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News March 14, 2005 Issue

Fund CCOs Begin to Address Annual Reviews at Board Meetings

The annual review process was a key agenda item for many fund boards during their first round of 2005 meetings. According to several fund lawyers, CCOs and boards generally focused on process: how the annual review would be conducted, what reports the board wanted to see, and how the board and CCO would communicate throughout the year.

Dechert partner John OíHanlon said that in the meetings he attended, the CCO typically reported orally on any material violations that needed to be brought to the boardís attention. "But short of that," said OíHanlon, CCOs spent most of the time "explaining to the board how they are going to go about the annual review process."

Many funds, he said, are coming up with an "annual review calendar," which divides up the universe of the CCOsí review responsibility "in a way that makes sense throughout the year." The calendar, he said, lays out for the board how the CCO is going to accomplish the annual review on a schedule "that will allow the CCO to drill down to the appropriate level of detail." For example, the calendar might specify which service providers are being reviewed each quarter.

Drinker, Biddle partner Diana McCarthy said that her board meetings also focused on process issues, such as how the CCO intended to review the fundís various service providers during the course of the year. There was "some give and take" in terms of what kinds of reports the board members wanted to receive, she said. In several cases, the fund CCO still was in the process of hiring staff.

And some fund CCOs still were finalizing the fundís compliance program. Those CCOs presented the board with a list of policies and procedures that had been formally documented during the quarter and where they stood on various outstanding items, she said.

McCarthy said she noticed a change in some CCOsí approach to the meetings. The CCOs, she said, seemed to be more proactive, seemingly "realizing in these meetings that they really did report directly to the board." For example, she said, a few fund CCOs had, on their own initiative, looked into how the fund was participating in class action settlements. The CCOs, she said, "stepped outside" the typical types of board reports and made presentations "that were not expected."

In general, fund lawyers said CCOs did not deliver written reports at the recent meetings. "I donít think the practice is to have the CCO provide a formal written report at the quarterly meetings, but rather to have an oral exchange with the directors about what he or she is doing day-to-day," said OíHanlon. He noted that as the CCO reviews various service providers throughout the course of the year, he "presumably" will prepare a written report on the service provider at the time of the review. However, instead of handing over that written report at the next board meeting, the CCO may decide to provide an oral briefing "at a very high level" to the board, and incorporate each of the service provider reports into the final annual review report. "The CCO does not want to have that kind of formal interaction with the board more than once a year," said OíHanlon, adding that the CCO would nonetheless have "a lot" of informal interaction throughout the year.

David Mahaffey of Sullivan and Worcester agreed that formal written reports typically are not being prepared on an interim basis. He said that many CCOs are, in effect, providing two types of briefing reports: "Here are the things, if any, that happened last quarter and hereís what Iím doing about it," and "Hereís how I plan to conduct the annual review."

In one meeting, he said, the CCO provided a two-page written report to the board covering his activity for the quarter ended December 31, 2004. The report described:

  • sub-certifications prepared for the various service providers;
  • quarterly personal trading reports;
  • compliance with the fundís fundamental policies;
  • the CCOís onsite visits to service providers; and
  • the next four things the CCO planned to do before the next board meeting.

Mahaffey noted that most fund CCOs are taking the view that they have to conduct on-site reviews of their service providers. "Even if you got all the certifications in the world, you have to go there to get a sense of the tone of the top," said Mahaffey. "Do people seem to know what they are doing?" He also noted that fund CCOs can request SAS 70 reports from service providers that are registered broker-dealers, to provide a baseline of information about the firmís controls. However, rather than presenting the board with conclusions about a service providerís compliance procedures on a quarterly basis, he said, CCOs are providing a description of the process they are following to evaluate the service provider, along the lines of: "I went to see the transfer agent, I met with this person. etc." and "Yes, Iím doing my job." Itís not a report in the sense of saying: "I found a material weakness in this, that, and the other thing," he said.

Of course, there are exceptions. One lawyer told the tale of an invigorated fund CCO who has adopted the practice of reporting "every single thing to the board" in "two or three" written memos per board meeting. The lawyer worried that this "premature reporting" could create a paper trail "that ultimately could be harmful to the fund."

In such a situation, no one should be perceived as "putting a damper" on a CCO who is inclined to provide written reports, advised Kirkpatrick & Lockhart partner Robert Zutz, particularly since the fund compliance rule contains a prohibition against unduly influencing a fund CCO. "Thatís what they are hired to do," he said. "They would rather err on the side of too much rather than too little."

He noted that issue of an over-zealous fund CCO could be addressed from the perspective of process, rather than liability: the board simply might not find the CCOís reports useful, particularly if they discuss non-material matters. In such a situation, he said, counsel could work collectively with the board and the CCO to identify what types of information the board finds useful. The board, he said, might tell the CCO "we want you to bring some judgment as to how you report to us."

Zutz emphasized the importance of tailoring the annual review process and reporting product to the fund. "I think everyone is feeling their way," said Zutz. "I think it really varies." He said that the CCO reporting and annual review process should suit the circumstances. For example, he noted that some fund groups donít have outside sub-advisers, whereas other fund groups have "literally dozens" that might have to be reviewed.

And, in contrast to other fund lawyers, Zutz thought that preparing interim written reports "as you go along" might make sense. Waiting until the annual report to report on a service provider review, he said, might result in statements along the lines of "Back in January, a year ago, hereís what I found." The details "may be a little bit stale" by the time the annual report is prepared. "Iím not sure that thatís the most effective way to be doing things," said Zutz.