Rule 206(4)-7 requires each SEC-registered adviser to review its policies and procedures annually to “determine their adequacy and the effectiveness of their implementation”.    This rule, adopted in December 2003, requires SEC registered investment advisers to establish and maintain comprehensive compliance programs.  Under the new rule, investment advisers are required to:

• Adopt written policies and procedures to ensure compliance with applicable regulations

• Conduct an annual review of those policies and procedures to determine their adequacy and effectiveness

• Designate a Chief Compliance Officer

The effective date was October 5, 2004 and contained a provision that required SEC registered firms to conduct the first annual testing of their policies and procedures within 18 months of adoption, and then annually thereafter.    

As stated above, the purpose of the testing provision is to ensure that the adviser's policies and procedures are adequate, effective, current, and relevant given the size and scope of their business and the demands placed upon the firm by applicable regulatory authorities.  The primary purpose of the rule is to encourage advisers to assess their business models with respect to areas where potential conflicts of interest may exist, determine the likely risk that these issues may represent to clients, and install procedures to monitor, mitigate, and/or eliminate such risks.  At the cornerstone of this assessment process is a requirement that all potential conflicts of interest and associated risks are adequately and transparently disclosed to clients.

Advisers are required to keep copies of their written supervisory procedures and any amendments thereto for 5 years as part of their normal books and records requirements under Rule 204-2.  In addition, advisers are also required to retain any records relating to the annual testing provisions, related findings, and remedial actions taken as a result of that process for the same period of time.

Failure to comply with the provisions of this rule constitute a violation of the anti fraud provisions of Section 206(4) of the Adviser's Act.  In addition, this rule potentially applies to state registered advisers as well since many states currently follow the provisions of the Adviser's Act with respect to the regulation of state registered advisers.  Where applicable, state registered advisers are encouraged to conduct the testing process as a best practice.

For more information on this topic please visit the SEC website at www.sec.gov/rules/final/ia-2204.htm.  For state registered firms, you are encouraged to contact your regulator directly with any questions pertaining to the applicability of this requirement. 

Contact information for state regulators is available at www.nasaa.org.  Please feel free to contact us with any questions or concerns regarding this topic.