On November 7, 2019, the staff of the SEC’s Office of Compliance Inspections and Examinations (staff) issued a risk alert (Risk Alert) on the most frequently cited deficiencies and weaknesses that the staff has observed in recent examinations of registered investment companies. The Risk Alert also provides staff observations from national examination initiatives relating to money market funds and target date funds.
Compliance Observations from Examinations of Investment Companies
The most frequently cited compliance issues noted by the staff were derived from almost 300 fund examinations over a two-year period. These issues relate to the fund compliance rule, disclosure to investors, the board approval process for advisory contracts, and the fund code of ethics rule. Certain key issues highlighted in the Risk Alert are summarized below.
Fund Compliance Rule
The fund compliance rule requires, among other things, that a fund adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws by the fund, including policies and procedures that provide for the oversight of compliance for each investment adviser, principal underwriter, administrator and transfer agent of the fund (collectively, fund service providers).1
The staff noted the following issues in connection with the fund compliance rule:
- Compliance programs not tailored to fund business activities. The staff found compliance programs that failed to address business activities or risks specific to the fund. For example, the staff discovered funds with policies and procedures that were inadequate in preventing the funds from violating their own investment limitations and guidelines. The staff also encountered funds that lacked procedures to (1) properly review the appropriateness and accuracy of methods used to price securities and (2) ensure the accuracy of disclosures made in advertisements and other sales literature.
- Failure to follow or enforce policies and procedures. The staff observed funds that did not follow or enforce their compliance policies and procedures. For example, the Risk Alert references instances in which funds did not follow their own policies and procedures with respect to (1) board approval or ratification of fair valuation determinations and (2) obtaining multiple broker quotes in connection with cross trades.
- Inadequate fund service provider oversight. The staff identified funds that failed to adopt and implement policies and procedures addressing adequate oversight of fund service providers, specifically with respect to (1) ongoing monitoring and diligence of services relating to the pricing of portfolio securities and (2) board approval of the policies and procedures of fund sub-advisers.
- Annual reviews not performed or failure to address adequacy of fund policies and procedures. The staff found that certain funds did not conduct annual reviews of their policies and procedures, or lacked supporting documentation confirming that such annual reviews were performed. The staff also observed that certain funds conducted annual reviews that did not address the adequacy of fund policies and procedures and their effectiveness.
Disclosure to Investors
Under the federal securities laws, it is 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 SEC or otherwise provided to investors.2 The staff noted that some funds had provided incomplete or potentially materially misleading information in their prospectuses and shareholder reports when compared to the actual particulars of the funds, including with respect to fees paid to fund service providers and disclosures regarding changes to fund investment strategies. The staff also cited to fund disclosures that identified investment strategies as principal, although the funds had not implemented (or did not expect to implement) these strategies.
Section 15(c) Process
Section 15(c) of the 1940 Act generally requires, among other things, that a majority of the fund’s independent directors approve the fund initially entering into, or renewing, an agreement with a person who serves as an investment adviser of or a principal underwriter for such fund.
The staff uncovered fund boards that did not request or consider the information needed to properly evaluate the fund’s investment advisory agreement (e.g., profitability of the fund to the adviser, economies of scale, or peer group comparisons for the advisory fee). The staff also found instances in which fund boards failed to request the necessary information, including fund performance data and profitability reports, to approve the agreement (particularly when the initial information provided to the board for such purpose was incomplete).
Furthermore, in the Risk Alert, the staff references fund shareholder reports that did not adequately discuss the material factors and conclusions that formed the basis for board approval of the investment advisory contract.3 In addition, the staff referenced instances in which (1) the board advisory contract review process may not have complied with Section 15(c); (2) funds did not keep copies of written materials considered by the board in approving advisory contracts;4 or (3) funds lacked supporting documentation, such as board minutes, making it unclear what information fund boards requested and considered.
Fund Code of Ethics
The fund code of ethics rule requires, among other things, that funds, in addition to other entities, adopt a written code of ethics containing provisions sufficient to prevent their “access persons” from engaging in any fraudulent, deceptive, or manipulative acts in connection with the purchase and sale of securities held or to be acquired by the fund.5
The staff identified funds that failed to, among other things, (1) implement procedures necessary to prevent violations of their codes of ethics, including to prevent access persons from misusing material non-public information (such as designating a separate person to review the CCO’s personal securities holdings and transactions reports); (2) use reasonable diligence to prevent violations of their codes of ethics – e.g., failing to collect or review personal securities holdings and transactions reports of its access persons or to enforce pre-clearance and holdings period restrictions; or (3) comply with the approval and reporting obligations in their codes of ethics – e.g., lack of initial board approval of the code of ethics, failure to provide the fund board the required annual report regarding code of ethics violations and sanctions, or provided reports that were inaccurate.
Observations from National Examination Initiatives Related to Money Market Funds and Target Date Funds
As part of the staff’s assessment of market-wide risks and matters of importance to retail investors and investors saving for retirement, the staff recently conducted national examination initiatives focusing on money market funds (MMFs) and target date funds (TDFs).
The staff examined more than 70 MMFs for compliance with the amendments to the rules governing MMFs that became effective in October 2016. The staff generally observed that the MMFs appeared to be in substantial compliance with the amended MMF rules but noted certain instances of deficiencies or weaknesses related to MMF portfolio management practices, compliance programs, and disclosures.
With respect to “eligible securities” and minimal credit risk determinations, the staff detected, for example, that some MMFs did not include in their credit files one or more of the factors required to be considered when determining whether a security presents minimal credit risks and is an eligible security, as defined under Rule 2a-7, while other MMFs did not adequately document the periodic updating of their credit files to support the eligible security determination. Some MMFs also provided stress test results to their boards that did not include the required summary of significant assumptions used in the stress tests. In addition, some MMFs failed to adopt and implement compliance policies and procedures adequate to address certain requirements under Rule 2a-7 and other areas. In this regard, some funds lacked policies and procedures that addressed, among other things, (1) periodic board oversight of the adviser’s delegated responsibility for written guidelines and procedures related to credit risk analysis and determinations; (2) periodic board oversight of net asset valuation deviation methods and the amount of the deviation; (3) limiting investors in retail MMFs to natural persons; (4) testing for issuer diversification; (5) incorporating all required elements for considering, imposing and lifting liquidity fees and/or gates; or (6) filing accurate and timely information with the SEC. Lastly, the staff identified deficiencies regarding compliance with disclosure requirements for websites and advertising materials, such as inaccuracies and omissions and lack of required legends in advertising materials.
The staff examined over 30 TDFs to review whether fund assets were invested according to the asset allocations stated in fund prospectuses, and whether the associated investment risks were consistent with fund prospectuses and other disclosures (including representations made in marketing materials). The staff indicated that most TDFs appeared to be in general compliance with the 1940 Act in the areas reviewed; the staff, however, noted instances of deficiencies or weaknesses related to TDF disclosures and compliance programs. For example, some TDFs had incomplete and potentially misleading disclosures in their prospectuses and advertisements, including disclosures regarding the following: asset allocations (both current and forward-looking); glide path changes and the impact of such changes on asset allocations; and conflicts of interest, such as those related to the use of affiliated funds and affiliated investment advisers.
Furthermore, many TDFs had incomplete or missing policies and procedures, including those related to monitoring asset allocations; overseeing implementation of changes to current glide path asset allocations; overseeing advertisements and sales literature (resulting in inconsistent advertising and prospectus disclosures); and monitoring whether disclosures regarding glide path deviations were accurate.
As the staff suggests in the Risk Alert, S&K encourages firms to review their own practices, policies, and procedures and to consider appropriate improvements in their compliance programs, including testing for effective implementation of policies and procedures. It is clear, based on the Risk Alert, that the staff has set particular standards in what the staff expects and will be looking for adherence to these standards in examinations.
1 Rule 38a-1(a)(1) of the Investment Company Act of 1940 (1940 Act). These policies and procedures are required to be tailored to the activities and compliance risks specific to the fund’s business. The fund compliance rule also requires approval of the fund service providers’ policies and procedures and an annual review of the operation of the fund’s compliance program (and those of the fund service providers). Rule 38a-1(a)(2) and (a)(3).
2 1940 Act Section 34(b), the Securities Act of 1933 Section 17(a), and the Securities Exchange Act of 1934 Section 10(b).
3 Item 27(d)(6) of SEC Form N-1A.
4 1940 Act Rule 31a-2(a)(6).
5 1940 Act Rule 17j-1(d).