Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News March 14, 2005 Issue

Getting Ready For The Annual Review

If you havenít already, itís probably time to start thinking ahead to your firmís first annual review. Hereís a guide to get you started:

What does the annual review requirement entail?

Under the Advisers Act compliance program rule, every SEC-registered adviser must:

  • review the adequacy of its compliance policies and procedures (i.e., do they cover everything?); and
  • review the effectiveness of the implementation of those policies and procedures (i.e., are they working?).

Thereís no requirement that the firm or CCO create a written report to memorialize that the annual review has taken place. As a practical matter, however, SEC examiners will expect to see some sort of written evidence of the firmís annual review process. And keep in mind that any records that are created voluntarily must be kept as part of the firmís required books and records.

How does the investment company annual review process differ from what advisers are required to do?

There are four significant differences between the adviser annual review and the fund annual review:

First, under the fund rule, an annual written report is required.

Second, the fund review and report must cover not only the adequacy and effectiveness of the fundís policies, but also those of the fundís adviser(s), principal underwriter, administrator, and transfer agent. In contrast, thereís no requirement in the advisers rule that advisers review the policies and procedures of their service providers (although some firms may undertake to do so voluntarily).

Third, the fund rule requires that the report address several specific issues:

  • The operation of the policies and procedures of the fund and its service providers;
  • Any material changes made to those policies and procedures since the last report;
  • Any material changes to the policies and procedures recommended as a result of the annual review;
  • Each "material compliance matter" that occurred since the last report, involving, among other things, a violation by the fund or service provider of the federal securities laws or applicable compliance policy or procedure, or a weakness in the design or implementation of the fundís or service providerís policies and procedures. In contrast, the Advisers Act rule does not specify the items to be addressed in the adviserís review (although the SECís release provides some suggestions).

Fourth, the fund CCO is required to meet with the fundís independent directors at least once a year in executive session. The advisers rule does not require the CCO to hold any special annual review meeting.

When is the annual review due?

Technically, the annual review must be completed 18 months after the adviser or fund first adopted its compliance program. So, for example, a firm that adopted its compliance program on October 5, 2004 would have until April 5, 2006. For simplicityís sake, however, some firms may prefer to complete their review on a calendar year basis, wrapping up their first review on December 31, 2005.

Fund CCOs must submit their first annual report to the fundís board within 60 days of completing the annual review.

Whatís the unofficial slogan of the annual review process?

"Kill two birds with one stone."

Industry experts agree: if you wait until the end of the year to do your review, youíll be slammed. The best advice: make all your little daily, weekly, monthly, and quarterly reviews "count" towards your annual review, with a final "wrap-up" push towards the end.

CCOs should identify "reviews that you are conducting all time, without really realizing it," said ICAA attorney Caroline Schaefer at the recent ICAA/IA Week conference. Pickard and Djinis partner Mari-Anne Pisarri agreed. "Review your compliance program at the same time you are doing something else," she said. For example, a firmís proxy voting policies and procedures can be reviewed at the end of proxy season (or, for funds, when Form N-PX is filed). Personal trading policies and procedures can be reviewed when reviewing access personsí quarterly transaction reports or annual holdings report. "Weave your annual review functions in with whatever else you are doing," Pisarri explained.

Thereís another reason why firms should perform an ongoing review of their compliance program: some things canít wait a year. If a problem happens and is "swept under the rug" because people decide not to worry about it until the annual review, "thatís not an effective compliance program," according to OCIE associate director Gene Gohlke, also speaking at the conference.

The SEC, in its adopting release, urged firms to conduct interim reviews in response to significant compliance events. "Event-driven" reviews, said Pisarri, could be triggered by:

  • new types of clients
  • new business arrangements (acquisitions, divestitures, new business partners)
  • expanding into a new geographical area
  • new SEC rules
  • compliance problems identified in the firm or elsewhere in the industry (Pisarri advised CCOs to review their own shop for problems receiving broader regulatory or press attention).

How much documentation is required?

Legally speaking, none. Practically speaking, some.

As previously noted, the advisers compliance program rule does not require CCOs to prepare a written report memorializing their annual review. However, firms must keep any documents that are voluntarily created in the course of their annual review.

As a practical matter, however, advisers should be prepared for SEC examiners to ask for documents evidencing the firmís annual review. A OCIE request list used earlier this year asked (somewhat prematurely) for:

  • Copies of all annual reports during the inspection period (or, if there are no annual reports, copies of documents created and used in the annual review process).
  • Any standard operating procedure that governed the process by which the annual, or more frequent, reviews are conducted, and related reports prepared.

According to Gohlke, advisers should develop their annual review documentation with an eye towards helping SEC examiners understand:

  • what was done as part of the firmís annual review;
  • what the findings were; and
  • if those findings reflect the need for improvement in policies and procedures, what improvements were made and how effective they were.

The documentation, said Gohlke, would "supplement our discussions with the firmís CCO, and perhaps other people in the firm as well, regarding what went on during this annual review."

Examples of what might be provided to SEC examiners: checklists, list of attendees at compliance training seminars and copies of materials distributed, list of employees interviewed, list of files reviewed, and list of exception reports run.

Should you additionally write a management report? If problems are identified and remedied, "I donít think the documentation can harm you," said independent consultant Peter Mafteiu. When you find the problem yourself, take the steps to correct it, and modify your procedures, under the protection afforded under Advisers Act Section 203(e)(6), "you wonít be faulted by the SEC for a failure to supervise," he said.

Pisarri added a word of caution. "Letís be real," she said. "There is a way to leave a record and a way not to leave a record." Her advice: "look at every piece of paper and imagine it with an exhibit sticker on it. Is this something that you really want to have left the way that it is currently written?" She noted that you can get the same thing accomplished by writing it different ways. "If you have problems or if you have questions," she advised, "go to counsel and say ĎIs this the best way to leave this record?í"

Pisarri added that she would hate to see the annual review process "devolve into a situation of busywork," where examiners come in and they say, "Well, you donít have this checklist and you donít have this report." If nothing changed in the firm over the year and there were no problems, an adviser shouldnít be cited for not having "enough pieces of paper" in the annual review file, she said.

Next week: More on the annual review.