acts by an adviser or its employees. Requiring advisers to obtain fidelity bond coverage can increase investor confidence in the markets, which benefits investors and promotes the integrity of the industry.
* * * * *
We commend the Commission for continually striving to improve mutual fund and investment adviser compliance, and we appreciate the opportunity to comment. If you would like to discuss these comments further, or if you have any questions, please feel free to contact me at 610-503-4016, or Barry Mendelson at 610-503-2398.
Attachment (Exhibit A)
cc: Paul F. Roye, Director
John J. Brennan, Chairman and CEO
EXHIBIT A - Proposed New Language for Compliance Rules
§ 270.38a-1. Compliance procedures and practices of registered investment companies.
(a) Each registered investment company and business development company ("fund") must:
(1) Compliance Program. Adopt and implement a compliance program that includes written policies and procedures reasonably designed to promote compliance with the Federal Securities Laws by the fund, or by its investment adviser, principal underwriter or administrator in connection with their provision of services to the fund;
(2) Board approval. Obtain the approval of the compliance program of the fund by the board of directors of the fund, including a majority of directors who are not interested persons of the fund;
(3) Annual review. Review, no less frequently than annually, the adequacy of the compliance program established pursuant to this section and the effectiveness of its implementation;
(4) Responsible Personnel. Designate one or more individuals responsible for administering the compliance program adopted under paragraph (a)(1) of this rule.
(5) Annual Report to the Board. No less frequently than annually, provide a written report to the board regarding:
(A)The compliance program, any material changes made to the compliance program since the date of the last report, and any material changes to the compliance program recommended as a result of the annual review conducted pursuant to paragraph (a)(3) of this section; and
(B) Any material compliance matters requiring remedial action that occurred since the date of the last report and that had not been previously reported to the board.
(b) Unit investment trusts. If the fund is a unit investment trust, the fund's principal underwriter or depositor must approve the fund'scompliance program, designate one or more individuals responsible for administering the compliance program, and receive all annual reports.
(c) Recordkeeping. The fund must maintain:
(1) A copy of the fund's policies and procedures that are in effect under its compliance program, or at any time within the past five years were in effect, in an easily accessible place; and
(2) Written reports provided to the board of directors pursuant to paragraph (a)(5) for at least five years after the end of the fiscal year in which the report is provided to the board, the first two years in an easily accessible place.
(d) For purposes of this section, 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 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 (15 U.S.C. 6801), any rules adopted by the Commission under any of these statutes, the Bank Secrecy Act (31 U.S.C. 5311) as it applies to funds, and any rules adopted thereunder by the Commission or the Department of the Treasury.
§ 275.211-1. Compliance procedures and practices.
Every investment adviser registered or required to be registered under section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) must:
(a) Policies and procedures. Adopt and implement written policies and procedures reasonably designed to promote compliance , by the adviser and its 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 compliance program established pursuant to paragraph (a) and the effectiveness of its implementation; and
(c) Responsible Personnel. Designate one or more individuals (who are supervised persons) responsible for administering the compliance program adopted under paragraph (a).