Speech by SEC Staff:
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.
As I stand before you today, I can't help but think back to the last time I addressed this group. It was four or five years ago; I was the Deputy Director of the Enforcement Division back then. It was one of the first times I'd had an opportunity to deliver a keynote-type address, and I was just a tad nervous. Yes, I was standing up in front of a big crowd of sophisticated lawyers and compliance professionals. But it was something else that was causing me to feel unsettled: There just wasn't enough mutual fund-related enforcement material to fill up a 20-minute speech. So I hoped you wouldn't notice - or that you'd be polite enough to pretend you didn't notice - that the cases I was citing didn't actually involve mutual funds. Well, it feels a bit different today, for me and I'm sure for you. I could spend a lot more than 20 minutes just walking through the last year's worth of mutual fund cases. But rather than do that, and tell you what you undoubtedly already know, I thought I'd offer up my parochial, enforcement-oriented views - and they are only my own views, not those of the Commission or other members of the Commission staff - as to some of the reasons for the explosion of cases, and what might be done to prevent it from recurring.
In my view, our collective success in avoiding another scandal requires focus on the three Ps - place, people, and process. Yes, the P thing is a bit contrived. But it helps make the points, so stay with me. By "place," I mean the culture of the firm - ideally, a culture that fosters and supports compliance, and treats the best interests of mutual fund shareholders as the highest priority. "People" are a firm's key personnel, those responsible for setting the tone and ensuring that the firm and its employees act in a manner consistent with the interests of fund shareholders. Finally, "process" refers to the process that a firm has in place to prevent compliance problems. Is the firm committed to proactively identifying areas of compliance risk and failure, and to taking decisive action when problems are discovered?
I will discuss these themes in more detail, but first I want to discuss briefly what we ourselves have done in the enforcement area to be more proactive - to identify and address more effectively the trends, practices, and risks within our capital markets that could be exploited to the detriment of investors. We have made a number of changes designed to help us better "see around the corner." For example, we've taken steps to take better advantage of the knowledge of those in the SEC's operating divisions and offices, including more frequent cross-divisional meetings, and increased coordination in the handling of enforcement referrals from our examination program. We are also integrally involved in the Commission's agency-wide risk assessment efforts, and recently hired our own "subject matter experts" to help us examine the implications of business practices in different areas of the markets, including the investment management industry. In addition, we have instituted a number of measures to improve how we handle the tidal wave of information we receive about potential enforcement issues by making a greater effort to expedite follow-up on communications from whistleblowers and others who raise concerns with us.
More broadly, we've tried to effect a subtle cultural change within the enforcement program to encourage a more proactive approach when it comes to initiating investigations. Rather than waiting until we have specific, hard evidence of wrongdoing - by which time investors may have already suffered substantial harm - we are probing practices that raise less developed suspicions or concerns. I expect some of you have already seen evidence of our efforts in this regard. We think the approach makes sense in this time and place despite the costs associated with it. And we don't discount the significance of those costs. We know that the resources and efforts required to comply with our subpoenas and document requests are not insubstantial. We also know that the firms that find themselves on the receiving end of our inquiries have reputations to maintain, and that our inquiries have reputational consequences. To address these concerns, we are trying to make sure that we don't regularly blanket the same firms with multiple requests, although this may occur on occasion if we have reason to believe different problematic practices might be occurring at the same firm. We are also taking pains, in those situations in which our inquiry of a firm is not based on specific evidence of wrongdoing, to try to let the firm know that. At the end of the day, though, we understand that our efforts to minimize the costs of our more proactive approach will not eliminate those costs altogether. We believe, however, that the costs here are justified and necessary, given both the widespread misconduct we have seen over the last couple of years, as well as our commitment to seeking to prevent such misconduct in the future.
We have also made some important changes in how we bring and settle our enforcement actions to maximize their effectiveness and deterrent effect. I know these efforts have not gone unnoticed by the investment management industry. We are focusing more closely on the role of the gatekeepers in the industry - including executives of investment management firms, directors, and lawyers - and will not hesitate to hold them accountable when we determine they have played a significant role in a company's wrongdoing. Our recent actions illustrate this renewed focus. Over the past year, we have brought actions against Dick Strong of Strong Capital Management and Strong's Chief Compliance Officer;1 Raymond Cunningham of Invesco;2 Garrett Van Wagoner and one of the independent directors of the Van Wagoner Funds;3 Gary Pilgrim and Harold Baxter of Pilgrim Baxter & Associates;4 Stephen Treadway, the CEO of PIMCO Advisors Fund Management;5 as well as executives of Heartland Advisors, Heartland's general counsel and compliance officer, and the independent directors of the Heartland funds.6 We are also looking closely at the role of lawyers in our ongoing market timing and late trading investigations and may recommend enforcement action in one or more of those cases if we find that lawyers assisted their clients in engaging in illegal late trading or market timing arrangements that harmed mutual fund investors. You can also expect to see, over the next year, a continued focus on whether independent directors have lived up to their role as guardians of the interests of the shareholders they serve.
Finally, in the last year or so we have imposed some of our highest penalties and toughest prophylactic measures ever in response to findings of egregious misconduct in the mutual fund industry. Some of the largest of these penalties have been assessed against mutual fund companies involved in the market timing and late trading scandals, including the $110 million penalty imposed against Invesco,7 the $100 million penalty against Alliance Capital Management,8 and the $50 million penalties imposed against MFS, Pilgrim Baxter, Putnam, and Janus.9 And I know you are very familiar with the prophylactic measures that have been a part of our recent settlements in the mutual fund industry. Our goal in imposing these carefully crafted measures is to put in place safeguards that should help prevent a recurrence of the types of violations that occurred.
We will continue to be vigilant in our efforts to protect mutual fund shareholders. But no matter how many enforcement actions we bring, how many rules we adopt, and how many firms we examine through our inspections program, we will never have the resources to root out or address every problem that may arise in the industry. That's why I want to focus on the role of the industry itself.
I begin with "place." In my view, one factor that contributed to the many violations we have seen over the past year is a breakdown in the corporate culture of many investment management firms. Our enforcement actions have revealed at many firms a culture that focused too heavily on the bottom line - in other words, revenues for the adviser and its affiliates - at the expense of fund shareholders. Former Chairman Levitt has observed that the mutual fund industry has "been changed to a marketing concept; the gathering of assets is all-important because that's where the payoff is. We have seen an industry veer away from fiduciaries toward marketing impresarios. . . ."10 I'm afraid our enforcement actions have borne that out. Sadly, at too many firms, the adviser's short-term interest in collecting more fees was allowed to overtake a long-term focus that would have recognized that decisions in the best interests of fund shareholders are ultimately in the long-term interests of the management company. Many of the violations that have been uncovered seem to stem from an attitude that "it's okay just this once," or "others are doing it," leading to an acceptance of practices without adequate, independent consideration of their implications for fund shareholders. In the end, a culture in which the shareholder is not placed first reflects a firm that has underestimated the value of its most important asset - shareholder trust.
So what type of corporate culture must an investment management firm foster if it is to head off future violations of law and effectively address problems when they do occur? I think the answer is clear - a culture that is based on an investment adviser's fiduciary obligation to fund shareholders, and puts the interests of those shareholders first. Paul Roye has referred to this culture as "a culture of fiduciary responsibility."11 Lori Richards calls it a "culture of compliance."12 But how can such a culture be created and sustained? In my view, it begins with the people.
So let me turn to my second "P" - the people within the mutual fund organization who have the ability to create and maintain the right "tone at the top:" the senior executives of investment management firms, mutual fund directors, chief compliance officers and lawyers who stand at the intersection of fund management companies and fund shareholders.
Responsibility for the recent abuses in the mutual fund industry, like many of the abuses that have been uncovered in the last couple years in corporate America, can in large part be attributed to failures on the part of senior management. Chairman Donaldson has called on senior executives in the investment management industry to "elevate their firm's moral DNA" by making integrity and honesty core values that permeate all levels and all operations of a firm.13 Our recent enforcement actions in the mutual fund area demonstrate that some industry executives sorely failed to do this. These failings included personal trading by fund executives at the expense of ordinary fund shareholders;14 the approval of market timing arrangements that were inconsistent with firms' representations to shareholders and, in many cases, firms' own internal policies;15 knowing or reckless misrepresentations of net asset values;16 and the charging of performance-based fees in a manner that significantly benefited the advisory firm at the expense of the funds.17 What these examples show is that fund executives can't just say that they place the interests of fund investors first. They can't just adopt an impressive-sounding code of conduct or mission statement. They also have to demonstrate that commitment through their actions - through decisions to forego a lucrative piece of business or a significant client in order to preserve the firm's long-term reputation and interests; through compensation and promotion decisions that reward ethical behavior and punish ethical lapses; and through a commitment of resources to controls and compliance. In other words, they can't just talk the talk - they have to walk the walk.
Directors of investment companies also have significant responsibility for creating an environment in which compliance matters. Independent directors, in particular, are entrusted with responsibility under the Investment Company Act to protect the investment companies they serve, and those funds' shareholders, against conflicts of interest. Because of the critical role they serve, independent directors of investment companies are often referred to as "'independent watchdogs,' . . . who [ ] 'furnish an independent check upon the management' of investment companies . . ."18 We want to be sure that the watchdog moniker is warranted.
In our investigations of mutual fund organizations over the past year, we have been looking very closely at fund directors. Were directors aware, or should they have been aware, of the abusive practices? If there were red flags, did the directors follow up? Did they question practices that could harm fund investors or did they passively acquiesce in those practices? In our case against the independent directors of the Heartland funds, we found that those directors failed to satisfy their obligations to ensure the funds' securities were accurately priced, and failed to heed red flags that indicated the funds were facing a desperate liquidity crisis that would ultimately result in a dramatic decrease in the funds' net asset value.19 We also found that, despite being on notice of the funds' valuation problems, the directors failed to adequately follow up on their requests for information to determine whether the securities were accurately priced.20
We have not, to date, brought an action against any independent directors in connection with the market timing and late trading abuses, or in connection with payments for shelf space. We recognize that, in some of these cases, the independent directors were victims of the inadequate or misleading information conveyed to them by the funds' adviser or its affiliates. We remain concerned, however, about the apparently passive role played by some directors in these situations - while such conduct may not always rise to the level of a violation of the federal securities laws, I think it is fair to say that some fund directors haven't distinguished themselves as vigilant watchdogs during this period of crisis in the mutual fund industry. Going forward, we will continue to closely examine the role of directors and will bring charges against them if we find they have failed in their duty to protect fund shareholders against management's overreaching. As the Commission recently stated, "[d]irectors should be highly skeptical of arguments that merely rationalize the resolution of conflicts in favor of the fund adviser, and should seek results that advance the best interest of fund shareholders."21
Directors can be a powerful force in establishing and maintaining a culture within a mutual fund organization in which the interests of fund shareholders are treated as paramount. The best practices recommendations by the Mutual Fund Directors Forum are an example of the type of proactive thinking that is essential for independent directors to be able to serve as an effective force in actively safeguarding the interests of fund investors.22 I also believe the position of independent directors will be further strengthened through a number of the Commission's recent initiatives, including the corporate governance measures recently adopted by the Commission,23 and the new requirement of a chief compliance officer, who can serve as a strong ally of, and source of information for, the independent directors in their efforts to fulfill their watchdog function.24
I realize that many investment management firms and funds only very recently selected their chief compliance officer, so it may be too early for firms to evaluate exactly how the chief compliance officer will function within the companies' management and compliance infrastructure. But I think even at this point it is safe to say that the chief compliance officer has a unique role within the investment management organization in identifying and addressing risks in the organization before they become legal violations, promptly uncovering and remedying compliance failures when they do occur, and fostering a culture of compliance throughout the firm.
One element of the compliance rules that, in my view, is key to the chief compliance officer's success, is that that person reports directly to the fund's board of directors. In a number of our enforcement actions over the past year, we saw situations in which firms had in place policies and procedures that would have provided a check on the abusive conduct that occurred, but where senior executives effectively overruled compliance personnel or other employees who expressed concerns about existing practices. In the Invesco case, for example, the company's chief compliance officer prepared a detailed memorandum for Raymond Cunningham, the Funds' CEO, explaining why Invesco's deals with market timers might not be in the best interests of the Invesco Funds and their shareholders.25 The compliance officer specifically discussed how Invesco's practices with respect to market timers were inconsistent with the Funds' prospectus disclosures. Mr. Cunningham, however, proceeded to ignore the recommendations in the memo and did not circulate the memo to the Funds' board of directors. Having a chief compliance officer who is directly accountable to the fund's board should help prevent these types of situations, and should provide the necessary authority for the chief compliance officer to effectively carry out his or her job.
That brings me to the lawyers. And I'm reminded of Judge Sporkin's question, in the context of another scandal, the S&L crisis: "Where were the lawyers?" Lawyers to funds, their independent directors, and investment management firms also have a critical role to play in helping to prevent violations of the law. So we're looking at them closely. What are we looking for, exactly? Intentional, knowing misconduct, for one. But we are also looking hard at situations in which lawyer misconduct meets statutory scienter requirements that are short of actual knowledge. Having said that, I do want to be clear that we are not in the business of enforcing malpractice rules or sanctioning lawyers for providing negligent advice.
We all know that the business and professional pressures on lawyers to accede to clients' wishes are greater than ever. But it is equally true that it is more important than ever (and, as a result of the Sarbanes-Oxley Act, sometimes even legally required) for lawyers to remain firm and stand up against a proposed action or course of conduct that would be inconsistent with the letter or intent of the law. And in advising clients, it is critical that lawyers take a sufficiently broad perspective in evaluating a client's proposed course of conduct so as to understand not just what the client wants to do, in the most narrow sense, but why the client wants to do it - in order to be able to fully evaluate the legal implications of the client's course of conduct. By following these principles, lawyers, and particularly in-house counsel, can play an integral role in fostering a culture of compliance within a firm.
On to the third and final "P:" Having a well-conceived, intelligent and thorough process for identifying and addressing potential problems is essential if the investment management industry is to successfully avoid in the future the problems of the recent past. More than a year ago, I challenged the financial services community to find the problems within firms' own organizations and correct them. I urged firms to 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, and to identify any situations in which the firm could place its or its employees' interests ahead of the firm's customers. In response to my challenge, we have had many broker-dealer firms come in to talk to us. But we've heard from altogether too few of the firms represented in this room. I hope we will hear from more of you in the near future. I want to emphasize that these meetings are intended to begin an ongoing, informal dialogue - they are not intended to be an exercise in "gotcha."
Whether or not you come in, I do urge that, as part of your compliance regime, you consider doing (if you haven't already done so), a top-to-bottom review of your business operations, with the aim of identifying and addressing any compliance gaps or conflicts of interest that may exist. I also urge you to make this part of an ongoing, dynamic process. The benefits of your review will be quickly lost if you don't have in place a continuing, sustainable program to identify and address risks and possible compliance failures going forward.
There are a few points that I think deserve consideration when you embark on this sort of effort. First, think expansively in figuring out where the hidden minefields may be and how to effectively defuse or eliminate them. Second, don't be afraid to challenge the status quo - just because a certain way of doing things is second nature to you, and appears to be standard operating procedure within the industry, doesn't mean it's the correct way of doing things. Third, you need to take a holistic approach and consider issues raised by the interaction of all parts of the business, including service providers and brokers. For example, as the recent market timing and late trading abuses have demonstrated, distribution pressures can easily leak into the portfolio management process, with significant consequences. Fourth, the better job you are able to do in rooting out and addressing conflicts of interest and potential problems within your own firm, the less likely the conduct or practices will have a chance to rise to the level of legal violations, and deserve our attention in Enforcement. And, finally, remember that when we consider whether a legal violation merits enforcement action, and the extent of the action warranted, we look closely at whether the firm has taken a proactive approach to addressing the problem, in addition to looking at the type of violation that was committed and the amount of harm that resulted from the violation. Specifically, one of the factors we look at, which ties in closely to the themes I've been discussing today, is whether a firm had in place effective self-policing mechanisms, including effective compliance procedures, and an appropriate tone at the top.26
Let me conclude by saying: I believe this is a time of opportunity for the mutual fund industry - an opportunity to regain the trust of fund shareholders that has been eroded by the recent industry scandals, and an opportunity to put in place now the safeguards that are critical to avoiding problems in the industry later. Whether the industry seizes this opportunity will, in my view, largely depend on whether it can keep its sights focused on place, people and process - the culture; the responsibility of senior management, directors, lawyers and compliance officers for setting the right tone; and, finally, an effective process for preventing and addressing violations.
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