The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations on November 7, 2019 issued a Risk Alert¹ in which the OCIE staff (Staff) discussed “the most often cited deficiencies and weaknesses” observed by the Staff during its recent examinations of nearly 300 investment companies registered under the Investment Company Act of 1940 (funds). The Risk Alert also provides Staff observations following OCIE’s review of money market funds and target date funds. The Risk Alert covers a two-year period, and provides general compliance observations applicable to funds as well as more specific observations regarding money market fund and target date fund compliance.

Compliance Observations Applicable to Investment Companies Generally

According to the Risk Alert, the most frequently cited deficiencies involving funds related to: the fund compliance rule (Rule 38a-1 under the 1940 Act); disclosure to investors; the board approval process for advisory contracts (pursuant to Section 15(c) of the 1940 Act); and fund codes of ethics (Rule 17j‑1 under the 1940 Act).

Rule 38a-1

Rule 38a-1 requires funds to adopt written policies and procedures intended to prevent violations of the federal securities laws by the fund. These policies and procedures must address oversight of specified service providers to the fund. In addition, the fund’s board, as well as its chief compliance officer, have initial and/or annual obligations. The Risk Alert notes four main Staff observations in connection with Rule 38a-1 compliance programs:

Compliance programs that did not take into account the nature of funds’ business activities or risks

As examples of these deficiencies, the Staff cited: lack of policies to prevent violation of investment limitations and guidelines; insufficient valuation procedures; and lack of procedures governing accuracy in advertising and sales literature.

Policies and procedures that were not followed or enforced

The Staff observed instances where funds did not enforce their stated policies, citing as examples instances in which boards did not ratify valuations and funds did not follow their rule 17a-7 cross trade policies.

Inadequate oversight of service providers

As examples of deficient oversight, the Staff noted instances where fund policies did not require ongoing monitoring of providers’ pricing services, or where boards had not approved policies and procedures of fund sub-advisers.

Inadequate performance of annual reviews

As examples of deficiencies, the Staff noted instances where funds: did not conduct annual reviews; had insufficient documentation of such reviews; or did not sufficiently address the effectiveness of the compliance program implementation in their reviews.

Disclosure

Various provisions of the 1940 Act, Securities Act of 1933 and Exchange Act of 1934 provide that it is unlawful to make untrue statements or omissions of material facts in certain documents filed with the SEC or provided to investors. The Staff observed instances where disclosures to investors may have been materially misleading because the disclosure did not comport with actual practice. Examples cited included failure to disclose or inaccurate disclosure of: payments to service providers; changes in investment strategies; and principal investment strategies as implemented.

Section 15(c) Process

Section 15(c) of the 1940 Act sets forth requirements with respect to board approval of contracts with fund advisers and principal underwriters (including information the board must request and review, which the respective service providers must furnish). As examples of deficiencies in the Section 15(c) process when approving or renewing fund investment advisory contracts, the Staff noted instances where: boards did not consider relevant information (e.g., adviser profitability, economies of scale, peer group advisory fees and performance data for other accounts managed by the adviser); and shareholder report disclosures did not adequately describe the board’s approval process. The Staff emphasized the need for funds to maintain adequate documentation of the 15(c) process, including the 15(c) review materials and board meeting minutes.

Codes of Ethics

Rule 17-1 under the 1940 Act sets forth requirements with respect to fund codes of ethics, which (among other matters) must limit the ability of the fund’s “access persons” to engage in certain trading practices with respect to securities held by the fund. As examples of deficiencies and weaknesses, the Staff cited instances where: codes of ethics lacked provisions reasonably necessary to prevent violations or misuse of material non-public information by access persons; funds did not adequately review and pre-clear access persons’ securities transactions; funds did not report violations to the board; and the board did not approve the code of ethics.

Observations from Money Market Fund and Target Date Fund Initiatives

In OCIE’s Examination Priorities for 2017, the Staff noted its focus on target date funds and money market funds. The Staff has recently conducted national examination initiatives focused on such funds, and the Risk Alert discusses Staff observations from these initiatives.

Money Market Fund Initiative

The Staff examined over 70 money market funds in connection with this initiative. The Risk Alert notes the substantial changes in money market fund regulation since the financial crisis, with the most recent round of amendments to Rule 2a-7 under the 1940 Act taking effect in 2016. The Staff observed that the money market funds examined “appeared to be in substantial compliance” with the amended money market fund rules. However, the Risk Alert notes deficiencies or weaknesses related to portfolio management, compliance and disclosure. Examples cited include instances where money market funds did not: adequately document credit risk determinations (in particular, the factors required to be considered in determining whether a security presents minimal credit risk and is an “eligible security”); maintain documentation of adequate collateralization of repurchase agreements; or include the required summary of key assumptions used when reporting stress test results to the board.

The Risk Alert also provides examples of deficiencies and weaknesses in money market funds’ policies and procedures required under Rule 2a-7, including with respect to: board oversight of written guidelines for credit risk determinations; board oversight of NAV deviation reports; issuer diversification testing; required fund filing procedures (e.g., on Form N-MFP); procedures designed to limit investments in retail money market funds to natural persons; and fee and/or gate determinations with respect to liquidity and master/feeder funds. The Risk Alert also notes instances of incomplete or inaccurate disclosure on money market fund websites.

Target Date Fund Initiative

The Staff examined over 30 target date funds in connection with this initiative “to review whether the [target date funds’] assets were invested according to the asset allocations stated in the funds’ prospectuses, and whether the associated investment risks were consistent with fund disclosures.” The Staff observed that most such funds “appeared to be in general compliance with the 1940 Act in the areas reviewed.” However, the Risk Alert notes compliance and disclosure deficiencies or weaknesses, including with respect to: glide path asset allocations and their change over time; differing disclosures in marketing materials and fund prospectuses; and conflicts of interest (e.g., use of affiliated entities). The Staff also observed that “many [target date funds] had incomplete or missing policies and procedures,” including for: monitoring and managing the glide path; oversight of advertisements and sales literature; and reviewing disclosures for accuracy.

Conclusion

The Risk Alert encourages funds to review their practices and procedures in the areas noted, and to consider improvements, as appropriate. While the Risk Alert is a statement of the Staff and not the SEC or OCIE itself, it demonstrates the Staff’s views in these areas and may help funds adapt their compliance programs accordingly.

Footnotes