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SECURITIES AND EXCHANGE COMMISSION

Veterans Affairs Department

CFR Citation: 17 CFR Parts 270, 275, and 279

RIN ID: RIN 3235-AI77

DOCUMENT ID: [Release Nos. IA-2204; IC-26299; File No. S7-03-03]

NOTICE: Part II

DOCUMENT ACTION: Final rule; request for comments.

SUBJECT CATEGORY: Compliance Programs of Investment Companies and Investment Advisers

DATES: Effective Date: February 5, 2004.

Comment Date: Comments requested in section II.F of this release should be received on or before February 5, 2004.

Compliance Date: October 5, 2004. Section III of this release contains more information on the compliance date.

DOCUMENT SUMMARY: The Securities and Exchange Commission is adopting new rules under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 that require each investment company and investment adviser registered with the Commission to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and designate a chief compliance officer to be responsible for administering the policies and procedures. In the case of an investment company, the chief compliance officer will report directly to the fund board. These rules are designed to protect investors by ensuring that all funds and advisers have internal programs to enhance compliance with the federal securities laws.

SUMMARY: Securities and Exchange Commission,

SUPPLEMENTAL INFORMATION

The Securities and Exchange Commission (``SEC'' or ``Commission'') is adopting new rule 38a1 (17 CFR 270.38a 1) under the Investment Company Act of 1940 (15 U.S.C. 80a) (``Investment Company Act''), new rule 206(4)7 (17 CFR 275.206(4)7) under the Investment Advisers Act of 1940 (15 U.S.C. 80b) (``Investment Advisers Act'' or ``Advisers Act''), and amendments to rule 2042 (17 CFR 275.2042) under the Advisers Act, and to Part 1, Schedule A, Item 2(a) of Form ADV (17 CFR 279.1).\2\
\2\ Unless otherwise noted, when we refer to rule 38a1 or any paragraph of the rule, we are referring to 17 CFR 270.38a1 of the Code of Federal Regulations in which the rule is published, as amended by this release; when we refer to rule 206(4)7 or any paragraph of the rule, we are referring to 17 CFR 275.206(4)7 of the Code of Federal Regulations in which the rule is published, as amended by this release; and when we refer to rule 2042 or any paragraph of the rule, we are referring to 17 CFR 275.2042 of the Code of Federal Regulations in which the rule is published, as amended by this release.
Table of Contents
I. Background

II. Discussion

A. Adoption and Implementation of Policies and Procedures

1. Investment Advisers

2. Investment Companies

B. Annual Review

1. Investment Advisers

2. Investment Companies

C. Chief Compliance Officer

1. Investment Advisers

2. Investment Companies

D. Recordkeeping

E. Private Sector Initiatives

F. Additional Request for Comment
III. Effective Date
IV. CostBenefit Analysis

A. Benefits

B. Costs
V. Consideration of Promotion of Efficiency, Competition and Capital Formation
VI. Paperwork Reduction Act

A. Rule 38a1

B. Rule 206(4)7

C. Rule 2042
VII. Summary of Final Regulatory Flexibility Analysis
VIII. Statutory Authority Text of Rules

I. Background

Earlier this year the Commission proposed rules that would require investment companies (``funds'')\3\ and investment advisers to adopt written compliance procedures, review the adequacy of those procedures annually, and designate a chief compliance officer responsible for their administration.\4\ We proposed the rules because it is critically important for funds and advisers to have strong systems of controls in place to prevent violations of the Federal securities laws and to protect the interests of shareholders and clients. The proposed rules were designed to foster, among other things, improved compliance by clarifying the compliance obligations of fund management and to strengthen the hand of fund boards and compliance personnel when dealing with them.\5\
\3\ In this release, we use the term ``fund'' to mean a registered investment company or a business development company, which is an unregistered closedend investment company. See section 2(a)(48) of the Investment Company Act (15 U.S.C. 80a2(a)(48)). We use the term ``mutual fund'' to mean a registered investment company that is an openend management company defined in section 5(a) of the Investment Company Act (15 U.S.C. 80a5(a)).
\4\ Compliance Programs of Investment Companies and Investment Advisers, Investment Company Act Release No. 25925 (Feb. 5, 2003) (68 FR 7038 (Feb. 11, 2003)) (``Proposing Release'').
\5\ Fortyeight commenters, most of which were investment advisers, fund management companies, and organizations representing those groups, submitted comments in response to the Proposing Release. Commenters generally supported the proposal to require funds and advisers to adopt and implement compliance programs, but many sought changes. The comment letters and a summary of comments prepared by our staff are available for public inspection and copying in the Commission's Public Reference Room, 450 5th Street, NW., Washington, DC (File No. S70303). The comment summary is also available on the Commission's Internet Web site (http://www.sec.gov/rules/extra/s70303summary.pdf. )

In recent months, the Commission and State securities authorities have discovered unlawful conduct involving a number of fund advisers, brokerdealers, and other service providers that confirms the need for these rules. Fund advisory or distributor personnel have engaged in, or actively assisted others in engaging in, inappropriate market timing, late trading of fund shares, and the misuse of material, nonpublic information about fund portfolios.\6\
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These personnel, including in some cases senior executives of fund advisers, have placed their personal interests or the business interests of the fund adviser ahead of the interests of fund shareholders, thus breaching their fiduciary obligations to the funds involved and their shareholders. These individuals have harmed the funds, their management organizations, and the confidence of fund investors.
\6\ The Commission has already obtained settlements in a number of actions arising from such violations. See, e.g., In re Putnam Investment Management, Investment Advisers Act Release No. 2192 (Nov. 13, 2003) (finding that an investment adviser failed to disclose potentially selfdealing securities trading by several of its employees, failed to have reasonable procedures to prevent misuse of material nonpublic information, and failed to reasonably supervise the employees who committed violations); In re Connelly, Securities Act Release No. 8304 (Oct. 16, 2003) (finding that a former executive of an investment adviser to a fund complex, in contravention of fund disclosures, approved agreements that permitted select investors to time certain funds in the complex); In re Markovitz, Securities Act Release No. 8298 (Oct. 2, 2003) (finding that a former hedge fund trader violated the Federal securities laws and defrauded investors by engaging in late trading of mutual fund shares).

Our response to these events is twofold. First, we are conducting an intensive investigation of funds, advisers, brokerdealers, and others.\7\ We will aggressively pursue and punish those who have violated the Federal securities laws and breached their fiduciary obligations to clients. When appropriate, we will actively work with other Federal law enforcement authorities and State authorities to see that the full weight of the law is brought to bear against those who have betrayed mutual funds and fund investors. Second, we will review all of our rules to determine what changes may be required to prevent this type of conduct.
\7\ To date, we have brought 10 enforcement actions. See SEC v. Mutuals.com, Inc., Civil Action No. 303 CV 2912D (N.D. Tex. Dec. 4, 2003) (alleging that dually registered brokerdealer and investment adviser, three of its executives, and two affiliated brokerdealers assisted institutional brokerage customers and advisory clients in carrying out and concealing thousands of market timing trades and illegal late trades in shares of hundreds of mutual funds); SEC v. Invesco Funds Group, Civil Action No. 03N2421 (PAC) (D. Colo. Dec. 2, 2003) (alleging that investment adviser, with approval of its president and chief executive officer, entered into market timing arrangements with more than 60 broker dealers, hedge funds, and advisers without disclosing these arrangements to the affected mutual funds' independent directors or shareholders); SEC v. Security Trust Company, Civil Action No. 032323 (D. Ariz. Nov. 24, 2003) (alleging that unregistered financial intermediary and three of its senior executives facilitated and participated in late trading and market timing schemes by a group of related hedge funds); SEC v. Pilgrim, Civil Action No. 03CV6341 (E.D. Penn. filed Nov. 20, 2003) (alleging that investment adviser and two senior executives permitted a hedge fund, in which one of the executives had a substantial financial interest, to engage in repeated shortterm trading of several mutual funds and that one of the executives provided nonpublic portfolio information to a broker dealer, which passed it on to its customers); SEC v. Druffner, Civil Action No. 0312154RCL (D. Mass. Nov. 4, 2003) (alleging that five brokers, with the assistance of their branch office manager, evaded attempts to restrict their trading and conducted thousands of market timing trades in numerous mutual funds); SEC v. Scott, Civil Action No. 0312082EFH (D. Mass. filed Oct. 28, 2003) (alleging that two senior investment executives of an investment adviser engaged in repeated shortterm trading in their personal accounts of funds over which they had investment decisionmaking responsibility and about which they had access to nonpublic information); In re Sihpol, Administrative Proceeding No. 311261 (Sept. 16, 2003) (charging former broker with playing a key role in enabling certain hedge fund customers to engage in late trading in shares of funds). See also supra note . A number of State actions are also pending.

We are taking our first regulatory actions designed to curb the abusive practices recently uncovered and to prevent their recurrence. In companion releases, we are proposing to amend our rules regarding mutual fund share pricing and prospectus disclosure.\8\ In this release, we are adopting new rules requiring advisers and funds to adopt strong compliance controls administered by a chief compliance officer.
\8\ Amendments to Rules Governing Pricing of Mutual Fund Shares, Investment Company Act Release No. 26288 (Dec. 11, 2003) (68 FR 70388 (Dec. 17, 2003)) (``Companion Late Trading Release''); Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings, Investment Company Act Release No. 26287 (Dec. 11, 2003) (68 FR 70402 (Dec. 17, 2003)) (``Companion Disclosure Release'').

II. Discussion

The Commission is adopting new rule 206(4)7 under the Advisers Act and new rule 38a1 under the Investment Company Act.\9\ The new rules require each registered investment adviser and each fund to adopt and implement compliance programs that conform to the new rules. Failure of an adviser or fund to have adequate compliance policies and procedures in place will constitute a violation of our rules independent of any other securities law violation. The new rules will thus permit the Commission to address the failure of an adviser or fund to have in place adequate compliance controls, before that failure has a chance to harm clients or investors.
\9\ We also are adopting related amendments to rule 2042 under the Advisers Act and a technical amendment to Form ADV.
A. Adoption and Implementation of Policies and Procedures

1. Investment Advisers

Under rule 206(4)7, it is unlawful for an investment adviser registered with the Commission to provide investment advice unless the adviser has adopted and implemented written policies and procedures reasonably designed to prevent violation of the Advisers Act by the adviser or any of its supervised persons.\10\ The rule requires advisers to consider their fiduciary and regulatory obligations under the Advisers Act and to formalize policies and procedures to address them.\11\
\10\ Rule 206(4)7(a). See also section 202(a)(25) of the Advisers Act (15 U.S.C. 80b2(a)(25)) (defining ``supervised person'' as ``any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment adviser, or other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser''). \11\ In response to several comments, we revised the text of the rule so that a violation of the rule would be deemed to be ``unlawful'' rather than ``a fraudulent, deceptive, or manipulative act, practice or course of business.'' This change, which responds to commenters' concerns regarding the optics of the rule, does not change its substance; failure to comply with its terms will result in a violation of section 206(4) of the Act.

Commenters generally supported these new requirements, but some expressed concerns for how they would be applied to smaller advisers. The Commission is sensitive to the burdens the rule may impose upon smaller advisory firms.\12\ The rule requires only that the policies and procedures be reasonably designed to prevent violation of the Advisers Act, and thus need only encompass compliance considerations relevant to the operations of the adviser. We would expect smaller advisory firms without conflicting business interests to require much simpler policies and procedures than larger firms that, for example, have multiple potential conflicts as a result of their other lines of business or their affiliations with other financial service firms.\13\ The preparation of these simpler policies and procedures and their administration should be much less burdensome.
\12\ In the Proposing Release, we requested comment on whether we should except a subset of investment advisers or funds from the requirements of the rules. Some commenters suggested that we except small advisers, but we believe that the flexibility of the rules obviates the need for this exception.
\13\ Even small advisers may have arrangements, such as soft dollar agreements, that create conflicts. Advisers of all sizes, in designing and updating their compliance programs, must identify these arrangements and provide for the effective control of the resulting conflicts.

Rule 206(4)7 does not enumerate specific elements that advisers must include in their policies and procedures.\14\ Commenters agreed with
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our assessment that funds and advisers are too varied in their operations for the rules to impose of a single set of universally applicable required elements. Each adviser should adopt policies and procedures that take into consideration the nature of that firm's operations. The policies and procedures should be designed to prevent violations from occurring, detect violations that have occurred,\15\ and correct promptly any violations that have occurred.\16\ \14\ Advisers already are subject to requirements to maintain written compliance policies and procedures in certain areas. The new rules do not alter those requirements. See, e.g., Investment Company Act rule 17j1(c)(1) (17 CFR 270.17j1(c)(1)) (requiring each investment adviser and principal underwriter of a fund to ``adopt a written code of ethics containing provisions reasonably necessary to prevent'' certain persons affiliated with the fund, its investment adviser or its principal underwriter from engaging in certain fraudulent, manipulative, and deceptive actions with respect to the fund); Advisers Act rule 206(4)6 (17 CFR 275.206(4)6) (requiring investment advisers to adopt and implement written policies and procedures reasonably designed to ensure that the adviser votes securities in the best interest of clients); Advisers Act section 204A (15 U.S.C. 80b4a) (requiring each adviser registered with us to have written policies and procedures reasonably designed to prevent the misuse of material nonpublic information by the adviser or persons associated with the adviser); Regulation SP (``Privacy of Consumer Financial Information'') (17 CFR 248.30) (requiring investment advisers to ``adopt policies and procedures that address administrative, technical, and physical safeguards for the protection of customer records and information'').
\15\ Where appropriate, advisers' policies and procedures should employ, among other methods of detection, compliance tests that analyze information over time in order to identify unusual patterns, including, for example, an analysis of the quality of brokerage executions (for the purpose of evaluating the adviser's fulfillment of its duty of best execution), or an analysis of the portfolio turnover rate (to determine whether portfolio managers are overtrading securities), or an analysis of the comparative performance of similarly managed accounts (to detect favoritism, misallocation of investment opportunities, or other breaches of fiduciary responsibilities).
\16\ In the Proposing Release, we noted that the compliance policies and procedures should be designed to prevent, detect, and correct promptly any material violation of the federal securities laws (or in the case of advisers, the Advisers Act). A number of commenters suggested that these objectives were unrealistic and recommended that the rules be designed instead to promote compliance with the securities laws. While we understand that compliance policies and procedures will not prevent every violation of the securities laws, we believe that prevention should be a key objective of all firms' compliance policies and procedures.

Each adviser, in designing its policies and procedures, should first identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm's particular operations, and then design policies and procedures that address those risks. We expect that an adviser's policies and procedures, at a minimum, should address the following issues to the extent that they are relevant to that adviser:
[sbull] Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients' investment objectives, disclosures by the adviser, and applicable regulatory restrictions;\17\
\17\ Rule 206(4)6 under the Advisers Act (17 CFR 275.206(4)6) requires registered investment advisers to adopt and implement written policies and procedures that are reasonably designed to ensure that the adviser votes securities in the best interest of clients. Similarly, funds must disclose the policies and procedures that they use to determine how to vote proxies relating to portfolio securities. Form N1A, Item 13(f) (17 CFR 239.15A; 274.11A); Form N 2, Item 18.16 (17 CFR 239.14; 274.11a1); Form N3, Item 20(o) (17 CFR 239.17a; 17 CFR 274.11b); and Form NCSR, Item 7 (17 CFR 249.331; 17 CFR 274.128).
[sbull] Trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (``soft dollar arrangements''), and allocates aggregated trades among clients;
[sbull] Proprietary trading of the adviser and personal trading activities of supervised persons;\18\
\18\ Section 204A of the Advisers Act (15 U.S.C. 80b4a) requires registered investment advisers to have written policies and procedures reasonably designed to prevent the misuse of material nonpublic information by the advisers or persons associated with the advisers. Rule 17j1(c)(1) under the Investment Company Act (17 CFR 270.17j1(c)(1)) requires funds and each investment adviser and principal underwriter of a fund to ``adopt a written code of ethics containing provisions reasonably necessary to prevent'' certain persons affiliated with the fund, its investment adviser or its principal underwriter from engaging in certain fraudulent, manipulative, and deceptive actions with respect to the fund. [sbull] The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements; [sbull] Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
[sbull] The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;\19\
\19\ Rule 2042(g)(3) under the Advisers Act (17 CFR 275.204 2(g)(3)) and rule 31a2(f)(3) under the Investment Company Act (17 CFR 270.31a2(f)(3)) require advisers and funds that maintain records in electronic formats to establish and maintain procedures to safeguard the records.
[sbull] Marketing advisory services, including the use of solicitors;\20\
\20\ Rule 206(4)3 under the Advisers Act (17 CFR 275.206(4)3) requires written agreements setting forth procedures to govern solicitation activities conducted by certain third parties on behalf of an adviser.
[sbull] Processes to value client holdings and assess fees based on those valuations;
[sbull] Safeguards for the privacy protection of client records and information;\21\ and
\21\ Regulation SP requires investment advisers to ``adopt policies and procedures that address administrative, technical, and physical safeguards for the protection of customer records and information.'' Regulation SP (``Privacy of Consumer Financial Information'') (17 CFR 248.30). Regulation SP also applies to funds.
[sbull] Business continuity plans.\22\
\22\ We believe that an adviser's fiduciary obligation to its clients includes the obligation to take steps to protect the clients' interests from being placed at risk as a result of the adviser's inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the death of the owner or key personnel. The clients of an adviser that is engaged in the active management of their assets would ordinarily be placed at risk if the adviser ceased operations.

Rule 206(4)7 does not require advisers to consolidate all compliance policies and procedures into a single document. Nor does it require advisers to memorialize every action that must be taken in order to remain in compliance with the Advisers Act. In some cases, it may be enough for the compliance policies and procedures to allocate responsibility within the organization for the timely performance of many obligations, such as the filing or updating of required forms.\23\ \23\ Advisers who are also registered as brokerdealers are not required to segregate their investment adviser compliance policies and procedures from their brokerdealer compliance policies and procedures.

2. Investment Companies

Rule 38a1 requires fund boards to adopt written policies and procedures reasonably designed to prevent the fund from violating the Federal securities laws.\24\ The procedures must provide for the oversight of compliance by the fund's advisers, principal
underwriters,\25\ administrators,\26\ and
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transfer agents \27\ (collectively, ``service providers'') through which the fund conducts its activities.\28\
\24\ Rule 38a1(a)(1). For purposes of rule 38a1, ``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. 107204, 116 Stat. 745 (2002)), the Investment Company Act, the Advisers Act, Title V of the Gramm LeachBliley Act (15 U.S.C. 6801) (governing disclosure of nonpublic personal information), any rules adopted by the Commission under any of these statutes, the Bank Secrecy Act (31 U.S.C. 53115314; 5316 5332) (imposing restrictions designed to prevent financial intermediaries from being used in money laundering activities) as it applies to funds, and any rules adopted thereunder by the Commission or the Department of the Treasury. Rule 38a1(e)(1).
\25\ A ``principal underwriter'' of a fund (other than a closed end fund) is ``any underwriter who as principal purchases from such company, or pursuant to contract has the right (whether absolute or conditional) from time to time to purchase from such company, any such security for distribution, or who as agent for such company sells or has the right to sell any such security to a dealer or to the public or both, but does not include a dealer who purchases from such company through a principal underwriter acting as agent for such company.'' Section 2(a)(29) of the Investment Company Act (15 U.S.C. 80a2(a)(29)).
\26\ An ``administrator'' is ``any person who provides significant administrative or business management services to an investment company.'' Investment Company Act rule 01(a)(5) (17 CFR 270.01(a)(5)).
\27\ Section 3(a)(25) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(3)(a)(25)) defines a ``transfer agent'' as ``any person who engages on behalf of an issuer of securities or on behalf of itself as an issuer of securities in (A) countersigning such securities upon issuance; (B) monitoring the issuance of such securities with a view to preventing unauthorized issuance, a function commonly performed by a person called a registrar; (C) registering the transfer of such securities; (D) exchanging or converting such securities; or (E) transferring record ownership of securities by bookkeeping entry without physical issuance of securities certificates.''
\28\ In this release, we use the term ``service provider'' to refer only to a fund's advisers, principal underwriters,
administrators, and transfer agents. By limiting the term in this manner, we are not lessening a fund's obligation to consider compliance as part of its decision to employ other entities, such as pricing services, auditors, and custodians.

a. Service Providers. Most of the operations of funds are carried out by service providers, which have their own compliance policies and procedures. Commenters pointed out that the proposed rule appeared to require a fund to adopt, as its own, the policies and procedures of its service providers.\29\ The final rule requires fund boards to approve the policies and procedures of fund service providers, and requires the fund's policies and procedures to include provisions for the fund to oversee compliance by its service providers.
\29\ Some commenters urged us to permit funds to simply rely on their service providers' policies and procedures. We have not adopted this suggestion because it would permit funds and their boards to absolve themselves of responsibility for compliance activities of the service providers through which funds conduct most of their activities.

Rule 38a1 provides fund complexes with flexibility so that each complex may apply the rule in a manner best suited to its
organization.\30\ A fund complex could, for example, adopt compliance policies and procedures that encompass the activities of the funds, the adviser and affiliated underwriters and transfer agents, while approving the policies and procedures of other service providers, such as subadvisers, over which it has oversight responsibility under the rule. Another fund complex could adopt policies and procedures that would cover solely activities of the funds, and could approve the policies and procedures of each of its service providers.
\30\ In this release, we use the term ``fund complex'' to mean a group of funds that share a compliance program and a common investment adviser and/or distributor.

b. Board Approval. Rule 38a1 requires a fund's board, including a majority of its independent directors, to approve the policies and procedures of the fund and each of its service providers.\31\ The approval must be based on a finding by the board that the policies and procedures are reasonably designed to prevent violation of the Federal securities laws by the fund and its service providers.\32\
\31\ In this release, we refer to directors who are not ``interested persons'' of the fund as ``independent directors.'' Section 2(a)(19) identifies persons who are ``interested persons'' of a fund. 15 U.S.C. 80a2(a)(19).
\32\ Rule 38a1(a)(2). In response to comments seeking
clarification of the board's responsibilities, we have added language to the rule text explicitly stating the basis for approval. If the policies and procedures of a service provider are included within the policies and procedures adopted by the fund, separate approval by the board is not required. A fund that is approving policies and procedures of service providers is required to make findings only with respect to activities of the service provider that could affect the fund.

Some commenters expressed concern that the rule would require directors to review lengthy compliance manuals and devote considerable time at each meeting to approving numerous amendments. Directors may satisfy their obligations under the rule by reviewing summaries of compliance programs prepared by the chief compliance officer, legal counsel or other persons familiar with the compliance programs. The summaries should familiarize directors with the salient features of the programs (including programs of service providers) and provide them with a good understanding of how the compliance programs address particularly significant compliance risks.\33\

In considering whether to approve a fund's or service provider's compliance policies and procedures, boards should consider the nature of the fund's exposure to compliance failures. In the case of a money market fund, for example, the board should consider whether the policies and procedures sufficiently address the fund's compliance with rule 2a7.\34\ Boards should also consider the adequacy of the policies and procedures in light of their recent compliance experiences, which may demonstrate weaknesses in the fund or service provider's compliance programs. We urge boards to also consider best practices used by other fund complexes, and to consult with fund counsel (and independent directors with their counsel), compliance specialists and other experts familiar with compliance practices successfully employed by similar funds or service providers.
\33\ Rule 38a1 does not require fund boards to approve amendments to policies and procedures of the fund or its service providers. Such a requirement would, as commenters pointed out, inundate fund boards with review of minor changes and detract from their ability to address significant responsibilities committed to them by the Act and our rules. Moreover, such a requirement could delay funds and their service providers from making needed changes. Instead, the rule requires the fund's chief compliance officer to discuss material changes to the compliance policies and procedures in his or her annual report to the fund board. Rule 38(a)
1(a)(4)(iii)(A). As we note below, however, serious compliance issues must be raised with the board immediately. See infra note 83. \34\ 17 CFR 270.2a7.

The Commission understands that, in some cases, the fund may employ the services of a service provider that is not an affiliated person of the fund, such as a transfer agent or administrator, and that provides similar services to a large number of funds. In such cases, it may be impractical for the fund or its compliance officer to directly review all of the service provider's policies and procedures. In such cases, we will consider a fund's policies and procedures to have satisfied the requirements of this rule if the fund uses a thirdparty report on the service provider's procedures instead of the procedures themselves when the board is evaluating whether to approve the service provider's compliance program.\35\ The thirdparty report must describe the service provider's compliance program as it relates to the types of services provided to the fund, discuss the types of compliance risks material to the fund, and assess the adequacy of the service provider's compliance controls.\36\
\35\ In these limited circumstances, we would also consider the fund to have satisfied the rule's requirement with regard to annual review of service providers, as discussed in section II.B.2. of this release, supra, and with respect to the chief compliance officer's annual report with regard to service providers, as discussed in section II.C.2. of this release, supra, if such reviews and reports use such thirdparty reports provided to the fund no less than annually. If the fund uses such reports for its approval of a service provider's compliance program or the annual review or reporting on the program, the fund must also gather and take into account other relevant information, such as its experience with the service provider.
\36\ See, e.g., Codification of Accounting Standards and Procedures, Statement on Auditing Standards No. 70, Reports on Processing of Transactions by Service Organizations (American Inst. of Certified Public Accountants).

c. Policies and Procedures. Funds' or their advisers' policies and procedures should address the issues we identified for investment advisers above.\37\ In
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addition, we expect policies and procedures of funds (or fund service providers) to cover certain other critical areas. In light of our recent enforcement actions against a number of fund managers and service providers,\38\ we are taking this opportunity to review the application of these policies and procedures to several important areas of compliance with the Federal securities laws by funds and their service providers.
\37\ See supra text accompanying notes 17 through 22. Funds are also subject to requirements to maintain written compliance policies and procedures in certain of our rules. The new rules do not supplant these requirements. See, e.g., Investment Company Act rules 2a7(c)(7) (17 CFR 270.2a7(c)(7)) (requiring boards of money market funds to establish written procedures ``reasonably designed * * * to stabilize the money market fund's net asset value per share'') and 17j1(c)(1) (17 CFR 270.17j1(c)(1)) (requiring funds to ``adopt a written code of ethics containing provisions reasonably necessary to prevent'' certain persons affiliated with the fund, its investment adviser or its principal underwriter from engaging in certain fraudulent, manipulative, and deceptive actions with respect to the fund); Form N1A, Item 13(f) (17 CFR 239.15A; 274.11A) (requiring funds to disclose the policies and procedures that they use to determine how to vote proxies relating to portfolio securities); 31 CFR 103.130(c) (requiring funds to develop an antimoney laundering program, which includes the establishment and implementation of ``policies, procedures, and internal controls reasonably designed to prevent the mutual fund from being used for money laundering or the financing of terrorist activities and to achieve compliance with the applicable provisions of the Bank Secrecy Act and the implementing regulations thereunder''); Regulation SP (``Privacy of Consumer Financial Information'') (17 CFR 248.30) (requiring funds to ``adopt policies and procedures that address administrative, technical, and physical safeguards for the protection of customer records and information'').
\38\ See supra notes 6 and 7 and accompanying text.
[sbull] Pricing of portfolio securities and fund shares. The Investment Company Act requires funds to sell and redeem their shares at prices based on their current net asset value, and to pay redemption proceeds promptly.\39\ The Investment Company Act requires funds to calculate their net asset values using the market value of their portfolio securities when market quotations for those securities are ``readily available,'' and, when a market quotation for a portfolio security is not readily available, by using the fair value of that security, as determined in good faith by the fund's board.\40\ These pricing requirements are critical to ensuring fund shares are purchased and redeemed at fair prices and that shareholder interests are not diluted.
\39\ Section 22(e) of the Investment Company Act generally prohibits mutual funds from suspending the right of redemption and prohibits funds from postponing the payment of redemption proceeds for more than seven days. 15 U.S.C. 80a22(e). Rule 22c1(b) under the Act generally requires that a fund's net asset value be computed at least once daily, Monday through Friday, at a time or times specified by the fund's board of directors. 17 CFR 270.22c1(b). \40\ Section 2(a)(41) of the Investment Company Act and rule 2a411 (17 CFR 270.2a411).

When fund shares are mispriced, shortterm traders have an arbitrage opportunity they can use to exploit a fund and disadvantage the fund's longterm investors by extracting value from the fund without assuming any significant investment risk. Mispricing may occur with respect to portfolio securities traded on a foreign market that closes before the time at which the fund prices its shares.\41\ If an event affecting the value of the portfolio securities occurs after the foreign market closes but before the fund prices its shares, the foreign market closing price for the portfolio security will not reflect the correct current value of those securities when the fund prices its shares. In 1984, we stated that, in these circumstances, a fund ``must, to the best of its ability, determine the fair value of the securities, as of the time'' that the fund prices its shares.\42\ We believe that funds that fail to fair value their portfolio securities under such circumstances may violate rule 22c1 under the Investment Company Act.\43\ Fund directors who countenance such practices fail to comply with their statutory valuation obligations \44\ and fail to fulfill their fiduciary obligation to protect fund shareholders. Accordingly, rule 38a1 requires funds to adopt policies and procedures that require the fund to monitor for circumstances that may necessitate the use of fair value prices; establish criteria for determining when market quotations are no longer reliable for a particular portfolio security;\45\ provide a methodology or methodologies by which the fund determines the current fair value of the portfolio security;\46\ and regularly review the appropriateness and accuracy of the method used in valuing securities, and make any necessary adjustments.\47\
\41\ Mispricing may also occur when a domestic trading market in a security closes before the time the fund prices its shares, or when market quotations for a security are not reliable because, e.g., sales have been infrequent or there is a thin market in the security. See Accounting Series Release No. 118 (Dec. 23, 1970) (35 FR 19986 (Dec. 31, 1970)). Thus, in addition to monitoring for events that may necessitate fair value pricing, funds must pay attention to circumstances that would suggest the need for using fair value pricing.
\42\ Pricing of Redeemable Securities for Distribution, Redemption, and Repurchase, Investment Company Act Release No. 14244 (Nov. 21, 1984) (49 FR 46558 (Nov. 21, 1984)), at n. 7 (emphasis added) (proposing amendments to rule 22c1). Subsequent to the issuance of this release, our staff has reminded funds of their fair valuation obligations. In 1999 and 2001, the Division of Investment Management issued interpretive letters elaborating on funds' obligations under sections 2(a)(41) of the Investment Company Act and rule 22c1 (17 CFR 270.22c1) thereunder. Letter from Douglas Scheidt, Associate Director and Chief Counsel, SEC Division of Investment Management, to Craig S. Tyle, General Counsel, Investment Company Institute (Dec. 8, 1999) (http://www.sec.gov/divisions/investment/guidance/tyle120899.htm ); letter from Douglas Scheidt,
Associate Director and Chief Counsel, SEC Division of Investment Management, to Craig S. Tyle, General Counsel, Investment Company Institute (Apr. 30, 2001) (http://www.sec.gov/divisions/investment/guidance/tyle043001.htm ).
\43\ 17 CFR 270.22c1.
\44\ Section 2(a)(41) (15 U.S.C. 80a2(a)(41)) of the Investment Company Act.
\45\ In some cases, funds have adopted policies and procedures requiring the use of fair value pricing in circumstances when prices may be affected by events subsequent to the close of trading, but have established criteria that result in infrequent use of fair value pricing, which provides an opportunity for price arbitrage. See, e.g., Susan Lee, The Dismal Science: The Feeling's Not Mutual, Wall St. J., Nov. 24, 2003, at A15. As we have stated previously, funds must fair value their portfolio securities whenever market quotations become unreliable. See supra note 42. The failure of a fund to establish sufficiently sensitive criteria for using fair value pricing should be recognizable in subsequent reviews of the accuracy of the prices used to compute the net asset value of the fund.
\46\ In determining fair value, some funds use correlations between the exchange prices of foreign securities and other appropriate instruments or indicators, such as relevant indices, American Depository Receipts, and futures contracts. Software developed by vendors is today available to assist funds to determine the fair value of portfolio securities.
\47\ In a companion release, we are proposing to amend funds' disclosure requirements with respect to the use and the effects of fair value pricing. See Section II.B of Companion Disclosure Release, supra note 8.
[sbull] Processing of fund shares. Our rules require forward pricing of fund shares.\48\ An investor submitting a purchase order or redemption request must receive the price next calculated after receipt of the purchase order or redemption request.\49\ Accordingly, rule 38a 1 requires that a fund have in place procedures that segregate investor orders received before the fund prices its shares (which will receive that day's price) from those that were received after the fund prices its shares (which will receive the following day's price).\50\ Because fund purchase and redemption orders are ultimately transmitted to transfer agents engaged by the fund, we have expanded the service providers covered by the rule to include transfer agents.
\48\ Rule 22c1(a) (17 CFR 270.22c1(a)).
\49\ Id. We adopted the forward pricing requirement in 1968 to eliminate socalled ``backward pricing'' that permitted sales and purchases of fund shares at a stated price. We concluded that backward pricing resulted in dilution of the value of fund shares, and that it disrupted fund management by encouraging shortterm trading in funds by speculators seeking to take advantage of fund prices that did not reflect the current value of the fund portfolio. Adoption of Rule 22c1 under the Investment Company Act of 1940 Prescribing the Time Pricing of Redeemable Securities for
Distribution, Redemption, and Repurchase, and Amendment of Rule 17a 3(a)(7) under the Securities Exchange Act of 1934 Requiring Dealers to TimeStamp Orders, Investment Company Act Release No. 5519 (Oct. 16, 1968) (33 FR 16331 (Nov. 7, 1968)).
\50\ Rule 38a1(a)(1). In most cases, we expect these matters will be addressed by the policies and procedures of fund transfer agents. See Companion Late Trading Release, supra note 8, for a detailed discussion of how fund share transactions are processed by intermediaries.

Many funds today have contractual provisions with transfer agents and other intermediaries that obligate those
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parties to segregate orders received by time of receipt in order to prevent ``late trading'' based on a previously determined price. Reliance on those contractual provisions alone would be insufficient to meet the requirements of the new rule.\51\ Funds should not only approve and periodically review the policies and procedures of transfer agents, as required by the rule, but should also take affirmative steps to protect themselves and their shareholders against late trading by obtaining assurances that those policies and procedures are effectively administered.\52\
\51\ In a companion release, we are proposing amendments to rule 22c1 under the Investment Company Act that would eliminate the need for funds and their transfer agents to rely on the segregation of orders by fund intermediaries other than a registered transfer agent or clearing agency. See Companion Late Trading Release, supra note 8.
\52\ We discuss methods funds can use to oversee such policies and procedures later in this Adopting Release, in connection with the chief compliance officer's oversight of service providers. See infra text accompanying footnote 91.
[sbull] Identification of Affiliated Persons. To prevent self dealing and overreaching by persons in a position to take advantage of the fund, the Investment Company Act prohibits funds from entering into certain transactions with affiliated persons.\53\ Funds should have policies and procedures in place to identify these persons and to prevent unlawful transactions with them.
\53\ See, e.g., section 17(a) (15 U.S.C. 80a17(a)) (prohibiting first and secondtier affiliates of a fund from borrowing money or other property from, or selling or buying securities or other property to or from the fund, or any company that the fund controls); section 17(d) (15 U.S.C. 80a17(d)) (making it unlawful for first and secondtier affiliates of a fund, the fund's
principal underwriters, and affiliated persons of the fund's principal underwriters, acting as principal, to effect any transaction in which the fund or a company controlled by the fund is a joint or a joint and several participant in contravention of Commission rules); rule 17d1(a) (270 CFR 270.17d1(a)) (prohibiting first and secondtier affiliates of a fund, the fund's principal underwriter, and affiliated persons of the fund's principal underwriter, acting as principal, from participating in or effecting any transaction in connection with any joint enterprise or other joint arrangement or profitsharing plan in which any such fund or company controlled by a fund is a participant unless an application regarding such enterprise, arrangement or plan has been filed with the Commission and has been granted); section 10(f) (15 U.S.C. 80a 10(f)) (prohibiting a fund from purchasing securities in a primary offering if certain affiliated persons of the fund are members of the underwriting or selling syndicate); section 17(e) (15 U.S.C. 80a17(e)) (limiting the remuneration that first and secondtier affiliates of a fund may receive in transactions involving the fund, and companies that the fund controls); and section 12(d)(3) (15 U.S.C. 80a12(d)(3)) and rule 12d31 (270 CFR 270.12d31) (together prohibiting a fund from acquiring securities issued by, among others, its own investment adviser).
[sbull] Protection of Nonpublic Information. The federal securities laws prohibit insider trading, and section 204A of the Advisers Act requires advisers (including advisers to funds) to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the adviser or any of its associated persons from misusing material, nonpublic information. Fund advisers should incorporate their section 204A policies into the policies required by rule 38a1. These policies typically include prohibitions against trading portfolio securities on the basis of information acquired by analysts or portfolio managers employed by the investment adviser. A fund's compliance policies and procedures should also address other potential misuses of nonpublic information, including the disclosure to third parties of material information about the fund's portfolio,\54\ its trading strategies,\55\ or pending transactions, and the purchase or sale of fund shares by advisory personnel based on material, nonpublic information about the fund's portfolio.\56\
\54\ In a companion release, we are proposing to require funds to disclose their policies and procedures with respect to the disclosure of fund portfolio holdings. See Section II.C of Companion Disclosure Release, supra note 8.
\55\ Thus, funds' and investment advisers' policies and procedures should preclude fund or advisory personnel from divulging a fund's portfolio schedule that has not been made generally available to the public. Divulging portfolio holdings to selected third parties is permissible only when the fund has legitimate business purposes for doing so and the recipients are subject to a duty of confidentiality. See, e.g., Selective Disclosure and Insider Trading, Securities Act Release No. 7881 at text accompanying n. 29 (Aug. 15, 2000) (65 FR 51716 (Aug. 24, 2000)) (noting that ``issuers and their officials may properly share material nonpublic
information with outsiders, for legitimate business purposes, when the outsiders are subject to duties of confidentiality''). See also Dirks v. SEC, 463 U.S. 646, 655 at n. 14 (1983) (``Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes.'') (citations omitted). We understand that many funds provide portfolio information in response to requests by rating agencies and similar organizations only after receiving written assurances that the information will be kept confidential and that persons with access to the information will not use the information to trade securities.
\56\ We urge funds and advisers to require persons who have access to nonpublic information to trade securities of the fund exclusively through identifiable accounts to enable the fund to monitor for excessive, shortterm trading. Alternatively, although not required by section 17(j) of the Investment Company Act (15 U.S.C. 80a17(j)) or rule 17j1 (17 CFR 270.17j1), funds and advisers should consider amending their codes of ethics to cover, and thus require reporting of, trades by persons who have access to nonpublic information about the portfolio, including information about the accuracy of the prices of portfolio securities used to calculate net asset value.
[sbull] Compliance with Fund Governance Requirements. A fund's board plays an important role in overseeing fund activities to ensure that they are being conducted for the benefit of the fund and its shareholders. Fund boards, among other things, are tasked with approving the fund's advisory contracts,\57\ underwriting
agreements,\58\ and distribution plans.\59\ The Investment Company Act requires that fund boards of directors be elected by fund
shareholders,\60\ and that a certain percentage be ``independent directors.''\61\ To rely on many of our exemptive rules, independent directors must constitute a majority of the board, must be selected and nominated by other independent directors, and if they hire legal counsel, that counsel must be an independent legal counsel.\62\ \57\ Sections 15(a) and (c) of the Investment Company Act (15 U.S.C. 80a15(a) and (c)).
\58\ Sections 15(b) and (c) of the Investment Company Act (15 U.S.C. 80a15(b) and (c)).
\59\ Section 12(b) of the Investment Company Act (15 U.S.C. 80a 12(b)) and rule 12b1(b)(2) (17 CFR 270.12b1(b)(2)).
\60\ Section 16(a) of the Investment Company Act (15 U.S.C. 80a 16(a)).
\61\ Section 10(a) of the Investment Company Act (15 U.S.C. 80a 10(a)) (prohibiting more than 60 percent of a fund's directors from being interested persons of the fund); section 10(b)(2) of the Investment Company Act (15 U.S.C. 80a10(b)(2)) (requiring, in effect, that independent directors comprise a majority of a fund's board if the fund's principal underwriter is an affiliate of the fund's investment adviser); section 15(f)(1) of the Investment Company Act (15 U.S.C. 80a15(f)(1)) (providing a safe harbor for the sale of an advisory business if directors who are not interested persons of the investment adviser constitute at least 75 percent of a fund's board for at least three years following the assignment of the advisory contract). See also rule 6e3(T)(b)(15) (17 CFR 270.6e 3(T)(b)(15)) (exempting certain funds underlying insurance products from various Investment Company Act provisions provided that independent directors constitute a majority of the boards of those funds).
\62\ See rule 10f3 (17 CFR 270.10f3), rule 12b1 (17 CFR 270.12b1), rule 15a4 (17 CFR 270.15a4), rule 17a7 (17 CFR
270.17a7), rule 17d1(d)(7) (17 CFR 270.17d1(d)(7)), rule 17e1 (17 CFR 270.17e1), rule 17g1(j) (17 CFR 270.17g1(j)), rule 18f3 (17 CFR 270.18f3), and rule 23c3 (17 CFR 270.23c3). See also rule 01(a)(6) (17 CFR 270.01(a)(6)) (defining ``independent legal counsel'').

The consequences of failing to meet the Investment Company Act's governance requirements are severe.\63\ Therefore, a fund's policies and procedures should be designed to guard against, among other things, an
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improperly constituted board,\64\ the failure of the board to properly consider matters entrusted to it, and the failure of the board to request and consider information required by the Investment Company Act from the fund adviser and other service providers.\65\
\63\ See, e.g., In re Charles G. Dyer, Investment Company Act Release No. 25107 (Aug. 9, 2001) and SEC v. Centurion Growth Fund, No. 948199CIVUNGAROBENAGES, (S.D. Fla. Apr. 22, 1994),
Litigation Release No. 14063 (Apr. 28, 1994) (56 SEC Docket 1776). \64\ A board lacking a sufficient number of disinterested directors, for example, would be improperly constituted. To avoid this, fund procedures should provide for a process of determining that independent director candidates are not ``interested persons'' and, after their election, for a periodic reassessment that they continue not to be interested persons. See rule 31a2 (17 CFR 270.31a2(a)(4)) under the Investment Company Act (requiring the maintenance of ``any record of the initial determination that a director is not an interested person of the investment company and each subsequent determination that the director is not an interested person * * * includ[ing] any questionnaire and any other document used to determine that a director is not an interested person of the company'').
\65\ Section 15(c) requires fund directors ``to request and evaluate * * * such information as may reasonably be necessary to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser of such company.'' A board that fails to acquire sufficient information about the advisory fee and other fund expenses will be unable to negotiate effectively on behalf of the fund. As a result, the fund may pay a higher than necessary advisory fee, fail to benefit from economies of scale as a result of insufficient breakpoints in the advisory fee, or bear too many operating expenses.
[sbull] Market Timing. In a companion release today, we are proposing amendments to our mutual fund disclosure rules to require funds to disclose their policies on ``market timing,'' i.e., the excessive shortterm trading of mutual fund shares that may be harmful to the fund.\66\ Many funds' prospectuses already disclose market timing policies, and failure to adhere to those disclosed policies violates the antifraud provisions of the Federal securities laws.\67\ Moreover, a fund adviser that waives or disregards those policies for the benefit of itself or a third party has breached its fiduciary responsibilities to the fund.\68\ Thus, under rule 38a1 a fund must have procedures reasonably designed to ensure compliance with its disclosed policies regarding market timing. These procedures should provide for monitoring of shareholder trades or flows of money in and out of the funds in order to detect market timing activity, and for consistent enforcement of the fund's policies regarding market timing.\69\ If the fund permits any waivers of those policies, the procedures should be reasonably designed to prevent waivers that would harm the fund or its shareholders or subordinate the interests of the fund or its shareholders to those of the adviser or any other affiliated person or associated person of the adviser. In this regard, we strongly urge fund boards to require fund advisers, or other persons authorized to waive market timing policies, to report to the board at least quarterly all waivers granted, so that the board can determine whether the waivers were proper.
\66\ See Section II.A. of the Companion Disclosure Release, supra note 8.
\67\ Failure to adhere to statements made in the prospectus may render the prospectus disclosure materially misleading and thus violate provisions of the Federal securities laws that prohibit fraud. See, e.g., section 17(a) of the Securities Act (15 U.S.C. 77q), section 10(b) of the Securities Exchange Act (15 U.S.C. 78j) and rule 10b5 (17 CFR 240.10b5) thereunder, and section 34(b) of the Investment Company Act (15 U.S.C. 80a33(b)).
\68\ An investment adviser has a fiduciary duty to act in the best interests of a fund it advises. Section 206 under the Advisers Act (15 U.S.C. 80b6) and section 36(a) under the Investment Company Act (15 U.S.C. 80a35(a)). See also Rosenfeld v. Black, 445 F.2d 1337 (2d Cir. 1971); Brown v. Bullock, 194 F. Supp. 207, 229, 234 (S.D.N.Y.), aff'd, 294 F.2d 415 (2d Cir. 1961); In re Provident Management Corp., Securities Act Release No. 5115 (Dec. 1, 1970) at text accompanying note 12.
\69\ See, e.g., C. Meyrick Payne, Strengthening the Role of Mutual Fund Directors after the Canary Scandal, Management Practice Bulletin (Oct. 2003) (http://www.mfgovern.com/reports/2_canaryscandal.html ) (explaining that ``periodic sales and redemption
data'' are useful for detecting practices such as late trading and market timing).
B. Annual Review

1. Investment Advisers

Rule 206(4)7 requires each registered adviser to review its policies and procedures annually to determine their adequacy and the effectiveness of their implementation.\70\ The review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the policies or procedures. For example, an adviser that is acquired by a brokerdealer or by the corporate parent of a brokerdealer should assess whether its policies and procedures are adequate to guard against the conflicts that arise when the adviser uses that brokerdealer to execute client transactions, or invests client assets in funds or other securities distributed or underwritten by the brokerdealer.

\70\ Rule 206(4)7(b).

Although the rule requires only annual reviews, advisers should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and regulatory developments. For example, we expect all registered advisers will begin reviewing their policies and procedures in light of our adoption of these rules.

2. Investment Companies

Similarly, rule 38a1 requires a fund to review its policies and procedures, as well as those of its service providers, annually.\71\ The rule does not require a fund board to conduct the review; the board would, however, have the benefit of the review in the report submitted by the compliance officer. We expect all funds will begin reviewing their compliance policies and procedures currently, not only in light of the adoption of these rules, but also in light of the recent revelations of unlawful practices involving fund market timing, late trading, and improper disclosures and use of nonpublic portfolio information.
\71\ Rule 38a1(a)(3).
C. Chief Compliance Officer

1. Investment Advisers

Rule 206(4)7 requires each adviser registered with the Commission to designate a chief compliance officer to administer its compliance policies and procedures.\72\ An adviser's chief compliance officer should be competent and knowledgeable regarding the Advisers Act and should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm.\73\ Thus, the compliance officer should have a position of sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures.\74\
\72\ Rule 206(4)7(c). We are also making a technical amendment to the item related to chief compliance officers on Form ADV, the registration form that advisers use to register with us under the Advisers Act. Form ADV, Part 1, Schedule A, Item 2(a) (17 CFR 279.1). The revision requires each registered adviser and each applicant for registration as an adviser to identify a single compliance officer.
\73\ Having the title of chief compliance officer does not, in and of itself, carry supervisory responsibilities. Thus, a chief compliance officer appointed in accordance with rule 206(4)7 (or rule 38a1) would not necessarily be subject to a sanction by us for failure to supervise other advisory personnel. A compliance officer who does have supervisory responsibilities can continue to rely on the defense provided for in section 203(e)(6) of the Advisers Act (15 U.S.C. 80b3(e)(6)). Section 203(e)(6) provides that a person shall not be deemed to have failed to reasonably supervise another person if: (i) The adviser had adopted procedures reasonably designed to prevent and detect violations of the federal securities laws; (ii) the adviser had a system in place for applying the procedures; and (iii) the supervising person had reasonably discharged his supervisory responsibilities in accordance with the procedures and had no reason to believe the supervised person was not complying with the procedures.
\74\ The rule does not require advisers to hire an additional executive to serve as compliance officer, but rather to designate an individual as the adviser's chief compliance officer. Several commenters who complained of the burdens this proposed requirement would impose on them appeared to have assumed that they would be required to hire an additional person to fill the position of chief compliance officer.
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2. Investment Companies

Rule 38a1 requires each fund to appoint a chief compliance officer who is responsible for administering the fund's policies and procedures approved by the board under the rule.\75\ A fund's chief compliance officer should be competent and knowledgeable regarding the Federal securities laws and should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the fund. The chief compliance officer of a fund, like the chief compliance officer of an investment adviser, should have sufficient seniority and authority to compel others to adhere to the compliance policies and procedures.

\75\ Rule 38a1(a)(4).

The rule contains several provisions, some of which were not included in our proposal, designed to promote the independence of the chief compliance officer from the management of the fund.\76\ First, the chief compliance officer will serve in her position at the pleasure of the fund's board of directors, which can remove her if it loses confidence in her effectiveness. The fund board (including a majority of independent directors) must approve the designation of the chief compliance officer, and must approve her compensation (or any changes in her compensation).\77\ The board (including a majority of the independent directors) can remove the chief compliance officer from her responsibilities at any time,\78\ and can prevent the adviser or another service provider from doing so.\79\
\76\ In the Proposing Release we requested comment on whether the chief compliance officer should be a senior manager of the fund because such a person would be in a better position to compel compliance with the fund's policies and procedures, and would less likely be intimidated in the performance of her duties. We are not adopting such a requirement because, as several commenters pointed out to us, it is very difficult to ascertain who is a ``senior manager'' in some organizations. Instead, we have described the authority we believe an individual must possess to be designated as a chief compliance officer, and have added a provision to the rule making it unlawful to exert undue influence on the chief compliance officer in the performance of her duties (see infra t

FOR FURTHER INFORMATION CONTACT Hester Peirce, Senior Counsel, Office of Regulatory Policy at (202) 9420690, or Jamey Basham, Special Counsel, Office of Investment Adviser Regulation at (202) 9420719, Division of Investment Management, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 205490506.