Recently, the Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert listing the deficiencies and weaknesses found most often by the agency while examining registered investment companies (“funds”). The Risk Alert also includes observations that focus on money market funds and target-date funds. According to the Risk Alert, the most common deficiencies and weaknesses are those related to the fund compliance rule, disclosure to investors, the board approval process involving advisory contracts, and the fund code of ethics rule.
The Fund Compliance Rule
Under this rule, a fund is required to “adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws by the fund.” The rule also requires that the fund board approve the policies and procedures of the fund’s service providers and annually review the adequacy and effectiveness of the policies and procedures. The most common deficiencies or weaknesses regarding the fund compliance rule are:
- That funds’ compliance programs did not consider the nature of the business activities or risks specific to the fund;
- That funds did not follow or enforce their compliance policies and procedures;
- That funds did not “adopt and implement policies and procedures” to monitor compliance by service providers;
- That some funds did not “conduct annual reviews of their policies and procedures,” and others had so little documentation that it was unclear whether the reviews had been completed at all; and
- That certain funds conducted annual reviews but did not address how effective and adequate the fund’s policies and procedures were.
Disclosure to Investors
“The federal securities laws make it unlawful to make untrue statements of material fact or omit material information necessary to make other statements not misleading in registration statements, reports, and other documents filed with the Commission or otherwise provided to investors.” The most common deficiencies or weaknesses observed involved:
- Funds that provided “incomplete or potentially materially misleading information in their prospectuses, statements of information, or shareholder reports when compared to the funds’ actual activities.”
Some examples of incomplete or misleading information include not disclosing the payment of fees made to service providers and not disclosing changes to an investment strategy.
1940 Act Section 15(c) Process
Section 15(c) “requires a majority of the fund’s independent directors to approve the fund initially entering into, or renewing, a contract or agreement with a person who undertakes regularly to serve or act as an investment adviser of or a principal underwriter for such fund.” Among other considerations, board members of the fund have a duty to request and asses the information needed to evaluate the terms of the contract and to preserve the documents considered by the board when approving the terms or renewal of the contract. The most common deficiencies or weaknesses involving the Section 15(c) process are:
- That some fund boards may not have requested or considered information necessary to evaluate the fund’s investment advisory agreement, while others may have received incomplete information and did not request the missing information.
- That funds’ shareholder reports that did not “discuss adequately the material factors and conclusions that formed the basis for the board’s approval of an investment advisory contract”; and
- That, in some cases, the funds’ advisory contract review process did not comply with section 15(c).
Fund Code of Ethics
The fund code of ethics requires funds and other entities “to adopt a written code of ethics containing provisions reasonably necessary to prevent their ‘access persons’ from engaging in fraudulent, deceptive, or manipulative acts in connection with the purchase and sale of securities held or to be acquired by the fund.” The most common deficiencies and weaknesses related to the fund code of ethics rule are:
- Funds that failed to implement procedures necessary to prevent violations of their codes of ethics or had procedures that were inadequate;
- Funds that failed to follow, enforce or “use reasonable diligence to prevent violations of their codes of ethics”; and
- Funds that failed to comply with their approval and reporting obligations.
In addition, OCIE conducted an examination focusing on Money Market Funds (“MMF”) and Target Date Funds (“TDF”) and found some deficiencies and weaknesses as well.
Money Market Funds
- When it comes to “eligible securities” and minimal credit risk determinations some MMFs did not maintain adequate records and in their credit files, did not include information required under Rule 2a-7;
- When it comes to “eligible securities” and minimal credit risk determinations some MMFs did not have policies and procedures that addressed, among other things, filling accurate and timely information with the Commission, and testing for issuer diversification to ensure that no more than 5% of the funds’ assets were invested in any one issuer.
- Some MMFs provided stress test results that “did not include the required summary of significant assumptions used in the stress tests”;
- Some MMFs had not adopted and implemented policies and procedures to comply with Rule 2a-7; and
- MMFs did not disclose on their websites information required under Rule 2a-7 and/or the information was inaccurate.
Target Date Funds
The OCIE noted that most of the TDF’s were following the 1940 Act in the areas reviewed, but there were still some deficiencies and weaknesses related to their disclosures and compliance programs. “Some TDS had incomplete and potentially misleading disclosures in their prospectuses and advertisements.” For example, some information in the TDFs marketing materials was different than the TDFs’ prospectus disclosures. In addition, TDFs had incomplete or missing policies and procedures. Some of the missing or incomplete policies and procedures involved monitoring asset allocations and overseeing advertisements and sales literature.
The key takeaway from this risk alert is that boards of funds need to take a more active role in ensuring compliance with securities regulations. In particular, to avoid non-compliance, funds should review the fund compliance rule, expand disclosure to investors, improve the board approval process involving advisory contracts, and ensure the thorough implementation of the fund code of ethics rule.
 Top Compliance Topics Observed in Examinations of Investment Companies and Observation from Money Market Fund and Target Date Fund Initiatives, Office Compliance Inspection & Examinations (Nov. 7, 2019), https://www.sec.gov/files/Risk%20Alert%20-%20Money%20Market%20Fund%20and%20Target%20Date%20Fund%20Initiatives.pdf [hereinafter Top Compliance Topics].  Id.  Id.  Id.  Id. at 5.  Top Compliance Topics, supra note 1, at 5.  Id.  Id.  Id.  Id. at 3.  Top Compliance Topics, supra note 1, at 3.  Id.  Id.  Id.  Id.  Top Compliance Topics, supra note 1, at 3.  Id. at 3-4.  Id. at 4.  Id.  Id.  Top Compliance Topics, supra note 1, at 4.  Id. at 5.  Id.  Id. at 6.  Top Compliance Topics, supra note 1, at 6.  Id.  Id.  Id. at 7.  Id.  Top Compliance Topics, supra note 1, at 7.