U.S. Securities & Exchange Commission
SEC Seal
Home | Previous Page
U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before The National Regulatory Services Investment Adviser and Broker-Dealer Compliance/Risk Management Conference


Stephen M. Cutler

Director, Division of Enforcement
U.S. Securities & Exchange Commission

Charleston, South Carolina
September 9, 2003

The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the staff of the Commission.

Thank you for that kind introduction. It's a pleasure to be here for this important conference. At the outset, let me remind you that the views I express today are my own and do not necessarily represent the views of the Commission or its staff.

I'm sure I'm not telling you anything you don't already know when I say that lately it is the financial services industry's turn in the hot seat. Due to the spate of accounting and financial fraud over the last few years, much of the attention of regulators, the media, lawmakers, and the public has been focused on failures by public companies, their leaders, and their auditors. For a time, it seemed the press couldn't report on the accounting industry without using the word "beleaguered." Lately, we've even grown accustomed to the term "imperial CEO." But now, I think it's time to add a new phrase to our lexicon: the conflicts crisis on Wall Street.

The most recent evidence of conflicts run amok is Attorney General Spitzer's action against Canary Capital Partners relating to its transactions in mutual funds. Mr. Spitzer described two trading practices in his complaint -- market timing and late trading. The allegations suggest that by allowing one or both of these practices, some number of mutual funds and other industry participants willingly sacrificed the interests - and earnings - of their long-term retail customers to obtain business and fees from their larger customers.

Mr. Spitzer has taken an important step in bringing his action, and I commend him for it. The Commission also is looking into these trading practices and taking steps to determine how widespread they are. Chairman Donaldson has contacted the Investment Company Institute, the Securities Industry Association, and the NASD requesting that each urge its members to review their policies and procedures on late-trading and market timing to ensure the policies are adequate. In addition, the Commission staff has sent detailed information requests to registered prime brokerage firms, other large broker-dealers, transfer agents, and the 80 largest mutual fund complexes in the country seeking information on their policies and practices relating to market timing and late trading. The Commission will pursue this inquiry vigorously and aggressively, and take appropriate enforcement actions against any wrongdoers. In the meantime, the Commission's broader look at mutual fund sales practices continues.

Of course, before there was an investigation of the mutual fund industry, there was a focus on the practices of research analysts. The research analyst investigations and the global settlement announced last April brought public scrutiny to the conflicts of interest that arise at financial services firms when they provide both investment banking and research services. While the emails and other revelations in those investigations prompted a firestorm of private litigation, arbitration, regulation, and legislation, many industry professionals have marveled at the public's reaction. From their perspective, it long had been evident that research analysts' recommendations often are driven by the preferences of their firms' investment banking clients.1

The disconnect between the views of Wall Street insiders and public investors is instructive and holds important lessons. First, it illustrates vividly that just because a certain way of doing things is second nature to you, and appears to be standard operating procedure on the Street, doesn't mean it's the correct way of doing things. Second, it suggests that when your customers finally do come to understand certain industry practices, they will care a great deal about undisclosed conflicts of interest. And as you have witnessed, when conflicts are exposed, the costs to the industry are enormous - in dollars, in reputation, and in investor confidence and trust.

Conflicts of interest are inherent in the financial services business. When you are paid to act as an intermediary, like a broker, or as another's fiduciary, like an investment adviser, the groundwork for conflict between investment professional and customer is laid. The historical success of the financial services industry has been in properly managing these conflicts, either by eliminating them when possible, or disclosing them. In the long run, treating customers fairly has proven to be good business.

But in case your thinking is not sufficiently long-term oriented, there's another reason why you should be thinking hard about conflicts of interest these days: the SEC and the entire regulatory community are doing so. So this is my challenge to you and your firms: find the problems and correct them now. I call upon every financial services firm to undertake a top-to-bottom review of its business operations with the goal of addressing conflicts of interest of every kind. No one is in a better position than you to identify the conflicts that arise from a financial services firm's efforts to pursue business profitability. I encourage you to approach the task systematically. You should search for those business practices that have the potential to sacrifice the interests of one set of customers in favor of the interests of another. You also should identify any situations in which the firm could place its or its employees' interests ahead of the firm's customers. Both types of conflicts need to be eliminated or disclosed.

To provide you a context in which to consider the challenge I've just put to you, I'd like to use the remainder of my time to do two things. First, I'd like to look back at some of the Commission's more significant recent cases in which conflicts of interest have figured prominently. Then, I'd like to discuss some of the conflicts that the Commission staff now has on its radar for further analysis or examination. Let me be clear, however: this discussion will be neither exhaustive nor exclusive. My challenge to you is to address not merely the conflicts I mention here, but the many others that no doubt reside within your firms. With that, let's take a brief look at where we've been to date.

Recent Conflicts Cases

In a precursor to the global analyst research settlement, we started the year off by bringing a case against Paul Johnson, a former senior research analyst at Robertson Stephens, Inc.2The Commission alleged in its complaint against Johnson that he issued research reports and made positive public statements regarding mergers proposed by two public companies without disclosing that he had conflicts of interest. Specifically, the Commission alleged that Johnson failed to reveal that he owned stock in the private companies that would be exchanged for public company shares if the mergers were completed, creating multimillion-dollar windfalls for him.

The Commission also alleged that with respect to another public company, Johnson issued recommendations that were inconsistent with his privately-held views. While he had an outstanding "Buy" recommendation on the stock, he advised a committee responsible for making investment decisions for a group of partnerships in which Johnson and other senior Robertson Stephens executives were investors, that he would not buy the stock until it fell to approximately half its current price. Moreover, Johnson sold his stock in the company shortly thereafter, and then reiterated his public "Buy" recommendation without disclosing his sales or advice to the firm investment committee. The Commission is seeking a permanent anti-fraud injunction, disgorgement, and civil penalties against Johnson.

The Commission also instituted settled administrative proceedings against Robertson Stephens, finding that Robbie Stephens published materially misleading research reports, and failed reasonably to supervise Johnson with a view toward preventing the violations arising from his undisclosed conflicts of interest.3 The Commission censured Robertson Stephens and ordered the firm to pay $5 million in disgorgement, prejudgment interest, and a penalty.

Of course, the Paul Johnson case was followed three months later by the landmark global settlement. I don't need to go into much detail with this audience: Our investigations, conducted jointly with the SROs and the states, revealed that research analysts frequently were subject to pressure to issue positive research about the firms' investment banking clients, and that this pressure was applied through firms' compensation and evaluation structures, among other means. The Commission also alleged that several firms received payments from, or made payments to, other firms for the creation of research without ensuring that the payments were disclosed. Each of the ten firms charged failed adequately to manage these conflicts and to maintain appropriate supervision over their research and investment banking operations.

As you know, the settlements of these actions, which are awaiting court approval, extracted significant monetary relief from the firms, including penalties that rank among the highest ever paid in civil securities enforcement actions. But more importantly for these purposes, they also included significant structural reforms designed to insulate research analysts from pressures by investment banking, and required firms to make better disclosure to investors concerning the limitations of research. In particular, each of the firms will include a disclosure on the first page of each research report stating: "this firm does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report."

Of course, analysts are not the only securities professionals prone to experience conflicts. The Commission recently brought a case against Prudential Securities in connection with a conflict that arises in the sale of different classes of mutual funds: Class B shares, which do not offer breakpoint discounts for large purchases and Class A shares, which do. Because brokers typically earn larger commissions on Class B shares than on Class A shares, there is a significant potential for conflict of interest between the registered rep and his client. In an effort to address this conflict, Prudential had in place policies and procedures requiring reps to advise their clients of the availability of different classes of mutual funds and fully explain the terms of each. Prudential branch managers were also expected to approve all purchases greater than $100,000 and confirm the suitability of the choice of fund class.

The Commission found, however, that Prudential failed to adopt a sufficient supervisory system to enable those above the branch manager to determine whether these policies and procedures were being followed. Under Prudential's system, branch office managers were solely responsible for ensuring that registered representatives followed the firm's mutual fund policies and procedures. As a result, when the rep's branch manager failed to abide by and enforce Prudential's policies and procedures, the firm had no way of detecting the lapse.

In resolving the Commission's action, Prudential was censured and agreed to pay disgorgement and a civil penalty. The Commission's action against the registered rep and branch manager, which charges them with fraud, is pending.

Let me now turn to some examples of conflicts we've encountered on the investment adviser side of the business.

In a recent action against the registered investment adviser Jamison, Eaton & Wood, the Commission addressed the failure to disclose a common conflict in the advisory business - the conflict that arises when advisers receive client referrals from brokerage firms and then used those firms to execute their clients' trades.4 In this case, Jamison failed to disclose to clients whose accounts were referred and held by full service broker-dealers that they paid higher commissions than Jamison's other clients whose trades were executed through a lower-cost entity. Jamison did not disclose to its referred clients that Jamison stood to gain by having its accounts execute trades through broker-dealers that referred clients to Jamison. Nor did Jamison disclose to all of its referred clients other available brokerage options. Jamison also did not regularly review the direction and placement of its client brokerage in light of its duty to seek to obtain best execution. These failures by Jamison violated the Advisers Act.

The Commission has also brought a number of cases involving preferential allocation of hot IPOs by investment advisers. In a recent action against Nevis Capital Management,5a registered investment adviser, and two of its officers, the allegations show how the differential treatment of clients can inure to the firm's own financial benefit. The Division of Enforcement alleged that the adviser allocated IPO shares to only two of its approximately 105 clients. Unlike the adviser's other clients, one of the two recipients of IPO allocations paid Nevis Capital a performance-based fee of 20% of profits. The other favored customer was a fund, whose enhanced performance attracted new investors, and thus increased the management fees paid by the fund to Nevis Capital.

A case we brought just last month against Deutsche Asset Management exposed the potential for conflict between investment banking and investment advisory businesses housed within a single firm.6 On March 19, 2002, Deutsche Asset Management (DAM) voted proxies on behalf of advisory clients on approximately 17 million shares of Hewlett-Packard stock. The proxies were voted in favor of a proposed merger between HP and Compaq. At the time of this vote, Deutsche Bank, through its investment banking division, had been retained by HP to advise it on the proposed merger. Moreover, after DAM had initially voted its clients' proxies against the merger, senior Deutsche Bank Securities investment bankers intervened by requesting that HP have an opportunity to present its strategy to the proxy voting group at Deutsche Asset Management. Following that presentation, Deutsche Asset Management re-voted, this time in favor of the merger.

The lesson here? If an adviser has a material conflict of interest, it must tell its clients about the conflict before voting and thereby empower its clients to decide - with their eyes wide open -- whether they want to vote the proxies themselves, allow the adviser to vote them, or make some other arrangement. By failing to inform its advisory clients of the existence of its material conflict of interest, the Commission found, Deutsche Asset Management willfully violated Section 206(2) of the Advisers Act. In settlement of the matter, the firm agreed to be censured, to cease and desist from further violations, and to pay a civil penalty of $750,000.

* * *

The cases I've just described are only a selection of the Commission's enforcement activities addressing conflicts of interest. Even this small sample highlights the variety of tensions that may exist within a single firm, particularly when engaged in numerous lines of business. Next, I'd like to turn to a more forward-looking discussion of conflicts of interest. These are just some of the conflicts on the staff's radar screen. They represent areas in which enforcement actions may or may not prove appropriate, but which cause us concern, nonetheless.

You should note that in many of the scenarios I'm about to describe, the interests of a potentially more lucrative category of customers are being placed above those of another, less profitable group of customers. These fact patterns reflect an effort by the firm to find -- or even to create - illicit opportunities to benefit the customers who are in the best position to enrich the firm. These benefits are, in essence, enticements to do more business with the firm. This suggests that in rooting out conflicts, your firms should begin by identifying where they make their money. "Follow the money," the saying goes. It's what we are doing and will continue to do.

Additional Conflicts of Concern

As I have discussed, much of the present focus on conflicts began when regulators exposed the vulnerability of research analysts to pressure from their firms' investment banking interests. But other business areas of full-service firms also may seek to influence the content of a firm's research, pitting the interests of their clients against those of research customers.

  • Consider the situation a firm's equity sales and trading desk would find itself in if, after recommending and selling a large block of company X stock to a major institutional customer, the firm's research analyst were to downgrade company X.7Could a desire to avoid such a situation, a situation that could jeopardize an important client relationship, cause senior sales and trading managers to seek to influence the firm's analyst? And what about a firm's advisory affiliate, which might hold a large position in company X for the firm's advisory clients - might that affiliate's managers, too, seek to influence the analyst's published views on company X?

  • The independence of a firm's research also might be compromised by the firm's proprietary interest in a company. During the tech boom it was not uncommon for a firm and/or a pool of its senior managers to take an ownership or creditor interest in a company whose offering the firm was underwriting. With the firm's own funds at stake in addition to a valuable investment banking relationship, surely the pressure on a research analyst to express positive views of a company is compounded.

  • Now put yourself in the shoes of your firm's asset management group, providing pension, 401(k), and cash management services for corporate clients. If your group managed the multi-million dollar pension fund of company Y, your biggest client, what might you do if your firm's analyst issued a negative report on company Y? Would you be concerned that company Y might reconsider its choice of pension manager? What safeguards do you have in place to ensure that your analysts aren't being pressured by asset managers wanting to maintain good relations with their corporate clients? For that matter, how do you ensure that the asset manager's own investment decisions aren't unduly influenced or affected by the desire to obtain or retain the money management business of companies in which it may invest?

  • Still another possibility is that the interests of investment advisory clients will be sacrificed to the investment banking considerations of the adviser's affiliate and in particular, the interest of an investment banking firm in demonstrating a strong track record of IPOs with good secondary market performance. Thus, an asset manager might feel pressured to invest in companies that its investment banking affiliate had underwritten. But certainly a firm's advisory clients would be interested -- not to mention, troubled -- to learn that their portfolios were viewed by some as a tool for attracting investment banking business to the firm.

  • Conflicts also may arise on the part of pension consultants.8 Pension consultants are retained by pension funds to advise them in selecting advisers, allocating assets, and other matters. Clients of a pension consultant may not realize that the consultant has an arrangement or relationship with a particular broker-dealer and therefore has an incentive to recommend advisers who are willing to direct the pension fund's brokerage business to that broker-dealer. Even if the commissions charged were in line with standard rates, pension clients may be interested to know that the pension consultant was benefiting from their having acted in accordance with the consultant's recommendation.

  • The power of allocation in any number of contexts raises a possibility of serious conflicts of interest as well. For example, a prime broker may be responsible for allocating a certain number of redemptions among its holders of callable bonds. Firms should do so equitably, of course - for instance on the basis of a lottery. Nevertheless, when having a bond called is costly to the holder, a firm may be tempted to avoid allocating calls to its most lucrative customers. Similarly, a firm may be required to allocate among its customers the profitable opportunity to supply shares in response to a company's tender for its own stock. This scenario too creates the possibility of a conflict unless the firm adheres strictly to an equitable allocation method.

  • Another perilous allocation situation may arise if a firm, either a broker-dealer or an investment adviser, bunches customer orders and engages in late-trade allocation - that is allocating among customers after execution. Armed with the knowledge of where the security traded between the time of execution and time of allocation, this practice enables a firm to allocate to its most lucrative customers the most beneficial trades that occurred during the day. Similar to the late-trading of mutual funds identified in Mr. Spitzer's action, this practice can minimize or even eliminate risk to favored customers.

  • Sales practices in the mutual fund area also create the potential for conflicts that may not be understood by customers. Do brokerage firm customers understand that the recommendation of one fund over another (cheaper or more suitable) alternative may have been influenced by the prospect of higher commissions from the sale of that fund? Or the prospect of attracting or retaining the fund's execution or back office business?9 Customers might be shocked to learn that the mutual funds the firm makes available to them are not selected solely on the basis of merit.

  • As further food for thought, I'll mention a final source of potential conflicts, which overlaps with another priority area for the Commission - hedge funds. Firms that provide credit to a fund or take an equity position in it, or provide execution or prime brokerage services while recommending that fund to their customers may raise conflict issues as thorny as the hedging strategies these funds employ. 10 Such conflicts must be addressed.


As I've briefly illustrated, the potential for conflicts, particularly at full-service firms, are numerous. Even the few examples I've provided are somewhat dizzying to contemplate. I hope you will accept my challenge to be proactive. Scour your firms for the conflicts I've described and for those I haven't. Be creative in your approach. Shed the blinders of "industry practice" that may have made it possible for you not to see the conflicts that surround you daily. Just because the industry has always done something "that way," don't assume it's acceptable. It won't be acceptable to your customers when they come to understand the conflicts involved, and it will not be acceptable to regulators either.

Once you've systematically identified the conflicts within your firm, work to address them, and inform us of any violative conduct. For if we find it on our own, I assure you that the consequences will be worse.

Each conflict has the potential, under the right circumstances, to blacken the eye of Wall Street. The future reputation of your firms could well depend on how you respond to the conflicts I've mentioned as well as those I have not. I reiterate that you have an opportunity here to get ahead of the curve by addressing the problems that now exist. I urge you to take that opportunity. Doing so will put you in a far better position from a regulatory perspective as the Commission and other regulators continue to uncover conflicts of interest within your firms.


1 Judge Pollack of the U.S. District Court for the Southern District of New York suggests that this fact should have been known to the general public as well. See In re Merrill Lynch & Co., Inc. Research Reports Securities Litigation, -- F.Supp. 2d --, 2003 WL 21518833 (S.D.N.Y. July 2, 2003).

2 SEC v. Paul E. Johnson, Litigation Release No. 17922 (Jan. 9, 2003).

3 In re Robertson Stephens Inc., Exchange Act Release No. 47144 (Jan. 9, 2003).

4 In re Jamison, Eaton & Wood, Inc., Investment Advisers Act Release No. 2129 (May 15, 2003).

5 In re Nevis Capital Management, LLC, David R. Wilmerding, III, and Jon C. Baker, Investment Advisers Act Release No. 2154 (July 31, 2003).

6 In re Deutsche Asset Management, Inc., Investment Advisers Act Release No. 2160 (Aug. 19, 2003).

7 See Michael Santoli, "The Whole Truth; It's time to repair Wall Street's dubious research machine - and here's how," Barrons, May 26, 2001 (available at: www.nasvf.org).

8 See Janice Revell, "Are Your Savings Safe? The Seamy Side of Pension Funds," Fortune at 105, Aug. 12, 2002.

9 See Julie Creswell, "Dirty Little Secrets; The mutual fund industry has been playing fast and loose with your dollars. Will the SEC finally take action?" Fortune at 133, Sept. 1, 2003.

10 See Mitchell Pacelle, Matt Murray, and Michael R. Sesit, "Hedge Funds Expect Troubles to Exact a Toll," The Wall Street Journal Europe, Sept. 29, 1998 (available at: www.sorostrading.com/art_wsj929.html).



Modified: 09/09/2003