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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Regulation of Investment Advisers: The View from Washington


Cynthia M. Fornelli

Deputy Director, Division of Investment Management
U.S. Securities and Exchange Commission

IA Week's 4th Annual Fall Compliance Conference
Philadelphia, PA
September 13, 2004

I. Introduction

Thank you for the kind introduction. I am very happy to speak with you today about our work at the Commission and specifically in the Division of Investment Management. But before I begin, I must note that my remarks this afternoon, as always, represent my own views and not necessarily those of the Commission, the individual Commissioners, or my colleagues on the Commission staff.

For the past few years, the Commission has focused on addressing a series of market scandals, implementing broad-sweeping changes in response to corporate wrongdoings throughout the financial industry. Most recently, this focus has been on the market timing and late trading abuses in the mutual fund industry, and has led the Commission to re-examine and overhaul a number of rules governing mutual fund trading and disclosure, as well as governance and compliance. For example, to reduce the possibility of market timing, the Commission has adopted rules that will illuminate mutual funds' anti-market timing policies and require fund executives to report their transactions in fund shares so that any abusive trading can be detected. The Commission has also mandated that mutual fund boards be led by an independent chair in order to strengthen the fund governance structure. To eliminate the possibility of late trading, the Commission has proposed a "hard 4 pm" close for mutual fund share trading.

The seriousness of the mutual fund scandal called for an equally serious regulatory response and some of the Commission's rules are not without controversy. For the "hard 4" rule alone, we received over 1000 comment letters. In some cases, we have been told that the Commission is over-reacting to the scandal, that actually only a few "rotten apples" spoiled it for the whole bunch. I understand that many investment advisers may feel this way. The mutual fund scandals involved a breach of the fiduciary and ethical principles that form the bedrock of the relationship between investment advisers and their clients. Advisers therefore have been swept up in the Commission's efforts to revive fiduciary principles and restore the trust and confidence of investors. Consequently, a number of the Commission's initiatives developed in response to the scandal affect advisers, with some of them aimed directly at advisers' activities.

However, as you know, investment advisers come in all shapes and sizes. The diversity of advisory relationships is recognized in the Investment Advisers Act of 1940, which provides advisers flexibility, with the overriding obligation of fiduciary responsibility. It is with this same spirit of flexibility that we are approaching the initiatives that affect investment advisers. I would like to review some of these initiatives with you today, highlighting the Commission's commitment to working with the industry in order to promote a culture of ethics and compliance, while not unnecessarily burdening smaller advisers or those that already demonstrate a commitment to acting in the best interests of their clients. Additionally, I will also discuss your role in ensuring that we at the Commission get it right and how you can assist in enhancing the effectiveness of our rules.

II. Investment Adviser Compliance Programs

One rule I am sure is on the top of your minds these days is the new requirements for investment adviser compliance programs. The rule requires advisers to adopt, implement and annually review compliance policies and procedures reasonably designed to prevent violations of the Advisers Act. The rule also imposes the requirement that investment advisers designate a chief compliance officer. As you likely are aware, these requirements kick in on October 5th. Although the compliance rule was actually proposed before the mutual fund scandals emerged, it serves as a key component of what Chairman Donaldson calls a renewed "culture of compliance" within the securities industry that brings the principles of integrity and fiduciary responsibility into focus.

This rule, coupled with the companion investment company rule, is, in my mind, the single most important initiative that the Commission has taken in my five years at the Commission. We have heard criticisms that the rule imposes costly burdens on small firms, although the perpetrators of the scandals were primarily large firms. Advisers in particular have criticized the Commission's approach, saying that the rule is too heavy-handed. One press article quoted an adviser as saying that the rule is like "shooting a mouse with an elephant gun."2

The rule, however, simply formalizes the prudent compliance practices followed by investment advisers that already have a dedicated compliance officer and meaningful compliance procedures. Previously, not all investment advisers adhered to these well-recognized and responsible practices, nor were they required to. The rule was designed to remedy that situation by raising the compliance standards of all advisers by requiring them to have the policies and procedures in place to prevent violation of the securities laws, detect violations when they occur, and promptly correct violations that have occurred. In this way, the rule reflects Chairman Donaldson's proactive approach to regulation of the securities industries. When opening the Commission meeting adopting the rule, Chairman Donaldson stated that

[the Commission's] commitment to investors must extend to anticipating the wrongdoing that often accompanies the constant change in our marketplace and remaining at least one step ahead. The investing public deserves nothing less.3

At the same time, the rule does not specify the types of procedures that advisers adopt, but rather provides them the flexibility to tailor their compliance policies and procedures to fit the scope and nature of their individual operations. And, again, the rule does not ask anything that any well-managed adviser should not already be doing.

III. Registration of Hedge Fund Managers

In July, the Commission proposed an important new rule and rule amendments under the Advisers Act that would require hedge fund advisers to register with the Commission as investment advisers. Similar to the compliance rule, the proposal did not originate with the mutual fund scandal, but the major role that hedge funds played in the late trading and market timing abuses crystallize just how important the proposal is.

The rule proposal came as a result of a two-year extensive study of hedge funds and their advisers by the Commission staff. The study culminated in a report that highlighted several key areas of concern related to hedge fund growth, including an increase in fraud cases involving hedge fund advisers and the Commission's limited ability to obtain comprehensive and reliable information about them. As a result, the staff report recommended that the Commission require hedge fund advisers to register as investment advisers, which would give the Commission greater insight into hedge funds' activities and improve our ability to deter and detect fraud, while in no way impeding the ability of hedge funds or their advisers to employ leverage, disclose or limit their proprietary trading strategies or otherwise interfere with how hedge funds go about their business. As this audience well knows, the Investment Advisers Act is largely an antifraud and disclosure statute. Registration would require only that hedge fund advisers report certain census-type information to the Commission and disclose to clients certain fundamental information that all investors should have, such as the disciplinary history of the principals and any conflicts faced by the adviser and how it manages those conflicts. Of course, a hedge fund adviser also would be required to comply with all of the rules applying to investment advisers, including the rule requiring the designation of a chief compliance officer and adoption and implementation of a compliance program, but as I noted earlier, this is just good business.

The hedge fund proposal also includes an amendment to the adviser custody rule in order to accommodate advisers to funds of hedge funds. Under the custody rule, an adviser acting as general partner to a pooled investment vehicle it manages has custody of the pool's assets. These advisers, including hedge funds, may satisfy their obligation to deliver custody account information to investors by distributing the pool's audited financial statements to investors within 120 days of the pool's fiscal year-end. Some advisers to funds of hedge funds have found it difficult to obtain completion of their fund audits prior to completion of the audits for the underlying funds in which they invest, and therefore, as a practical matter, will be prevented from complying with the 120-day deadline. The Commission proposed to extend the period for pooled investment vehicles to distribute their audited financial statements to their investors from 120 to 180 days so that advisers to funds of hedge funds may comply with the rule.

The comment period for the rule proposal closes on Wednesday. We already have received many thoughtful comments on this proposal and I expect we will receive more in the next two days. And, of course, the Commission has actively sought public comment on hedge fund adviser registration every step of the way during our 2-year study of the issue. As always, comments from interested parties are a way for the industry to work with us to make sure we get it right and we strongly encourage their submission on all of our proposals.

IV. Investment Adviser Codes of Ethics

Another new rule that the Commission recently adopted requires registered investment advisers to adopt codes of ethics that set standards of conduct for advisory personnel and address conflicts that arise from their personal trading. The purpose of the rule is to ensure that the ethical standards of advisory firms reach all employees, especially those who have access to nonpublic information about the firm's securities recommendations and its clients' securities activities. As I know that personal trading is a topic that is covered at this conference, I won't go into detail about the rule's requirements. Rather, I would like to highlight a significant development that followed the rule's adoption.

While the rule itself is an important initiative, when coupled with the issuance of the ICAA's Best Practices, it is a model of how industry can work with the Commission to develop a cohesive and effective regulatory framework. In reference to advisers' codes of ethics, Chairman Donaldson stated that:

"'[o]pportunity may only knock once, but temptation leans on the doorbell.' As much as we might wish to, we will never be able to set and enforce rules that govern every situation in which an investment adviser's employees might be tempted to exploit the adviser's clients for personal profit. We have no choice but to rely on the advisory firms themselves to step into the breach — establishing a culture where the highest standards of behavior are practiced and where that doorbell is never answered.4

The issuance of the ICAA's Best Practices demonstrate that Chairman Donaldson's reliance on the industry is not misplaced. By assisting firms in adopting codes of ethics to fit their unique situations, these Best Practices work to enhance the effectiveness of the codes of ethics requirement while minimizing the burden on the firms themselves. I commend the ICAA for its work in developing thorough and useful guidelines that will serve advisers well in developing a culture of ethics within their firms, while also setting what I hope is a precedent for future collaborations between the SEC and members of the securities industry.

V. Portfolio Manager Disclosure

One more initiative that affects advisers to mutual funds was the Commission's recent adoption of rule amendments to improve the disclosure that mutual funds provide about their portfolio managers. The amendments require that a fund disclose basic information about its portfolio managers, as well as information regarding their financial incentives, such as their compensation structure and their ownership of fund shares, and any potential conflicts of interest. These conflicts include those that may arise from a portfolio manager's simultaneous management of the fund and other accounts, such as hedge funds or separate accounts. This disclosure was designed to provide greater transparency regarding portfolio managers that would assist investors in evaluating fund management in making their investment decisions.

VI. Risk Management Initiative

Finally, I would like to mention a new risk management and assessment initiative set forth by Chairman Donaldson in response to recent events, including the mutual fund scandals, to anticipate potential problems across the investment industry. As part of this initiative, the staff has been working to develop an enhanced risk based approach to oversight and examination of investment advisers. Chairman Donaldson has specifically directed that members of the Commission's senior staff, including the head of the Office of Compliance Inspections and Examinations, the Director of the Division of Market Regulation, the Chief Economist, the General Counsel, and Paul Roye, the director of the Division of Investment Management, work together to develop risk assessment protocols which could be used to identify investment advisers whose activities are raising "red flags" that suggest a more focused, cause inspection may be in order. It is anticipated that this approach will allow the Commission to increase its surveillance capacity and better target the use of examination resources to high risk advisers.

VII. Conclusion

I would like to conclude my remarks on a personal note. I have, over my five-year career at the Commission, addressed investment advisers and their compliance personnel a number of times. And each time, I have stressed what an important role compliance plays in the industry. I have also implored compliance officers and compliance personnel to strive to make compliance important at their advisory firms.

As many of you may know, it is now time for me to put my good advice to good use. I will be resigning my position as Deputy Director of Investment Management on September 23 to leave Washington to join Bank of America in Charlotte. At BofA, I will fill the newly created role of senior vice president and compliance executive for securities regulation and conflicts management. It is a large title for a large job. In this new position, I will be joining the ranks of compliance personnel. My primary role will be to help the bank comply not only with the letter of the federal securities laws and regulations, but also with the spirit of those laws and regulations.

This past year has been a difficult one for all of us in the investment management industry — for investors, for funds and advisory firms and even for regulators. And yet, we all have pulled together to bring about enormous and important change in the industry. At the SEC, we instituted a host of new regulations designed to strengthen the disclosure, governance and conflict management processes. Investors, for the most part, kept their investments in the investment management industry, although those firms involved in the scandals saw investors leave for other firms. And the industry, it appears, has rallied to embrace reform. We have received a record number of comments on a number of our proposals, and industry groups have issued best practices on a number of important issues. More importantly, I am heartened to see a number of firms embracing the new reforms not because they have to (which they do!), but because it is the right thing to do.

I appreciate your time today and look forward to continuing to work with you, albeit in a different capacity!

1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement by 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.

2 Herbert Lash, SEC Compliance Rules May Shut Some Asset Managers, Reuters News (Aug. 10, 2004).

3 Opening Statement by Chairman William H. Donaldson at December 3, 2004, Open Meeting of the U.S. Securities and Exchange Commission.

4 Opening Statement by Chairman William H. Donaldson at May 26, 2004, Open Meeting of the U.S. Securities and Exchange Commission.



Modified: 09/16/2004