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May 12, 2017

June 2007

Dear Chief Compliance Officer:

The SEC staff conducts compliance examinations of SEC-registered investment advisers, investment companies, broker-dealers, and transfer agents to determine whether these firms are in compliance with the federal securities laws and rules, and to identify deficiencies and weaknesses in compliance and supervisory controls. This “ComplianceAlert” letter summarizes select areas that SEC examiners have recently reviewed during examinations and describes the issues that we found. By periodically sharing this information with compliance personnel, our intent is to alert you to these issues, encourage you to review compliance in these areas at your firm, and encourage improvements in compliance and in compliance programs. We note that this document was prepared by the SEC staff.1

I. Investment Advisers/Mutual Funds

Closed-End Fund Distributions

Many closed-end funds have a policy that provides that the fund will pay periodic, level distributions to their shareholders monthly or quarterly (these policies are often referred to as “managed distribution policies”), which are designed to address the needs of investors seeking reliable periodic cash flow from their fund investment. The amount of the distribution that exceeds net investment income earned or net capital gains realized may represent a portion of shareholders’ original investment. These distributions are referred to as “return of capital distributions.” While a distribution may lawfully include a return of the investors’ capital or net realized capital gains, the Investment Company Act of 1940 requires that funds provide a written statement to shareholders about the source of the distribution whenever the distribution comes from a source other than the net investment income earned by the fund.2 The written statement must be provided contemporaneously with the distribution.

During examinations of closed-end funds, examiners noted that many funds that paid a return of capital to their shareholders had not sent shareholders an appropriate written “Rule 19a-1” notice along with distributions that included a return of capital component. Failing to disclose the source of the distribution may cause the fund’s “distribution yield,” a common performance metric used by closed-end funds in marketing (e.g., on fund websites, in press releases, and in communications providing data to third-party information disseminators) to be misleading. A high distribution rate largely comprised of return of capital might cause investors to erroneously conclude that the fund is generating a high total return. If the fund maintains a set distribution rate, the fund’s CCO and board should consider whether the fund is describing effectively the fund’s sources of distributions (e.g., a fund maintains a distribution rate (based on NAV) in excess of the fund’s long-term historical average annual total return (based on NAV) and the fund’s shares trade at a premium). The staff did note that all funds examined had provided an Internal Revenue Service Form 1099-DIV to shareholders (within 31 days of the end of the calendar year) that disclosed the portion of the distributions for the year that were characterized as return of capital. This calendar year-end disclosure, however, does not satisfy the statutory and rule requirements.

Performance Advertising Deficiencies

During a risk-targeted examination review of performance advertising by several registered investment advisers, examiners identified a number of deficiencies with respect to the advisers’ advertisements of their performance returns for client accounts.3 The most common deficiency was that many advisers did not include in their advertisements the disclosures necessary to prevent their advertising from being misleading. For example, among other things, firms did not: deduct advisory fees from performance results; disclose whether results reflected dividends; and disclose differences with the particular index used to benchmark performance claims. Also, many of the advisers had inappropriately advertised their partial list of past specific recommendations.

In addition, about a third of the advisers lacked any compliance policies and procedures governing marketing and performance advertising, and others maintained procedures that did not appear to be effective. For example, inadequate policies and procedures did not:

  • address the operations or practices of the adviser’s businesses;
  • ensure that third-party consultants used compliant presentations;
  • address the methods the adviser used to treat cash (and equivalents) when “carving out” separate equity and fixed income performance from balanced accounts;
  • ensure the adviser was in compliance with all applicable requirements of the CFA Institute’s performance presentation standards (currently called “Global Investment Performance Standards” or “GIPS”) prior to making a claim of such compliance;
  • require a consistent comparison of composites to appropriate benchmarks; and
  • ensure accurate composite descriptions.

Some examples of policies and procedures in place at the firms with fewer deficiencies included:

  • a multi-level review process among an adviser’s performance group, portfolio managers, and marketing group for the accuracy of marketing materials prior to their use;
  • the creation of “tolerance reports” on a monthly basis to compare all composite accounts to their respective benchmarks, with any material discrepancies being investigated;
  • a composite committee review of all accounts on at least a quarterly basis to ensure proper composite construction and maintenance; and
  • the use of a second independent pricing service to periodically verify the accuracy of prices supplied by the primary pricing service, with any material discrepancies in prices being investigated.

About a quarter of the advisers examined used some type of “hypothetical return” number in their performance claims, though most coupled the hypothetical return with supplemental explanatory disclosure. Examiners identified several composite construction issues and noted limited instances where advisers had inappropriately advertised a prior adviser’s performance record as its own. Examiners found that inadvertent errors in the calculation of performance results appear to have been reduced by the increased use of automated software programs to calculate performance.

A very common deficiency was with respect to advisers’ inappropriate claims of compliance with the CFA Institute’s performance presentation standards. The majority of the advisers examined during these risk-focused examinations claimed that they had presented their performance in a manner that was consistent with the CFA Institute’s performance presentation standards, though only one was in full compliance. This was a common deficiency even though most of the advisers that claimed compliance with the CFA Institute’s performance presentation standards had previously had their calculations and methodology “verified.”

Mutual Funds’ “As-Of” Transaction Practices

During examinations of mutual funds to assess their policies and procedures for processing “as-of” transactions, examiners found that some funds’ policies and procedures appeared to be inadequate to mitigate the risks inherent in as-of transactions.4 Although as-of trades may provide a means to correct legitimate errors made in processing fund share orders, such trades may also serve as a vehicle for improperly executing transactions at an earlier day’s more favorable NAV. In addition, purchase transactions that receive a lower than current NAV, or redemption transactions that receive a higher than current NAV, dilute the share value of other investors’ holdings. Because of this potential, funds’ policies and procedures should be crafted to ensure appropriate monitoring of dilution and to prevent or discourage abusive trading practices using as-of trades.

Examiners found that several fund complexes allowed intermediaries to enter as-of transactions through an investment network system, but only one of these complexes had implemented effective control procedures to review the legitimacy of the reason codes selected by intermediaries. Also, some funds had inadequate or no procedures for monitoring the cumulative effect on NAV of as-of trades. Examiners found that the boards of directors at a few funds had not reviewed or approved their funds’ overall policies and procedures for processing fund shares.

Many funds did not adopt control procedures expressly requiring their transfer agent to maintain documentation of the reason for allowing an as-of transaction, or retain correspondence relating to an as-of transaction. Examiners also found instances where as-of processing was unnecessarily delayed a day or more after receiving the as-of transaction request in good order (or becoming aware that a processing error required an as-of transaction).

Advisers’ Disaster Recovery Plans

Examinations of investment advisers located in Louisiana and Mississippi that were affected by Hurricane Katrina in August 2005 indicated “lessons learned” by advisers’ implementation of their Disaster Recovery Plans.5 Most of the advisers examined had a written Disaster Recovery Plan in advance of the hurricane, and most but not all of those Plans addressed hurricanes/flooding. All of the firms had to relocate their business operations as a result of Hurricane Katrina. On average, firms relocated 330 miles away from their original office space, and all of the firms were able to conduct general business operations at their temporary location for an extended period of time. On average, firms were able to resume trading and manage accounts within 32 hours of the hurricane, and to resume general operations within five days of the hurricane. Most, but not all firms were able to immediately access their electronically-maintained business records and client data from their remote location. This was accomplished through the use of remote servers, laptop computers, back-up data tapes, Internet access and online trading platforms. Some firms had to physically retrieve their server from their original office space in the days/weeks after the hurricane.

Most firms maintained communication with their clients via email and the firm’s website. Many firms utilized cell phones for communication, primarily via text messaging, rather than traditional voice calls. None of the firms reported clients having difficulty accessing their funds or initiating transactions in the days and weeks following Hurricane Katrina. Most firms reported that in addition to contacting the adviser, clients could contact their custodian directly to access funds and initiate transactions. None of the firms reported receiving any client complaints as a result of client dissatisfaction with the adviser’s operations or client service in the days and weeks following Hurricane Katrina.

Particular provisions of the advisers’ Disaster Recovery Plans that appeared to be effective with respect to the adviser’s ability to provide uninterrupted advisory services to clients in a compliant manner after a disaster included:

  • a pre-arranged remote location for short-term and possible long-term use;
  • alternate communication protocols to contact staff and clients, such as cell phones, text messaging, web-based email accounts, or an Internet website;
  • remote access to business records and client data through appropriately secured means that ensure ongoing compliance with Regulation S-P and other confidentiality requirements;
  • temporary lodging for key staff where necessary as a result of a relocation of the firm;
  • maintaining accurate and up-to-date contact information for all third-party service providers, including custodians, broker-dealers, transfer agents, pricing services, and research firms;
  • familiarity with the business continuity plans of such third-party service providers;
  • contingency arrangements for loss of key personnel, such as the president or primary portfolio manager, either temporarily or permanently;
  • effective training of staff on how to fulfill essential duties in the event of a disaster, including compliance matters;
  • periodic testing, evaluation, and revision of disaster preparedness plan; and
  • maintaining sufficient insurance and financial liquidity to prevent any interruption to the performance of compliant advisory services.

II. Broker-Dealers

Sales of Section 529 College Savings Plans

During examinations of broker-dealers that sold 529 College Savings Plans to retail investors, examiners found that many firms appeared to lack adequate written supervisory procedures or supervisory processes to review the 529 Plan transactions and customer accounts.6 For example, in many instances, there was little or no evidence that supervisory principals had performed a supervisory review of the suitability of recommendations to customers with respect to 529 Plans, the underlying investments in the account, and the expected duration of the investment. In addition, the manner in which the broker-dealer created or maintained its records did not facilitate supervision, including review of transactions. For example, at many firms, many 529 Plan transactions were not entered into any computer system. Consequently, those transactions did not appear on the broker-dealers’ trade blotters and bypassed most exception reports. As a result, those transactions bypassed crucial aspects of the firms’ supervisory systems and procedures.

Examiners found that most 529 Plans sold by the firms examined were sold to out-of-state residents. As investors who purchase an out-of-state 529 Plan may not receive some or all of the state tax benefits or may be subject to certain state income tax penalties, the tax treatment of purchasing out-of-state plans may be relevant to a suitability inquiry. Examiners did find that disclosure provided to investors in 529 Plans appeared to meet legal requirements.

Finally, it did not appear that firms had incorporated training for registered representatives or supervisors with respect to the specific factors that could impact the suitability of the firms’ recommendations with respect to 529 Plans.

Sales of Collateralized Mortgage Obligations

In several examinations of broker-dealers that sold collateralized mortgage obligations (CMOs) and asset backed securities to retail customers, examiners identified deficiencies in the disclosures provided to customers and in other areas.7 The broker-dealers examined had sold some of the most complex and riskiest classes of securities to their retail customers. In some cases, the firms did not provide investors with NASD-required educational materials. At other times, firms presented investors with sales literature that appeared to be unbalanced and misleading concerning the risks and yields of the securities, and that generally minimized the risks of the securities.

A few of the firms had not provided their advertisements and sales literature concerning CMOs to the NASD for its required review and approval prior to use, or failed to respond adequately to NASD’s comments prior to using sales material. These firms disseminated information which did not appear to provide balanced and complete disclosure of the risks inherent in the CMOs that were sold.

Examiners also found a lack of supervisory procedures to review the adequacy of disclosures made to investors in connection with the sale of CMOs, indications of recommendations that retail customers purchase CMOs that appeared to be unsuitable (e.g., transactions that were inconsistent with the customer’s stated investment objectives and, in some cases, represented a significant portion of the customer’s liquid assets), and in some instances, undisclosed markups that appeared to be excessive.

Sales of Real Estate Investment Trusts

Examinations of broker-dealers that sold real estate investment trust (REIT) products indicated deficiencies of several types.8 The examinations concentrated on the sales of unlisted public REITS to retail investors, which have grown in popularity in recent years. Examiners found indications of inadequate and potentially misleading disclosures to investors concerning the risk of the investments, the possible future public trading market for the REITs, and their liquidity. Examiners also noted deficiencies relating to the valuation of the investments in REITs, the source of dividend payments, sales of the securities prior to registration, lack of supervision over registered representatives selling REITs, and potential conflicts of interest arising from excessive non-cash compensation paid by sponsors of the REIT to the broker-dealer and/or its sales force.

Supervisory Procedures to Ensure Compliance with Regulation SHO

Recent examinations indicated deficiencies with respect to compliance with Regulation SHO.9 Specifically, many firms did not have adequate written supervisory procedures to ensure compliance with the Rule. Some of the firms examined appeared to have incorrectly marked short sales and long sales, many firms did not have procedures or a system to monitor whether long sales were resulting in fails to deliver, and some firms did not perform a locate or adequately document a locate prior to the execution of a short sale. Examiners found that many firms did not close out fail to deliver positions within thirteen consecutive settlement days (though the number of incidents found was quite small). Some firms allowed additional short sales in a security without pre-borrowing when a fail to deliver position remained for more than 13 consecutive settlement days.

Charges in Separately Managed Accounts

During examinations of some broker-dealers that offer separately managed accounts (SMAs), examinations found instances where customers had been overcharged for SMA fees in a significant number of customer accounts.10 In these instances, charges assessed to customer accounts were inconsistent with the charges outlined in the customer agreements, with breakpoint discounts, and/or with offering documents. These firms appeared to lack sound control procedures to ensure that the fees assessed to customers were consistent with the charges outlined in customer agreements and offering documents.

Part-Time Financial and Operations Principals

NASD Rules require all broker-dealers to have a Financial and Operations Principal who is responsible for the final preparation and accuracy of financial reports submitted to securities regulators and the supervision of individuals who assist in the preparation of such reports and who maintain the firm’s financial books and records. During examinations of broker-dealers employing part-time Financial and Operations Principals (so-called “Rent-A-Finops”), examiners reviewed the firms’ compliance with books and records and minimum financial requirements under the broker-dealer financial responsibility rules and found that some firms appeared to have inaccurate books and records, which resulted in erroneous financial reports to regulators.11 The inaccuracies included the understatement of liabilities, erroneous net capital computations, and net capital deficiencies. Examinations also found that many Rent-A-Finops had no role in the actual supervision or the creation and maintenance of various books and records, as required by NASD Rules. Examinations further indicated that some Rent-A-Finops may be overextended (some were registered at more than 15 firms simultaneously). .

Expense-Sharing Arrangements

During targeted examinations of select broker-dealers that utilize expense-sharing agreements, examiners noted various deficiencies, including indications that some firms operated while failing to maintain required minimum net capital. These deficiencies were caused by the inappropriate shifting of a liability from the broker-dealer to an affiliate.12 Examiners also found that some firms had failed to maintain adequate expense-sharing agreements.


This “ComplianceAlert” letter summarizes select areas that SEC examiners have recently reviewed during examinations and describes the issues that we found. We encourage you to review compliance in these areas at your firm, address any compliance or supervisory weaknesses and implement improvements as appropriate to your firm’s compliance and supervisory programs.

1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the staff of the Office of Compliance Inspections and Examinations, in coordination with other SEC staff, including in the Divisions of Investment Management and Market Regulation, and do not necessarily reflect the views of the Commission or the other staff members of the SEC. Examinations indicating deficiencies generally result in (non-public) deficiency letters requesting that the firm take corrective action. Serious deficiencies may be referred to the SEC’s enforcement staff.

2 Certain relevant law/rules in this area include Section 19(a) of the Investment Company Act and Rule 19a-1 thereunder.

3 Certain relevant law/rules in this area include Section 206 of the Investment Advisers Act of 1940 and Rule 206(4)-1(a) thereunder.

4 Certain relevant law/rules in this area include the “Compliance Rule” - Investment Company Act Rule 38a-1, and Investment Company Act Rule 22c-1.

5 Certain relevant law/rules in this area include the “Compliance Rule” - Advisers Act Rule 206(4)-7.

6 Certain relevant law/rules in this area include Section 10(b) of the Exchange Act, and MSRB rules regarding sales practices, supervision and books and records.

7 Certain relevant laws/rules in this area include Rule 17a-4 (books and records) of the Exchange Act, and SRO rules regarding supervision, sales practices and advertising.

8 Certain relevant laws/rules in this area include Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and SRO rules regarding supervision, registration, non-cash compensation and sales practices.

9 Certain relevant laws/rules in this area include Regulation SHO of the Exchange Act, and SRO rules regarding supervision and books and records.

10 Certain relevant laws/rules in this area include Rule 17a-3(a)(2) (books and records) of the Exchange Act, and SRO rules regarding standards of commercial honor and principles of trade, supervision and sales practices.

11 Certain relevant laws/rules in this area include books and records and financial responsibility rules of the Exchange Act, and SRO rules regarding financial/operation principals, supervision and books and records.

12 Certain relevant law/rules in this area include net capital and books and records rules under the Exchange Act and NASD Notice to Members 03-63.

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