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Investment Management Alert

March 2006

Compliance Reminder: Conducting Your First Internal Compliance Manual Review

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he investment management industry has recently become the subject of increased regulation by the Securities and Exchange Commission (the “SEC”). Regulations adopted on February 5, 2004 required that federally registered investment advisers designate a chief compliance

• fficer and adopt a manual of comprehensive

compliance policies and procedures by October 5,

• 2004. The regulations also required that

investment advisers review the effectiveness of their compliance policies and procedures within 18 months of the date of their adoption of a compliance manual and annually thereafter. Many investment advisors adopted a manual of compliance policies and procedures on October 5, 2004, and are now required to conduct their 18 month internal review.

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lthough it may appear that the compliance review is a mere formality, the potential benefits of such internal reviews are compelling. Annual internal audits, coupled with remedial action when necessary, can be very useful in dealing with the SEC, which will soon be conducting a review of its own. An SEC registered investment adviser is generally subject to an on-site examination by the SEC Office of Compliance Inspections and Examinations once every few years. The examinations are designed primarily to determine whether investment advisers are complying with the Investment Advisers Act of 1940 and its rules and regulations (the “Advisers Act”). When an examination begins, it is likely that the SEC staff will initially request a copy of the adviser’s Form ADV and its compliance manual and use these two documents as a road map to be followed during the

• examination. Your internal audits will be the first

step towards ensuring your compliance with the roadmap you will have provided the SEC, and will allow you to be prepared for the SEC staff when they arrive. Below is a brief outline of some important areas that the SEC staff has highlighted as areas of concern; particular attention should be paid to these issues when conducting your internal compliance review.

Internal Controls and Supervisory Procedures.

The SEC staff have stated that their primary focus will be on an adviser’s controls and procedures and that “where those controls are found to be weak and ineffective, or non-existent, an adviser will be considered high-risk, and will have more frequent and in-depth exams.” During your internal examination you should seek to

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. 65 Livingston Avenue www.lowenstein.com Roseland, New Jersey 07068-1791 Telephone 973.597.2500 Fax 973.597.2400

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ensure that (i) each employee has a current copy of your compliance manual and is familiar with the procedures therein, (ii) the procedures in your compliance manual accurately reflect the practices that are followed by each employee, and (iii) each employee has a supervisor providing clear

• versight of such employee’s work. Discuss with

employees their current practices, whether such practices are consistent with the compliance manual or whether there are additional measures that should be taken. If there are frequent

• ccurrences of non-compliance with a particular

procedure, it is a strong indication that the procedure needs revision and/or the employee requires additional training or supervision. In addition, you may want to request that certain supervisors demonstrate that they are appropriately supervising their employees’ work. For example, if your compliance manual requires that the portfolio managers supervise the firm’s traders and their brokerage choices for the purposes of best execution, you should inquire as to how they are doing so. Do they review every trade? Do they hold quarterly best execution meetings? Ensure that they can demonstrate that the procedures they are following are consistent with those set forth in the compliance manual.

Accurate Disclosure.

Pursuant to the Advisers Act, an adviser has an affirmative duty to disclose all material facts to its clients in a written disclosure document, usually Form ADV, Parts 1 and 2. During your inspection, you should distribute copies of your Form ADV to all relevant personal for their review, to ensure that your disclosure therein is still accurate and does not omit any material information.

Books and Records.

The Advisers Act requires advisers to make and keep true, accurate, and current certain books and records relating to their investment advisory

• business. An adviser who reluctantly or slowly

produces requested materials during an SEC examination will likely be deemed high-risk, and face the prospect of more frequent and in-depth

• exams. An adviser that produces incomplete

records will likely be penalized. While conducting your audit, it is a good idea to review your books and records policy and test your employees’ ability to produce various documents in a 24 hour period. In addition, you should review all material produced to ensure that all files are complete.

Best Execution and Soft Dollars.

Advisers have a duty, in executing client securities transactions, to seek to obtain the best net price reasonably available under the

• circumstances. The SEC expects firms to pay

special attention to best execution when they are utilizing soft dollar arrangements and are expected to demonstrate to examiners why they are receiving quality trade execution, given the other products and services they are also getting. During your examination it is important to review your best execution policy and ensure that you are following the procedures set forth therein. If you are required to have best execution meetings or reviews, ensure that such meetings or reviews have been held, documented and that such documentation can be easily produced. In addition, you may want to perform certain surprise best execution checks, by choosing a few random trades and request that traders explain their brokerage choices.

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Personal Securities Transactions.

The staff reviews personal trading practices of investment advisers closely during compliance examinations because of the potential for abuse. It is important to maintain adequate records of personal securities transactions as required pursuant to your compliance manual. During your examination it is important to ensure that the required information is being collected from all relevant personnel and that the Chief Compliance Officer or other designated person reviews such documentation consistently and can demonstrate that he has done so. In addition, you should review any employee trading requests and ensure that any required restricted securities list is appropriately maintained and distributed.

Compliance with Advisory Agreements.

A review of investment advisory agreements is a standard component of compliance examinations because these agreements play an important role in defining the adviser’s relationships with its clients. During an examination, the staff will look to see whether the adviser is complying with its own representations and with the expectations of its clients as set forth in the advisory contract. However, very often an adviser and its client will maintain a course of conduct that is mutually satisfactory, but may be contrary to the procedures contained in the advisory agreement governing the relationship. During your examination it is important to review your advisory agreements and ensure that any representations therein are accurate and that all of your obligations are being fulfilled.

Referral Arrangements.

The Advisers Act establishes requirements that must be met if an investment adviser pays a cash fee for client referrals or solicitations. The adviser also must maintain certain records related to its referral arrangements, such as the written agreements between the adviser and the referring party and the referring party’s written disclosure

• documents. During your examination it is

important to ensure that all solicitors used by your firm meet the requirements of the Advisers Act and that all required documentation has been

• btained.

Recidivism.

The examination staff closely reviews the actions that advisers have taken to remedy the deficiencies cited during past examinations. During your examination it is important that you review any past deficiencies cited by the SEC staff following an examination and ensure that any such deficiencies have been corrected.

Demonstrating A Culture of Compliance.

The SEC staff have stated that they are now “refining and formalizing their approach to identify, and examine more frequently, those firms that present the potential for greater harm to the investing public. An adviser with a strong compliance program, generally, will present a lessened risk to clients; while an adviser with few

• r ineffective compliance controls presents a much

higher risk.” While conducting your audit, it is important to document all the areas reviewed and any remedial action taken. It is also important that your employees can demonstrate that they are following firm procedure. For example, if your policies require that the Chief Compliance Officer review all records of employee personal trading quarterly, you may request that the Chief

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Compliance Officer demonstrate that he or she has done so by initialing and dating each page

• reviewed. Voluntary disclosure to SEC staff of the

results of your internal investigation and clear evidence that employees are following firm procedure will make them aware that you are diligent in seeking to prevent and detect inappropriate conduct by your employees and agents and can substantially reduce the potential for a negative or intrusive response from SEC examiners during an investigation. * * * * * We hope this alert was helpful and will assist you in conducting your business. If you have any questions or would like assistance with your internal review or any other matter, please feel free to contact any member of our Investment Management Group.

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The Investment Management Group Lowenstein Sandler PC Co-Chairs: Allen B. Levithan Robert G. Minion Partners: John L. Berger Andrew E. Graw Michael N. Gooen Steven J. Tsimbinos Peter D. Greene Marie T. DeFalco Counsel: Paul W. Hartzel Douglas N. Bernstein Brian A. Silikovitz Elaine M. Hughes Sharon M. Mousserie Associates: Steven P. Kirberger Scott H. Moss Javier Cuebas Erik W. Johnson Mario V. Hernandez Richard Bernstein