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News September 13, 2004 Issue

Compliance Programs: Fund Subadvisers Feel the Heat

Youíve given them your policies. Youíve had a conference call with the board. Youíve been grilled by their lawyers. And now, you wait.

By October 5, boards of all registered funds must approve the compliance programs of the fundís advisers and subadvisers. The standard of approval: an adviserís compliance program must be "reasonably designed to prevent violation of the Federal Securities Laws by the fund and by the adviser." Although some boards began the approval process back in July, for most boards, this is a September project.

So how are things going? Some subadvisers may feel like they are being judged on a work in progress, given that advisers are not required to have their final compliance programs in place until October 5 (and, as some lawyers have noted, that compliance program is required to address only the Advisers Act, rather than the entire federal securities laws). One lawyer reported that some of the more sought-after subadvisers, who may feel they hold the balance of power in their relationship with their funds, are acting "high and mighty" and are telling fund boards that they arenít going release their policies and procedures until October 5. "Itís a real Ďgo pound sandí attitude," said the lawyer.

On the fund side, some boards are grappling with the question of when, exactly, a service providerís compliance program is not reasonably designed to prevent federal securities laws violations. Or, put another way, how bad does an adviserís compliance program have to be to merit termination, even when the fundís performance is good and the adviser is otherwise pleasant to work with?

Overall, however, things seem to be going smoothly. DrinkerBiddle partner Diana McCarthy, who represents several funds and fund boards, reports a positive experience with subadvisers. "They are being very cooperative" in providing information on their operations and assurances when requested and assisting the board in reviewing their policies and procedures, she said. In fact, McCarthy noted that the greater challenge is for fund boards to oversee and approve the compliance procedures of the fundís transfer agent and administrator involved in back office functions such as preparing financial statements and settlement. The operations of those service providers "can be much more technical and complex" than subadvisersí operations, she said.

McCarthy noted that, to their credit, the "large and well-organized" transfer agents and administrators are "coming forward" by holding workshops and webcasts about their policies and procedures, in order to help those on the fund side understand the significant risks and controls relevant to their operations. State Street, for example, has already held several webcasts, with more scheduled for October and November

Why would a fund board be interested in a service providerís compliance program post-October 5?

Crafting a compliance program "might be more of an ongoing process," predicted McCarthy, with firms "doubling back" after October 5 to make sure that their compliance program is effective. Moreover, she noted, a good compliance program should always be viewed as a "work in progress." Aside from the changes driven by internal business developments, such as new products or clients, McCarthy pointed out that "the regulatory landscape keeps changing, so the SEC expects that advisers and funds will periodically review and refresh their compliance policies and procedures."

Helping things along: a July 23 Investment Company Institute memo to ICI members recounting some informal SEC staff guidance. Basically, the staff said that a fund CCO can reasonably rely on a summary of a fund service providerís policies and procedures, provided the service provider presents limited risk exposure to the fund. For example: if a subadviser manages a limited amount of the fundís assets, a summary could be used. Similar, where the fund has had a long-standing relationship with a subadviser, knows the subadviserís experience, and consequentially the CCO has confidence that the subadviserís policies and procedures are reasonably designed to prevent violations of the federal securities laws, it would be reasonable to rely on a summary.

According to the ICI, the SEC staff emphasized that the CCO must have a reasonable belief that the information relied upon is sufficient to enable the fundís board to determine that the service providerís policies and procedures are reasonably designed to prevent violation of the federal securities laws.