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U.S. Securities and Exchange Commission

Speech by SEC Staff:
A Renewed Commitment to Compliance


Paul F. Roye
Division of Investment Management

Remarks Before the
Glasser LegalWorks Seventh Annual Investment Advisers Compliance Conference
New York, NY
May 1, 2003

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

I. Introduction

Good afternoon, and thank you for inviting me to speak to you today. I believe that this conference's focus on advisers' compliance issues is important-and timely. As you are aware, we recently have witnessed a growing sense of skepticism among America's investors. The events of the past 18 months have tested their confidence in the markets and in the professionals through whom they invest and rely on.

Earlier this week, Chairman Donaldson announced the settlement of enforcement actions imposing record-setting penalties against ten securities firms regarding the activities and conduct of certain of their research analysts. According to Chairman Donaldson, these cases "are an important milestone in our ongoing effort both to address serious abuses that have taken place in our markets and to restore investor confidence and public trust by making sure these abuses don't happen again." He further explained that, "the hallmark of our business and financial system is the rule of law and the rule of law must prevail. And when wrongdoing occurs, it must be confronted and punished .... These cases reflect a very sad chapter in the history of American business, a chapter in which those who reaped enormous benefits based on the trust of investors profoundly betrayed that trust." Consequently, even though investment advisers were not the subject of this settlement, in light of the general sense of investor skepticism, it is imperative that, at this time, more than at any other time in our recent past, investment advisers renew their commitment to compliance and reinvigorate their efforts to establish meaningful and effective compliance controls to avoid the problems we have experienced in other segments of the securities industry.

Today I would like to discuss some of the Commission's recent actions and initiatives implicating investment adviser compliance issues. Before I begin, however, I would like to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual commissioners or my colleagues on the Commission staff.

II. Compliance Rule and Concept Release

The recent Commission action that most directly impacts adviser compliance issues is the Commission's February 5th rule proposal regarding investment advisory compliance programs. I believe that Gene Gohlke of the Commission's Office of Compliance Inspections and Examinations discussed the Commission's proposed rules with you this morning. The proposal would require investment advisers to adopt, implement and annually review compliance policies and procedures reasonably designed to prevent violations of the Investment Advisers Act. The proposal also would require investment advisers to designate a chief compliance officer.

In many cases, the proposals would formalize the prudent compliance practices followed by investment advisers that already have a dedicated compliance officer and meaningful compliance procedures. This proposal is necessary, however, because not all investment advisers adhere to these well-recognized and responsible practices. Therefore, we want to raise the compliance standards of all advisers to those that already have implemented comprehensive compliance policies and designated a compliance officer. In addition, as I imagine Gene Gohlke and John Walsh discussed this morning, the maintenance of compliance procedures is vital to the new investment advisory compliance program being instituted by the Office of Compliance Inspections and Examinations. Along these lines, it is intended that the rules would provide advisers the flexibility to tailor their compliance policies and procedures to fit the scope and nature of their individual operations.

You may ask, why this proposal now? Quite simply because we want to take steps to prevent the types of scandals that have plagued other segments of the securities industry from tainting the investment management industry. Today, advisers control over $21 trillion in assets. Industry growth has substantially exceeded the growth in Commission resources. Unlike the brokerage industry, the Commission has sole oversight responsibility for the approximately 7,800 investment advisers that are registered with us.

Our oversight is predicated on the assumption that advisers have procedures to comply with the law. But in fact, with the exception of a few discrete areas, there is no requirement that advisers have a comprehensive set of compliance controls, although most do. Many of our enforcement cases in the investment management area, however, are often the result of weak or nonexistent compliance controls. If adopted, these rules should help protect investors by improving day-to-day compliance with the federal securities laws, while at the same time, increasing the efficiency and effectiveness of our examination program. Again, these rule proposals do not ask anything that any well-managed adviser should not be doing today.

The rule proposal exemplifies Chairman Donaldson's approach to proactive regulation of the securities industries. He has stated that he hopes the agency can "play offense more often, be more proactive, and anticipate the problems we may face."

Unfortunately, the compliance policies and procedures proposal has been largely overshadowed by the request for comment on the advisability of additional private sector involvement in promoting adviser compliance with the federal securities laws. I believe that the events of recent months highlight the need for the Commission to regularly reassess whether it is achieving its mandate as best it can in light of the growth and change in the financial services industry.

Requesting comment on these questions, however, does not necessarily indicate that implementing additional forms of oversight is the approach the Commission ultimately will take. Rather, we feel it is important to advance a public dialogue on these issues, so that the Commission can consider whether the regulatory oversight scheme can be improved in the best interests of investors.

One of the questions that the Commission asks in the concept release is whether investment advisers should be required to obtain a fidelity bond from a reputable insurance company. Investment advisers are among the only financial service providers holding client assets that are not required to obtain fidelity bonds. Moreover, the Investment Advisers Act does not require advisory firms to have a minimum amount of capital, and indeed many advisers have few assets. It is not uncommon that when we discover a serious fraud by an adviser, that the assets of the adviser are insufficient to compensate clients. A fidelity bond requirement would provide a source of compensation for advisory clients who are victims of fraud or embezzlement by an adviser or its personnel. Such a requirement would result in additional oversight of advisers by insurance companies, who would be unwilling to issue bonds to advisers with poor compliance controls or advisers that hire employees with criminal or poor disciplinary records. We want to consider the costs and benefits of such a requirement.

We look forward to considering your reasoned views on this idea and the other ideas set forth in the concept release, as well as any other ideas you may have that will improve adviser compliance and enhance the regulatory framework.

III. Proxy Voting

A new compliance requirement that advisers must prepare for is the new proxy voting rule. As I mentioned earlier, investment advisers generally have discretionary investment authority with respect to approximately $21 trillion of assets, including large holdings in equity securities. In most cases, advisers are given authority to vote proxies relating to equity securities on behalf of their clients. The enormity of this voting power gives advisers significant ability collectively, and in many cases individually, to affect the outcome of shareholder votes and to substantially influence the governance of corporations. Accordingly, advisers are in a position to have a significant effect on the future of corporations and the value of securities held by advisory clients. The importance of proxy voting by advisers - both to their clients and to the system of corporate governance, particularly in light of the spate of recent corporate scandals, as well as the many conflicts faced by some advisers, suggested a need for the Commission to address proxy voting by advisers.

The new rule, which went into effect on March 10th, requires an investment adviser with voting authority over client proxies to adopt policies and procedures on voting those proxies. The policies and procedures must be reasonably designed to ensure the adviser votes client proxies in the best interest of clients, and they must discuss how the adviser addresses material conflicts of interest that may arise between the adviser and its clients.

The new rule requires investment advisers to describe their proxy voting policies and procedures to clients and furnish a copy of them to clients upon request. The rule also requires advisers to disclose to clients how they may obtain information on how the adviser has voted their proxies. Unlike the proxy voting rule that the Commission adopted for mutual funds, the advisers' rule does not require advisers to publicly disclose their voting records. In the mutual fund context, the Commission concluded that public disclosure of a fund's proxy voting record was necessary as a means of communicating to fund shareholders how the fund voted its proxies. However, the Commission concluded that it was not necessary to require public disclosure of adviser voting records, since advisers could communicate to each client how the adviser has voted a client's proxies.

This new requirement will force consideration or reconsideration by advisers of a range of issues when reviewing their proxy voting policies and procedures. These issues include whether the firm accepts authority to vote client proxies, whether the firm's controls in this area are adequate, how does the firm evaluate proxy proposals, how will the firm identify material conflicts of interest, how will the firm handle material conflicts of interest in voting proxies and how will the firm meet the associated recordkeeping requirements?

These new requirements will undoubtedly focus investment advisers on fulfilling their fiduciary obligations with regard to voting client proxies, the ultimate objective of the Commission in moving forward on this rule.

IV. Custody Rule

Another important rule proposal that the Commission has outstanding is the proposed modernization of the adviser custody rule. Last summer, the Commission proposed amendments to the adviser custody rule, which has not been substantively updated since it was adopted in 1962. With the proposed amendments, the Commission hoped to enhance the protections afforded to advisory clients' assets, harmonize the rule with current custodial practices and clarify when advisers have custody.

The proposed amendments would require advisers with custody to maintain client funds and client securities in accounts with "qualified custodians," which includes banks, savings associations, brokers, futures commission merchants and certain foreign financial institutions. Currently, the custody rule requires an adviser with custody to segregate and safekeep client securities and to deposit client funds in bank accounts. The proposed change is designed to prevent advisers from, for example, keeping clients' stock certificates in their office files.

Under the proposed amendments, qualified custodians generally would deliver monthly account statements directly to the adviser's clients to permit clients to determine whether there has been any improper trading in the account. This new requirement would replace the current requirement that the adviser itself send quarterly account statements to its clients and have an independent public accountant conduct annual surprise examinations. This new requirement would address concerns raised by several enforcement cases in which advisers have fabricated account statements and is designed to better deter fraud.

In circumstances where the adviser does not provide client information to qualified custodians so that the custodian is not delivering advisory account statements, an adviser with custody would continue to be required to deliver quarterly account statements and undergo annual surprise examinations. In this case, the independent accountant would be required to report to the Commission any irregularities in the advisory accounts.

Another issue addressed by the rule proposal is that the current rule does not define "custody." The proposed amendments would define "custody" as holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. As proposed, the custody rule would not apply to clients that are registered investment companies (which are subject to their own custody requirements under the Investment Company Act) or limited partnerships, such as many hedge funds, that undergo an annual audit and distribute the results to limited partners.

The Commission received roughly 50 comment letters on the custody rule proposals. Most commenters strongly endorsed the approach of the proposed rule. Commenters also noted that the proposed rule would provide greater clarity regarding the application and the scope of the rule. The devil is always in the details, however, and the staff is working through some technical issues with the proposed rule that commenters identified. In the final analysis, I believe that the technical issues can be worked out and that we can recommend that the Commission adopt a revised adviser custody rule that provides greater protection to investors while removing unnecessary compliance burdens for advisers.

V. Part 2 of Form ADV

When discussing adviser compliance initiatives, I should also mention the Commission's proposal to amend Part 2 of Form ADV. Amending Part 2 will complete the first major overhaul of the 18-year-old form, which greatly impacts the day-to-day operations of all investment advisers and also impacts advisers' relations with their clients and potential clients.

The Commission has proposed substantial amendments to Part 2 of Form ADV. The Commission adopted amendments to Part 1 of the form in September 2000 and at the same time instituted the IARD electronic registration system. The Commission delayed adoption of the amendments to Part 2 because commenters expressed more significant concerns with Part 2 than with Part 1 and because the Commission and the staff wanted to focus on the transition of Part 1 to electronic filing through IARD and the implementation of the IAPD public disclosure website in the fall of 2001. Unfortunately, events forced the Commission to focus on other priorities in 2002, but I can tell you that the Division staff is actively working on a recommendation to the Commission regarding adoption of Part 2. We also are coordinating with the states on final Part 2 amendments.

As proposed, Part 2 would call for a plain English, narrative brochure. We believe that the proposed narrative approach would be much more useful, readable and helpful to advisory clients. Commenters agreed with us. The areas of the proposal that drew the most concern involved updating firm brochures and proposed "brochure supplements," which would contain background information about individuals who work for an adviser.

The overhaul of Part 2 is a large-scale project that will have a universal impact on the advisory industry. Few, if any, regulatory matters under the Advisers Act affect so many people so substantially. Therefore, we want to make sure we get it right. We are working to recommend a final version of Part 2 that remains true to the principle that advisory clients should receive meaningful and readable information about their investment advisers.

VI. Adviser Advertising Rule

As most of you are probably aware, the Commission is undertaking a multi-year effort to dust the cobwebs off our Advisers Act rules and bring the advisers regulatory scheme, and adviser compliance practices, into the 21st century. In light of the Commission's efforts, various industry groups have made requests that we update particular rules. For instance, the ICAA has requested that the Commission revise the investment adviser advertising rule. I agree that the advertising rule is in need of revision. The ICAA advocates modernizing the rule and eliminating its specific prohibitions in favor of a general anti-fraud standard. I believe that there are improvements that can be made when it comes to adviser advertising, and I look forward to the staff focusing on this important area.

VII. Principal Transactions Rule

Other rulemaking requests we have received include one from the Securities Industry Association. The SIA has requested that the Commission promulgate an exemptive rule to allow investment advisers to engage in principal transactions with clients without first obtaining client consent for each principal trade. The SIA recommends that advisers be able to obtain prior blanket written consent from their clients. We have been considering new principal transactions relief in circumstances where there is little or no likelihood of abuse involving securities that have broad and liquid markets where there would be minimal risk of dumping or unfair pricing. We are considering appropriate parameters as we work on a proposed rule to recommend to the Commission.

VIII. Exemption for Thrifts

We also have received requests from the thrift industry that the Commission exempt thrifts from applicability of the Advisers Act. The thrifts have argued that this exemption would put thrifts on a level playing field with banks, which are excluded from the definition of investment adviser except to the extent that they advise registered investment companies. However, the ICAA and The Financial Planning Association on behalf of the advisory industry have argued that a thrift exemption would actually un-level the playing field between thrifts and other advisers. In addition, legislation endorsed by the Office of Thrift Supervision has been introduced that, if enacted, would treat thrifts the same as banks under the Advisers Act. We have been considering whether there is regulatory action that could be taken in this area to provide thrifts relief from the application of the Advisers Act, without compromising investor protection.

IX. Broker-Dealer Exemption

In addition to these projects, the Commission has outstanding a proposal to exempt from the definition of investment adviser certain broker-dealers that charge an asset-based fee, if those brokers make appropriate disclosures and do not have discretion over client funds. The proposal was precipitated by the development of new brokerage compensation systems and the development of on-line trading at reduced brokerage rates. The proposal contained a no-action position for brokers with asset-based compensation programs. The proposal generated over 250 comment letters. Brokers strongly supported the proposal, and advisers and financial planners strongly opposed it.

The rule proposal and its comment letters have highlighted certain broader, more fundamental issues regarding broker-dealers and adviser regulation. For instance, the Advisers Act excepts broker-dealers from the definition of investment adviser to the extent that the advice they provide is solely incidental to the conduct of their business as a broker or dealer. But what does it mean for advice to be "solely incidental"? Some contend that the Commission needs to provide further guidance in this area.

Additionally, the exception creates some anomalous situations. For instance, it seems odd that a broker-dealer with full discretion over client assets might not be an investment adviser. Under the Commission's broker-dealer rule proposal, a broker with discretion that charges an asset based fee would be an investment adviser, while a broker with discretion that charges only commissions might not be an investment adviser. From the client's perspective, however, those two brokers are performing exactly the same services. While there may have been clear lines between investment advisers and broker-dealers in 1940, the financial services industry has evolved to the point where the differences are not quite so clear. I believe that we need to consider how we can eliminate these anomalies.

X. Examination Program

As I am sure you are aware, the Commission has a very active examination program, and our examination staff is in the process of revising this program to examine more frequently those firms that present the potential for greater harm to the investing public. We expect that an adviser with a comprehensive set of compliance policies and procedures in place will present a lower risk of harm to clients. Thus, our compliance staff is hoping that their new examination approach will encourage advisers to establish a tailored, appropriate and meaningful compliance framework.

Along these lines, I recommend you review a speech delivered earlier this week by Lori Richards, the Director of the SEC's Office of Compliance Inspections and Examinations. The speech is available on the SEC's website at www.sec.gov. Also of interest in the speech is a review of the most common problems that the staff sees in its examinations of advisers. Top among these is a failure to disclose material information to clients. In fact, the staff finds disclosure deficiencies in approximately 70 percent of their exams. This rate of deficiency is far too frequent, and I suggest that all advisers should commit to reviewing their Form ADVs to determine that the appropriate information is provided to clients and that there are no discrepancies between the adviser's written disclosures and the actual practices.

Other compliance issues frequently cited by our examination staff include brokerage problems, including with respect to soft dollars and best execution, failure to have effective internal controls and failure to maintain adequate books and records. On this last point, the staff of the Division of Investment Management has undertaken a project to recommend to the Commission revisions to the adviser books and records rule, which hopefully will provide advisers with updated standards with respect to the materials they must maintain.

XI. Enforcement Actions

Unfortunately, the conduct of some investment advisers merits enforcement actions by the Commission. The Commission recently has brought enforcement actions against investment advisers where the Commission has alleged the misappropriation of client assets, misrepresentation of performance records, investing in violation of investment restrictions, unfair securities and foreign currency trade allocations, prohibited principal transactions, failure to obtain best execution and the failure to establish procedures to present the misuse of non-public information. Earlier this week, the Commission fined a broker-dealer firm affiliated with several investment advisory firms and two of its traders $2.7 million in settling charges alleging that the broker-dealer "marked the close" of a publicly traded security (also know as portfolio pumping) to advantage its adviser affiliates. Unfortunately, this is one of several portfolio pumping cases the Commission has brought recently.

X. Conclusion

In conclusion, as you can see from my outline of rule modifications and my discussion of the evolving examination program, adviser regulation is in a state of flux. However, even during this period of change, one thing remains constant. And that is the importance of compliance and putting your clients' interests before your own. Advisers must establish effective and meaningful internal controls. And the supervisors who oversee these controls must be dedicated and vigilant. Lax internal controls signify an advisory firm that is not truly dedicated to its clients. Advisers that "put their clients first" will institute strong internal compliance systems to ensure that client interests, and client assets, are not put at risk. Year in and year out, compliance is a top regulatory priority for the Commission staff. We, and clients, expect that compliance is a top priority for advisers as well.

Once again, I thank you for including me in your conference. It is always a pleasure to meet with you and focus on the importance of adviser compliance. I hope that you continue to have an informative and productive conference and thank you for your attention.


Modified: 05/05/2003