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Speech by SEC Staff:
The Need for More Proactive Risk Assessment


Lori A. Richards

Director, Office of Compliance Inspections and Examinations, Securities and Exchange Commission

Remarks at NRS Annual Spring Compliance Conference

April 14, 2004

As a matter of policy, the SEC disclaims responsibility for any private statement by an employee. The speaker's views are her own, and do not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

Thank you. I'm pleased to be here with you today at this conference dedicated to discussion of current compliance topics in the financial services industry, including with respect to broker-dealers, investment advisers and mutual funds. At the outset, let me say that the views I will express today are my own, and do not necessarily represent the views of the Commission or other staff.

The focus of this conference is certainly timely - as it is clear to me, and I hope to all of you, that financial services firms must step back and think about the events of the last couple of years, and really take stock. Indeed the very title of this conference - "Risk Management for the Real World" reflects that risk management and compliance are not in the realm of the esoteric, not simply topics for conference panel debate and discussion, but are "real world' imperatives. We all know why this is so, and the reality is not pretty -- analysts' conflicts of interest, mutual fund trading abuses, failure to deliver breakpoint discounts, trading abuses by specialists -- clearly, there have been simply too many examples of compliance breakdowns and failures. I believe that these breakdowns, as well as other problems we have seen in our examinations, indicate a need for more vigorous compliance programs by financial services firms. More broadly, however, I believe that recent events should signal a need for deeper and more meaningful change than just adopting a new policy or procedure dealing with whatever particular misconduct may be on our radar screens. I believe that recent experiences indicate a need for firms to consider how they can be more proactive in ensuring that problems never occur in the first place. The concept of prevention is not new and is in fact a key aspect of the federal securities laws - as the Exchange Act, the Investment Adviser's Act and the Investment Company Act all have provisions that reflect the need for registered firms to have policies and procedures reasonably designed to prevent violations of the federal securities laws.1 And prevention is what I want to speak with you about today - what you, and your firms, can and should be doing to ensure that you've reduced or eliminated the risk of the next compliance headline-grabbing failure. I'll also spend some time sharing with you some of the issues that we are focusing on in SEC examinations at the moment.

I. The Need to Take Proactive Steps to Identify Risk

Let me begin by telling you about our philosophy -- we have dedicated ourselves to being more proactive, to identifying high risk conduct and taking steps to mitigate or eliminate it, before it can blow up and investors are harmed. This is a fundamental goal of our Chairman, and as an examiner, I've simply seen too much investor harm and abuse, and have heard from too many investors who were misled or taken advantage of not think about how this misconduct might be prevented. I know that industry compliance staff would also agree that the best outcome would be for compliance and other problems to be prevented, rather than to deal with them after the fact. Think about the damage done in the last few years, which has had a real impact on investors, not just in terms of the dollars lost due to particular fraudulent or abusive behavior, but also in terms of trust, your customers' trust. I have often said that what's good for investors is good business for those who serve investors. The inverse is equally true -- loss of investor trust has real economic consequences for firms and for our markets overall. Think too about the clean-up costs. Think about all the time and resources that firms, maybe your firm, puts into responding to customer complaints, to arbitrations, to investigating possible misconduct, to hiring outside lawyers to defend the firm. In my view, too much time and resources are spent after the metaphorical barn door has been left open. Consider now the alternative - to proactively identify areas where your firm may be at risk and to implement controls to reduce or eliminate that risk. Again, I know that industry compliance staff is in accord with this notion, and I also know that this kind of proactive change can't be driven by compliance staff alone.

At this conference just a year ago I spoke about the need to instill a "Culture of Compliance" within firms- what I meant by that was establishing, from the top of the organization down, an overall environment that fosters ethical behavior and decision-making.2 This notion certainly goes beyond having good policies and procedures, beyond having a dedicated compliance staff, and beyond having sufficient compliance resources and electronic exception reports, although the absence of those things can certainly indicate a poor culture of compliance. Our Chairman has talked about the need to instill an ethical culture as part of the "essential DNA" of the corporate body itself. He said that companies must "look beyond just conforming to the letter of the new laws and regulations. They must redefine corporate governance with practices that go beyond mere adherence to new rules and demonstrate ethics, integrity, honesty, and transparency."3 Simply put, this means instilling in every employee an obligation to do what's right - even if there is no clear legal restriction or regulatory guidance. As we all know, this is a fast-paced and dynamic industry. Indeed, one of the hallmarks of the industry is rapid change - new products, new systems, and competition among market participants. In this environment, practices will often outpace any government regulator's ability to craft guidance or specific rules governing the practice. This is where having a culture of doing what's right, even in the absence of particular rules, and importantly, even when your competitors may have made different decisions, is so important. While lawyers may opine on the technical legality of a practice, its up to leaders of the firm to question conduct that nonetheless may not be ethical or which may not be in the best interests of clients or customers.

I also said, a year ago, that this culture will underpin all that the firm does, and must be part of the essential ethos of the firm, so that when employees make decisions, large and small, and regardless of who's in the room when they make them, and whether or not regulators are looking, they are guided by a culture that reinforces doing what's right. To be really effective, this culture can't exist just at the senior management level, can't exist just in the compliance and legal department, can't just be some mantra that's included in corporate policy statements, but must be inculcated in, as Chairman Donaldson has said, the firm's "essential DNA."

Then, last September, my colleague Steve Cutler, the Director of the SEC's Enforcement program, spoke about the "conflicts crisis" on Wall Street.4 He said that one of the lessons of the research analyst matter -- and I will add to that, a lesson too from the current mutual fund scandal -- is that it illustrates that just because a certain way of doing things seems to be industry practice, it doesn't mean that this is the correct way to do things, and, when investors (your customers) come to realize certain industry practices, they care a great deal about how and whether the firm has told them about it. Mr. Cutler then challenged firms to undertake a top-to-bottom review of their business operations with the goal of addressing conflicts of interest of every kind. He urged that firms conduct this review systematically and to search for business practices that have the potential to sacrifice the interests of one set of customers over the interests of another, and situations in which the firm could place it or its employees' interests ahead of customers. He challenged firms to eliminate or disclose these conflicts. We believe that this is an area that firms should be keenly interested in, as they are in the best position to identify and eliminate or mitigate conflicts of interest in their operations. And, this is an area that we as regulators are interested in as well.

Earlier this year, we asked large financial services firms to describe any review for conflicts of interest that they have performed or are performing, and the results. What conflicts were identified? What steps did the firm take to eliminate or mitigate the conflict? I am pleased that so many firms are working proactively to conduct this kind of analysis, and invite all firms to talk to us about the work they are doing. I believe that this is a positive step, and indicates to me that firms have recognized that they must be proactive in identifying conflicts of interest that might incentivize illegal or unethical conduct, and take steps to eliminate or mitigate those conflicts. I believe that firms that are undertaking this effort are doing so with the right spirit - "let's figure out where our vulnerabilities are, and engage in dialogue with our regulators about how to fix those areas."

Beyond conducting a review to identify conflicts and potential conflicts of interest, there are other steps that firms can take now that may help to proactively reduce the possibility of problems. I suggest that firms undergo a careful and thorough self-assessment of existing compliance practices. It seems to me that another lesson of recent scandals is that whatever compliance practices that were in effect in the past, simply did not work. Disturbingly, in recent instances, we have learned that compliance staff were ignored, that compliance controls were overridden or were otherwise ineffective.

With this in mind, I believe that this moment in time presents firms with an opportunity to review and retool existing compliance practices. For funds and advisers, the SEC's new Compliance Rule will become effective on October 5, requiring that all funds and advisers have written compliance policies and procedures covering their operations and those of their service providers, and to designate a Chief Compliance Officer. We will expect, and fund boards of directors will expect a compliance program reasonably designed to prevent, detect and correct violations of the law. Given that the rule goes into effect in October, now is a perfect time to conduct a review of all of your existing compliance controls, looking for holes and weaknesses and ways that they can be strengthened.

For broker-dealers, the NASD has proposed a rule that would require firms to designate a Chief Compliance Officer, and for the CEO and the Chief Compliance Officer to annually certify the sufficiency of the firm's compliance program. And, if you need any more incentive, SEC, NASD and NYSE examiners are reviewing the compliance programs of many firms. More broadly, under our risk-based examination program, we focus our examination efforts on those firms, and those areas within firms, that are most at risk of compliance problems, and where we believe the investing public is at risk. Again, this is a perfect time to conduct a thorough review of your existing program and to make changes. I urge you, whether your firm is an adviser, a fund company or a broker-dealer, to conduct a fresh review of your compliance program, and to do so with the admonition in mind that I noted a moment ago -- that many compliance controls in place in the past simply did not work.

II. Select Areas of Examination Interest

Let me now turn to our examination program, and some of the areas that we are focusing on at the moment. These areas are not all-inclusive and are not static, indeed, in our own risk management analyses, we are designing new approaches to better identify existing and emerging risk areas. One tool that we are increasingly using to quickly identify the nature and scope of a particular problem, is to conduct "mini-sweep" examinations. These examinations, often of a select number of firms ranging from half a dozen to many more, are focused narrowly on a particular compliance risk or industry practice, and allow us to get a sense very quickly of the nature and scope of a problem. Then, along with our colleagues in other divisions at the Commission, we can start to identify possible solutions sooner, whether by rulemaking, guidance, enforcement actions, investor alerts or some other action. We have many, many of these "mini-sweep" examination initiatives underway, and will continue to initiate these rapid-fire examinations whenever we identify emerging or resurgent compliance risks.

I will summarize some of the areas of focus for us now, first in our examinations of advisers and funds, and then in our examinations of broker-dealers. As I said, these are selected focus areas, and are not all-inclusive.

Examinations of Mutual Funds and Advisers

1) Fund Shareholder Trading: A continuing focus area for SEC examiners is to identify abusive market timing, late trading, selective disclosure of portfolio holdings, and abusive personal trading by access persons. We have found firms willing to value their own profits over the interests of their clients, even to the extent of letting their own employees market time their own funds. To detect instances of abusive trading, examiners will obtain and analyze shareholder transaction data, as well as review emails and personal trading records of fund and adviser employees.

2) Fair Value and NAV Calculation: As we have seen, failure by funds to value portfolio holdings at prices that reflect the value that could be obtained upon a current sale can harm investors - not only by selling and redeeming shares at incorrect prices but also through market timing. Examiners will focus on each fund's valuation, fair valuation, and NAV calculation practices, especially with difficult to price securities. Staff also will review procedures for calculating NAV, correcting net asset value errors, and using pricing services and price overrides. They will be looking, in part, for stale or inaccurate prices, or failure to correct errors or restrict or monitor overrides.

3) Use of Brokerage: The use -- or misuse -- of brokerage is another focus area. Our concern is that an adviser might select a broker -- not because the service and price are best for clients -- but because the adviser gets something extra in return that falls outside any safe harbor. Examiners will be looking for undisclosed use of brokerage in connection with soft dollars, non-research or mixed-use products, distribution, client referrals or other uses.

4) Fees: The unique structure of mutual funds poses potential conflicts of interest between an adviser and its funds. These conflicts make it important for examiners to pay special attention to board approval of advisory fees, 12b-1 fees, fees paid to service providers, and all other fees paid by funds. Excessive fees, fees for which no service is provided, and any undisclosed fees could lead to enforcement referrals.

5) Advisers' Custody: When the adviser has custody and access to client assets, risk of misappropriation, unauthorized trading or other abuse exists. Examination staff will review compliance with the amended custody rule, effective just two weeks ago on April 1 - particularly to ensure that client assets are held by a third party custodian that sends account statements directly to advisory clients. Given the risks, advisers that do not have periodic statements sent to their clients by an independent custodian can expect examiners to be quite exacting in reviewing the handling of their customers' accounts, including in select instances by seeking confirmations of account activity directly from the clients. Custody continues to be an area of concern and an area in which we continue to find violations.

6) Side-By-Side Management of Hedge Funds: Conflicts of interest also arise in the side-by-side management of hedge funds. In particular, we are concerned that a portfolio manager will give preferential treatment to its hedge fund, which pays performance fees, rather than its mutual fund. Examiners will focus on such relationships and will review how the conflicts are being monitored and controlled.

7) Affiliated Transactions: As the financial services industry consolidates, there is a growing opportunity for firms to enter into transactions with affiliates that -- while benefiting the firm -- are not in the best interests of clients and shareholders. Examiners will focus on affiliated transactions, looking for favoritism, abusive and undisclosed transactions, and payments involving the use of clients' assets.

8) Advisers' Disclosure of Conflicts: Advisers have a special fiduciary duty to their clients, which requires full disclosure of any potential conflicts of interest. Examiners will focus on each adviser's ADV Part II to make sure an adviser is disclosing fully all conflicts inherent in the advisory relationship, the adviser's business, and its fees.

9) Allocations: Conflicts also arise when an adviser allocates trades among clients, presenting the potential for an adviser to favor certain clients or even its own accounts over other clients. Examiners focus on the adviser's policies and procedures and allocations, and the adviser's disclosures to clients about allocations.

10) Advisers' Performance Calculations: Performance advertising continues to be a risk area. By inflating performance, an adviser seriously misleads the investing public. Examiners will focus on performance advertising of advisers, and review performance calculations, back-up documentation, and advertisements.

Examinations of Broker-Dealers

In broker-dealer examinations, some of the compliance issues we're focusing on currently are:

1) Sales Practices: A continuing focus for SEC examiners is on retail sales practices - suitability, disclosure of risks, costs and fees, unauthorized trading, churning and switching. We're placing particular emphasis on sales practices for products that are popular with retail investors -- mutual funds and variable annuities.

Given the complexity of variable annuities and in light of the many customer complaints we have received, we think that many firms should devote more compliance and supervisory attention to ensure that a thorough suitability analysis is performed. With respect to mutual funds, we're looking at many compliance pitfalls, in addition to market timing and late trading. In general, we are concerned that salespeople may not always be recommending funds most suitable for customers and may instead be influenced by a variety of conflicts of interest that place their own remuneration above the interests of their customers. We see too many examples of the following types of conduct:

  • Selling class B shares where class A shares would have been more beneficial for the customer, or selling a customer multiple funds in different fund families just short of the breakpoint amount; and

  • Selling proprietary funds that have higher 12b-1 payments to the salesperson, instead of a fund that offers the customer a low fee or a "no fee transfer" opportunity, and with no disclosure of the relative benefits of each option to the customer.

    These practices are incentivized by compensation grids that provide salespeople with more money to sell particular products. Given this incentive, it would seem to be timely, as firms are identifying conflicts of interest, for firms to take a fresh look at their compensation systems.

Relatedly, we have just concluded an examination sweep of broker-dealers looking at revenue-sharing arrangements and whether they provided preferred "shelf-space" in exchange for payments from funds or from their advisers. We also looked at whether the firms were paying their salespeople more to sell these funds. Our concern is that fund shareholders and broker-dealer customers may not fully understand the broker-dealer's conflicts of interest in recommending one fund over another. As you may know, this is an area in which the Commission and the NASD have brought enforcement actions and are also seeking rules that would provide greater disclosure of this practice to customers. As well, the Commission has proposed to ban the use of fund brokerage commissions to pay for distribution.

2) Supervision: Most of the deficiencies and violations we see could be prevented with better, more vigilant supervision at the branch level. However, at times it seems as if the compliance staff are the only reviewers of trading! When compliance staff then have to rely on outmoded, manual reviews of trading activity, and lack quality exception reports, detecting patterns of "red-flag" trades by a salesperson or within a branch is quite difficult, if not impossible. The deference to "large producers" also seems to continue to a problem.

3) Compliance Reviews: A year ago we initiated a series of special examinations to review firms' overall compliance programs, working jointly with the NASD and NYSE. We're examining enterprise-wide compliance programs of the largest firms this year, looking at various compliance procedures and their implementation.

4) Internal Controls: We're continuing to conduct specialized reviews of large firms' risk management and internal controls -- evaluating the processes and procedures that firms use to measure and manage risk relating to trading, credit, liquidity, and new products. What we're looking for in these exams is essentially a system of controls -- written guidelines, a clear delineation of responsibility, and independent and periodic oversight that the guidelines are being followed.

5) Procedures to Prevent Misappropriation: Another continuing focus area now for examiners, both SEC and SRO examiners, is evaluating supervisory procedures to ensure that firm personnel can't misappropriate customer assets. Even after all the 'stealing the money' cases we've seen, many firms still have weak controls related to: the handling of checks and cash; customer changes of address, particularly to P.O. Boxes; customer authorizations for withdrawing or transferring funds; independent follow up with customers in response to unusual account activity; and supervisory controls over producing branch managers.

6) Best Execution: We're continuing to focus on order routing and execution practices of both broker-dealers and investment advisers. For broker-dealers and advisers, there are significant conflicts of interest in the routing and execution of customer orders, including soft dollars, payment for order flow and internalization. We continue to review routing and execution practices at the market's opening.

7) Structured Finance Products: We are concluding a series of focused examinations of firms' internal controls for the sale of certain structured finance products, in light of Commission enforcement actions alleging that firms aided and abetted securities violations by issuers. We know that many firms are enhancing controls in this area, and we hope to strengthen controls by providing firms with guidance, jointly with the Fed and the OCC.

8) Net Capital and Customer Reserve: We continue to see both intentional and unintentional net capital and customer reserve violations. In the last 2 years, SEC examiners found that many firms were violating these rules, and we referred many of those, which we thought were likely intentional violations, to SEC or SRO Enforcement.

9 ) Books and Records: We're examining firms for compliance with the SEC's year-old books and records rules, which require that information about customers be available at branch offices for inspection. With additional resources in the exam program this year, we expect to increase the number of retail branch offices that we visit, and both the NASD and NYSE will also increase the number of branch offices they visit.

10) Mark-ups: We're looking at markups on corporate and municipal bonds. Greater transparency of pricing data in TRACE will certainly yield positive benefits, including allowing investors to check on prices directly.

11) Information Security: Finally, we're expanding our reviews of firms' compliance with Regulation S-P, particularly with respect to controls over customer records and information. One area we're concerned about is the adequacy of controls to prevent the misuse of non-public information. You may know that we have heard complaints from buy-side traders that information about their trades is inappropriately leaked by sell-side traders to hedge funds and other large customers, which then front-run the buy-side firm's trade. Would you know if a trader was purposefully leaking information about trades to favored customers?

Some other areas of interest for us are: sales of 529 College Savings Plans, anti-money laundering, prime brokerage activities, and products sold in exchange for soft dollars.


As you can see, we both -- firms and regulators -- have a full plate. In light of recent compliance failures, I urge firms to step back and take stock, and to take proactive steps to change, in a significant and meaningful way, the culture of compliance within the firm.

Preventing problems of the type I have outlined today should certainly be a goal, but more importantly, your firm's goal should be to identify the next compliance or reputational risk, and to get out in front of it, and prevent it from becoming a problem. As compliance and legal staff, I urge you to be activists in helping foster this change, and to take steps now to ensure that the firm's compliance program is as vigorous as it can be.

Thank you.




Modified: 04/21/2004