In a Risk Alert dated November 7, 2019, the SEC’s Office of Compliance Inspections and Examinations reminded investment company advisers and boards that examiners are looking carefully at how firms approach and document the annual Section 15(c) contract review process. The Alert also summarizes OCIE’s compliance observations on the compliance rule, fund disclosures, codes of ethics and money market funds, among other issues.

Section 15(c) Contract Review Process

Although in recent years OCIE has omitted mention of the contract review process in its list of examination priorities, it is clear that OCIE is focused on the responsibilities of board members to evaluate investment advisory contracts. The Risk Alert summarizes two regularly cited “deficiencies or weaknesses” it has observed in connection with the Section 15(c) process:

  • Reasonably necessary information not requested or considered. OCIE found that in some cases fund boards “may not have requested or considered information reasonably necessary to evaluate the fund’s investment advisory agreement.” By way of example, OCIE found that certain boards “did not appear to consider relevant information” that the U.S. Supreme Court has identified as relevant to the board’s consideration, such as the adviser’s profitability, economies of scale or peer group fee comparisons. In some cases, OCIE noted that material provided by advisers to the boards omitted comparative performance data, data concerning the adviser’s other managed accounts and profitability reports.
  • Inadequate discussion of the review process in shareholder reports. OCIE observed that some shareholder reports “did not appear to discuss adequately the material factors and conclusions that formed the basis for the board’s approval of an investment advisory contract.” SEC rules require funds to disclose this information to shareholders in meaningful terms, and the SEC has said that mere boilerplate disclosures will not suffice. As a related matter, OCIE said that it found in some instances that funds did not maintain documentation to support the board’s conclusions, such as copies of the written materials that the board considered when reviewing the contracts.

Other Compliance Issues

  • OCIE also cited deficiencies it found in the following areas:
  • Fund Compliance Rule (Rule 38a-1). OCIE said that its examinations found that in some cases:
    • Compliance programs did not take into account the nature of the funds’ business activities and risks specific to the particular funds;
    • Compliance policies and procedures were not followed or enforced, including, among other things, board-approved fair valuation policies and procedures;
    • Funds did not adopt and implement policies and procedures “reasonably designed to oversee compliance by service providers,” especially relating to pricing of portfolio securities and fund shares; and
    • Funds did not perform annual reviews of the adequacy and effectiveness of fund policies and procedures
  • Disclosures. OCIE found that some prospectus and statement of additional information disclosures were incomplete or potentially misleading when compared to funds’ actual activities. For example, OCIE found that certain funds did not disclose the payment of fees made to service providers or disclose a change of investment strategy. OCIE said it found instances when funds identified principal investment strategies even though the funds did not implement them.
  • Code of Ethics. OCIE said that its examinations found that some funds:
    • Failed to implement a code of ethics, or that the code of ethics did not designate the proper individuals as access persons;
    • Failed to follow or enforce the code of ethics, particularly with respect to pre-clearance of trades or review of holdings of access persons; and
    • Failed to comply with approval and reporting obligations required by the code of ethics, including initial approval by fund boards.
  • Money market funds. OCIE found that most money market funds it examined were in material compliance with the rules that were finalized in October 2016. Among other things, it noted some recordkeeping and reporting deficiencies, and some failure to adopt adequate compliance procedures.
  • Target date funds. OCIE noted that most target date funds appeared to comply with applicable rules but noted some deficiencies concerning prospectus disclosures as well as incomplete or missing policies and procedures for monitoring asset allocations, among other things.

Our Take

OCIE appears to be taking a “back to basics” approach here. Accordingly, many fund firms will review these deficiencies against their own practices and determine that any needed enhancements are at the margins. But the larger point is that attention to the basics will always be important and requires continuous care.