A recent case brought by the SEC highlights the regulatory vulnerabilities of contracting with outside third parties for CCO and fund administrative services. The SEC found that two affiliated firms providing compliance and fund administrative services to funds of two series trusts violated certain rules under the Investment Company Act as did the Trustees to the Trusts. The funds failed to provide proper disclosures, reporting, recordkeeping and compliance activities as required under the Investment Company Act and as delegated to fund service providers under contractual arrangements with the funds. Further, the trustees of the funds failed to follow the requirements of Section 15(c) and Section 34(b) of the Investment Company Act which imposes a duty on the directors of a registered investment company to evaluate fund service providers and disclose to shareholders the factors considered in its evaluation.
According to the SEC, the outsourced CCO firm providing services to the trusts violated Rule 38a-1 of the Investment Company Act by failing to provide proper information to the Trustees regarding service provider compliance programs. Directors are allowed to satisfy their obligations under the Rule by reviewing summaries of compliance programs prepared by the CCO, which should “familiarize the directors with the salient features of the programs (including programs of the service providers) and provide them with a good understanding of how the compliance programs address particularly significant compliance risks.” (Investment_Company_Act_Release_26299) Instead, the outsourced CCO firm prepared short, written statements at the conclusion of its compliance review and provided no back-up with the statements when presenting the statements to the Trustees for review and approval of the service providers’ compliance programs.
This case should serve as a warning to funds and their boards that a compliance review process that is “rubber stamped” without adequate review according to Rule 38a-1 may cause a fund, through its third party providers, to be subject to an SEC action. A fund CCO has a responsibility to assist fund directors in the evaluation of fund service providers. The quality of the information provided to fund directors makes all the difference in the Board’s ability to make sound decisions regarding the fund and its shareholders.