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U.S. Securities and Exchange Commission

Division of Investment Management:
SEC Roundtable on
Investment Adviser Regulatory Issues

On May 23, 2000, the Securities and Exchange Commission hosted a conference discussing several issues relating to investment advisers. The Commission has several initiatives on its agenda to modernize and improve the rules under the Investment Advisers Act. Investment advisers, representatives from various trade associations, legal counsel to advisers, representatives from state regulatory bodies, representatives from the National Association of Securities Dealers, and others met at the conference, discussed these issues and offered their recommendations.

The conference consisted of a series of panel discussions moderated by officials from the Commission's Division of Investment Management. Topics of discussion included modernization of adviser regulation, the distinctions between advisers and broker-dealers, adviser trading practices including the use of soft dollars and the obligation to seek best execution, personal trading and other conflict of interest issues, pay-to-play practices, advertising and performance reporting, technology and adviser regulation, and a new electronic filing and registration system for investment advisers. The complete agenda for the conference is at http://www.sec.gov/news/press/2000-56.txt.

The panelists and the public were invited to submit written comments on the issues discussed at the Roundtable. All such comments are available for review and copying in the Commission's Public Reference Room. Comments that were received electronically are available on the SEC website.

Note:  This transcript was prepared by a certified court reporter. The Securities and Exchange Commission is not responsible for the accuracy of this document.


9:00  9:15

Introductory Remarks

Paul F. Roye
SEC – Division of Investment Management

Arthur Levitt

9:15 – 11:00

Investment Advisers In Today's Competitive Markets / Modernization of Adviser Regulation

Paul F. Roye, Moderator
SEC – Division of Investment Management

Phyllis Bernstein
Director of Personal Financial Planning
American Institute of Certified Public Accountants

Roy T. Diliberto
The Financial Planning Association

Paul S. Gottlieb
First Vice-President and Assistant General Counsel
Merrill Lynch Pierce Fenner & Smith Inc.

R. Clark Hooper
Executive Vice President
National Association of Securities Dealers Regulation

Joanne T. Medero
Managing Director and Chief Counsel
Barclays Global Investors

Robert E. Plaze
Associate Director
SEC – Division of Investment Management

Bradley W. Skolnik
North American Securities Administrators Association
Indiana Securities Commissioner

David G. Tittsworth
Executive Director
Investment Counsel Association of America

11:00 – 11:15 Break

11:15 – 12:30 Trading Practices

Cynthia M. Fornelli, Moderator
Senior Adviser to the Director
SEC – Division of Investment Management

Gene A. Gohlke
Associate Director
SEC – Office of Compliance Inspections & Examinations

Paul G. Haaga, Jr.
Executive Vice President and Director
Capital Research and Management Company

Henry H. Hopkins
Managing Director and Chief Legal Counsel
T. Rowe Price Associates

Thomas P. Lemke
Morgan, Lewis & Bockius

Charles Tschampion
Association for Investment Management and Research

12:30 – 2:00 Lunch Break

2:00 – 3:15 Other Conflicts of Interest

Robert E. Plaze, Moderator
Associate Director
SEC – Division of Investment Management

Guy M. Cumbie
The Financial Planning Association

Meyer Eisenberg
Deputy General Counsel
SEC – Office of General Counsel

Susan MacMichael John
Government Affairs Liaison
National Association of Personal Financial Advisors

Ellen R. Porges
Managing Director and General Counsel
Investment Management Division
Goldman Sachs

Sandra P. Tichenor
Investment Counsel Association of America

Mary Ann Tynan
Senior Vice President, Partner
and Director of Regulatory Affairs
Wellington Management Co., LLP

3:15 – 3:30 Break

3:30 – 4:30 Advertising and Performance Reporting

Douglas J. Scheidt, Moderator
Associate Director / Chief Counsel
SEC – Division of Investment Management

Luis Aguilar
General Counsel

Michael S. Caccese
General Counsel and Senior Vice President
Association for Investment Management and Research

Thomas M. Mistele
General Counsel, Secretary and Vice President
Dodge & Cox

Kathryn L. Quirk
Managing Director and General Counsel
Scudder Kemper Investments Inc.

Lori A. Richards
SEC – Office of Compliance Inspections & Examinations

4:30 – 5:30 Technology and Investment Adviser Regulation

Robert E. Plaze, Moderator
Associate Director
SEC – Division of Investment Management

Jilaine Hummel Bauer
Senior Vice President and General Counsel
Heartland Advisors, Inc.

Scott W. Campbell
Vice-President and General Counsel
Financial Engines Advisers, LLC

Alton "Chip" Jones, Jr.
Vice-President of Securities Affairs
Regulatory and Industry Affairs
American Express Financial Advisors

Melanie Senter Lubin
Investment Adviser Section
North American Securities Administrators Association, Inc.

John D. Markese, Ph.D
American Association of Individual Investors

Craig S. Tyle
General Counsel
Investment Company Institute


I. Introductory Remarks

Mr. Roye:  Good morning. My name is Paul Roye and I am Director of the Division of Investment Management. It is truly a pleasure to welcome all of you to our roundtable on Investment Adviser Regulatory Issues. I am glad to see that we have such a big turn out. Although I am not surprised because we have an impressive group of panelists and a host of timely and engaging issues to explore. As all of you know or you would not be here, this is an exciting and dynamic time for the investment advisory industry. With major rule proposals pending and others to follow shortly. Chairman Levitt felt that now was the time to take a step back to review the state of the industry and the state of our regulation of the industry and consequently yes, the Division so we organized this roundtable.

The Investment Advisers Act is enjoying its sixtieth year since enactment. It is an amazingly well crafted statute that with relatively few amendments has withstood the test of time. Nonetheless, we at the Commission must be ever vigilant in reviewing the regulatory framework and in reviewing our rules and regulations. This has never been truer than now when we are in the midst of an intense period of tremendous technological change and innovation that I believe will truly be viewed as a watershed period for our securities markets and the investment management industry.

Now after the passage of the NSMIA legislation in 1996, the Division of Investment Management formed the Task Force on Adviser Regulation to implement the provisions of that legislation. We are currently engaged in revisiting our regulatory approach on many issues under the Advisers Act in a comprehensive effort to modernize our regulations to respond to the changes that are sweeping across all financial services industries. The purpose of this roundtable is to elicit the views of consumers of investment advisory services, the industry, and state and federal regulators regarding the state of the industry, where it is headed and how the industry should be regulated.

Before we begin the first panel, I would like to ask Chairman Levitt to make a few remarks. As all of you know, in his remarkable tenure at the Commission, Chairman Levitt has distinguished himself as not only the longest serving chairman of the SEC but also for his energetic devotion to satisfying the Commission's mandate to serve as the investors' advocate. He has continually spoken out on preserving the high fiduciary standards that are hallmarks of the investment advisory profession and he has be a proponent of forums like this to seek the views of interested parties. Chairman Levitt.

Chairman Levitt:  Good morning and thank you Paul.

Today more and more Americans are investing in stocks, in bonds, in our markets whether they are investing through pension funds, investment companies, endowments, charitable trusts, thousands of individual portfolios. Investors have placed over $18 trillion under the care of people such as yourselves. Never before have the roles and the responsibilities of all of you in the investment management industry been more crucial to protecting more and more of America's citizens. The profound and far reaching changes sweeping our market place demand that we remain proactive in reexamining the way the profession carries out its fiduciary responsibilities. New imperatives demand that we embrace the benefits of technology. To streamline industry oversight and more importantly to serve a more informed and a more energized investor base.

After nearly six decades since enactment of the Investment Advisers Act, the Commission has undertaken a comprehensive effort to modernize the regulations that govern advisers. Under Paul's leadership and with the tireless efforts of Dave Fielder, Paul's adviser, today's roundtable brings together representatives from advisory firms and their trade associations, state regulators, consumer advocacy groups and the NASD to discuss proposed rules and the many issues, challenges and opportunities before us.

The Commission's modernization drive began almost five years ago after the passage of the National Securities Markets Improvement Act which was aimed at establishing sensible jurisdictional boundaries between the SEC and the states' regulation of advisory firms. Among other benefits, the initiative eliminated duplicative regulation of investment advisers. Today, approximately eight thousand investment advisers are registered with the Commission and another 12 thousand are registered with state securities regulators. The Commission today has several pending rule proposals that we believe represents significant steps toward continuing our commitment to modernization of investment adviser regulation.

One of these initiatives is the Investment Adviser Registration Depository or IARD. This Internet based filing system will enable investment advisers to satisfy their reporting obligations under both state and federal laws with a single electronic filing. The system will help us better monitor advisers to analyze the impact of regulatory changes and to anticipate areas that may require special attention. Most importantly, investors will be able to access the system free of charge through the Internet.

The proposal also requires that all advisers provide clients with a kind of narrative brochure that will be written in plain English. Now this document will contain meaningful disclosure about the advisory firm. In addition, a new updated Form ADV would provide even more information to investors, specifically when it comes to financial conflicts of interest between advisory personnel and their clients. This also means enhanced disclosure of soft-dollar practices.

Another pending proposal addresses the issue of precisely when broker/dealers are subject to regulation under the Advisers Act. Many full service brokerage firms now charge asset based fees rather than commissions for their services. This new pricing of brokerage services is responsive to the best practices identified in 1995 by the Committee on Compensation Practices and better aligns the interests of brokers, their registered representatives and their clients. We recognize though that the Commission needs to address the fundamental issue of what distinguishes broker/dealers from investment advisers. Toward that end our pending rule proposal seeks to delineate advisory services from brokerage services based on the nature of the services provided rather than the form of compensation received. More specifically, if a broker has discretionary authority to trade securities in an account and charges an asset based fee, the account would not qualify for exemption from the Advisers Act. But if the broker does not have discretionary authority, the Act generally would not apply. We are sensitive to many of the concerns that a number of you have who feel that these asset based brokerage accounts have the potential to mislead investors.

Currently, the proposal requires that all ads and agreements for exempted accounts contain a prominent statement declaring that the accounts are in fact brokerage accounts. Based on your comments asking for greater safeguards however, the Commission is now considering more specific disclosure requirements for the final rule.

Finally, I know that many of you are familiar with our rule proposal addressing pay-to-play in the investment adviser area as well as the rather enormous controversy it has generated. But few can disagree that pay-to-play is entirely inconsistent with the high fiduciary standards of investment advisory professionals. While we've received many comments questioning the approach and the scope of the proposed rule, we remain convinced that a rule is long overdue. The Commission must and will act by specific regulation to prevent the practice of buying government business with campaign contributions. It is simply the right thing to do. We are mindful however that differences between the municipal finance industry and the advisory industry might warrant somewhat different regulatory approaches. We are pleased that the Investment Council Association of America has recommended best practices for advisory firms to prevent pay-to-play practices. We are going to evaluate these best practices as we begin to craft our final rule. Working together, the SEC and the advisory industry I believe can eliminate the abusive practices that undermine the integrity of the adviser selection process.

As we move forward on these and other initiatives in investment advisory regulation, we intend to address a number of issues, including the circumstances under which an adviser can engage in principal transactions, revisions to our advertising rules to provide for greater flexibility and enhanced investor protection and possibly mandating that advisers have codes of ethics addressing personal trading. I really believe that the future success of the investment management industry depends on an unwavering commitment to the very highest fiduciary standards first embodied in the Investment Advisers Act of 1940 and honored by the profession ever since. While much as changed over the past sixty years, the guiding principles of the investment adviser profession remain timeless. The adviser's role is still built on a relationship of trust, a promise of integrity and a covenant between fiduciary and client. We ask that you work with us in preserving the high fiduciary standards of your profession that have been and will continue to be the bedrock for enduring success.

It is our hope today that this forum will result in an interface of ideas; that you will feel free to speak out as well as listen; that we will come away from this with a better feeling for the problems of the industry and that this will result in a commitment between the industry and ourselves to do the kinds of things that will retain the primacy of America's investors as our principal concern.

I think that all of us who have ever had any experience in terms of dealing with clients, whether we be brokers or advisers or investment companies, understand the kind of fragile nature of a relationship of trust upon which our markets depend. If we lose that trust, trust in our markets, trust in the structure of those markets, trust in the rules and regulations that govern those markets and maybe most importantly for our purposes today trust in the independence and the integrity of the people who represent them and represent their futures in a very special way. If we do not have that we do not have markets in this country and none of us have a justification for doing the kinds of things that we are doing. I know that all of you represent a kind of proud heritage. You represent a unique position in the linkage between investors and our capital markets. We respect you for your independence and it is terribly important that the dialog today not be viewed as thunderbolts coming down from Mt. Olympus while you all sit there listening. Hopefully we have a common goal. I think we do and we have to gain a better understanding of how we can be helpful to you and hopefully you will gain a better understanding of what our priorities are in terms of the public interest and if this works right, as I expect it will, we will work cooperatively toward not just preserving but nurturing and enhancing that public interest. Thank you very much.

Mr. Roye:  Thanks for those remarks Chairman Levitt.

He set the stage for our discussions today. Many of the issues outlined in the Chairman's remarks we expect to cover in the course of today's roundtable. Before we get going with the first panel and ask those panelist to come up if they would, I want to take care of a few housekeeping items. First, I'd like to say for myself and on behalf of the Commission staff participating in the roundtable, that the views that we express are our own views and don't necessarily reflect the views of the Chairman and the other Commissioners or other members of the staff.

Now I'd like to briefly go over the structure of how we're going to operate the panels this morning and this afternoon. In an effort to foster a dialog on the issues that we want to cover, we structured each panel in a question and answer format whereby the moderator will ask questions and the panelist will then weigh in with their answers.

Because we have a full agenda and a limited amount of time, we have determined not to take questions from the audience but you may be able to talk to some of the panelist after other panels are over and have some of your questions answered. However, because we wanted to afford interested persons the opportunity to participate, we have a public file that we have created where you can submit your comments on the issues covered in the course of the roundtable. We have already received comments on a number of the issues that we are going to cover today and indeed some of the questions that will be posed to the panelists were crafted from some of the questions that we got from information submitted to that public file. Again, we urge you to submit comments to that public file as we consider some of the issues. We will have a transcript of today's discussions available approximately two weeks after the roundtables over. There are phones out in the hall if you need to make phone calls and upstairs in the lobby. There are restrooms down the hall and with that I want to get started with our first panel.


II. Investment Advisers in Today’s Competitive Markets/
Modernization of Adviser Regulation

Moderator Roye:  Our first panel will focus on really the role of investment advisers in today's competitive markets and the modernization of the investment adviser regulatory regime. It's more of an overview type panel. We want to focus on whether or not the existing regulatory regime is indeed effective, where it can be improved. The scope of the investment adviser regulatory regime, whether or not some of the exclusions in the statute indeed make sense in today's new economy. So, let me start by introducing our panelists. They are on our first panel and I will introduce them in alphabetical order. We have Phyllis Bernstein who is a Certified Public Accountant. She is the Director of Personal Financial Planning for the AICPA. She spearheads the efforts of the AICPA in the financial planning area. She is responsible for a number of their publications in the financial planning area and is in the process of updating their guidance on how to register as an investment adviser.

Next, we have Roy Diliberto who is a certified financial planner and a chartered financial consultant. He is the President of the Financial Planning Association which is an organization that is the result of the merger of two of the largest financial planning organizations with about 30 thousand members, I understand. He is the President of RTD Financial Advisers Inc., a financial planning and asset management firm in Philadelphia.

Next, is Paul Gottlieb. He is the First Vice President and Senior Counsel for Merrill Lynch. He served as a Chairman of the Securities Industries Association Investment Adviser Committee. Prior to joining Merrill Lynch, he was the Chief Counsel for E.F. Hutton's asset management group where he was responsible for mutual fund and investment advisory issues. He served in various capacities with the Shearson Lehman Brothers and PaineWebber.

Next, we have Clark Hooper who is an Executive Vice President of the NASD Regulation where she has the office of disclosure and investor protection. She has a fairly broad mandate in that position. She is over the advertising regulation arm of the NASDR which is responsible for review of all the advertising communications with the public, the corporate finance group within the NASD, the internet and investor education operations at the NASD, the investment company regulation operations as well as the CRD and public disclosure operations for the NASDR.

Then, Joanne Medero who is Chief Counsel and Managing Director for Barclays Global Investors. She joined Barclays in 1996. Prior to that, she was in the law firm of Orrick & Harrington where she was a partner in their New York office specializing in derivative and market regulation issues. Prior to that she served has general counsel of the Commodities Future Trading Commission and then prior to that was in the office of Presidential Personnel in the White House.

Then, we have Robert Plaze who is an Associate Director in the Division of Investment Management. Bob is responsible for a lot of the policy and rule making initiatives in the Division. He also heads up the Investment Advisers Regulation Task Force and really is the chief architect of the rules and policies in the investment adviser area.

Then we have Brad Skolnik who is President of the North American Securities Administrators Association which I'm sure as you know is the umbrella organization for the states and the provincial securities authorities in the United States and Canada. He is also the Securities Commissioner in the state of Indiana. I think Brad is particularly proud of the fact that in his tenure they have imposed more fines and penalties than any other securities regulator in the state of Indiana. Under Brad's leadership, he has ably lead NASAA in taking a number of steps to promote affective regulation of advisers at the state level.

Finally, we have David Tittsworth who is the Executive Director of the Investment Counsel Association of America. It is a trade association that represents federally registered advisers with about 250 members with $2 trillion under management and prior to that, David had various positions on Capital Hill. He served as counsel to the House Commerce Committee.

Again, this panel as I mentioned was going to focus on the investment advisers regulatory regime. As many of you know the statute in large part is an antifraud statute that requires advisers to disclose conflicts to clients. The Act itself contains very few substantive requirements and most of them really emanate from the antifraud provisions in the statute like the advertising rules, custody requirements, imposing disclosure of financial and disciplinary information on advisers. The first question we want to explore this morning is really does the Act work in today's increasingly complex economy. Can investors make intelligent decisions about investment advisers? Should a different regulatory framework be considered? Are there additional protections that are needed in the investment adviser area? Are there areas in the Advisers Act where maybe there is too much regulation and we need to reduce some of the regulatory burdens? I'd like to start with maybe David Tittsworth and get your reactions about the statute today and its effectiveness or lack thereof.

Mr. Tittsworth:  Thank you Paul. I first want to speak on behalf of everybody here and everybody to follow that we really appreciate the leadership of Chairman Levitt and yourself and your staff for convening this roundtable today. I consider it to be a very historic opportunity. You certainly don't have, well you do have so many other things on your plate it's fairly astounding to me that you took time to include this roundtable on your busy agenda and I just want to express our great appreciation.

I think you have to say that the Advisers Act has worked remarkably well. Sixty years, there has been a hell of a lot of changes in 1940 when the Advisers Act was created. You didn't have a lot of things that you have today. You didn't have television. You didn't have the NASDAQ market. You didn't have the internet, and yet I think that the basic structure has remained intact and serves investors well. And you basically have three pillars upon which the Advisers Act regulations are premised.

First is full and fair disclosure. In my written statement, I go to some length to describe the disclosures that advisers have to provide to their clients. It's unprecedented in terms of how you compare it to other professions that are out there. The second thing Chairman Levitt alluded to in his statement is the fiduciary duty that advisers owe their clients. Again, a very unique aspect of investment adviser law, adviser regulation that fiduciary duty was really articulated by the Supreme Court in the 1963 case Capital Gains. It's been expanded upon and reiterated by the Commission over the years, but it is a key component of an adviser's specific legal regulatory obligations. Then, finally of course you have very broad antifraud authority vested with the Commission that allows it to do a lot of different things to the investment adviser profession. I'm not aware of any fundamental break down that has occurred in the last sixty years in investor protection.

There have certainly been isolated cases, some enforcement actions that were fairly ugly but no systemic problems of abuse. No history of prolific client investor complaints and I think that's attribute to this flexible standard and whatever scheme your going to employ, if you were sitting in Congress in 1940 or sitting in Congress today or at the Commission, you obviously need a fair amount of flexibility and that's to deal with future problems but also the profession itself is very, very diverse and it's getting more diverse all the time.

I think the one problem that has been identified the last sixty years was on really the inspection examination side. It wasn't with the basic legal regulatory framework, but given the growth of the investment adviser profession in the 80's and into the 90's the Commission, Congress itself was faced with the situation where you had virtually – well you had a limited examination oversight of the profession. Testimony of the Commission on Capital Hill back ten years ago or so was that examinations of smaller advisers were occurring only once every forty-four years; other advisers, fifteen to thirty years. However you want to cut it, it was unacceptable. That has all been changed with the advent of the Coordination Act under NSMIA in 1996. I know we will talk about that a little more but I think that's the only real problem that has been identified. Final point and then I'll shut up because I know you want the other people to talk. I do think that there are some challenges that all of us face, policy makers, the Commission, Congress, and the profession itself going forward and those relate to really the scope of the Advisers Act. I think that again, my view is that the Act itself, the legal regulatory frame work is flexible, it's broad, it protects investors, it's adequate, it's effective but who is included in this scope of the Act. Whether it is the broker dealer rule that we're going to talk about or whether it's internet providers that are doing a lot of things that are different and whether or not it's advised, whether or not your providing personalized advice.

I think the ICI has written an excellent paper and I know on the last panel today they are going to talk about some of the implications of technology and changes in the profession. The bottom line is I think that the scope of the Act is definitely on the table and those are probably the most important issues that the Commission and the profession and other policy makers face going forward.

Moderator Roye:  Before we move on to some of the other panelists, let me make a disclaimer on behalf of the panelists as well, that the views that they express are their own views and don't necessarily reflect the views of the firms that they work for, so we have a disclaimer similar to ours.


Mr. Tittsworth:  I'm going to reject that disclaimer.

Moderator Roye:  Paul Gottlieb: your perspective on the statute.

Mr. Gottlieb:  Thank you Paul. I'm going to basically agree with what we just heard. I think the industry has worked remarkably well and when something works well, we should applaud it and not change it. The industry, the signs of health are really all around. The industry as a whole has grown. Client assets have grown. More and varied products are being offered to clients to meet their needs and while even a single infraction is too much, I think a broad view of the industry is that it works well and the disclosure model has been one that meets the needs of our economy and our clients.

The disclosures required for advisers are indeed formidable and I would compare it truly to any other profession. The disclosures on our policies and procedures and our personnel, on our fee schedules, on the varied items that are both required by the Advisers Act and Form ADV and the other disclosures that we just feel appropriate to explain to clients as they enroll in a program and as they continue a client relationship.

These disclosures are formidable. That's not a complaint by any means. We think that they are appropriate to be disclosed but I think it's fair to state that a high standard has been placed for advisers and that the advisory industry has by in large met the challenge reasonably well.

I'd point out that to call the legal framework a disclosure model is not entirely correct for dual registrants, firms that are both registered broker/dealers as well as investment advisers. There's a substantial body of regulation to be met under the broker-dealer rules and that is again a fairly formidable system of rules to follow that the brokerage industry does comply with and for dual registrants, both the requirements have to be met.

Nonetheless, I think things are working reasonable well. Chairman Levitt mentioned principal transactions, I know that's a topic that is going to be raised later on in the roundtable. That's an important area for reflection and reform as we try to provide the best services and best execution possible to our clients.

Certainly, the consolidation of the industry has made reform here in our minds substantially more important than ever before. So that's a focus for deregulation and further flexibility that is an exceedingly important topic both today and for the Commission as a whole but I think the model has worked well and I think that basic model should continue.

Moderator Roye:  Roy from the perspective of the financial planners, what's your perspective on how the statute and the regulations have worked?

Mr. Diliberto:  Well, I agree also that the Act has worked very, very well. However, I am concerned that if it's not uniformly applied to people who are functionally acting as investment advisers that it's in danger of not protecting the public as it has over the years. I think that uniform regulation under the Act is very, very important from financial planners' point of view. Financial planning as a profession is growing very, very rapidly and there are many organizations and institutions who are jumping on that bandwagon and that's good for the public. However, the public will not be protected in my opinion unless the Act is uniformly applied to all those who are functionally practicing financial planning and investment advice.

So I think the Act has worked. I think it can continue to work but if it becomes watered-down, I am concerned about how it may work in the future. Another question that came up was, "do we need alternate regulation?" One of the things that financial planners would like to see is some kind of regulation for financial planning because investment advice is only one part of what a financial planner does and there are other competency levels that a planner should have and should meet and should be responsible for answering to some regulatory authority to make sure that they are competent in those areas that are being supervised in those areas. At some point, I would like to see that happen.

Moderator Roye:  So Roy your saying that beyond the organizations out there that certify financial planners and apply the standards that you think that there's a need for government regulation of financial planning?

Mr. Diliberto:  Yes, because financial planning is a multi disciplined approach to finances and to regulate only a part of what a financial planner is doing I don't think protects the public as well as an agency that would regulate the entire scope of what financial planners do.

Mr. Plaze:  Roy, the regulation and financial planners rarely what has taken place through private initiatives by the Board of Standards and the marks that it so carefully guards and enforces detailed rules. Do you think that that's inadequate, that government needs to step in and do that?

Mr. Diliberto:  Well, I think it's adequate for those people who are certified financial planners but there are many others who practice financial planning who are not regulated and so that code of ethics and those practiced standards work very, very well and they're stringently applied by the board but there are only 34 thousand certified financial planners and I don't know what the number is but I've heard two hundred, 300 thousand people who hold themselves out as financial planners.

Moderator Roye:  Let me go to Brad, since a lot of financial planners are really registered on the state level as advisers if they're giving investment advice with regard to securities. Do you have any reaction to what Roy said about the need for additional regulation?

Mr. Skolnik:  Roy raises an important question that I think many of us have given thought and consideration to. One problem we confront however is the fact that financial planning is often times really a multi disciplinary type of profession. It involves not only those who hold securities or investment advisory licenses but insurance professionals, certified public accountants and the like. It seems to me if we're going to regulate financial planning as a profession, that both at the federal and state level we're going to really have to make some determination as to what agency or agencies would ultimately have responsibility for oversight.

I know if you look inside the telephone book in any community you're going to find under the heading of financial planners not just investment advisers or broker/dealers, but also folks who are accountants, insurance salespersons or advisers and a number of people who maybe hold more than a single license. I'm not saying that it's something we shouldn't do. It's just a matter of I think we're going to have to look at it a little differently than the way we currently categorize the way services are delivered.

Mr. Plaze:  That would require quite – to achieve that wholesale changes in existed statutory structures which of course involves robbing Peter and paying Paul. Both in terms of the regulator as well as the regulated interest who are becoming attached to their regulatory systems? Of all the systems that regulate, isn't the Advisers Act the broadest one in terms of capturing most people who are actually financial planners because it is very difficult to be a financial planner without giving advice about securities. Is that a fair statement?

Mr. Diliberto:  It's a fair statement that it captures that part of the advice, yes absolutely and most financial planners do provide investment advice so under the current structure it's probably the most likely place for it to fit but it doesn't fit perfectly.

Mr. Plaze:  Some states have advisory laws, which include holding out as a financial planner brings all of those advisers and all those insurance agents and accounts within the advisory statutes based on holding out. Should the federal statue be changed similarly to achieve that Roy, do you think?

Mr. Diliberto:  I would applaud a holding out provision, absolutely.

Mr. Skolnik:  It's a small number of states, if I'm not mistaken that really have that holding out provision in their state law. For example, in my state of Indiana we do not have that so if someone holds themselves out as an investment adviser they fall within the Act but the term financial planner or even financial adviser probably does not fall within any statutory definition.

Mr. Plaze:  That would work as a way from concepts of functional regulation whereas we're regulated based on what you do and what not you call yourself which is, which runs a little bit counter to the direction the Commission policy is going in the past years.

Mr. Diliberto:  Just to add from a consumer's point of view. If the consumer goes to see an adviser who calls him or herself a financial planner, a financial consultant or any one of the number of holding out titles, there should be an expectation on the part of that consumer on what will happen when they see that person and today that doesn't exist.

Ms. Hooper:  If I could just speak up for one moment. I really think Roy has raised an issue that is probably the most forward looking issue that we may discuss because we can look at the variety of different types of schemes of regulation and statutes et cetera but what your raising Roy is something beyond that. Which is really getting at the convergence of the industries and your are right we don't really have anything in place?

First of all we don't have a definition for a financial planner but if you look at what the scope of a financial planner's responsibilities, they're regulated independently and individually and yet to the consumer, to the investor – the one person that we're really trying to protect. Those are transparent. That person is going to a financial planner and they are asking them to help them in a variety of ways. Whether it's estate planning, whether it's purchasing securities, whether it's investment adviser, investment planning and whatever the person is being called and whoever is regulating that individual is totally transparent to the consumer.

So I think that this is really an issue that we all need to look at from a forward looking perspective as to if the industries are going to continue to converge and there's nothing that's giving us an indication that they're going to reverse that trend. Then we need ourselves to be thinking about how we can best do two things. Obviously, first of all protect the investor but maintain the integrity of this industry regardless of how it evolves so that the consumer has the confidence in it. I think it's an excellent point, no answer of course.

Ms. Medero:  I do think though before you suggest a federal solution that you have to find whether there's a problem that needs to be resolved and whether perceptions can be handled through investor education. Which I know a number of private agencies, as well as the SEC, have undertaken.

Mr. Gottlieb:  I guess I would agree with that last comment. Many of these folks are already regulated in one framework or another. Let's be careful in just deciding there's a problem here and slapping another layer of regulation, or another regulator on top of something that's already subject to rules, procedures, disclosures et cetera. For example at the brokerage firms, many brokers even traditional commission based brokers in the ordinary and historical sense pride themselves in providing some planning advice to clients and I think that's something that should be applauded since our emphasis is to get away from the tunnel vision approach on a particular trade and rather provide some broader perspective on how does a particular transaction fit within a broader investment outlook.

So let's be careful. Planning is not an evil word and lets not try to restrict something that we actually want to encourage as far as the provision of advice to clients.

Ms. Bernstein:  A significant number of our members provide financial planning services and financial advice with integrity and objectivity and really have been doing that as part of the profession. So it becomes difficult to say that all financial planners are investment advisers because a significant number of CPA's who are in the business of giving financial advice are not in the business of giving investment advice.

There are significant numbers and growing numbers of our members today who are registering as investment advisers or who are serving as registered reps of brokerage firms. They're in a different business and those members are registered and regulated, but those who are really just giving financial advice and financial planning who are not in the investment area providing tax advice, providing information on retirement distributions on cash strategies, on charitable giving, on estate planning may not be getting involved in the investment area. So I think you have to look at what the person does, what the function really is and not necessarily the nomenclature, what the words are. It's what the person does and I think that's really where the line has to be drawn.

Mr. Skolnik:  I agree that I don't – I abhor the thought of adding more regulation or another layer of regulation. However, I do concur with what Clark said, that the manner in which financial services are delivered today do not fall neatly within the categories established by the 34 or '40 Act or states' securities laws. I think the fact is that the law is set forth in many of our state statutes as well as at the federal level have maybe not kept up with some of the changes that are occurring within the industry. By the industry, I am referring to the broader financial services sector.

Sometimes I'm left with the impression that when we're trying to determine who should be regulated as an adviser as opposed to a broker/dealer as opposed to maybe some other financial professional that we're left trying to almost pound square pegs into round holes.

The fact of the matter is back in the 1930's and 40's so called financial planning and investment advisory and broker/dealer services were much different than they are today and I think it does raise the broad question. Do we need to take a fresh look at the way we regulate the entire profession? I agree with Bob Plaze; that would be a massive undertaking.

Mr. Plaze:  The difficulty you have moving from the current scheme which is based on function to the later scheme which is based off of a financial planner which is a multi-disciplinary exercise by however you define it. I think everybody would agree it involves brokerage, involves investment advice, involves accounting and a number of other services is that you either have two choices to make. Either you have a separate layer of regulation that applies just to financial planners and leave the additional regulatory structures in place for the other functions. Or, you part out a special group of people who call themselves financial planners and regulate them separately and then not regulate them as investment advisers or brokers or accountants. The problem of that approach, I think, will be illustrated if Merrill Lynch decides that it rather be a financial planner not regulated as a broker/dealer. Which is obviously I think an absurd consequence of that latter approach and so you're left with the current approach. You like it or don't like it, is you do have a separate layer of financial planner regulation and it's voluntary regulation.

The marks which are enforced and to the extent that the marks become more popular and more in part a part of marketing financial planning services in today's market place. That effectively it will have greater and greater teeth. I think those choices is what you're faced with in terms of models.

Ms. Hooper:  I also do think however that – I'd like to suggest at least that you don't have to automatically assume there have to be additional layers of regulation. I think it's very critical in fact, that one doesn't do that. Because, we are all trying to get away from duplicative or multiplicative regulation and it's not serving anyone good by having a firm have to submit itself to layer upon layer upon layer of substantially the same types of regulation.

It's an enormous, as I said earlier, it's an enormous question. I do not know how you get it. It's like getting your arms around smoke but I do think that we need to think more forward in terms of the way the industry has developed.

Mr. Plaze:  I guess one of the middle ranges also is trying to adapt the individual regulatory structures more to accommodate financial planning. I know that with our ADV forum that we have recently proposed a number of questions that deal with new issues that come up. For instance, we asked for the first time, "Do you have a professional designation at your financial planner?" "Has that designation been revoked?" Those were not issues twenty years ago.

Moderator Roye:  Roy seems to be suggesting, that at least in the financial planner segment of the industry, that maybe sort of a voluntary self regulation is not sufficient. In the investment adviser area generally the notion of self-regulation periodically rises. Bob maybe you could speak, since you have been here doing some of those initiatives going back to the Commission submitting even a legislative proposal to establish one or more self-regulatory organizations. What is behind those kinds of efforts?

Mr. Plaze:  Well, back in 1988, when we submitted the proposal I had an occasion to do some work on that proposal, we were faced with an exploding population of investment advisers. We were at a crisis here at the Commission. There were almost 6 thousand advisers registered with the Commission. Of course, by the time 1996 came around and legislation was enacted dealing with that issue we had about 23 thousand investment advisers. So we saw it coming. It was mostly dealt to address that issue. The SRO issue came up again in '93 and '94 on the Hill. There was legislation that was introduced that would make the NASD the inspection-only SRO for investment advisers. The board of standards of the institution of CFP's, as again from time to time expressed an interest in being a SRO for financial planners.

Legislation would be required to make a SRO. The SEC could not do that under our statutory scheme by ourselves. The Exchange Act was amended to accommodate a SRO for broker/dealers; the NASD and again it would require legislation. It hasn't happened and I think there are some reasons for that but then again there are some good arguments that you can make for a SRO.

The reasons first, I guess, the con would be that NSMIA, which we will talk about, really addressed our problem in terms of our registrant population, we're down to about 8000 investment advisers. Which with our current staffing, we can handle.

Second, advisers, to some extent are different than broker/dealers. SRO is initially organized for broker/dealers on the notion that they trade together, and there's a lot of interdependency and rules of the road which government was in a good position to dictate. The industry was in a better position to set those rules for its members. Investment advisers do not have that much interaction.

The third reason, and I think this had to do with a lot with why 1988 proposals did not go anywhere. It's an additional layer of regulation and it's a regulation that has to be borne by the people who regulate. There are fees and costs associated with that on top of the current registration regulatory costs on advisers.

Finally, the politics of investment advisers. Question is okay, if you decided your going to have a SRO, then the question is "Who's going to be an SRO?" One thing was consistent in 1988 when we sent that proposal up to the Hill is, a lot of people opposed it but they said, "Well, if you're going to have one that's okay but I don't want that other guy to be the SRO." "I want to be the SRO." "My trade association will step up to the plate but not that other guy." It was a little bit like a circular firing squad and that's why the regulation proposals never went anywhere.

There are a number of pro's here. First of all, again, there is expected to be continued growth in this industry. I presume a good market correction could resolve that but we're all hoping that's not going to happen. Secondly, the continued crisis today in regulation isn't with the volumes but it's with SEC staffing issues.

SRO could pay more market salaries to keep people, a lower turn over. Maybe Clark could talk about her success at doing that at the NASD. Develop by a greater expertise than you are able to the staff here. Where we are able to keep people for 18 months before they leave for higher salaries. Is SRO's closer to the industry? It understands much more is going on as opposed to SEC staff people here in Washington who really isn't in the industry. Utilizing industry committees. Bring a lot of expertise, a lot of knowledge to regulation.

Finally, a SRO can impose tougher standards than the SEC can, which is our regulation of the Advisers Act is based on prohibiting fraud. All of the NASD and other self-regulators impose principles of business. Prevent sharp practices, which perhaps don't rise to the level of fraud but really shouldn't take place in the industry. So there are a number of advantages that a SRO might have.

Moderator Roye:  Clark, you have experience obviously with SRO, do you want to comment on those advantages and disadvantages and how they might play out in the adviser context.

Ms. Hooper:  Well, if you talk about advantages and disadvantages of a SRO, I really don't know, certainly I can speak to the SRO model for broker/dealers because that's what we are. The only thing I would say is I would like to discuss that model with an eye towards giving you a feel for the expansiveness of what we do and what an enormous undertaking it is because, when you look at the types of things that the NASD regulates for the securities industry.

I mean, as Bob articulated, we are really geared towards a different standard than the antifraud standard. We're looking at standardizing the principles and practices of the industry and promoting high standards of commercial honor, adjusting equitable principles of trade, enforcing fair practice regulations and making sure that our members observe the federal and state securities laws.

We have a variety of functions that we undertake, that spring out of those basic mission or core statements. I mean, we have to process all of the membership applications, individual qualification and testing. We run the CRD program, as has already been mentioned to you. The NASD has around 56 hundred-member firms and over 600 thousand registered reps with those member firms.

So for all of those members and individuals, we're responsible for insuring that they are supervised properly, that they are complying with the conduct rules that we have enforced. We do, in fact, participate readily in rule making and examinations, investigations, enforcement. You can go up to our web site and look at every bit of that. What I'm basically trying to say, this is not something that is a start up program that's to be taken lightly.

So if an SRO for another industry is being contemplated, I think you really have to look at whether or not it will work for that industry. I don't know whether the SRO model would really work for the investment adviser industry. It's just not clear that that would be something that would be effective.

As Bob has said, the NASD was founded to regulate broker/dealers, and that's an industry in which members frequently transact business with each other. Like introducing and clearing brokers. There are mutual beneficial incentives for broker/dealers to regulate themselves in order to preserve efficient and effective securities markets that protect investors and promote orderly trade.

Investment advisers, on the other hand, generally only conduct business with their clients or with broker/dealers that execute trades for their clients. They do not generally conduct business with each other. Therefore, a SRO structure may not work well for advisers since they have different incentives for dealing with each other.

One of the unnamed benefits however, of an SRO is its flexibility and changing as the market place changes and applying its regulations through interpretations and using its rule making process instead of having to amend a federal statute. So there is a certain amount of flexibility in accommodating the changes that are going on in the market place that an SRO is able to provide.

A real downside to an SRO or to establishing one, is the enormous cost, which I think would be a real disincentive to having an SRO. You've mentioned that as well, but I don't think one can overstate what it would cost, not only to start up an organization like this but the cost to the membership of providing. I know that at the NASD, our larger member firms, and I know there's probably one at this table that would agree with me. Our larger member firms subsidize the regulation of the majority of our members who are small broker/dealers because they can't afford to pay for it.

So one would have to ask the question, in all likelihood, if an adviser SRO were created, it most likely would be primarily responsible for regulating smaller advisory firms. Probably those that are registered with the states rather than the SEC and it just seems to me that you are going to be confronting a financial question that is not going to be easily resolvable.

Moderator Roye:  Phyllis, is there a need for SRO in the adviser's area?

Ms. Bernstein:  We have concluded that no SRO is needed. That a SRO is unnecessary and inappropriate for the investment advisory and financial planning community, but there's no evidence of a serious flaw in the present and state structure and it seems to be regulated well. But what is confusing, and I think we've talked about that earlier, is that the marketplace is confused about the definitions. Who is an investment adviser? Who is a broker/dealer and who is a financial planner? For those in the business, when you cross lines, do the functional definitions still work or have they become blurred? As there has been changes in the business, do the definitions still work? There needs to be a consistent, clear bright line that is applied with uniformity and we would recognize that need. Not a need for an SRO but yet a need for clear bright lines that are uniformly applied and would be willing to see a debate as to what the definitions are and who should be regulated and who should not be regulated. But not to say it needs to be a whole new structure in place, but yet who needs to be part and who doesn't of any regulation for investment advising.

Moderator Roye:  David, Roy, a perspective on that issue?

Mr. Diliberto:  Sounds like everybody agrees an SRO is unnecessary Paul.

Moderator Roye:  I wonder Roy, whether or not the SRO is a substitute for a federal or state regulation of financial planners?

Mr. Diliberto:  I concur that we probable don't need a SRO for investment advisers. I think the Act works well, as I said earlier. However, an SRO for financial planners is something that I would support. The problem financial planners have when they're regulated is that the people who are regulating them frankly have very little understanding about what we really do. So we're regulated as investment advisers, which is a part of what we do but there's much more that we do that is not understood. To me it always gets back to the holding out provision.

Now, there was some proposed regulation, proposed laws perhaps back in 1988 but the bottom line it did not work. It was never passed politically. There was a problem because of so many of the larger organizations and larger institutions that didn't support that provision. But I think the public needs to know, if someone holds them out as doing whatever it may be, and financial planning is obviously what we are talking about here, they should know there is an expectation of what they will get when they go to someone who is a financial planner. If that person is basically an insurance agent with one product, they need to know that and that person needs to be regulated and disclose the fact that there are those kinds of conflicts. Right now, they escape that regulation. They're basically regulated by perhaps an insurance department that doesn't look at those kinds of issues.

Ms. Hooper:  If I could add to that. While we've ..

Mr. Skolnik:  I'd like to hop in here if I could. I wasn't quite done before, Paul whenever I talked about the SRO, everybody agrees, and in my statement we talk a lot about NASD and my good friend Clark Hooper and I have had some conversations about this in the past. Our organization is worried about NASD and its role and the noises that it has made over the past several years. I even found one quote from the Wall Street Journal in 1986 that there was a roundtable at the SEC on securities regulation, and the day before the NASD Board got together and unanimously approved an SRO for investment advisers, dually registered investment advisers. I guess there's no surprise then.

Ms. Hooper:  I was there then.

Mr. Skolnik:  Okay, I'm sorry, there's no surprise announcement today. Which we are grateful for Clark.

We are concerned, there has been this steady drum beat and talk about regulatory black holes and the fact that there seem to be these problems. I simply don't see them. If you're talking about the financial planners, maybe that's a different dialogue. I think in the level-playing field as well has been characterized. That the '34 Act regulation is more stringent and more comprehensive than the Advisers Act regulation and I think that's just wrong. I guess that's when I go back to, you look at, we don't have an SRO for federally registered investment advisers, thank God. We don't want one. And we'll fight against one. And we certainly don't want NASDR to be the SRO because that blurs the distinction between broker/dealers and investment advisers even further than it is already. And we continue to believe that there is a core fundamental difference between brokerage activities and investment adviser activities. Yes, there is blurring. Yes, this is 2000 not 1940 anymore. But, there still are, at the core, very fundamental differences between the two industries. An SRO simply is not warranted for the investment adviser industry.

There are no documented cases of persistent frauds and abuses like you have on the broker/dealer side. You don't have the level of inter-connectivity, vis-à-vis, I guess that's the way they say it today, right? Investment advisers usually aren't hooked up the same way that the brokerage industry is, and you don't have these technical issues relating to settlement, execution, reconciliation, all those things on the brokerage side. They just simply don't exist.

So I hope maybe today we can all agree that an SRO is absolutely unwarranted and talk about some of the blurring, the important distinctions. But again, I think that it's very important to understand that it would be highly inappropriate, I'm very glad to hear what Clark had to say about cost, it would be absolutely crazy to impose that type of cost on our industry. Our associations always supported reasonable regulation. We've supported fees at the SEC to fund inspections if that's what we need to do. It's more effective folks. It's more effective to have that direct regulation.

When you look at the results of the Coordination Act, the last three years, it's been an overwhelming success at solving the only problem that has ever been identified and that was inadequate oversight of the profession.

Mr. Plaze:  I would just very quickly add, it sounds like a stake has been put through the heart of an adviser SRO. I do think though that many of those same negatives would apply in the financial planning context as well. It's not clear there is a need for that regulation. It is not clear that the mammoth effort would be worth imposing this kind of regulatory scheme when in fact these folks are frequently regulated by a variety of other regulators, whether it is insurance or adviser or broker/dealer.

To have to pull out the financial planning folks from each of those other regulatory schemes and place them under an SRO I think would be enormously dislocating. If you don't do that and you simply put the SRO on top of the existing scheme then you have the duplicate regulation, the cost that we are all trying to avoid. I think we had best be very careful determining if there really is a sufficient problem here that merits that kind of approach.

Ms. Hooper:  One of the things that this dialogue, I think really points to is just how extremely diverse the investment adviser financial planning industry is. Because, I think it's much easier to draw a bright line between your members David, and broker/dealers and the activities, and see clearly why this Advisers Act is working well for your members. And yet, on the other hand, the real blurring of the lines seems to come with the financial planning industry, and who's doing what to whom. I can understand your concerns and it just shows the wide-spread disparity. The breath of the industry and why it's so difficult to come up with one scheme that fits all and I think that we do want to avoid duplicative regulation but I would go so far as to say that the financial consultants in your firm Paul are dealing with different issues than the financial planners in your association Roy so all of this just adds to the complication I believe of trying to come up with a scheme that makes all of the participants feel like they are being regulated fairly and not onerously and perhaps the NASD should be looking at its own rules to insure that it's not over burdensome.

I think in the long run, we can't lose sight of the ultimate goal, which is, as I said earlier, is to ensure the protection of investors and the integrity of the industry at the same time.

Moderator Roye:  Let's move on. Going back to the structure of the statute. If you look at the investment adviser regime and you look at the requirements in the statute, unlike some of the investment adviser regimes and some countries where you have good character requirements, you can only be an adviser if you're quote fit and proper. You have minimal educational and experience and knowledge requirements. For example, in the state level Brad, you have bonding requirements. You have the new competency exam on the state level. Are these concepts that are needed at the federal level, Brad?

Mr. Skolnik:  I really cannot assess whether federally covered advisers would benefit from net worth or bonding requirements. That's something that I think is often times more appropriate for the smaller investment advisers who are engaged in a retail business.

As far as competency examinations go, I think that is something that professionals at all levels should possibly have to face. Regardless of whether they are in the securities industry, the legal field, or the accountants industry. We've been very pleased with the implementation of the new investment adviser competency exam affective January 1. Prior to that examination, there are really very little, in terms of barriers, to entry into the investment advisory field at least at the retail level. Advisers were required to pass an examination. They tested them on state law but lets face it, it was not a particularly rigorous exam and it really did not test them regarding their knowledge regarding product knowledge, theory and the like.

The implementation, I believe, of the competency exam will go a long ways in ensuring that the advisers to whom millions of small investors entrust the good portion of their life savings, demonstrate, at least, some level of knowledge regarding the field in which they purport to be a professional in. I don't know whether say, a competency examination for individuals who fall under the federal regime would necessarily be advantageous. Certainly, it's something that we feel for those advisers who are engaged in the retail level, providing services that it has been a benefit.

The competency exam has been met with I believe a fairly wide scale success among both consumer groups as well as the industry. It was devised in large part, with a great deal of input in advice from members of the industry, to make sure that it was appropriate.

One issue that we faced from the outset was the fact that it's very difficult to define what an adviser does because there is such an array of differences in terms of services provided even to small retail investors. But, I think the competency exam really is potentially long-term very beneficial for the well being of the investors.

Moderator Roye:  Bob, do you have any reactions? I know you thought some about this issue.

Mr. Plaze:  Yes, I had an occasion to be involved in these issues over the years. Bonding is quite interesting. You know the Commission proposed legislation supported by many areas of the industry a few years ago that would have added a bonding requirement. Advisers are the only financial service industry in the country that I know of that is not subject to some bonding requirement to protect the investor assets. Typically when we see large frauds and we go in to clean up the mess, so to speak, there are not sufficient assets to pay off the clients who have losses as a result. Another area, one you might want to consider bonding for is its another form of self-regulation. There is no organization more interested in protecting its assets than the bonding company or imposing stringent controls on people they bond.

Look at the fraud a number of years ago, Steven Wymer from California. A number of mid-western, western communities lost their savings. University and college systems lost tremendous amounts of money by his fraud. However, note, the ERISA assets under his control that were subject to the bonds, he never touched. So I think there is some learning there and something that might be useful for considering. I think it would have to be a meaningful bonding requirement.

In the competency requirement, I speak for only myself here, I think we have to be careful as government regulators before we pursue this. I think it's a difficult area.

One, when we initiate competency, we prevent people from entering a profession, entering a means of livelihood until we say they are qualified. Until the government says, they are qualified. That's a difficult standard to impose upon people. Particularly in an industry as varied as the advisory industry. From the small financial planner who is giving very simple advisory services, to the community, to the most sophisticated international portfolio manager. How do you devise a set of tests that is meaningful for both, to allow them entry into this field? If you set it too low so that you do not deny services to middle America, because simply the people cannot afford the education, the backgrounds to pass those exams. If you set it too low then are they really competent because they indeed will market that?

Finally, how do you test competency in investment advisory area? I know Brad; you're going to want to respond to this. There are theories of investment advice. One that I like to give, there is this Elliot wave theory you see sometimes in some of these magazines. I know most advisers do not subscribe to that but who are we in the government to say that's a wrong theory of investment advice. That if you checked the box or you're writing an essay that you are not going to be able to give investment advice. I don't think there is any consensus among financial professionals as what is appropriate investment advice.

So one thing possibly to do is well, you simply don't test on investment advice, you test on law and process. Another question is, "Well does the person really know how to give investment advice?" If they are claiming that they are certified to be competent, have we created a greater problem than existed at the beginning?

Those issues concern me. Brad, maybe you would want to talk about how you have thought about these issues and dealt with them in your contact.

Mr. Skolnik:  No, these are issues that the states obviously considered when devising the examination. That's one reason why we work closely with the professional testing service, to make sure that the exam was what we would considered to be a valid one. I don't think it's inappropriate to ask that those folks to whom millions of small investors entrust their life savings to demonstrate some appropriate level of competency or understanding of basic investment principles. We do it with lawyers. We do it with accountants, with physicians and others to whom we entrust important issues in our lives to.

I think the same thing should apply in the investment advisory field. The fact of the matter is, if you deal with an investment adviser or if you receive, advice from someone who is not capable and does not know what they are doing, you can lose your entire life savings. The same way that dealing with an incompetent lawyer or accountant can have devastating consequences for an individual. Certainly there is no exam or test that is going to insure that somebody is ethical and that somebody is going to do a good job. If you think about it, when it comes to the practice of law, the accountant's profession, we do require testing that is very rigorous and does involve some level of competency there. I think it's only appropriate that we demand the same thing of investment professionals.

Mr. Plaze:  I think Brad, for each one of those organizations that do that, there is a self-regulatory organization involved for the medical, legal and other professions rather than government doing it directly. There is also an issue, of course, is raising barriers to entering and keeping prices high.

Mr. Skolnik:  The competency exam has not – the cost of entering the investment advisory field was really not increased at all by the implementation of the competency examination. I will tell you from having to review some of the sample questions myself; it is basic information that I think any investment adviser should have because I was able to answer a surprisingly large number of the questions. I will tell you I'm a lawyer, which qualifies me for probably very little. I'm a lawyer, not an investment professional and I would be very concerned if I went to an investment professional and he or she could not pass that examination.

Moderator Roye:  Let's keep moving. We wanted to discuss NSMIA. I think we are going to move quickly by that one. I think from the SEC perspective we have a sense that NSMIA is working well. I think it's been alluded to. It's allowed us to reduce the inspection cycle from fifteen to twenty years to five years for the federally registered advisers. We have the sense that it is working well on the federal level. Brad, on the state level, any quick reactions?

Mr. Skolnik:  There's still a number of outstanding issues that we have dealt with in terms of implementing the Coordination Act in a uniform manner. I think we have made significant progress in doing that. Equally important, I think for investors, the states have now begun the focus much more heavily on investment adviser's examinations and inspections.

I can speak from personal experience in my home state. Prior to the passage of NSMIA, we did not have any formal examination or inspection program for small investment advisers. After Congress bestowed full responsibility for the registration and oversight of small investors upon us, we implemented an inspection and examination program in my state. In a little over two years now since it has been in place, we have conducted approximately two hundred examinations. Which has resulted in, I believe in only about a hand full of referrals to our enforcement department for further investigation.

Maybe every bit as important however, there has been numerous examinations that have resulted in detection of rather minor compliance issues that we have been able to help the firms resolve through either deficiencies letters or even exit interviews. I think that is an important step we have taken because it allows the firms to nip potential problems in the bud before they escalate or fester. In addition, the industry's responded very favorably to the fact that the state is now out in the field. I think, by and large, they have welcomed our oversight in that area. We try not to be burdensome and I don't think we have. I know in my home state, the fact of the matter is it has resulted in increased oversight in protection for investors.

Mr. Tittsworth:  Paul, I know you want to move on, but I can't resist another opportunity to barge in here. I don't think very many people; probably the people in this room do recognize what impact the Coordination Act had. It's a grand experiment in federalism. You had this problem. You had all these registered investment advisers, 23 thousand of them, in 1996, a growing industry, managing trillions of dollars in investor assets. Typically or historically, our profession has been dually regulated by both the states that were there first starting in 1919 in my home state of Kansas and the fed.'s who popped in 1940. You had this system where both of them were out there regulating the same profession, there were problems, there were costs, and there were inefficiencies. We talked about the SRO proposed legislation. There were other proposals in the early '90's that would have imposed fees on federally registered investment advisers to give this Commission more resources. None of those bills made it through but in 1996, the Coordination Act was passed and by this division or allocation of regulatory responsibility, Congress solved a hell of a big problem. It has been very successful.

On the state side, from our federally registered adviser point of view, we definitely commend our friends at NASAA. I won't go into detail. We think there are some problems, referring to the state of Texas. That is a very unfortunate as part of the promise of the Coordination Act, was uniformity, getting rid of this state regulation that was unnecessary and it's still not uniform. My former boss John Dingle used to have an expression about herding minnows and I'm sure that's Brad's dilemma. It's a constant problem.

By and large, on the state side, it's been successful. On the federal side, Paul, I guess you give yourselves an "A" plus. You look at the regulatory side. You have the creation, the investment adviser task force in 1997. It's in the process of reviewing every regulation on the books concerning investment advisers. I put in my statement, all the rules that have already come out. The damn rules you've got that are pending. The ones that are coming up. This is a revolution folks; this isn't just that Congress passes a law and something sort of changes a little bit. This is a full-scale revolution in adviser regulation.

Moderator Roye:  Thanks, David.

Mr. Tittsworth:  I don't know whether I should be thanking you or not. On the inspection side, my good friend Gene Gohlke sitting here. The inspection cycles have gone from once every thirty years, fifteen years, forty-four years, pick it. To once every five years, more sweeps. It's an unbelievable story. Enforcement, the numbers are --.

Ms. Medero:  Some of us traveled a little farther than you did that maybe would like the chance to speak. Thank you.

Mr. Tittsworth:  Sure, Sorry.

Moderator Roye:  Let's move on to some of the exclusions in the statute. One of the ones that's been a focus recently is the broker/dealer exclusion where brokers are obviously engaged in re-pricing their services, charging asset based fees, execution only services, side by side, full service, brokered services. We have a rule proposal pending that goes to that issue. Let me start with Paul. What's happening in the broker/dealer community, Paul, that raises these issues?

Mr. Gottlieb:  Well, obviously a lot has been happening and the asset based pricing alternative that all the firms have come out with over the last couple of years has really been the focus of a lot of comment and is in the process of changing the industry pretty significantly in terms of giving clients a choice and how they pay us. Do they want to pay us on the basis of assets or do they want to pay us in the traditional commission based model.

We think that this new pricing is a pretty startling development and a pretty beneficial one as far as our clients are concerned. Obviously, clients have agreed to the extent that they are literally flocking to these new alternatives. There has been a lot of confusion as well and we're really only talking about a pricing alternative here. Just briefly, one of the benefits of this kind of alternative, well first off you're giving customers a choice. We believe choice is basically always good. It offers clients a chance for better predictability of their costs and that seems like a pretty beneficial thing. It can significantly reduce costs for clients who want to trade frequently and that seems like a pretty beneficial event.

Most importantly from our perspective, this type of pricing moves us away from the traditional commission based concerns that clients have had, that compensation is tied to particular trade and in doing so, in aligning client interest and firm compensation in a better way, we're moving towards the recommendations that were made by the Tully Commission's Report and really trying to minimize those conflict of interests concerns that have bedeviled the brokerage industry for a fairly significant period of time. So what we're doing here is offering the same services. Really the same traditional services but with a new pricing alternative. We should be clear because the advice word, the "a" word is used.

Traditional brokerage service, traditional full service brokerage service includes advice. It's incidental to the trade but the advice is definitely there. Congress recognized this when the securities laws were passed; the SEC has recognized this. Advice has been with the brokerage industry since the beginning of the brokerage industry. We don't think that there is anything to apologize for with regard to that. I have a quote here from the Tully Commission Report that I thought was worth mentioning. "The most important roll of the registered representative is after all to provide investment counsel to individual clients." We think that's true. So we take these words seriously. We provide them. Clients now have the choice of commission based services, or asset based services, nonetheless we think this is all a positive development. Needless to say, we support the adoption of the rule.

Moderator Roye:  Roy is the issue special compensation or is it really that advice is no longer incidental?

Mr. Diliberto:  It's actually both in my opinion. As I was listening to Paul, I thought about my own personal situation when I was earning commissions only and not fees and I gave advice and obviously I wasn't registered. When I decided that I needed to charge fees, I didn't ask for an exception, I got registered because that's what I needed to do.

There is a major difference here and the advice, whether it is incidental or not, and I don't think it's incidental because Paul said it wasn't. He said many of his brokers provide financial planning services and I commend it. I agree that what they are doing is extremely positive. When a customer goes to a full service broker and the customer understands that the compensation will be transaction based. The customer puts up some antenna to judge the advice. In the context, that that customer knows that there is inherent conflict of interest between that customer's interest and the interest of the broker. The customer knows that. It's implicit in the relationship and the transaction is what drives it and there may be some advice and maybe that is incidental.

However, a customer's level of expectation increases significantly, and I can tell you that from personal experience, when you're charging a fee, they fully expect objectivity and as a result, I believe you now become a fiduciary. You're a fiduciary under the Act; you're not necessarily a fiduciary under the NASD regulation. So it's that fiduciary relationship and it's the disclosure of all conflicts of interest that the consumer needs to be provided with.

So it's a question of a level playing field. I don't see any difference in what the major brokerage firms are doing and what investment advisers, if you will, did in the early '80's when they decided to go into the fee business. They registered. To have a level playing field my question would clearly be as a financial planner who provides asset based fees, why would I not be excepted from the Act when, in fact, functionally we are doing the same thing.

Mr. Gottlieb:  I guess we think there's a pretty clear line of distinction here. When you're providing brokerage services I think it's pretty clear on its face what it is and I have to smile here a little bit because it's a little bit damned if you do and damned if you don't. When the industry was entirely commissioned based, there was criticism. How can you have a system that compensates you for doing a trade? Maybe a trade is not always the best thing to do. Now that we're going to a system that your not tying compensation into the trade, you're getting criticism from the other side. How can you possibly give advice when maybe you don't do a trade? Well, maybe the point is we should not have a theoretical argument about it.

Clients, pretty clearly I think, understand this service because it is held out as a brokerage service and if the SEC rule is adopted it will state that advisements specify it as a brokerage service. We use a client agreement that says it's a brokerage service. In fact, the trading function continues to be the hallmark of what is being provided here.

I really think it is pretty clearly, excuse me for repeating myself again, pretty clearly brokerage and that clients understand it. Now your getting away from the tyranny of commissions and giving customers a chance to feel that they're on the same side of the table as their broker. That alignment is I think something that we should applaud. Something that was in line with the Tully Commission Report and one that really doesn't raise great theoretical issues since we still have a frame work that talks about services being provided incidental to a trade.

Mr. Diliberto:  All you need to do is watch television and look at the ads. Look at some of the full-page ads that are run in the newspapers almost every day of the week and see what is being promoted. Advice is being promoted and by the way, I don't quarrel. I absolutely totally agree that this is a positive thing for all consumers. I just have a question that I don't understand. I don't understand why the exception is necessary. My question is if functionally this is what you're doing, then what is it about what your doing that you don't want to be part of the Act and the fiduciary relationship that you say you have with your client, being on the same side of the table. That sounds like fiduciary to me and why wouldn't you want to adhere to the disclosure requirements and the antifraud provisions of he Act. What is wrong with registering? I don't have a quarrel with you doing it, I think it's wonderful. I have a quarrel with you not being registered while your doing it.

Mr. Plaze:  If I could respond. I don't register so I could do so. I'm a big fan of the Advisers Act. Most of my career has been spent working with this statute and I'm a true believer in what it does. At the same time, I have to recognize that the Advisers Act was passed six years after the Exchange Act. It was written to regulate broker/dealers and from the get-go the authors of the statute, the Commission, recognized that investment advice was an intricate element of brokerage services, and the Act was not intended to be an overlay of broker/dealer regulation. It was intended primarily to pick up a group of individuals giving investment advice that was not subject to Commission regulation at all. So therefore, it creates an exception for broker/dealers who provide services that are incidental and then receive no special compensation.

My view of the primary condition is the incidental, the special compensation. The brokerage commission is what they were looking at in the 1940's; well what did brokers do in 1940? How are they compensated and special compensation was thought of something besides the fixed commissions that brokers were receiving at that time.

Let's hyperlink, shall we say, up to 1999 when the broker services started to be re-priced. Finally eliminating the primary source of conflict of interest that has resulted in a phenomenal percentage of enforcement cases the Commission has brought over the last fifty or sixty years as well as the other problems that we have seen in the industry.

There's conflict. They achieve this after the Tully Report and then the first thing what's going to happen is their going to have applied to them the Advisers Act which is specifically intended to deal with conflicts of interest. So just when they've eliminated the principal conflict of interest, the operation of the statute designed sixty years ago is going to apply on another scheme of regulation on top of them that's going to not supplant broker/dealer regulation, but it's going to be an additional overlay of regulation. To some extent the overall issues of public policy here, it seems to me that, the elimination of commissions that the industry has been tethered to since many years as Paul spoke of has more positive investor benefit protections than any statutory scheme we could ever devise. Because it is the system is of incentives and pay incentives that drives how people behave in this industry.

The criticisms that this is not exactly a bright line or not completely a functional test, I plead guilty. Because, I don't think it is possible in this area of broker/dealer advisers divide a bright line and have all advice governed here and all broker serviced here. They're inextricably linked in a broker/dealer. The question is where do we draw an administrable rough line, rough justice, governing. Who shall be governed by the broker/dealer regulations? You're subject to fraud, intend be, a whole host of regulations related to that and who should be regulated just under the Advisers Act. It's not easy to do.

Mr. Gottlieb:  I guess I would add that it's not a matter of being afraid to register. In fact, every major brokerage firm is already dually registered as a broker/dealer and an investment adviser. Speaking for my firm, we have more assets under management as an adviser than we have in the fee based programs at this point where we're entirely comfortable with the rules and regulations and the disclosures et cetera.

In the brokerage industry, we are now seeing a significant transformation in terms of how customers can compensate their brokers. We think this doesn't raise, as Bob said, this puts aside some of the conflicts that have existed in the past. There is simply no reason to consider that function, which continues to be brokerage and which, is truly held out as brokerage. There simply is no reason to put it under the overlay of the Advisers Act.

Moderator Roye:  We want to move on to some of the other exclusions, particularly the bank exclusion and the accountant's exclusion in the statute. The Graham Leach legislation has really narrowed the bank exception. Those banks that advise investment companies have to register now. Joanne, how will banks operate? How will they register? What bank itself will register? Will they register separately identifiable divisions? How will the operations of the bank be affected as a result of this?

Ms. Medero:  I think as they, at least as they taught in my law school, the best answers to those questions are, it depends. I think a lot depends on the current situation a bank is currently in. A number of them, as the Commission is aware, already have separately created investment advisory subs that advise mutual funds. A number of banks do not and I think a lot of it will depend on what kind of color the SEC puts around what is a separately identifiable department.

There are advantages to the push-out provisions. A separately created entity could permit a bank for example to provide more flexibility on how it compensates its portfolio managers. It may aid retention. It may make the business more transparent to analysts. Traditionally, people have thought that the steady stream of income from investment advisory worked where mutual funds is a positive to your stock price and you would have advantages of having one regulator, that's assuming your over 25 million in management.

The disadvantages, I think, are the costs. There are push-out costs that are one time, creating the subsidiary, soliciting proxies for a change of adviser. Then there are continuing costs in maintaining a separate corporation. There may be duplication, loss of synergies between the bank and its subsidiary and monitoring and establishing service arrangements to assure that you do get the investor protection that we all seek. So I think it will depend I think, and frankly the sooner the Commission does provide some direction as to what it would consider to be the separate identifiable department, working of course with bank regulators. I think it will put the industry in a position where it can evaluate these various pros and cons and move forward.

Mr. Plaze:  Do you think that banks will create the "SIDDs" or will they drop things down into subsidiaries or register the entire bank under the Act. What's your expectation?

Ms. Medero:  I think – well, some people will put the subsidiary off the bank holding company, is that what you're asking? Some will put it underneath the bank. Right now in our situation, it happens to be for historical reasons underneath the bank. I think there is a concern by particularly large commercial banks that to register the entire bank as an investment adviser may provide an opportunity for the SEC to go beyond its investment advisory typical exam. Therefore, I think that's one reason why people sought the separately identifiable department, which is actually, where the investment advisory work for the mutual funds would be occurring.

Moderator Roye:  So you don't see, in terms of splitting off the investment company advisory operations, you don't see other bank advisory operations in that unit necessarily because of the concern that the SEC may be looking at more than what it --

Ms. Medero:  No, I'm actually thinking is whether or not it gives a more of a car wash into other activities of the bank, and rather than the investment advisory activities that may be conducted, let's say, in the trust department for separate accounts or individuals.

Mr. Plaze:  Part of the problem and this "SIDD" development is not, I guess a wholly satisfactory resolution or at least from our perspective. One of the things that we look for in an exam, a mutual fund exam, is to determine whether there is trade allocation that disadvantages the investment company clients. Let's say the bank does a trade and allocates parts of it to its private clients, its trust accounts, its collective funds and part to the investment company. We would obviously like an opportunity to see whether that allocation was fair. Whether the investment company clients were not disadvantaged and the current scheme simply does not allow that area of examination for us.

Moderator Roye:  Does anybody else have a perspective on the way the bank exclusion works today, in terms of a level playing field type issues?

Mr. Diliberto:  That's obviously the theme of what I have been saying. That whoever is in the business and is functionally doing investment advice needs to be regulated on an equal basis so we're just looking for a level playing field. I believe that at some point solely incidental needs to be defined.

Ms. Medero:  I actually think the playing field is more level than perhaps banks are given credit for. There is a shared core principles for bank fiduciaries that is invited also in the Advisers Act which is the avoidance of conflict of interest and self-dealing. There is supervision by either state or national bank regulators and the common law of fiduciaries and trust. I think banks may get there a different way but I think if the goal of regulation is customer protection, I think it is achieved without an overlay of the Advisers Act.

Moderator Roye:  But Joanne, do you think that giving the bank regulators primary mission, which is the promoting the safety and soundness of the bank. In other words, the investment adviser regime has sort of a different thrust and purpose. Are the bank regulators going to be effective applying those kinds of standards when there's a problem within some of the advisory functions?

Ms. Medero:  Well, a few years ago the bank regulators moved to a concept of supervision by risk and particularly for an institution that is principally a trust bank or where a lot of its income comes from that activity. Reputational risk is one of the issues that the bank examiners look at and how one handles fiduciary issues. In the event of a conflict with a client and how you manage, that I think is something that is looked at by bank examiners. Maybe a few years ago, less so, but I know from our own experience that those type of issues are part of the bank examination and it is not just the safety and soundness of the bank or the banking system can be affected very much by a large reputational event affecting the bank. I think we are examined with a customer perspective because of that.

Mr. Gottlieb:  Paul, we also look at banks as providing banking services and therefore appropriately monitored and supervised by banking regulators. That's one reason why one of the dichotomies under the Advisers Act that we would like to see fixed is the dichotomy with regard to thrifts and how thrifts are regulated. Given the changes that Graham Leach has brought us, we think it is time for the staff to think about whether thrifts should be considered banks for the exclusion. Given the fact the many are in fact providing very traditional banking services, similar to national banks, that they're under the supervision of the OTS and FDIC which is providing rigorous, to say the least, regulatory review. We think it really is time that they be recognized as banks on their face.

Moderator Roye:  Of course the Congress just visited this issue and did not extend definition to ---

Ms. Medero:  I understand it's up again.

Moderator Roye:  Let's move to the accountant's exception. Phyllis, there are a number of your members who are relying on the accountants exclusion, a number of your members who actually do register as investment advisers. Any trends in that area, any problems with the accountant's exclusion from your perspective?

Ms. Bernstein:  Well, I think it's important to note that sixty years ago accountants did not receive compensation in the form of commissions or referral fees or contingent fees. Today in some states they can, actually in forty states, they can. The practice of accountancy is changing for those CPA's who are providing services in advisory area in tax planning, in estate planning, in non-attest functions. They can receive with disclosure to their clients new fee sources that they never were able to receive before. By "commission" in accountant's language, they're talking about a fee paid by a third party and not by the client which is new for CPA's. Back in the beginning, in 1940, CPA's were only paid by clients for giving advice for providing services to the client. Today that is different. CPA's can be paid by third parties. They're required to disclose that. They are not permitted to do that for attest clients. Attest meaning audit review and compilation. So things have changed in the accounting profession. What are the natures of services that a CPA is providing? When have they crossed the line to be in this new world of investment advice or in the world of being subject to representative of broker/dealer firms? It's a question that comes up. It's a new service for many of our members and many of them have become investment advisers and registered reps.

There still are significant numbers of members of our profession who will be doing, and will continue to do, traditional services, attest function, audit review and compilation of financial statements, providing insurance to third parties that the financial statements fairly present generally accepted accounting principles. That's what the profession does primarily and the financial planning, the tax planning and the estate planning are services that are beyond that, and those services are traditional services as well. Both a part of the scope of what the practice of public accountancy is all about. That's part of what state boards regulate. When you hold out as a CPA, and you do a state planning and financial planning and tax planning those services are regulated. So for that same client that you do estate planning for, if you also do an audit of those financial statements you would be precluded from receiving a commission. A fee paid by a third party. Therefore, our profession will not wholesale become a registered investment adviser. Therefore, our profession will not therefore all wholesale become registered reps of brokerage firms. There are reasons they are prohibited and really, it has to do with third party assurance to the financial statement. How could you attest to the financial statement to the fairness if you've recommended their products? How could you attest to the fairness of value if you've sold that product? These are subjects that are prohibited.

By and large, more of our members are getting involved in advice and probably should be extending their relationships with their clients to be more involved in advice. But yet at the same time when they are involved in third party attest services, which significant numbers of our profession do that, they will not be involved in the practice of investment advising.

When they give advice about investments and they receive fees for that, either contingent fees based on assets or fees from third parties. Today, you see many CPA firms setting up entities and registering. And you see many CPA's individually becoming representatives of federal investment advisers or state investment advisers. So CPA's by and large understand that when they're in the business of giving investment advice and that getting paid for that, they should register.

It's just a question of the word "commission". How does the word commission translate in accounting terms versus how it translates in securities terms. CPA today hears the word commission and says the word commission, they're talking about a payment they receive from a third party for recommending services of a third party or products of a third party. So in other words it's not paid by the client. It's paid by a third party.

Many times we see in our profession CPA's talking to other financial service providers saying they would liked to get paid commissions and they really are hearing it and the other parties hearing the word commission and hearing that word they're saying well you need to get a license to sell products and really what the CPA is looking for is a referral fee for referring that client to adviser not necessarily to be selling products but really to give advice about another adviser. To get paid for the referral of another adviser. What you might call an introduction fee or a solicitation fee.

So there is some, we'll call it language barrier, between CPA's when they use the word commission and the financial services industry, when they use the word commission and I think there needs to be some clarity into that issue to help our members understand that there are different meanings to that term.

Moderator Roye:  I guess Phyllis, you focus on the notion of commissions and I think from an SEC perspective we view those commissions as compensation no matter what the source from the stand point of the definition of what an investment adviser is. I guess, at least in my mind, it would come down to a question whether or not your members are giving advice with regard to the value or investing in securities. In the business of doing that that wouldn't make them an investment adviser.

Ms. Hooper:  One of the things that our board has strongly urged us to do, is come back to you all Paul, and ask you to look at the term commission and give some more clarity to it. Because, there are a number of payments today that seem to be for payments for sale of securities that could trigger broker/dealer registration. Like the receipt of 12(b)(1) fees. We really would encourage you all to take a look at the word because it seems to be generating as much confusion in other areas as in our own. And see if we cannot make some distinctions as to what you really are using the word "commission" for in terms of, for example, an exemption from registration as an adviser as opposed to whether or not the term should encompass something that would require registration as a broker/dealer.

Moderator Roye:  We've gone a little bit over our time. We wanted to cover the publisher's exclusion particularly in view of what's happening on the internet and the uses there. I think we're going to defer that. We have a panel this afternoon that focuses on technology and internet issues and they'll get into a discussion hopefully of the publisher's exclusion.

I would like to thank our panelists. I think there was an interesting discussion of some things for us to think about. We will start our next panel promptly at 11:15 on trading practices. Thank you.

(A brief recess was taken.)


III. Trading Practices

Mr. Roye:  Starting with our next panel. The focus of our next panel is trading practices, an area that is very critical in the investment adviser's area. Let me turn it over to Cindy Fornelli who is Senior Adviser to the Director of the Division who is going to moderate this panel.

Moderator Fornelli:  Thank you Paul. I'm honored to introduce all of you today to our illustrious panel of experts that we have assembled. Although I'm sure most of them are well known to all of you. To my immediate left is Paul Haaga. Paul is the Executive Vice President and Director of Capital Research and Management Company as well as Chairman of Capital Research's Executive Committee. He is the Director of a number of mutual funds managed by Cap Research as well as a member of the Executive Committee of the Board of Governors of the Investment Company Institute. Additionally, he is Chairman of the Investment Companies Committee of NASDR and of course, we're proud to claim him as a former member of the SEC staff.

To Paul's left is Henry Hopkins who is a managing director, member of the Board of Directors and Chief Legal Counsel for T. Rowe Price Associates in Baltimore. Henry is Chairman of his firm's ethics committee, a member of the equity fixed income and municipal bond brokerage control committees and serves as Vice President of all of T. Rowe Prices' funds. Outside of T. Rowe Price he serves as the Chairman of ICI SEC Rules Committee and is Chairman of the Board of ICI Mutual Insurance Company.

Next to Henry is Tom Lemke who is a partner in the Washington DC office of Morgan, Lewis & Bockius where he concentrates on investment management matters. He started his career here at the SEC in the division of investment management serving as Chief Counsel during his last three years of his tenure. Prior to joining Morgan, Lewis, Tom was a General Counsel and the Chief Operating Officer of a mutual fund company. He is a frequent speaker on investment management issues and has co-authored a number of books in the area including the seminal Regulation of Investment Advisers and Soft Dollars and Other Brokerage Arrangements.

Rounding out our industry panelist is Chuck Tschampion, who is sitting next to Tom. Chuck is Managing Director of Investment Strategy and Defined Contributions Plans at General Motors Investment Management Corporation. Outside of GM, he is Chair of the Board of Governors of the Association of Investment Management and Research, or as we commonly call it, AIMR. Chuck has been actively involved in AIMR standard setting in the areas of performance presentation, soft dollars and personal investing.

Last, but not least, at the end of our panel is Gene Gohlke, an Associate Director for Investment Company and Adviser's Compliance in the SEC Office of Compliance, Inspections and Examinations. In this position, Gene is officially responsible for managing the Commission's program for the examination of registered investment companies and investment advisers. Unofficially, he is of valuable assistance to us in the Division of Investment Management.

I'd like to point out that several of our panelists have submitted materials. They're in your notebooks and, in Gene's case, they're available out on the table. So I would invite all of you at your leisure to review those and with that, I think, we will turn to our first topic.

We have quite a number of topics to discuss today; in fact, I'm not sure that we will get to the last two, which is custody, and trade correction, but we will try. But, we want to start our first panel discussion with best execution and the use of soft dollars. Specifically what is an adviser's obligation when seeking to obtain best execution and when using soft dollars?

The Commission recently in the last few years has launched three major initiatives in this area. As all of you know OCIE conducted sweep exams and issued a report on soft dollars.

The Division of Market Regulation currently is working on an update to the 1986 28(e) release, which they're consulting with both OCIE and the Division of Investment Management on.

Then finally, OCIE, also in coordination with the Division of Investment Management and the Division of Market Regulation, is conducting best execution sweep exams. Although that effort is much more of a fact gathering effort and I think they are just winding down their fact gathering and have yet to reach any conclusions in that effort.

So those three things are currently going on and with that backdrop I would like to begin our discussion by asking each of our industry panelists in one sentence to please define what each of you think best execution is. I am going to start with you Paul.

Mr. Haaga:  $.06 a share. Mike Eisenberg jumped out of his seat when I said that. Can I have one more sentence?

Moderator Fornelli:  Yes.

Mr. Haaga:  Same brokers, same cost, as you would have used if there were no conflicts of interest.

Moderator Fornelli:  Henry.

Mr. Hopkins:  Combination of price, commission, time and size.

Moderator Fornelli:  Tom

Mr. Lemke:  I think it's the adviser's duty to seek the best net price for the client under the circumstances and in light of the conflicts of interest that the adviser has.

Mr. Tschampion:  I think it's very hard to define what it is. One thing that I would want to point out that it isn't, is that best execution is not necessarily good execution, nor is the obligation to get best execution, it is to seek it.

Moderator Fornelli:  Gene do you have anything you want to add to the definition?

Mr. Gohlke:  I could add one. It's a little different, actually it's the same I think but said in different ways. Placing trades in ways that are intended to capture for clients the maximum value of the investment ideas, giving due regard to the circumstances in which the trade is placed. This, I think, goes back and looks at the investment advisory firm as in business to produce investment performance.

Obviously, there are transaction costs in putting investment ideas into client's portfolios so the idea is to get those investment ideas into client portfolios and capture the maximum amount of the value of those ideas. But there are costs obviously in effecting those transactions and the ideas to minimize those costs but recognize the circumstances that surround how those trades are being placed.

Moderator Fornelli:  Well a number of you mentioned costs as a factor in considering best execution. Paul jokingly mentioned $.06 a share, but what are the other costs? What are other transaction costs that are associated with best execution besides just the transaction compensation? Are there other ways to quantify costs or other things to consider in that?

Mr. Haaga:  If you ask our traders, one of the biggest factors that they consider in dealing with brokers is confidentiality. There are some firms that you use and somehow the word seems to get around that you have a big trade working and there are others where you don't and that dwarfs cost. I joke about $.06 a share. I think I would be more worried if I find out that an adviser was executing trades for $.00 a share because I would know there was some other way of getting compensated. I would have no way of telling how it was.

Moderator Fornelli:  Any other costs that you all deal with?

Mr. Tschampion:  There is sort of a whole iceberg of transaction costs of which the commission cost is naturally the most obvious but also possibly the smallest one that you have to worry about because it is so transparent. Things like the market spread in seeking best execution, the ability of the broker that you use, to be able to get inside that spread and make it as narrow as possible.

There is the issue of market impact of which confidentiality with the broker is a key aspect of making sure that you minimize that, but there are a whole host of other factors that get into it in terms of the liquidity of the issue, the ability of the agent that you are using to commit capital if necessary to ease the cost of getting that transaction to take place in the market. These can add up to be really the seventy-five or eighty percent of the cost of the transaction and all of these have to be taken into account in my mind in seeking best execution.

Mr. Hopkins:  Confidentiality, we think, is a very important issue. Occasionally we're disturbed that there appear to be breaches in confidentiality of our trades. Looking at the broker/dealer rules, there really does not appear, at least we could not find any specific rule, which established a requirement of confidentiality on the part of the broker. Something to think about. MR. LEMKE: Cindy, one other thing I'd throw in is that transaction costs are a short-term element, but there is also the longer term element of an adviser's trading pattern with brokers. And it's quite common that advisers want to have good relations with broker/dealers for the long term.

Because while they do want to get the best on this particular trade, there are also situations where they may, in the future, need the broker to do something in addition to a typical transaction. So you want to build up good will and long term costs into the trading patterns.

Moderator Fornelli:  I suppose that's the difference than when your setting up a brokerage relationship, in trying to set up these various programs, than issues that might come into consideration on the trading desk. Are there tensions at different levels within a firm with seeking to get best execution?

Mr. Gohlke:  Perhaps, could I say it in maybe a little bit different way. Are there considerations going to best execution at perhaps two different levels within a firm? Think of the trading desk level where an order has come. On the front of the portfolio manager, buy 250 thousand shares of "x". What is the primary focus of the trader on the desk that is trying to execute that trade?

Mr. Haaga:  The focus – first of all on Tom's point, it's a good one. It's a long-term relationship. You can't pick the broker based on how they would have done on that trade because you don't yet know. You pick them based on how they have done in previous trades, kind of obvious but worth remembering.

In terms of consideration, the portfolio counselors are evaluated and paid according to the investment results in their accounts. So when they decide that they want to get a security and they want to get it at a particular price or at a particular time. If they give some discretion, and different portfolio of managers will work differently on different trades, they want the trade to happen and they don't have any individual incentive in creating any rewards for research or for sales. They want things to happen and I think that's what you were getting at, that it's that kind of incentive that I think helps mitigate the conflicts within the organization.

You've got a group of people who are, and by the way, they're the people who evaluate the traders for their annual review and annual bonus. They are very, very personally interested in getting the securities they want, when they want them and at the price they want.

Mr. Gohlke:  So at the trading desk level, at least from what I've heard in talking to traders, is that liquidity or looking for liquidity is terribly important, at least for larger trades. Trying to find liquidity at the lowest possible cost. I would say that's what the trading desk is about.

Mr. Tschampion:  Maybe a little bit more theoretically that the cost is sometimes gauged in terms of time as opposed to dollars. I think traders can be viewed as people who try to buy time economically for their order initiators, the portfolio managers. If they are subject to a price constraint, as opposed to a time constraint, they may have much more latitude in reducing a lot of those market related costs. On the other hand, if the portfolio manager says I have to have the security now because I feel I have information that is important, then they may very well have to pay up, if you will, into the market place in order to get that in the portfolio. But, in either case you're serving the interest of the client to the trading desk.

Mr. Hopkins:  In evaluating and monitoring best execution on our trade desks, it's really from a lot of different sources.

Number one, our clients, many of our clients, monitor our execution skills and abilities. The portfolio managers monitor very closely the effectiveness of each trader that is assigned to their account.

In addition, at Price we have an equity brokerage control committee which was mentioned earlier, which I've been on for quite a few years, that committee not only oversees soft dollar allocations but they also oversee the entire process of the trading function including best execution. The boards of our funds review best execution and most recently, we hired an outside expert to come in and independently evaluate overall the effectiveness and the best execution capabilities of our trading desk, to really get a totally independent third party to evaluate the efficiencies of our trading process.

A lot of scrutiny has been given to the trading process, some people feel maybe too much. We think that in today's environment it is necessary.

Mr. Haaga:  We talk a lot about measuring best execution and having consultants come in and look at the average trade price for the day and things like that. There is sort of two parts you can look at. You can look at best execution or you can look at the other end, which is what are the distractions. Best execution, it seems to me because it's so hard to prove, it's one of those things where whoever has the burden of proof loses in the case.

I said to our mutual funds boards, one of our jobs as fund officers is to select custodians for the funds and to negotiate those fees and the amounts paid to the custodians are fairly substantial, but I have never been to a conference on the topic of best custodian. No one ever talks about best custodian selection. The reason is there aren't conflicts.

When we tend to address this with the boards, we tend to talk about okay; you cannot prove that you got the best execution. Let's go to the other end of the issue, talk about the conflicts, and tell you how we deal with the conflicts and how we minimize them. That's issues like not making specific comments, not communicating to brokers, what the sales targets are and I think most importantly, having a very small percentage of your total trading dollars that are in any way targeted toward anything so that most of your trades are being placed without regard to whether you need to reward anybody.

Mr. Lemke:  Cindy, getting back to your question. I think what Paul was just saying was that, the way typical advisers are set up – the traders, I think their job is to focus on the mechanics of execution. They're generally not the ones making the decisions on the conflicts. That's typically done some place else and then the order goes to the trader to say, "Execute as best you can." Maybe in light of certain factors, given conflicts that may have been considered by the traders; I think what I have seen the pattern is, their job is simply to go out and find the best price, best market, best way to execute the trade.

Mr. Tschampion:  Maybe to bill the cat on this issue a little bit more directly, when we consider our soft dollar budget it is done in a very ex fashion. We happen to make very little use of third party research but we do value a lot a brokerage input in terms of their own proprietary research throughout our firm. We're not a largely staffed internal organization, when we talked about in-house management of the GM pension funds, so we sort of have to rely on street research a lot more than others that are in the business might. We still tried to spread it out and have it be a factor where the trading room is not on any individual trade or even over the course of a month or a quarter constrained in their ability to seek best execution on behalf of the client which is the GM pension funds and so we're able to take that conflict out of their day-to-day operation. They are very much as Paul said trying to keep the portfolio managers happy in the context of getting the best price for that portfolio manager. I think it's important that you have something like that when your dealing with the aspect of using brokerage credits to generate distractions, if you will, to the seeking of best execution.

Moderator Fornelli:  We're going to have to move on to our next topic soon, but before we do I do want to ask this specific question about soft dollars which is, whether or not client referrals in exchange for brokerage should be considered in the definition of soft dollars? If each of you could speak to that briefly, I'd appreciate it.

Mr. Haaga:  We just manage mutual funds so it's a little bit, I can take the liberty of announcing the rule for everybody else here. It seems to me that that would be the kind of thing that would be the equivalent of directed brokerage. If the client himself would agree that it would be disclosed to the client and the client would agree. So I'd put that more in the directed brokerage camp than the soft dollar camp.

On the other hand, that's the kind of thing you wouldn't want to necessarily have a rule that outlawed it because then if you accidentally for some other reason use somebody who referred you, you'd put yourself in a problem.

Mr. Hopkins:  I'd agree with Paul. I think the important thing is, that all these types of challenges are either the responsibility of a central committee that is composed of more than one person so that you have the balance and checks and balances. I cannot more highly recommend the utility and value of such a committee to provide a real oversight on the brokerage practices of your firm's trading.

Mr. Lemke:  I don't think I would put it in the category with soft dollars because, at least the way the law is now, it's an after the fact decision. If you achieve best execution and your doing the best for your clients, it's a tie-breaking factor that you can use and I think that has worked fairly well.

Mr. Tschampion:  We have not had to confront it in my day job. I believe the soft dollar standards of AIMR do address this issue and I believe they encourage not doing it. I don't think, Mike correct me if I am wrong, I think it's a recommendation as opposed to a absolute – you should not do it as opposed to, you cannot do it, in order to be in compliance with the soft dollar standards.

Moderator Fornelli:  Gene, are there any other questions on soft dollars or best execution that you would like to touch on briefly before we move on?

Mr. Gohlke:  I think we should move on.

Moderator Fornelli:  Okay. Our next topic has to do with allocation of investment opportunities. Just a few weeks ago, the Commission imposed sanctions on an investment adviser and a portfolio manager in connection with the allocation of shares and in initial public offerings among the funds managed by the portfolio manager. At issue was four funds managed by that portfolio manager. Each of the funds were of various asset size; however, they all had the same stated investment objectives and all of them could invest in hot IPO shares. Interestingly the prospectuses for the newest fund explicitly stated that if the other funds advised by the investment adviser invested in or sold the same securities, those trades or those opportunities and sales would be allocated equitably to each of the investment companies managed by that or advised by that adviser.

However, the Commission found that during the newest fund's first fiscal year, the managers' IPO allocations favored that newest fund over the other funds, particularly with respect to hot IPO issues. Failure to disclose the preferential allocation of IPOs was of course found to be a material omission and the newest fund's prospectus disclosure regarding the equitable allocation of investment opportunities was found to be false and misleading, all in violation of section 206(2) of the Advisers Act. Specifically failure to supervise the portfolio manager in connection with IPO allocations was found on behalf of the adviser and also the adviser was faulted for not having established adequate allocation procedures.

Now as all of you know, neither Section 206(2) nor any other provision of the Investment Advisers Act specifically requires investment advisers to have allocation policies and procedures. However, it's generally understood that an investment adviser's fiduciary obligations require that, at least over time, the adviser fairly and equitably allocate investment opportunities among its advisory accounts.

So what I would like to ask the panelist is, what exactly does that mean? What does the fair and equitable allocation of investment opportunities mean in the advisory context?

Mr. Tschampion:  I think at the first cut of it, it's a matter that if there is a security that's purchased that is felt to be value adding, that each client should be able to get, barring restrictions the client has to holding, such as security. Each client should get the ability to benefit from the perceived value equitably. Which, I think basically the bottom line comes down to pro rata allocation among all of your clients portfolios.

Moderator Fornelli:  Even in the context of hot IPOs or other investment opportunities of limited opportunity?

Mr. Tschampion:  Maybe even more so in hot IPOs, when it is so obvious, at least going in, that there's suppose to be some economic benefit. That's why you're doing it and in fact many people just take the economic benefit that occurs in the first day and then allocate it. I think it's even more important that everybody be treated fairly in those instances.

Mr. Gohlke:  Chuck, in that regard, I've seen any number of firms that have a de minimis policy, in which a hot IPO will not be allocated to an account if, let's say, it's a hundred shares going into a $10 billion account. The idea is, well it doesn't have any impact on the bottom line and it's going to cost, in terms of the portfolio manager following that security. Would that type of policy make since?

Mr. Tschampion:  I think in terms of your example that seems to make sense. Without getting Talmudic about it, which is where you could go in a lot of this discussion, I sort of feel that you want to apply what I might call the "mother test" or the client test. Would you be willing after the fact to go to your mother and describe what you did and have her feel that you had actually lived up to the expectations that she had for you.

Moderator Fornelli:  I don't think anyone wants to pass that test Chuck.

Mr. Tschampion:  More to the point, would you be willing to go to a client and tell them that's the way that you treat it and that was your policy and feel comfortable that you did the right thing for the client. That the $10 billion account that didn't get the hundred shares, would they understand, in that context?

Mr. Haaga:  To keep this with a family analogy, I think anybody who has more than one child has learned how to explain very well the difference between fair and equal. I worry about an implication that the only appropriate way of distributing things is on a pro rata basis because there are going to be many other considerations. For example, you have different portfolio counselors of different accounts, some of them want to participate, and the opportunity, not just IPOs sometimes it's when you didn't get all you wanted of a certain security in a trade. Some people want to participate, some people don't. They place orders of relative size. Some funds might have a larger cash position. I think it's dangerous to start looking at the impact on the fund because then you end up giving all of them to the smallest funds.

I was interested in the case Cindy talked about. When I heard what had happened and actually read the rest of the case, I thought I was going to find that one of the funds was small and the other three were very large and that was going to be the excuse but they weren't. Couple of the other funds were pretty small, too. I think what you need to do is basically have somebody independent of the process who is overseeing it and making sure that there aren't some really obvious, really devious schemes going on that can't be explained by anything other than, that I wanted to pump up the performance of this account and not the others.

Mr. Lemke:  I would agree with Paul and I think much like in the case of best execution, the focus here needs to be on the conflicts that the adviser faces. We are talking about, partially a mathematical issue of allocations that come up when you don't have enough securities to give every one of your clients some of the securities. Advisers would love to give everyone IPOs but they just can't get a sufficient supply to do it.

So the focus then, I would think for an adviser, needs to be, well are you unfairly discriminating among your clients for some reason that benefits the adviser? For example in the case that Cindy talked about, one of the funds was getting most of the IPOs and the adviser was advertising heavily that fund and looks clearly like it's not fair to the other clients. It's unfair for a reason that it raises a conflict on the adviser's part.

Moderator Fornelli:  What about a lot of times you hear people say that, IPO allocations should go to the client or the fund that generates the opportunities. That if you have a client that trades a lot and gets those opportunities to the adviser then that client should get more of the IPO shares. How do you feel about that, is that fair and equitable? Is that fair?

Mr. Haaga:  I guess I wouldn't disagree that that could be one of the factors but I would be concerned if that were the only factor and if it were applied on some kind of formulaic basis.

Mr. Hopkins:  In some cases, I might use this opportunity to say, I started out with that pro rata thing just to sort of get the discussion going. That doesn't necessarily even mean that I believe in that.

As the case in point and sort of off of what Paul was saying, we have – I was sort of viewing it as from this aspect of the trading room but we have different portfolio managers that deal in different aspects of the market. Some might be that much more prone to dealing with hot IPOs in their portfolio. If they were to identify one and want to put it in there, they would have an obligation if they're running multiple portfolios to treat all of their clients fairly. But there would be no obligation as a whole to then take somebody else's portfolios and give them the opportunity to get into them unless that portfolio manager was making that decision to do so. So I think by that you sort of get toward that sort of allocation. Those that are using them the most often are getting the benefit of them are sort of favored in the whole process of portfolio management. That isn't necessarily unfair.

Participant: We've really had two problems with allocating trades. One is, allocating trades among portfolio managers. You also have the potential problem that an individual portfolio manager will unfairly allocate his trades among his clients. That is a more difficult area to detect and that's why I think it is very important to have the equivalent of, let's say an equity steering committee, which oversees the relative performance of accounts. So that if there are discrepancies that come up that you can analyze and find out well, why did this person's account do much better than another account that he manages even though they have the same investment objective. When it comes down to allocating trading opportunities among portfolio managers, again in our case we have the equity brokerage control committee which reviews and monitors the implementation of our formal written allocation procedures. I will say that, many years ago certainly when I first came to the firm, there was nothing written as to how you allocated trades among clients. It was done fairly over time and I was in the mind of the head of the equity-trading desk. Today, that is not good enough certainly when it comes to a SEC audit. It's not good enough when a client asks you for your allocation procedures. You have to write them down and it is quite a challenge to verbalize exactly how you do it because you have some many permutations and combinations. Then of course when you have a computerized trading platform, you have to have in many respects the trading platform affect a lot of the allocations. That can be an equal challenge.

Mr. Haaga:  You know I think it's important in this area as well as in others to look at what your compensation structure is internally. People will generally act in accordance with financial motivations and if you have things set up so that somehow individual portfolio counselors can benefit by unfair allocations then you have just incentivized them to do the wrong thing. So it's another area to look at beside just the oversight and the procedures.

Mr. Lemke:  I'd second what Paul said earlier, that I don't think the law currently requires or it should require that advisers have to allocate simply on a mathematical formula. Because there are a variety of other factors that might say it would be appropriate to give certain clients or certain portfolio managers in your group additional shares of IPOs. The level of brokerage commissions are a key factor in how much IPOs an adviser gets from the broker/dealers, but also some portfolio managers will work extra hard to get additional allocations. They will participate in road shows. They will do various things they can do to try to get an additional allocation. And they ought to be rewarded for that, and their clients ought to be rewarded for that.

One thing that I wanted to ask Cindy and Gene is that in the recent enforcement action, the Commission in analyzing the case looked at allocations to four mutual funds and really applied a mathematical formula and then said, "Well this is way out of kilter with what the other funds were getting and it's the smallest fund." I wanted to ask you, are you sending the message here that you are looking more toward pro rata allocations from advisers?

Moderator Fornelli:  Tom, you don't get to ask questions.


Mr. Tschampion:  One other point about --


Moderator Fornelli:  Thank you Chuck.


Mr. Tschampion:  This isn't an attempt to answer your question either.

Mr. Roye:  Tom, the answer to your question is, we're looking for fairness.

Mr. Haaga:  The way I read that was not that they should have been allocated pro rata. It was that the numbers were so far off that they were eight standard deviations away from even and then that's where they got in trouble. I never read anything in there that implied or otherwise that said because they weren't exactly pro rata. Therefore, they flunked.

Moderator Fornelli:  Don't forget too they didn't have good procedures that explained how they were going to allocate in those situations. So I think that in lieu of that we sometimes have to look at the numbers. Not that it's dispositive but it is what we have to look at after the fact. Especially in the absence of other procedures or others way to do it.

Mr. Lemke:  And clearly, I think if there were other circumstances that were relevant, we would have read about them, but I gather there weren't any.

Mr. Tschampion:  The one other point on this is that, let's say in the IPO context, I agree with everything that's said from the context of that you have the possibility of an IPO and you have some sort of procedure for fairly allocating it among your various clients. Once you do that, it's also important though that once the IPO comes to market and the hundred thousand shares that you wanted turns out to be ten, that you not then undertake to revamp that allocation. I mean if it was good enough at a hundred thousand to fairly treat clients, then it should not change even though it was ten thousand shares in terms of the fair treatment.

I think there are potential problems sometimes within a firm that when you get a small amount that you are then going to start to change that allocation and that I think could be really problematic.

Mr. Roye:  Cindy, could I ask a question? The notion of fair and equitable in a situation where someone says to that we're allocating the hot IPOs to some under-performing accounts. Is that a fair basis for making a cut on this?

Moderator Fornelli:  Can you ever use allocation to even out performance?

Mr. Haaga:  I think you would look – I wouldn't say that exactly you would use that to even out performance but I think under-performance may be one of the things that your oversight committee would look at, to decide whether these accounts had gotten their equitable share of the IPO. So would it be a factor, yes. Would it be something that you would do to – would it be a driving factor, no. I think it is something maybe we do look at to decide whether things are being done equitably.

We always talk as though the market always goes up and IPOs always trade at a premium, it might be that some day we will quit allocating IPOs to an account because it's under- performing.

Mr. Lemke:  I'd agree with Paul, and also if you all remember a few years ago when Netscape came out. It was one of the first tech IPOs that really took off, and I think advisers got small allocations. What you found was you could have a random rotation and you end up with someone's taxable account doing very well because it got some Netscape, but it wasn't the IRA's turn to get Netscape. So you end up with two accounts that the client is expecting to be managed identically with fairly significant performance differences based on the luck of the draw. It would seem to me in a case like that you could use, I have some flexibility to use future IPOs to try smooth out the performance. Particularly when you have clients that are expecting a narrow band of differences in their accounts.

Mr. Tschampion:  Putting my plan sponsor, manager of managers hat on, I have real problems that if I put myself in the place of a client then I have had good performance from the manager and then by reason of that I am possibly excluded from even enhancing that performance knowing how difficult excess return might be. Because, I will not get a normal allocation except for the fact that the performance is different. That sort of gives me real problems.

Mr. Hopkins:  I don't think poor performance currently is a factor that is considered in the allocation of investment opportunities. How do you know that the allocation that you're going to give this account to try to boost it's performance is necessarily going to help it?

Moderator Fornelli:  One of the factors, as we mentioned in the case we discussed, was that there was prospectus disclosure about how they were going to allocate. Which of course they didn't follow. This leads me to my next question, which is, can an adviser use any method of allocations so long as it's disclosed adequately to clients and then followed?

Mr. Tschampion:  I don't like the word "any".

Moderator Fornelli:  Any reasonable?

Mr. Hopkins:  There are not that many methods. You've got pro rata, bunching, random, rotational; I'm not sure what else you have. I guess Ouija board or something. It has to be fair over time, equitable over time. It doesn't necessarily, on every trade, somebody may get a benefit certainly if you do rotational. But, over time, the averages will have come out to a fair allocation.

Mr. Haaga:  I think the direct response to your question is no. I think you can imagine some methods of allocation that would be so unfair, inappropriate that they just shouldn't be used even if they were disclosed. I am not sure to what extent I'm talking as a businessperson and to what extent I'm talking as a lawyer. I certainly wouldn't counsel anybody to say, this is something you can disclose your way out of.

Mr. Lemke:  I would agree with Paul that you would think that at some point disclosure can't cure a breach of fiduciary duty. That's what an adviser is and while disclosure is generally deemed to be a cure for issues about our conflicts, we have such a basic conflict that calls into the question the adviser's reason for being in business. I don't see how disclosure corrects it.

Mr. Haaga:  We're sitting here and we can't work up a definition of best execution. We can't work up an agreed upon procedure of fair allocation. How are we going to disclose something that is so certain and so well communicated that everybody understands it so well, we are not going to object. It is a little unrealistic.

Moderator Fornelli:  Gene, do you have any further questions on this topic before we move on to personal trading?

Mr. Gohlke:  No.

Moderator Fornelli:  Okay. Our next topic is personal trading which is been back in the news lately; if it ever even left. In part because our amendments to rule 17j-1 under the Investment Company Act have gone into effect over the past couple of months. As you all know, the Investment Company Act requires advisers to mutual funds to have written codes of ethics that deal with personal trading. However, there is not a similar requirement under the Investment Advisers Act. Having said that, though, various industry groups including AIMR, the ICAA, and of course the ICI, have issued best practices with respect to personal trading which a lot of advisers do follow. So my first question to the panel is, should advisers be required to maintain a written code of ethics?

Mr. Hopkins:  I seen no rationale that they should not. Whether they manage investment companies or solely individual accounts. I think all advisers should be required to have a code of ethics.

Mr. Haaga:  I agree.

Mr. Lemke:  I agree. We use the terms code of ethics and personal trading interchangeably. I assume there's a lot more to most people's code of ethics than just the personal investing rules. I think it has worked well in the mutual fund industry and there's no reason it can't work for the advisers.

Participant: I'd agree that this is an area where employees of advisers need guidance. They need something to have in front of them to help them make sure they do the right thing.

Moderator Fornelli:  One question that you hear, or one criticism that I've heard, with respect to having advisers to non-mutual funds have codes of ethics, is who is going to administer it. There is not a board of directors to oversee it. That's always rung a little hollow to me but I'm curious if any of you see problems with who would administer the code of ethics.

Mr. Hopkins:  First of all, the fund boards do not administer the code of ethics of the adviser. They simply approve the code and are given an annual report regarding the administration of the code and any material violations of the code are given to them on an annual basis and if it's a very serious violation, it is given to them immediately.

So I think the same person will administer the code and normally it is someone within the adviser or a committee within the adviser who has a responsibility for the actual administration and the rendering of decisions with respect to either granting exceptions or issuing out punishments et cetera, et cetera. Investment advisers are fiduciaries under the law and have an obligation. They're held to a much higher standard of care than many other professionals.

Mr. Tschampion:  As a practical matter, while we are under the Advisers Act and haven't had to file a code of ethics there. We have created a code of practice and ethics for personal investing for all of our people, and we have a mechanism in place to make it effective looked at. People's personal investing activities are being monitored and disclosed. I think that's part in parcel, not just having the piece of paper but you also have to have the internal mechanism that is going to be able to make sure that your employees are conducting themselves in line with it. It's not necessarily a police state, but it is a matter of just having the reporting mechanisms and somebody that's looking at them in compliance.

Mr. Haaga:  I would agree. I think it's a specious argument to say that because you don't have independent directors you can't have a code. Who administers all their other compliance procedures? Who runs the firm? I appreciate and support the role of independent directors but I don't think they need to do everything.

Moderator Fornelli:  One of the new requirements under 17j-1 is that advisers to mutual funds, or that mutual funds themselves, have to disclose the code of ethics. Is that something that if we were to move forward with a rule for advisers, it would also make sense that investment advisers have to provide or disclose their code of ethics that should be mandated by the rule?

Mr. Hopkins:  I personally have no problem with that. Any client or potential client that asks whether we have a code and to see a copy of it, we provide it to them. Now whether or not I want a provide four million shareholders with a copy of the code is another thing. Down the road, it's something which we could put on the Web, and anybody could have access to it. It's a document, which we live by. It sets forth what our policies are and I would have no problem providing it to anybody.

Moderator Fornelli:  Tom, do you think any of your clients would have trouble?

Mr. Lemke:  Well, I would think to start out, in the interest of fairness, if you're going to have mutual funds and investment advisers should have the same standards. We are talking about the same basic issue. I don't think anybody objects to summarizing their code. I have never seen an adviser that wouldn't give the code to any client who asked for it.

I think the one issue that people are concerned about though is to mandate disclosure and mandate detailed disclosures is really what investors need to know. Is it an issue that affects them directly or, really to me, it goes back to the core issue of the adviser fiduciary duties.

Merely disclosing is not going to change the adviser's duty to make sure the employees of the firm are not taking inappropriate advantage of the information that they have. So I think the concern is disclosure creep rather than should we do it or shouldn't we.

Mr. Tschampion:  We went through this issue at AIMR when we were dealing with the soft dollars standards in terms of disclosure and record keeping. I think where we came out on that is maybe a model for this, is that you may require that there be a code of ethics, and you may require that you make your clients aware that you have a code of ethics and it will be available upon request but that you don't necessarily have to publish it to whatever constituency is out there in all of its fine detail.

Mr. Haaga:  You all may be wondering why all four of us answer every question. It's because we're trying to use up the time before we get to error corrections.


I did have an additional point on that. One of the things you have to be careful of is that the ICI's personal trading best practices were written very much as best practices. Same for the corporate governing things and when you do those, you really take advantage of the fact that you are writing them as best practices. You don't necessarily have to draw a bunch of bright lines so people know exactly when they are in compliance and exactly when they aren't. I always worry that if a disclosure requirement gets too detailed then it pushes everybody in the direction of having bright line tests, no flexibility and bright line tests tend to be less rigorous and less restrictive than tests that are expressed more subjectively and they end up being actually worse in terms of compliance in achieving the policies. I think it's wonderful to require a general description of the policy. I think it would be awful if they required a detailed description of the policy.

Mr. Hopkins:  It's amazing how our philosophies of compliance and personal trading have changed. Mr. Price who founded our firm in 1937 and who has been deceased for quite some time had a very simple philosophy on investing. He felt it was inappropriate for him to allow it, to put any client in a stock until he had purchased it for himself first. That would not go over today, I think.

Moderator Fornelli:  Given what you have said about disclosure of codes of ethics, I am curious whether we are going to have a requirement that all advisers have a code of ethics. The next question is, what specific policies and procedures should be required? I'd suppose we start with looking at the ICI's, the ICAA's and AIMR's best practices. Are the best practices working? Are there problems? Are there problem areas? Have people abandoned any of the best practices wholesale? What are the issues that you see with the best practices?

Mr. Tschampion:  I would just comment that back when the catalyst for the creation of these three sets of best practice standards occurred, it was the result of a couple of instances within two large investment organizations. Both of which were identified by the practices that those investment organizations already had in place and it was only in the press that they got blown up to be a problem really. I think that defining the standards has been good for the industry but again, I think by and large, things are in place to take care of it and that even with the recent spate again, it's a matter that these are being discovered because people have practices that are pointing them out.

Mr. Lemke:  I would agree. I think the ICI and ICAA has done an excellent job in flagging the kinds of things people should look for. I think the big issue in this area is making sure that advisers have sufficient resources to monitor their codes. We know what the principles are, it's a question of, and do you have the systems and the people that can track through and make sure that everybody is complying with the requirements.

Mr. Haaga:  Any code worth its salt is going to have tough enough specific requirements that it is going to need an exceptions procedure and indeed the ICI's best practices contemplate exceptions. We have had some debate, I guess, with the SEC staff over which of those provisions allow exceptions.

One of the problems you could get into, of course, is that the Exceptions Committee is too lenient. The answer is yes, what's the question and so you have a policy that's a non-policy because you waive it every time it might apply. I don't see or hear of the happening in the industry.

The case you talked about, the one about the allocation of the IPOs, you also brought a proceeding under 17(j) and I was very interested that the portfolio manager involved had followed all of the literal parts of the literal tests under his firm's code of ethics. He had gotten pre-clearance and apparently he'd reported properly, his own investments in IPOs but what he flunked was, what we call in military justice, conduct unbecoming. The general part of the code that says we will not take advantage of or interfere with the investments of clients. That code appropriately had a provision that you could flunk even if you literally complied with all of the pre-clearance and reporting aspects. I hope codes will continue to have those because you do have to have the flexibility to deal with issues that may or may not be covered by the specific term.

Mr. Lemke:  I think the standards and best practices, which have been recommended by the ICI, and ICAA have worked very well. I think the industry by and large is following them. I think this industry probably has the tightest set of personal security transaction standards of any professional group in the country. Certainly, the brokerage industry does not have anywhere near the type of pervasive restrictions on personal security transactions as the adviser industry has today.

Moderator Fornelli:  Has it become a competitive issue? As I was preparing for the panel, I saw some press releases or some newspaper articles that indicated that a lot of advisers have started cutting back on best practices because they're using it as a way to attract and retain talent in their shops. Have you seen that?

Mr. Hopkins:  I don't know if anybody is cutting back. I think that there is no question, we've seen it in our shop when we have a young aggressive portfolio manager come and find out that their personal security transaction abilities are significantly restricted. It is not something, which they look upon with favor but they abide by it. It's just the name of the game today and you have to accept the rules. There is no question that we have lost a few people to hedge funds but I think that's more on the compensation issue than it is on the trading restrictions issue.

Mr. Lemke:  I would think if any portfolio manager is going to make a job decision based solely on personal trading, you should wish him well and let him go.

Moderator Fornelli:  Let him go.


Gene, when OCIE goes in to do examinations do they bring in best practices and expect to see them and quarry whether or not there are deviations, why there are deviations?

Mr. Gohlke:  Well, at the time the ICI adopted their best practices we looked closely at what firms were doing in responding to those recommendations. Now that the Commission has put in place amendments through 17j-1, I would suspect we wouldn't be looking as much to the best practices.

However, if we're looking at a firm, yes they're complying with the 17j-1 but not going beyond that. We see that their business practices would seem to, in a sense, cry out for something more than what the minimum requirements in 17j-1 requires and yes the ICI's best practices or in one of the other organizations best practices would provide that. I would suggest we would make those comments.

I think most of the problems though, we find in looking at codes of ethics is the lack of firm's implementation of the codes. They have fine codes on paper but there isn't sufficient follow up to make sure people are actually complying or perhaps they've delegated the responsibility for reviewing reports of personal transactions or even perhaps if they have pre-clearance, the pre-clearance process to somebody we might refer to as a clerk. It's much more mechanical than really looking for situations where this trade may have presented a conflict of interest with a client. It's more those types of concerns that we see during the examinations rather than the codes as written not going far enough.

Mr. Hopkins:  One of the things I will say that the new rules, especially the one with regard to access persons, have to submit an annual portfolio listing is really because of the shared numbers. We always required all employees to, in essence, be access persons but with this new requirement to process thirty-seven hundred portfolio listings would be quite immense. Especially to do what you are required to do so we have now for the first time, we actually are deciding who is and who is not a true access person. So we have cut down the numbers from about thirty-seven hundred to a thousand. That's still a lot and I think in some respects, personally I think that the rule went too far. It should have been limited really to investment personnel as opposed to the broader term access persons. But, it is going to be a real change to process that and to get it in on a timely basis.

I also think the requirement to have access persons, when they become an access person, to give a listing within ten days is a little bit unrealistic and the time frame really does not have to be that short. It could be thirty days and it would be a lot easier to administer. I think when they do the audits, if they look at the time frames they will probably see that a lot of people have had a difficult time adhering to the ten day limit.

Moderator Fornelli:  If none of you have anything further on personal trading, we will move on to custody. I still think you're safe Paul in that we will not have time to get to trade error.

In the first panel, they talked about possibly bonding. The bonding of investment advisers to protect against the misappropriation of client funds. Another way, of course, to offer those protections is under our custody rules, which we do currently have the custody 206(4)-2.

I know when Paul and I were talking about the custody rule, Paul mentioned that you cannot read the rule and know exactly what it requires of you. There is a lot of information in the no-action letters and a lot more out there. And so one thing we will be looking at is seeing whether or not we should revise the custody rule to make it more clear.

One issue that advisers face and struggle with, I know with respect to the Custody Rule, is when they take fees directly out of their advisory accounts and when they're not deemed then to have custody. So I guess my first question is, should advisers be permitted to take advisory fees out of advisory accounts without being deemed to have custody and without following the current procedures that are currently set forth in the no-action letters?

Mr. Lemke:  Cindy, it's good to hear you thinking about the rule because, while I think advisers all agree with the concept of the rule, the real problem with this rule is the fact that it's fairly outdated. And it's fairly difficult to figure out when you have custody and historically, the staff has taken such a broad and expansive view of it that more advisers don't know what to do and how to comply with the rule rather than questioning the basic concepts of the rule which are clearly designed to protect investors. The deduction of fees is a perfect example of the way the rule is now interpreted. An adviser cannot have a client automatically authorize its custodian to send the adviser's fee to the adviser without going through a series of procedural blips that increase costs, and I would argue, don't provide a substantial degree of protection from the fraud that the rule is designed to do.

So I think this is clearly one of the areas where the rule needs to be modernized to reflect the fact that for limited purposes, advisers should be able to fairly easily present their bills, present other kinds of invoices to the client account and have it paid without having to jump through hoops.

Mr. Gohlke:  That might work best if it's an individual client's account and that client is getting a periodic statement from the custodian where it could see then, okay, during the last three months the adviser deducted its fees. But, in the context of adviser advising a limited partnership where the limited partners do not get quarterly statements. In those situations, and that's by far the most frequent type of situation we see in which the advisers deducting its fees as well as paying partnership expenses, authorizing capital withdrawals. Which based upon the interpretations that are out there, give the adviser custody of that limited partner/clients assets and there doesn't seem to be a good control mechanism that could be substituted for having some independent person look at and approve these disbursements.

Moderator Fornelli:  Do any of you see any problems with requiring third party custodians or banks or brokers to send statements directly to clients and not go through the adviser?

Mr. Lemke:  I think the issue there, I don't think people would have a problem, the issue is going to be client relations and who is reporting to the clients. Typically, the adviser would want to send a consolidated package to its clients and here's what's happened during the last quarter including material from the custodians. I think it's going to be more a question of coordinating the materials going out rather than how it gets to the client.

Participant:  I think some of the scandals in recent years, I have the impression that if the clients had gotten statements from the custodians they could at least have learned that some of the things they thought they owned, they didn't own. So some of the out and out theft could have been prevented by that, so I would say unless I to have some compelling reason not to do it I would think that would be a good idea.

Mr. Tschampion:  In the institutional world of pension funds basically we get both flows of information from both the outside investment adviser and from the custodian and at least as it relates to holdings and transaction statements for the account. It seems to me it's a fairly benign practice that could have some very great beneficial results in this area.

Mr. Lemke:  Except though, this rule has a lofty goal but if the custodians had to send statements out to the clients you can be sure the adviser would have done a different kind of fraud so I don't know if this is going to fix the problem. It might be nice to do it but we should figure out the best way to get it done and not assume that it will automatically correct the issues because when you look at these cases, these are extremely creative people who have figured out some way to get around whatever requirement is put in front of them.

Mr. Haaga:  That's the NRA argument.


You could say that about every rule and therefore not have any rule.

Mr. Tschampion:  Off of what Gene said before though, if the situation is that there's a sort of a circumscribed area of the market place which accounts for most of the considerations that you have in terms of these rules might there be some way of targeting the regulation toward that? Toward the advisers to limited partnerships, where the reporting to the ultimate client isn't quite as developed, as it is when you're in a direct publicly traded portfolio type of situation.

Mr. Lemke:  And Gene, I would think too if this rule is – When you talk to advisers about it, this rule raises people's blood, and if we got rid of some of the mechanical things, I think you could even get the industry to help you figure out better ways to protect these frauds that have happened.

Right now, you really can't have a dispassionate discussion of the rule because so many people are frustrated by so many of the mechanical things that aren't really furthering the long-term goals of the rule.

Mr. Hopkins:  The fact is, the rule is archaic. It's out of date. It doesn't really reflect all the policies the staff has adopted over time. So we really do have to look at all the no-action positions and really adopt a rule which reflects the current status. And I think we all should look into a lot of the issues we've discussed and try to come up with a reasonable compromise which both protects clients and doesn't overly burden the advisers.

Moderator Fornelli:  Well, with that, unless Paul would like to talk to us about trade error correction, I will thank all of our panelists, Paul, Henry, Tom, Chuck, Gene. Thank you.


Mr. Roye:  We're going to break for lunch and resume at 2:00 p.m. We're going to focus on conflicts of interest and advertising and performance reporting as well as technology this afternoon. Thank you.

(A recess was taken.)

Mr. Roye:  We want to get started this afternoon, we want to focus on conflict of interest issues this afternoon. That's the next panel. We are going to have a panel on advertising and performance reporting issues. Then we are going to close out with technology issues and implications for the investment adviser regulatory regime.

Let me turn it over to Bob Plaze, who I've introduced to you previously. Bob heads up our task force on investment adviser regulation. Again, Bob is a chief architect of many of the rules under the Advisers Act, and the proposals that we have pending and will be charged with developing a lot of rules that come out of this roundtable.


IV. Other Conflicts of Interest

Moderator Plaze:  Good afternoon, thank you very much for coming back to round two of our roundtable discussion this afternoon.

This panel will discuss three conflicts of interest that advisers have with clients that have not been covered in earlier panels. They didn't quite fit in to the topics the other panels covered today but they involve cutting edge issues before the Commission and the investment advisory industry.

The three topics are principal trading by advisers with clients, pay-to-play practices by investment advisers, and the proposed SEC rule making in this area and transaction base compensation of financial planners.

With us this afternoon to discuss the topics we have a distinguished panel of experts including Guy Cumbie. He is President-Elect of the Financial Planning Association and a gentleman who has his own financial planning firm.

Mike Eisenberg, Deputy General Counsel at the SEC in the office of the General Counsel. Mike before becoming Deputy General Counsel was in private practice for a number of years.

Susan John, Government Affairs Liaison of the National Association of Personal Financial Advisers. Susan has her own financial planning firm in New Hampshire, where it must be very nice right now.

Ellen Porges, Managing Director and General Counsel of the Investment Management Division of Goldman Sachs.

Sandra Tichenor, President of the Investment Counsel Association of America and General Counsel.

Finally, our good friend Mary Ann Tynan who is Senior Vice President and Partner and Director of Regulatory Affairs at Wellington Management Company up in Boston.

Let me give a brief introduction of principal trades and sort of frame what the issue is before we begin to discuss.

A principal trade occurs when an adviser or an affiliate acting for its own account or the account of an affiliate sells a security to or buys a security from a client's account. In the Investment Company Act, these transactions are called affiliated transactions that are strictly prohibited unless the fund and the adviser gets an exemption from the Commission.

Section 206(3) of the Act is substantially less strict. It requires an adviser contemplating a principal transaction, once before the completion of the transaction not before the trade before the completion of the trade to disclose the capacity in which the adviser proposes to act; obtain the consent of the client. A couple of important points and understanding of this provision.

First, this section doesn't apply to a customer if a broker/dealer is not acting as an adviser with respect to the trade. You have an adviser, so you're a client, and you call up the adviser in its capacity as a broker and say, "Please buy me a hundred shares of Exxon." The broker adviser can do that without complying with this provision.

Second, section 206(3) requires disclosure and consent before each transaction. Up front disclosure at the beginning of the relationship, say in the brochure, is not enough.

Now in 1998 the SIA submitted a rule-making petition arguing that section 206(3) does not work well today. It asked the Commission to adopt an exemptive rule permitting clients to give blanket consents to principal trades based upon certain conditions.

Ellen, your firm's a member of the SIA and was involved, I think, in this petition. It's a diversified financial firm offering a variety of advisories as well as underwriting in broker/dealer services.

Could you share with us your perceptions of the problems section 206(3) causes your firm and your clients and why you believe that the SA petition should be acted on?

Ms. Porges:  I'll start off by saying, if you step back and look at the rule and when the rule was initially adopted, the structure of the securities markets today are clearly enormously different than they were at the beginning of the century which was the era in which the trading practices giving rise to this rule as it exists today developed. If you look at the differences in the markets between the 1920's and now you have to at least, as we've all discussed over the course of the last few years, accept the fact that there were such significant changes in the markets that some changes to regulation would be normal to expect. It would be odd if the same rule worked 80 years later. It would be like saying the '33 Act was developed in the Civil War era securities markets.

You step back and you say, "What is different?" Well, first of all there are a lot of things that are different. There are very effective information barriers between different parts of large organizations. They're there because both the lawyers and the law require them to be there and they're there because there is no other way to do business. The presumption or the ability to even know what other parts of an organization of significant size do – it just doesn't exist. While human nature, and there are certain issues in affiliate trading and principal trading that would concern anybody, are always part of a landscape that regulation addresses. The fundamental nature of the size and the trading in the securities markets have changed. One of the changes is truly effective both practical and legal information barriers.

Another change has been far more deep and liquid securities markets. This is not to say that every security and every market is deep, transparent and liquid. But, there have been enormous changes that ought to give us the ability to make rules that are more reasonably tailored to the markets we see now and to affect changes in continually changing markets in a way that is beneficial to everybody. Both to the traders, to the portfolio managers, and to the public because increasing the amount of trading activity or the counter-parties increases transparency, liquidity, availability, and helps the liquidity and transparency of the markets generally.

There have been some successful rules that have been adopted over the years that have helped both the transparency and regulatory side of things. I think 10f-3 under the 40 Act is an example of a rule which is designed and has been modernized and improved over the years, that allows a reasonable amount of beneficial trading to exist without just adopting what is effectively a blanket prohibition to an activity.

There is increased disclosure compared to the 1920's section 13, section 16. The ability of people to manipulate, while always in existence because of human nature, is fundamentally, the mark has moved somewhat and what I think we have all agreed over the last couple of years is we need to find that reasonable mark and promote the active liquidity of the markets and create the right lines, where the lines should be drawn. So that the market continues to work effectively and is responsive to 80 years of fundamental change in the structure of the securities markets. It's just not the same place as it was in the 1920's.

Moderator Plaze:  Any other thoughts from our panelists on this exercise, Mike?

Mr. Eisenberg:  I'm not sure, given the new technology in terms of the ability to communicate quickly. It would seem to me that getting permission is a lot easier these days than it was ten years ago. Furthermore, some of the things that have happened in the market have increased the pressure on people who are trading to get the most they can out of a trade and pressures to use principal trades that may be disadvantageous to clients have increased rather than decreased in the pressure for the production of profits. That may not happen at Goldman Sachs, but it certainly has happened at other places and it's been written about. These are just not ancient tales from the 1930's or from the 1940's. These are things that happened just within the past several years. Even books have been written about it. Liar's Poker was one of them. The idea that you can't get permission, or you shouldn't get permission from your client that he or she knows what it is you're doing and that it is a principal trade and what the basis is, seems to me that that is not much of an imposition and it's not going to interrupt the way honest people do business.

Ms. Porges:  Well, there are many clients, for example, who are located around the world that do not fundamentally understand or are not attuned to the availability constraints that may be a presumption in some of these laws.

It's very hard to explain to somebody truly half way around the world how to give informed consent when they can't tell the difference between a liquid trade and Microsoft and a trade in IBM. So what I would say is that while dangers exist in the world for sure, that there are reasonable ways to develop standards and that what we ought to be doing is trying to find the ways and find the places where reason tells all of us that for the time being that trading is fair, appropriate and there is no reason to impede that particular type of trading.

Mr. Eisenberg:  I take it you would have no objection then toward adopting such a provision for Americans?

Ms. Porges:  I think even for Americans, I think a lot of American clients don't want to be sitting there and responding to a series of documentary requests from their advisers in areas where there are other safeguards that exist. I don't think anybody would ever want to go past the line of where those safeguards exist. I think it's time to find where the market has changed and where things can change so that the right line is drawn. A certain point in 1940 it was drawn at agency vs. principal trading. I'm not sure that's the right line anymore and I can think of examples where there could be problems. I could think of examples where there wouldn't be problems and I think the challenge is to find the right place. It may not be the same place as it was.

Moderator Plaze:  Ellen, your and my comments really well illustrate the tensions in this area and any rule making which we have announced that we are going forward with is going to attempt to reconcile those conflicts.

Let me just identify three of them that people who are working on the rule are trying to struggle with right now and see if the folks in the panel, others can get involved in this and indicate what they think of it.

First is dumping. The sparse legislative history of the statute indicates that I think you had the folks in the Commission staff saying, "Well if a fellow wants to put a sour issue in our account, I think that's just wrong." That's the existence of the legislative history of this provision in the Investment Advisers Act back in 1940.

The other is correct price. Historically, the prohibitions go back to common law times and middle ages, the agent never deals with a principal. A principal never deals with his agent in establishing a price. It's not an arm's length price so how do you create a price. Maybe a modern market or efficient market can do that.

The third conflict is to what extent can a rule address the issue of when an adviser is using a client account for purposes other than for the benefit of the client; that is, for the benefit of the affiliate. Let's say you have a transaction that's fair, fair price, not dumping. But yet the transaction would not have occurred but for the need of the affiliate to remove those securities from books, the affiliate's. How do we craft a rule that, some of you might disagree with those concerns, but if those were concerns that you agreed with how would we craft a rule that would try to address these types of issues? Any thoughts?

Ms. Porges:  I throw out on the dumping side, I think 10f-3 is at least a model, a conceptual model, which has certainly, since its been adopted and amended over the years, served without significant problem. If you can think of the 10f-3 type model as a dumping solution and try to work out something that goes in that direction and then perhaps on the price side have multiple prices and records of multiple prices being kept, you go a lot of the way towards that. You might also cut out classes of securities you feel particularly subject to manipulation. I don't know whether there are volume constraints or types of securities. There are a lot of different lines you can cut that, or combinations of them, that you could make that could be both easy for the advisory community to self monitor and disclose to the regulatory community on inspection.

Moderator Plaze:  10f-3 has a model of an offering price, a fully subscribed offering price where many of these securities there's not an offer or it could be in terms of IPO or something. But, I was thinking more of 17a-7, the cross trades of highly marketable securities on the theory that the adviser could essentially have sold into the market. Although when 17a-7 was adopted, the Commission specifically declined to give relief for principal trades. Arguing, at least at that time, that the motivations were of a whole different kind. How does that 17a-7, when you have trades between affiliates at a price let's say at the mid-point at the market seems to have worked pretty well; how do you deal with situations here where one of the inclinations might be to do a principal trade in order to move a large amount of stock out of the portfolio of the adviser or an affiliate and not have the market effect. That is if you looked at the market to price that transaction, the market may not reflect what the fair price would be if that transaction were exposed to the market. How do you realize a price for that type of a transaction, what price would be a fair price?

Ms. Porges:  Well, maybe one of the things you do and this is an area where I would say you would reassess after a period of time. You wouldn't say, "This is the rule and I'm never going to change it for another 80 years." The markets are changing and you have to develop some reasonable responsiveness on all sides. Perhaps what you start with are volume limitations in the context the SEC has granted affiliated transaction relief for ten, fifteen years now in the context of affiliated money market funds. Part of the premise of those is restrictions on volume. I would say as long as they are easily enough monitored and don't create so much of an impossibility because in fact knowledge of the other side of the barrier positions is so difficult to obtain. As long as they are easy enough to grapple with as a practical matter that is probably a positive step. In the end, I don't think anybody is saying it's all or none. I think people are saying what is the right place to cut this now.

Moderator Plaze:  Any other thoughts from participants?

Ms. Tynan:  I would just make an observation that actually came up at lunch. That some of us were talking about this subject and a colleague of mine had an interesting observation because she wasn't quite as close to the sort of, if we're going to write the rule, what would we do and I guess I'd start by saying that our firm does not engage in principal transactions and doesn't have any ability to do that. So I come at this without, on the one hand, without a business interest, on the other hand with no knowledge either because we don't do this kind of thing.

My colleague's observation, which I thought was a very interesting one and I guess to some of what Ellen was talking about it, about the markets being so different. They are not only dramatically different than they were, however many years ago, but pace of changes accelerating very rapidly and with the advent of electronic crossing networks and other kinds of trading facilities which raise a whole series of issues about transparency and about pricing, and about liquidity. One wonders if this issue shouldn't be taken in the context of what a lot of us would like to see the industry and the Commission do which is to kind of step back and look at the way markets are changing and what the ramifications of that are. In other words, one question I would I have is, "Do you really increase counter-parties as the markets are developing or do you in fact take some of these trades off the table, consolidate them further within the house and reduce counter-parties?" I don't know the answer to that. I just think that I'd hate to see this issue considered as a discreet piece when it looks like it's much more of a picture of the larger market place.

Moderator Plaze:  I agree with you Mary Ann. Its developments in the markets, I've been around this issue for about 15 years and it's been those developments that I think have made viability of a rule and the ability of the Commission to make a finding that we have to make in terms of the interest and protection of investors.

A money market fund was an excellent example. There were no money market funds when this was issued and there was no commercial paper market of the sort that we know today. The easiest of all findings to make is in the commercial paper area where the principal trading, the risks are so much, and the opportunity is so limited – high quality commercial paper, government bond market.

Although maybe it's getting smaller. Things do change. I think this really fits in well with the themes of the roundtable today. The changes and how we have to adapt and the authority we unfortunately, under the Advisers Act, have to adapt to these markets.

Our next topic of the day is the proposed pay-to-play rules. Now, you get a little history here before we get into what I suspect will be a lively discussion of the rule. I have not had a discussion with the rule without it being lively so I have no reason to doubt today will be any different.

In 1994, the Commission approved MSRB rule G-37, which essentially prohibits pay-to-play in the broker/dealer municipal finance area. We knew this rule to have been very successful in curtailing pay-to-play in the broker/dealer area. But, the rule was challenged on first amendment grounds and upheld in a decision called SEC vs. Blount. The court held that rule G-37 was a permissible burden on speech because it served an important purpose of rooting out corruption in municipal finance.

In 1998 we began receiving reports that pay-to-play was involved in the municipal pension market and it was being participated, investment advisers regulated under our statute were participating in that. Chairman Levitt asked the division to look into the question and we in the division, I must tell you, were completely unfamiliar with this problem and this issue. We watched G-37 from afar but never really participated in those discussions. We saluted and went to do our research and were fairly startled to what we found. Allegations in 18 states, lots of newspaper reports but also legislative proceedings, litigation, Pennsylvania, some studies that have been done in municipal areas, New York, other problems.

The Commission proposed 206(4)-5 in August '99 and let me just go quickly what it would do, very briefly. Advisers would be prohibited from providing investment advice for compensation to state and local government entities for two years after the adviser, any of its executives, partners are solicited or solicitors make a political contribution to an elected official of the government entity. Only if that government elected official was in a position to influence the hiring of an investment adviser. Now there is a de minimis provision, which says if you make a contribution of no more than $250 to an official for whom you can vote, the two-year time out will not apply.

Lots of comments on this rule. Let me ask the broad question first and Sandy if you want to be a lead off batter on this issue, is there a problem here? Should advisers to government funds, municipal pension plans be subject to a SEC rule regulating, prohibiting pay-to-play practices? If they are, should that rule be any less stringent given the critical position advisers play to these municipal areas?

Ms. Tichenor:  Well, as those of you who have either seen the ICAA report or those of you who will look at the materials that were handed out from the roundtable have seen, the ICAA has issued a report addressing pay-to-play practices and the investment advisory industry.

Let me just say as a starting point that the ICAA, as does the SEC, strongly condemns the practice of investment advisers making political contributions for the purpose of acquiring or maintaining business. The ICAA recognizes that its member firms have a fiduciary duty to its clients and in some cases those clients are the pension plans themselves not the individual persons who serve on the boards or otherwise serve on the staffs or otherwise part manage and administer those funds. We see that responsibility and that fiduciary obligation to be not much different than a corporate lawyer has to a corporate client where its fiduciary and ethical obligation runs to the entity not to either the general counsel who may be making decisions about hiring or firing any particular law firm or even the CEO or CFO. As a starting point, I would say that I think that the ICAA and SEC both recognize that there is a fiduciary obligation that runs from an investment adviser to the client. The client is the entity, not any individual, and that engaging in activities that might cause the entity to buy services that would otherwise not be appropriate for the entity because of some side deal cut with the individual is probably a breach of that fiduciary duty.

So I don't believe Bob that there is a difference of opinion between the ICAA and SEC as to whether or not there ought to be a broad prescription against pay-to-play, if pay-to-play is defined as making political contributions for the purpose of either buying or maintaining business from public plans. Where the ICAA and the SEC differ and I think that a review of our report which is included in your materials, make those differences clear, is the approach taken to implement that policy. We think that the Commission's rule is an overly broad imposition on the free speech rights of our member firms and their employees and that there is a more appropriately, there is another approach that could be taken that would be a better balancing of the free speech rights of our individual employees and the government's interest and our own interests in assuring that we serve our clients' interests well. If I can just take a minute to outline what the alternative approach that we suggest in our report is which is styled as a best practices approach. But it would require cooperation, I think, by the SEC, members of the industry, and perhaps even our clients in order to make this work. The ICAA recommends that the SEC adopt a rule in lieu of the current rule which imposes substantive rules and regulations upon the industry as a whole which has as its primary feature this penalty provision of what they call a two year time-out after any campaign, any prescribed campaign contribution would be made. We propose as an alternative that the SEC adopt a rule that would require every registered investment adviser or every investment adviser subject to the SEC jurisdiction, to adopt a policy prohibiting pay-to-play. Again, defining pay-to-play as making a campaign contribution for the purpose of acquiring or retaining public entity money. Whether it's a public pension plan or another governmental entity and that each investment adviser would be obligated pursuant to that rule to implement policies and procedures that are reasonably designed to detect and deter pay-to-play. In other words, come up with policies and procedures that are appropriate, given its structure and given the amount of governmental business it has, the type of governmental business it has, how it either markets for that business or services that business. Take a look at how it is structured and figure out appropriate policies and procedures that it would utilize in order to assure that it's broad policy prohibiting pay-to-play was being followed.

In our report we offer several different alternatives that could be utilized without specifying that any firm take any particular approach, again recognizing that there's a wide difference in the industry both in terms of how firms are structured, how they market their services, how they provide service to all their clients including governmental plans and that we offer three alternatives essentially. We suggest that firms could adopt any or all or some combination of this or something else that they thought might be more appropriate for their circumstances. But that they could adopt a bar on political contributions of all types. That bar could be limited to some subset of their employees who they think are more directly involved in the kinds of activities that might give rise to the abuse of activities. They could require a pre-clearance, utilize a pre-clearance regime which many firms already have utilized successfully to deal with the perceived conflict in the personal securities area or they could adopt a disclosure regime. In that regard I would note that I have taken a look at some of the letters that were made available in the public file and I note that MOSERS, which is the public pension plan for the state of Missouri, public employees plan has suggested that a disclosure regime might be an appropriate approach to take in this area. We would expect that firms set up within either a code of ethics or perhaps simply as a, if the Commission did not move forward with requiring that, each investment adviser adopt a code of ethics. Which by the way, ICAA also supports. That if they do not require codes of ethics that they could require the adoption of this policy and they could require the adoption of appropriate procedures tailored to implement that policy and we would expect that those procedures would include things again similar to what we see in the personal securities areas for dealing with conflicts of interest there. Things like annual certifications from employees that they have read, received, understood and complied in all respects with both the policy and whatever procedures were adopted. Reporting of political contributions, again in keeping with whichever approach the adviser took, whether it was a bar, a pre-clearance or a disclosure regime and monitoring of political contributions, sanctions for failure to follow the procedures that are set forth in the code and possibly interaction in dealing with clients.

I would just like to say one other thing about why we believe that this approach is more appropriate for the advisory profession than the G-37 approach and that is that times have changed a lot since G-37 was adopted. There is now a whole range of state and local laws that address pay-to-play. The pension plans, the governmental pension plans themselves, have adopted fairly rigorous codes of ethics or codes of conducts themselves. The advisory business is obtained in most cases through an RFP process, and in that RFP process many of our clients already are requesting information about campaign contributions, if any, or other potential conflicts in the process of acquiring the business and none of that we think was the case when G-37 was adopted.

Moderator Plaze:  Thanks Sandy. Mary Ann you had some thoughts on this, I know.

Ms. Tynan:  Well, I do have some thoughts and actually what's interesting is since we've began to prepare for this panel and began to talk to each other as Sandy indicated the ICAA has just released their report and their recommendations. Neither I nor anyone else at my firm had any involvement in the preparation of that. So I read it with as much interest as I think all of you do. By and large, with very little exception, I think they're right on the money in terms of their recommendations and I guess what I would like to do is maybe highlight some of the things that I see.

I think it's significant and interesting that in the most recent SEC rule adoptions relating to codes of ethics in the investment company world, there could have been a much more hard wired prescriptive approach taken to codes of ethics for investment companies. But the SEC, in fact, recognized that the circumstances of different investment companies in different complexes participating in different markets have an opportunity and should be given the opportunity to craft codes that really do fit their own circumstances. If there is one thing that I've learned over a quarter of a century in this business, is that if you have prescriptive rules that in fact don't work on a one size fits all basis your asking for inadvertent violations. Your asking, as I think Paul Haaga said this morning, for rules that appear to be very rigid and very strict and in fact and miss the big stuff. I think there are people in the public funds arena who would argue that as the climate has changed campaign contributions, given the sunshine that's on those contributions in many jurisdictions, the changes over the last ten years that campaign contributions per se to individual office holders are in fact what they're least worried about. They're much more worried about other areas in which there is a question of influence being improperly used.

Interestingly enough, just last Friday – we do a fair amount of public funds business ranging from some of the very largest plans to some of the very smallest at the municipal level – we got a very interesting request for proposal, which is the way these contracts are typically put out now to bid. Very, very rarely is the contract, in my experience, not without going to a request for proposal stage. With that, all of the information that comes back particularly in these areas of disclosure becomes a matter of public record. The press is actively involved. They have access. Often times you can get this information on web sites. So this is very, very different from the late '80s and the early '90s when the municipal securities issue came up. The request for proposal that we got in just last week asked a very long, I think seven or eight different questions related to disclosure of possible areas in which a bidder for this contract could be exerting undo influence, could have relationships that should be disclosed. It was very particularly crafted to this jurisdiction and was the decision making process works for this particular pension plan. To me, not only are we seeing much more of it, but that's the way to get at the issue. They know where their influence makers are and they know who's in a position to influence the awarding of the business. Sunshine, I think is the way to go in this. I clearly support a code of ethics that all advisers should adopt given their own particular circumstances.

It's interesting, our own code has related to not just campaign contributions but to other forms of sensitive payment. Those provisions have been in writing and in place since before I joined the firm. That's well over twenty years ago. These are not new as best practices in a large part of the industry. What is new I think is the landscape out there in terms of the rest of the environment. I think it would be a mistake to have a rule in place that is intended to do all the right things but in fact is hard-wired in a way that may in fact act to the detriment of the plan beneficiaries themselves and in fact would not cover the breath of the areas that we all should be concerned about.

Moderator Plaze:  Thanks, Mary Ann. Mike, you have played a key role in advising the Commission on these pay-to-play issues and were instrumental in persuading our colleagues in the bar association to do the right thing. Are you persuaded?

Mr. Eisenberg:  Not yet. First of all, I think there's nothing inconsistent between the adoption of best practices, as the ICAA recommends what I think is a very useful report, which has some very useful ideas. There's nothing inconsistent with best practices and the adopting of a rule that would serve as a grounding for at least the base line for what you have to do. If all of these things are happening out in the real world and are basically cutting down on the practice of pay-to-play, then the rule will be effective. It will have less effect on what goes on because presumably the best practices would be stricter than the rule or should be stricter than the rule.

I think that the rosy picture of what's going on out there, there is some question about that that we ought to think about. One of them is, is that the pressure for campaign contributions is growing and not shrinking. The campaigns are costing more money today than they ever have. The pressure is increasing and we have heard from people who are subject to G-37. Thank God, we've adopted G-37, we can just say no. If we go to just best practices without any rule, we have heard that many jurisdictions, some states, and a number of pension plans. That means that there are other guys out there that are not part of some or many and that consequently, the fact that a number of many investment advisers have their act together and have things straight and have codes of ethics and have review committees. A lot of them don't. The pressures out there will be there and probably will increase. I think it's relevant that the fiduciary duty of investment advisers to their clients is, if anything, even more clear than that of an underwriter and a muni bond offering, although they also have fiduciary responsibility. It seems incongruous to impose a tougher standard on an underwriter than on an investment adviser without the most compelling showing of harm to investors resulting from the rule. I guess that raises the question of how this pay-to-play potentially harms public pension plans and plan holders. First, the most qualified adviser may not be chosen which can lead to inferior management and poor returns for the beneficiaries. Second, the pension plan may end up trying to get higher adviser fees because the adviser may want to recoup the amount of the contributions. In other words, there is pressure to get back what you have put in. Further, the manager may be tempted to engage in reciprocal brokerage practices which direct the benefits of the allocation of planned brokerage to the manager rather than reducing the expenses to the fund. If you need a diagram, maybe we can review some of the best execution discussion that was out at the roundtable this morning and earlier at the Mutual Fund roundtable.

In a discussion of best execution we didn't hear anything about ECNs at $.02 a share. We didn't hear anything about Instinet at $.01 a share. We didn't hear about the possibility of recouping benefits for the plan holders, which exist. Seems to me that any discussion of what the temptations are has to include some of these things and we haven't exhausted them. Which are conflicts of interest, which ought to be looked into?

We are told that there are highly significant differences between the underwriters of municipal bonds, which are purely transactional. In the investment advisory business, there are continuing relationships. The continued relationships are important, vital, and accepted and normal. That characterization, if you will excuse some skepticism, is somewhat over simplified. Although I think there is some truth to it. The fact is that in many cases, the underwriting business is indeed a long term relationship where the public official responsible for bond offerings in many areas, hospitals, dormitories, roads, municipal stadiums that we're building for people that all of these are long and continued relationships. The favored pay-to-players gets to participate in a series of offerings over a period of years. It's a continuing relationship. It's not just a project by project deal very often. The other side of that coin is that the investment adviser often ends up being a sub-adviser, and the adviser is one of six or seven or ten sub-advisers who may be subject to termination and in recent years they get terminated. Being an investment adviser to a pension plan is not the annuity that it used to be. Some of the nice distinctions that are drawn by some don't ring entirely true nor do they comport with what I experienced in private practice or that with some of my former private practice colleagues experience. There are differences between underwriters and investment advisers. But to my mind the question is, I think it has to be cut a little bit more finely, are they sufficiently fundamental to warrant significantly different treatment so far as a G-37 type rule is concerned. It seems to me that the burden would be that in the situation of an investment adviser with a clear fiduciary duty that we would have to have some showing that there would be a detriment to adopting this kind of a rule. Now that doesn't mean that the staff is ignoring the comments. There are a number of comments that have to do with scope, have to do with how you deal with the people that are covered and other issues which have come out in the comments which are useful. I think the ICAA's comments are useful and we want to take a look at them. Nevertheless the argument that, if so a fact though, we shouldn't adopt G-37. The atmosphere has changed. We shouldn't adopt a G-37 type rule because things are different out there. That advisers and underwriters are really different. I think there are some serious expirations and I don't think as the Chairman indicated this morning, I think we will adopt a rule. We think it will be a rule that will bar pay-to-play and will not undercut G-37 and the operation of G-37. We had a hard time persuading the bar, or attempting to persuade the bar, and I think in the business law particular not notoriously a highly liberal innovative group to which I belonged for a long time. We are in the forefront of saying, "This pay-to-play business has really got to stop." I think we have learned that how we stop it, there are differences. We will see where this goes but I am reluctant to say at this point that we ought to do anything that will undercut G-37. I don't think that either of the divisions that are concerned with this would want to do that as well. Best practices are good. Best practices are useful. The ICAA report is useful. The comments are useful. We will read them carefully and I think that there is still a way to go in showing us that best practices are enough and that the Commission does not have to go further. So far, that case has not been made.

Moderator Plaze:  Thanks, Mike. I promised you a lively debate and I feel I've come through here. Let me take my hat off as moderator for one moment to explain something and then I'd like to ask Ellen Porges a question on her firm.

One of the reasons we did not go the disclosure route is that we did not feel that disclosure would work in the proposal. That is the traditional approach of the Advisers Act we discussed this morning. An approach typically used by campaign finance reform. The idea being fully disclose the contributions that if people don't like who's given you money, they won't vote for you. This isn't about finance. This is about campaign finance reform. It's about market reform as Chairman Levitt said. Our concern there is who do you make the disclosure to. The elected official who your giving the money to. Well I presumably he or she already knows that. You can make disclosure to the beneficiaries. Who are the people who are presumably losing out on this? But they can't fire you. Especially in municipal pension area. They can't find a new pension plan or they can't get the adviser to affect who is hired as the adviser. We weren't sure that disclosure was going to affect something.

One of the more interesting things that happened after this rule was opposed and I was at a conference of state comptrollers and treasurers and was being treated very unpleasantly. I've gotten used to this in this rule proposal. This is hard ball by the way, as opposed to most of the issues we are used to dealing with in this area. This is hard ball. After getting off the dais and being slightly dazed, I was approached by a tall gentleman with gray hair said that he was a partner of Ellen's. He didn't refer to it that way. They had adopted a voluntary ban on contributions shortly after G-37, dealing with the municipal finance area. I think this was in response to the problems in Chicago, at the time he said. He wished us luck. He wasn't speaking for the firm either, I'm sure. I wondered Ellen what your firm's experience has been under G-37 and how you have adapted to that regime?

Ms. Porges:  As I said before, it's part of a large firm and I have virtually nothing to do nor no knowledge of the municipal underwriting department.

Moderator Plaze:  It sounds like the disclaimers we usually get.

Ms. Porges:  It is in fact a prime example of the effective nature of information barriers. However with the development of G-37 I personally, I don't know about Chicago or not Chicago, thought it was just best. What worked in our system and was easy for us to police and seemed to do the trick in terms of maintaining the right ethical standards and being able to administer it in our environment was we applied those rules in our case to the department that I work with, the asset management group. That works for us. I'm not saying there are not any other ways that things can work for us. It works for us and we also have the RFP process that we have come to know and have increasingly disclosure obligations with respect to. Hopefully the cleaner the investment advisory industry is the better off all of the players are from our standpoint and everybody in the room. Pay-for-play is nothing that anybody would have ever wanted. It's not beneficial to anybody from our standpoint. In our experience, the G-37 rules have worked in part because it was something that worked with our system. We have a mechanism in place and we used it.

Moderator Plaze:  The judge in the court in Blount had a very interesting opinion, his economic approach to law. Which we are not usually used to reading. He talked about pay-to-play involving a collective action problem. That all of the participants know that they would be better off if we didn't do this. But none of the participants individually cannot do it for fear that they're going to lose out on both sides of the transaction. The official as well as money they manage to collect. If they do not contribute, their competitor is going to contribute and they're not going to be able to be considered. Pay-to-play doesn't occur just when you essentially bribe somebody, it's when you make contributions just to be considered on the list. The Court said you need essentially some outside force to impose what all the participants would be better off doing. Question is, is this the way to do it? If you just go on best practices, it sort of the collective action problem persists until everybody does it. If you're strict and your competitors not strict how are you going to do it?

Ms. Tichenor:  Except, Bob, we started out by saying that there would be a rule. There would be an SEC rule. The SEC rule would require that each federally registered investment adviser or all advisers subject to your jurisdiction had to adopt a policy prohibiting pay-to-play. Pay-to-play would be defined, not as simply making campaign contributions. Because we believe that there are legitimate reasons why employees that work in the investment advisory profession will want to provide campaign contributions for reasons totally unrelated. If you look at someone that is in our accounting department or is in our research department or is in the legal and compliance department for example who has either religious or political or personal beliefs that they want to support. It seems like an unnecessary burden on their ability to participate in the political process. Simply because they work for an investment advisory firm. For them to be prohibited from participating. The premise is that there will be an SEC rule of some type that would require that every firm adopt a policy prohibiting pay-to-play again. Making campaign contributions for the purpose of either obtaining or retaining business. Beyond that, it would look to the individual firms to develop procedures that they found to be appropriate for their circumstances in order to detect and deter and root out any practices that were in violation of that policy.

Mr. Eisenberg:  It seems to me that raises the problem. Whenever you have a for the purpose of test that pay-to-play is prohibited and pay-to-play is defined the contribution for the purpose of. Then you have to prove for the purpose of. You have to show the intent. That's very difficult to do. Just as in G-37 which was a similar kind of situation that makes it very difficult to enforce. There is an exception for de minimis contributions of $250.00 and so on. Then you can deal with those kinds of situations through that kind of exception. To make a for the purpose of a part of the rule, you can drive a truck through that. It seems to me, at least in my views, same argument that was had in G-37. It's inadequate and that's why they adopt a more blanket kind of rule that says, no you're not going to be able to do that. Except for what we except. Whether it is the $250.00 and you have to be of the district in order to vote for the person which seems to be a reasonable restriction. Now you could argue about whether that's enough. Maybe it ought to be increased, shouldn't be increased. It shouldn't cover certain people. To get for the purpose of in there raises very serious problems.

Ms. Tynan:  Mike, just a couple of points again to the differences. We again, are supporting a rule. I think that is an important point not to be missed. It's the question of the rule itself. One question I think your colleagues in the bar did for a reason, include for the purpose of in the standards that they proposed. I don't know what that is because I'm not one of your colleagues in the bar. They presumably had a reason for that.

Secondly, unless I'm mistaken, G-37 exempts competitive bid offerings. I think there was a reason why that was done. The rule that has been proposed for the investment advisory profession would not exempt competitive bid process and the award of contracts.

Moderator Plaze:  Actually, the competitive bid process that's contemplated by G-37 simply doesn't exist. It's where you put out a bid and whoever comes with the best interest rate gets it.

Ms. Tynan:  Right, but where a competitive bid process and sunshine does exist in the investment advisory side then I think you have a very different circumstance.

Moderator Plaze:  We have got to move on here to our third topic. I thank you very much. We could continue this into the evening and I bet you some people will be doing that.

Our third topic deals with an area where our colleagues are involved in the financial planning process, dealing with transaction based fees. These are fees typically, money managers don't get. Then we will be talking about conflicts money managers have primarily today. This is a conflict that has concerned the Commission historically and has been an enduring issue in the financial planning profession. It somewhat, it distinguishes participants in that profession. We have a deep regulatory concern in this area. It is consistent – and that issue has been raised again by the Tully Report a couple of years ago, which urged broker/dealers to look to other models of compensation that involved fewer conflicts.

I would like to turn it over first to Susan and then Guy to discuss this. Susan, you are involved with a professional association that by its own definition under its own – choose transaction based compensation. Could you talk a little bit about those issues and what's motivated your members and how that portion of the industry is developing?

Ms. John:  Sure. NAPFA actually was founded on the principle that clients wanted a higher level of trust in their advisory relationships and that the true fiduciary relationship was most likely to flourish when the client paid the adviser directly for services. We eschew any third party compensation whatsoever. In the beginning, and this is early '80s. It was fairly easy to distinguish conflicts of interest in the fee arena because the primary method of charging for services in those days was on a hourly rate or as a percentage of assets under management. To address the question that you brought, Bob, we find going forward that advisers have become very creative in the way they designed fee compensation. There are many opportunities where it is necessary to disclose conflicts of interest to clients directly.

Moderator Plaze:  When we started this discussion, I did in my career some time ago, the financial planners kept coming to us and saying but our clients want to pay commissions. They don't want to pay separate fees. The submissions that Susan, both you and Guy have promoted, suggested there is a sea change going out there. The attitude of investors and there's recently been a report by Schwab that came out just the other day that Mr. Tittsworth kindly faxed me this morning, suggesting the same thing. Guy could you talk about what's going on out there and how you're dealing with it and how your members are dealing with it who actually do? Are commission-based planners or people switching over to a combination and how are clients reacting to this?

Mr. Cumbie:  Sure. I've been fortunate to be involved in retail personal financial planning on one level or another for about seventeen years now. I have been able to participate in the unfolding, the emergence of this arena, the various compensation modalities, the practices for that length of time and from a historical prospective as a student of history of the financial planning profession for probably 30 years, 17 years as an active participant. During that time, we were talking at lunch today. It's interesting to observe and I think to the comments that Paul Gottlieb made this morning about, you get whacked for one thing you make a shift and you wind up getting whacked for something else.

Moderator Plaze:  No good turn goes without punishment.

Mr. Cumbie:  Paul, one of your predecessors, Kathryn McGrath, made the comment very clearly; I believe it was in an IFP conference about ten years ago. That if you're holding out as a financial planner you need to register as investment adviser. A very definitive remark. If you're holding out to the public as a personal financial planner, you need to register as an adviser. At that time probably most personal financial planners were not registered as investment advisers. That shift has been happening. There was a big shift when that was said because it was said with a lot of authority.

Moderator Plaze:  Kathy had a way of doing that. We loved her for that. There are very few financial planners who hold themselves out as planners. Who would qualify for any exemption that would make them subject to. It is theoretically possibly to be a financial planner and not give any advice about securities. I don't think in that speech those people Kathy was worried cared about theories.

Mr. Cumbie:  You would have to weave your way through 1092 in a way very few people could do.

Moderator Plaze:  Successfully do that. Perhaps try.

Mr. Cumbie:  Some of Phyllis Bernstein's peers are doing that. She suggested that. That was very well put, very articulate the way that you put that. That there are ways to do that but it is very difficult, very limited application of the regulations.

At the financial planning association we have a very diverse membership. We have a lot of people that are in various stages of transitioning, compensation modes. A lot of my peers are constantly looking at different mixes, different blends of compensation. Be it fees, commissions, different types of fees that a lot of people consider commissions. The securities industry has responded to this issue by creating certain share classes to create level compensation. To a significant degree, dispense what problems of excess activity being incented. Our basic position as an organization as Mary Anne put it, the Sunshine deal. We applaud the SEC with this new on-line ADV that is going to be replete with disclosure on an all new kind of level about compensation. I have not read it. It is a 108-page document.

Moderator Plaze:  Three hundred eighty.

Mr. Cumbie:  Three hundred eighty page document. I have not read the package yet. Do intend to give it some time. I understand 22 hours of time is the estimate time to complete it. We estimate three probably three times that in reality.

Moderator Plaze:  Can you imagine writing it?

Mr. Cumbie:  We applaud the concept of disclosure and on three different levels. Full and complete disclosure, real disclosure, meaning not just saying here read this to the client. Full and complete, real, and ongoing. It has to be ongoing. Retail clients don't tend to seize on this kind of stuff as being an issue. That's been my experience. It has to be full and complete. It has to be put forward in a comprehensible manner. It as to be ongoing. Many of us in our profession are certified financial planner licensees. The second level of consumer protection is the code of ethics in the practice standards that are being promulgated regularly by the CFP board. I like to think that one of our toughest standards is as Chuck Tschampion put it, the mother standard. I like that. A lot of us do that. How would you explain this to your mother, literally? The disclosure from three aspects full and complete, real beyond legalistic disclosure, and ongoing disclosure, ethics and professionalism pursuant to our code of ethics. The FPA, the Financial Planning Association, has adopted a version virtually a clone of the SFP boards code of ethics for all of its members that are going to hold out to the public as financial planners. That's basically the way we approach it. We are desirous of having flexibility in the market place.

Moderator Plaze:  This is a real serious problem in some ways. I don't want to besmirch the profession in general because I think there is always bad apples. This is an area that is particularly harmful. When you are planning for a retirement and you're put into something. Let's say in the problem in the 80's was limited partnerships. That just blew up. Our examiners go in and they look in and they wonder why was this person put into that. The only explanation is, they're paying out an awful a lot more than the mutual funds. Today we are looking at similar things and we are saying, why would you put a variable annuity in a tax-advantaged plan. The only explanation our examiners walk away with is, they are a bigger pay out than a mutual funds. The disclosures have been the traditional answer. Doesn't disclosure, if properly affected, interfere with the relationship between a planner and its client. If the first thing your telling your client is, you have to watch me very carefully because I have all sorts of incentives. How do you deal with that with a client?

Ms. John:  I don't think that's really true. I think if it's done correctly and it's done on an individual level with clients, it actually fosters a relationship over a long period of time. The longer you're involved with an individual client, the more likely you are to come up against items that present a conflict in one way or anther. They may not be conflicts in a sense of compensation advice particularly. But they may be conflicts that involve client goals for example. My experience is been that has you discuss this kinds of issues with clients, it gives them a better understanding perhaps of their total situation. It does foster the relationship. I really do believe that ongoing disclosure on a very personal level is an important thing. Your new brochure proposal in the ADV is very interesting because I think that it provides a way to put plain English explanation to a lot of common areas where there could be conflicts of interest. Perhaps there needs to be some press practice or higher standard as far as ongoing disclosure and individual relationships is concerned.

Moderator Plaze:  We talk about that in the form. The form is not intended to be the exclusive list of disclosure of conflicts. That's an issue that has come up before.

Let me go over the new form. It would require a general description of how the adviser is compensated, a fee only or a compensation based adviser. If the adviser receives transaction-based compensation, that this does involve a conflict of interest. It gives an adviser or its associated person incentive to recommend investment products based upon its compensation received and not necessarily the needs of the clients. Describe the practices or procedures that the adviser uses to control these conflicts. Larger firms particularly have a supervisory structure in place to make sure that recommendations are consistent with the needs of the client and that full disclosure has been made. Finally if your investing in mutual funds, your going to have to understand the client is not going to get no mutual funds recommended to him if you're a transaction based adviser. Have we caught most of the things here that you think we need to deal with? Are there other issues we need to deal with, is this adequate?

Mr. Cumbie:  From an understanding perspective on the fee side of the conflict. If you look at conflicts as being conflicts of interest and compensation as being something that's just inherent to compensation. It is there on the fee side as well. No matter how you slice it and dice it. In our firm we have been working on this, evolving this, thinking, scratching our head, trying to discern best practices of an offering away to please clients. To make an offering that has broad appeal perhaps and then we say no we just need to have a flexible offering where we tower to the situation.

We charge a lot of hourly fees in our practice for planning work. The problem with hourly fees is it can inhibit relationship. It can inhibit people from wanting to pick up the phone and call, when they really ought to be picking up the phone and calling. Hourly fees can be problematic.

Flat fees, one of the problems associated, that can be a problem with flat fee retainer type fees or just flat project fee quotes is the impression involved. You have to guess. Somebody is not going to come out as well as they could have if you just had a meter running on an hourly basis.

Moderator Plaze:  One of the problems with an asset based fee for financial planning is that it may dissuade somebody for suggesting that they liquidate assets and payoff a debt.

Ms. John:  Not only that but in addition to that, when fees are deducted directly from client accounts there is a requirement there to have the cash in order to deduct the fees. If there is no cash available, then you're in a situation where you perhaps need to suggest a sale of securities which also may not be in the best interest of the client.

Moderator Plaze:  Or to invest in dividend paying securities at least to meet the cash flow needs of the accounts.

Ms. John:  Exactly.

Mr. Roye:  Let me ask the panel a question. Is this an area where we need a suitability rule? Do we need a suitability rule that applies to planners and advisers? I think at one point there was a rule proposal to make what we believe is a suitability obligation. That it's implicit in the statute, explicit in the form of a rule. Would a formal suitability rule help in terms of the commission based planner situation?

Ms. John:  I think it's already implicit in the fiduciary relationship.

Moderator Plaze:  The trouble is that the suitability has grown up in the broker/dealer area and most of the cases involve widows and orphans. Here we're dealing securities that shouldn't be in the account. Although maybe some of them shouldn't be, but maybe aren't the best ones.

Mr. Cumbie:  I'd like to address that question two ways. There is a standard that is higher than a suitability standard that's already in the fiduciary role of the adviser, which is the client's interest first standard. I believe most of us think that's above and beyond fair practice or suitability. Secondly, in most instances or at least that I am aware of, transaction-based compensation when it's happening is happening in a context of dual registration. So that a per se suitability requirement already exists from the RR side, the BD side.

Moderator Plaze:  When we go into financial planners' offices and we see things in accounts like the variable annuity in a taxed advantaged account. We really don't have the tools at that Commission to deal with that. Is it fraud? How do you think we should deal with that? Is there a problem? Is this something that maybe a SRO could do or could deal with better than the SEC could?

Ms. John:  Well doesn't that fall under the insurance jurisdiction to some degree. Isn't that where the licensing for those products is typically?

Moderator Plaze:  It's both securities and insurance.

Ms. John:  I personally can't even imagine a justification for that.

Moderator Plaze:  I hear it at the Financial Planning Conferences. There is a discussion quite often.

Mr. Cumbie:  I'm thinking a little bit in line with what Susan just suggested, realizing that I am surrounded by a bunch of institutional peers. It seems like at a higher level is where that might be better approached, from the product manufactures.

Moderator Plaze:  Any final words in our last sixty seconds of this panel? This has been very interesting, I hope you and the audience have enjoyed it. I know I have. Thank you very much.


Mr. Roye:  We'll take a 15-minute break and resume at 3:30 to discuss advertising and performance reporting.

(A brief recess was taken.)

Mr. Roye:  We have another stimulating group of topics that we want to cover with the next panel. Advertising issues as they affect and involve investment advisers and performance reporting. We have a distinguished panel. Our moderator is Doug Scheidt. Doug is our Associate Director and Chief Counsel in the Division of Investment Management. Doug is, as many of you know, responsible for a lot of the interpretations in this area, particularly in the performance area in some of the recent letters that have come out. Let me turn it over to Doug.


V. Technology and Investment Advisor Regulation

Moderator Scheidt:  Thank you, Paul. Welcome to the ultimate panel of today's roundtable. We are going to be discussing advertising and performance reporting issues. With me are my fellow panelists today. To my immediate left is Luis Aguilar the General Counsel of INVESCO.

To his left is Michael Caccese, General Counsel and Senior Vice President of the Association for Investment Management and Research. I will call it AIMR from here on in.

To his left is Thomas Mistele, General Counsel, Secretary and Vice President of Dodge and Cox.

To his left is Katy Quirk, the Managing Director and General Counsel of Scudder Kemper Investments.

Last, but not least, is Lori Richards, Director of the office of Compliance, Inspections and Examinations in the Securities and Exchange Commission.

Our first topic today is adviser advertising and SEC guidance. Over the years the SEC staff has provided a substantial amount of guidance on adviser advertising issues through no-action letters and interpretive releases. The Commission has provided additional guidance in terms of enforcement actions involving investment advisers and adviser advertising. Many counsel and advisers have generally been satisfied with the level of guidance and the specificity of the guidance provided by the Commission and its staff on these issues. Some advisers and their counsels, however, have observed that their ability to comply with the law and the positions of the Commission and staff is made more complicated by the sheer number of SEC enforcement no-action letters and enforcement actions and by their fact-specific nature. They contend that it's very difficult to sort through the patchwork of no-action letters and enforcement actions to really ascertain the views on the position of the Commission and its staff. I'd like to ask the panelists today whether they agree with this observation?

Mr. Aguilar:  Short answer is yes. Turn the emphasis to the patch work on no-action letters and the difficulty in trying to work our way through them in trying to apply them to specific fact situations we are dealing with on a day to day basis.

Ms. Quirk:  I don't think you'll get any objections from any of us that some way of bringing some clarity to this and bringing it in to a single location where people can take a look at what the staff's positions are in various things would be helpful to the industry.

Mr. Mistele:  When confronted with a marketing person standing in front of you, you need something more concrete than a series of no-action letters which are again fact specific.

Moderator Scheidt:  Lori, has it been OCIE's observation that advisers and their counsel misunderstand staff positions?

Ms. Richards:  Well, we spend a lot of time in our examinations of investment advisers looking at advertising and its compliance with advertising rules. I guess we see a lot of problems. I'm not sure I can attribute it to misunderstandings or not. We do see lots of problems in investment adviser advertising. Some of the types of non-fraud based problems that we most often see are advisers that inappropriately use gross fee performance results. That seems to be an area where there are lots of deficiencies. Inappropriate use of predecessor firm performance results. We see lots of examples of advisers not complying with the guidance that's been provided by the Commission in no-action letters. We see lots of examples of inadequate documentation to support performance claims by advisers. Advisers don't seem to be aware that they need to keep records substantiating performance for at least five years from the time that they used the ad. I guess, beyond that the most common type of area where I think there probably are misunderstandings by advisers is what it takes to constitute compliance with AIMR standards. Michael can probably talk about this a little bit more. In many of our exams of advisers that claim that they're AIMR compliant we find that in fact that they're not appropriately applying the AIMR guidelines. While that's not a violation of SEC rules we do criticize advisers for representing that they're AIMR compliant. Which can be a material representation to clients and potential clients. When in fact they are not. Whether it's because of misunderstandings of the law or more intentional misconduct, the consequences can be very serious if it results in a performance claim or an advertisement that misstates actual performance results.

Moderator Scheidt:  Do the panelists believe that if the staff were to issue staff legal bulletins on various issues involving adviser advertising issues that that would be helpful to the industry and to counsel?

Ms. Quirk:  Yes.

Mr. Mistele:  Yes, I think an interpretive release would be helpful and certainly interpretive release that addresses the consulting community and the interplay between institutional managers and the consultants would be very helpful.

Moderator Scheidt:  Are there any other areas of concern that you might want us to address?

Mr. Caccese:  I think the best thing would be if there was one document that pulls it all together as long as it is consistent. I think whether we would support it or not really depends what it ultimately says. When there is one document that pulled everything that's out there together and worked out some of the inconsistencies, I think that would be very helpful to the industry as well.

Moderator Scheidt:  I think to some extent, if the staff were to prepare a document like that it would be to some extent a compilation of what the staff has done in the past. I think there is a reluctance, and I think it's a good reluctance in some respects for the staff to not opine on particular issues when they don't have a specific fact situation before them. We could in all good faith come up with a position on an issue when particular facts situation hasn't been put forth to us. Which we might otherwise bless in an no-action context. To some extent, it would be a compilation but to another extent it might be an avenue for the staff to articulate in a written document some of the positions it has taken in the inspection process that the entire industry has not seen. The staff has dealt with through phone-day questions that come in. We don't have a written vehicle to announce and position them.

Ms. Quirk:  I think that would be very, very helpful. I think where you articulated things that were inappropriate which can come out of the inspection process. I think that kind of guidance can be very helpful.

Moderator Scheidt:  Second topic that we're going to discuss today is investment adviser performance reporting. Mutual funds are subject to Rule 482 which requires them when they advertise their performance to present that performance in a standardized format. In contrast, the Investment Advisers Act does not require advisers to present their performance information in ads in a standardized manner. Instead, their advertisements are subject to the general antifraud provisions of the Advisers Act. Before we get into a discussion of whether there would be some value to a SEC rule standardizing performance presentations for advisers, Lori can you identify problem areas in performance advertising by advisers for us please?

Ms. Richards:  Sure. Bob Plaze mentioned that we are most concerned sometimes with the bad apples and I have to say in my program I tend to see more of the bad apples. Most advisers get it right but when advisers get it wrong, it's typically based on a couple of different techniques. We see advisers that use selective performance results that are based on composites that don't accurately represent what they claim to represent. As you know, a composite combines actual historical performance of a number of accounts to one figure that shows a single return for a given period of time. In computing a composite, an investment adviser has to make a number of different decisions including what time period to include in creating the composite and what accounts to include in the composite. We see composites that only include profitable accounts for example and exclude the unprofitable accounts. Advisers can accomplish that in a number of different ways. They can exclude the accounts that were closed during the period. Accounts that are more likely to be closed by a client are unprofitable accounts where the client is unhappy with the adviser's management. That composite may only include selective profitable periods of time and exclude periods of time for which the accounts were unprofitable. The composites can include accounts with different and more profitable investment strategies. Let me give you a couple of examples of this. We found one adviser that advertised an overall composite that only included composite for clients that used very risky investment strategies, options trading and short selling that was profitable during the period in a composite, along with client accounts that use more conservative investment strategies. So the use of composites that don't accurately compile accounts that are representative and don't accurately represent what they claim to represent. Another area – fraudulent ads include the use of back-tested or model performance data that's misrepresented as real performance. Both techniques use hypothetical performance models that are based on hypothetical ongoing performance and back-tested performance is based on how an adviser would have performed assuming that he invested in a certain manner. We sometimes see advisers that use model or back-tested performance and represent that performance as actual performance. There are lots of examples of that and those cases are maybe best exemplified in the enforcement actions that the Commission has brought.

Probably our most common finding of violation in this area is advisers that misrepresent and exaggerate the number of clients they have, their assets under management, the length of time they've been doing business, and their personnel's' education or experience. Finally, we also see ads and marketing materials that misrepresent the adviser's investment philosophies or management techniques. They may represent that the adviser uses a conservative investment strategy, when in fact, the adviser uses a very risky investment strategy. So marketing materials that misrepresent investment philosophies, the use of false information about clients, assets under management, use of back-tested or model performance data that doesn't represent real performance, and the use of composites that don't accurately represent what they claim to represent are probably the most common examination findings in this area.

Moderator Scheidt:  It sounds like, Lori, that some of these practices wouldn't be stopped by the adoption of numerous rules by the Commission, but for the adviser that is trying to comply with the antifraud provisions, they complain there isn't enough guidance out there. There should be a mandated way to calculate their performance and present their performance so that they know what the rules are, and they claim that it's unfair without such rules. How do the panelists feel about that observation and what do they think about the Commission adopting a rule standardizing the performance advertising?

Mr. Mistele:  I think in that area, there are standards out there and they've been out there since at least 1985, 1986 is really the AIMR Performance Standards. They are the created industry standards. Right now they are being accepted around the world as a global standard. I think as Lori pointed out, there are errors that are being found and the inspection really is covered by the antifraud provisions. I think one thing at least we found from AIMR, I'm sure the Commission would find too, in the investment adviser area is a very diverse area of the business. There are very many different investment styles and strategies. If you come out with a regulation that would be fairly technical, it may stifle the ability of managers to be creative in the positive way to help their clients presenting the performance. Another thing is whatever is designed by the SEC may not be subject to other areas of the investment business not subject to the regulation of the SEC.

Ms. Quirk:  There are a couple of things for me as I think about this subject. The first is that I think we need to distinguish between numbers that are used to entice people to become your client and the kinds of numbers that you report to someone who already is your client. I think that is a critical distinction if the SEC were to start thinking about rule making in this area because the enticement process is probably the one that required more standardization. When you're talking to your client they ought to be able to ask you for whatever numbers they want to have which leads to the second point. As Mike has noted, this is an industry where clients range from the largest public kinds of funds with billions and billions of dollars under management down to whatever is considered a high net worth individual given a firm's target market, and the levels of sophistication and the levels of information, which if they want in terms of raw data from which they can calculate your performance themselves, varies greatly. And so, I think in trying to come to a "one size fits all" in this area, it would be very difficult. You really need to think about the market more in segmentation, which gets very tricky, I understand, but a retail client probably would benefit from a standardized performance presentation when trying to compare investment advisers who say are participating in a wrap program. Whereas, the largest pension funds in the country probably don't need, nor even particularly want, that kind of standardized rule. I think we have to be careful not to cram everybody into the same box.

Mr. Mistele:  The example cited by Lori wouldn't pass the "tell-your-mother test" that was articulated this morning. We would not favor the SEC standardizing performance. Looking at the consulting community and the demands of clients' unique flexibility, performance can be driven by investment objectives and tax considerations and change in guidelines, change in cash flow, and you need to have the flexibility to address those issues which may not be accommodated by a standardized formula.

Moderator Scheidt:  Is the guidance from the Commission sufficiently adequate to put most advisers on notice about what may be misleading and what may not be in terms of advertising their performance?

Mr. Caccese:  My view would be the guidance of the Commission has been through the general antifraud provisions and especially now through the enforcement area. I think if the Commission wanted to pursue rule making in this area, it should be very broad and basically address some of the very fundamentals of performance such as showing your performance in composites, all the firm's fee-paying discretionary accounts should be in a composite so they not only represent their best accounts, but their best composites. The composite performance be calculated the same way, and also you have certain disclosures such as the total assets of the firm, what's the assets the composite represents versus the total firm, when the composites were created. There are whole, broad principles that could be given guidance, but there's really no difference in what's being followed in the AIMR Standards. These were the principles that were followed by the industry through its own self-regulatory process in the mid-'80s when at that time there were questionable practices in firms showing their performance.

Ms. Quirk:  I do think that at least it's a subject that ought to be explored at a more detailed level. As I said, I think when you're talking about a more retail-oriented offering that some standardization around the kinds of things that Mike is talking about probably makes some sense. Time periods are different, of different interest to different clients, institutional clients probably have a different time horizon than an individual client, and so I think it's something that would have to be looked at. In terms of the adequacy of the current, the problem with the current stuff is we all know is episodic. If there were some effort to bring in a more regularized way the kinds of things you're seeing in inspections, and begin to give people a sense of where people can go astray. I think that would help perhaps to have standards develop than cause a rule not to be necessary. But at least it would put everybody on the same playing field, which is clearly what you want to do here is make sure investors have the right kinds of information that they need to make the decisions about whether to do business with you in the first place or to continue doing business with you going forward.

Mr. Aguilar:  I think that would be helpful when there's well-intentioned misunderstandings, but things that Lori mentioned to me, I don't believe they are well-intentioned misunderstandings. If you want to lie about your performance, you're going to regardless of what rules or standards you have out there.

Ms. Quirk:  But as somebody pointed out this morning that's true of all rules.

Mr. Aguilar:  That's true. The thing about too much information be provided, "put-beans-in-your-ear test" which is up there with the "mother's test," you're going to give people ideas they never had.

Mr. Caccese:  The beauty of Rule 482, which I'm responding to one of your comments, Katie, is that it permits the use of nonstandardized performance information provided that the standardized performance information is included. So that could possibly address your concern that different types of clients want different kinds of information. It would allow an adviser the flexibility to provide whatever additional supplemental information.

Moderator Scheidt:  I would also like to take this opportunity if anyone has comments they would like to make, they would like the staff to address in staff legal bulletins on any advertising issue, we would be glad to hear them and glad to try to incorporate them in anything it is that we produce. We would be more than happy to have you point out all the areas where we haven't addressed particular issues or where you believe that there is conflicting or insufficient guidance. We would be glad to try to provide that to you.

The third topic of discussion is portability. Advisers frequently recruit portfolio managers from other firms and seek to advertise the performance of those portfolio managers that they achieved at their former firms. In addition, portfolio managers sometimes open up their own shops, and they seek to advertise the performance they achieved at their former employer. A legal issue, under the Advisers Act, is whether, consistent with the antifraud provisions of that Act, the new advisory firms can advertise this performance information, and if so, under what circumstances? This issue is generically referred to as portability. The staff has provided guidance in this area in a handful of no-action letters. The two principal aspects which are that the person whose performance at the prior firm is being advertised must have been primarily responsible for that performance. And that the account that the person is managing now must be substantially similar in style to the account that he or she managed at the prior firm. There's been a lot of debate about this. There's a NASD rule proposal concerning the use of this kind of information in mutual fund ads. Some people have strongly criticized the staff's positions, arguing portfolio mangers should never be permitted to take their performance with them. Before we get to the debate, I would like to follow a pattern here. Lori, has your staff seen problems in this area?

Ms. Richards:  Yes. Regardless of how you feel about whether portability is a good thing philosophically or not, it's very difficult for SEC examiners to determine whether or not a firm that uses the prior performance results from a prior employer is in compliance with the no-action rule. Sometimes when a portfolio manager leaves, he or she is not able to take with him or her the documents that would substantiate the performance claims. In addition, the provisions of the no-action letter itself are difficult for us to determine whether or not the new firm that's advertising the old firm's performance is in compliance. The kinds of problems that we see are situations where it does not appear to us, based on the records that are available to us, that he or she was primarily responsible for the performance results achieved in the portfolio at the old firm. It also appears to us in some situations, the accounts at the old firm and the new firm are not substantially similar or were not managed in a substantially similar manner.

One bit of guidance I would throw out there for advisers is that if they do intend or want to use the performance results achieved by a portfolio manager while with a prior firm, they need to document for themselves internally that they are able to comply with the provisions of the no-action rule, the no-action guidance. That means they have to have a paper trail that carefully evidences their conclusions in that respect so that those documents are available for examination when we come in.

Moderator Scheidt:  What are the views of the panelists on this issue, Katie?

Ms. Quirk:  This is one of those where when they are leaving the firm, I don't think it should be portable. When they're coming, sure, of course. I'm a little of two minds about this as it were. In thinking about this, though, I think that what we're really talking about here is the need to balance an individual portfolio manager's stock-in-trade as a knowledge worker against the institutional right to that work-for-hire. I was thinking about it in those terms, all the while, of course, keeping paramount the protection of investors because after all this is an exercise in making sure people aren't misled.

It seems to me that the primarily responsible test is a good one, but one which is at least in other than a one-person shop, pretty difficult to meet. If you have a process which is in a large firm where you have separate research department and a separate trading department, and potentially a top-down decision-making process, where portfolio managers are in fact implementers of decisions rather than makers of decisions, I'm not sure you can find anybody who can say they are primarily responsible for something. In much as a mutual fund must be able to own its own performance record, it is a separate legal entity and you can't deprive it of its performance record by change in personnel or at least you shouldn't be able to. I don't think institutions should be deprived of their performance record either. Then you get to the place where you've got, perhaps if somebody makes enough moves, you've got seven or eight firms all claiming the same investment performance. In thinking about this you really have to focus on the test which I think is a reasonable one, which is the primarily responsible and if someone can truly demonstrate that they were the one. I assume there can only be one primarily responsible person, and if that's the case, then I think the standard that's been articulated is fine. It's just going to be very difficult, I think, for people who come from large institutions to meet it. Because how much weight do you give the trader's skills as we heard this morning? That can be a significant part of the process in getting the value of the investment idea is execution. So if that's part of the game and you have a separate research analyst, does the research analyst get to say it was my ideas? The fact that somebody chose to implement them, why do they get the credit? It can get very complicated, I think, in this area.

Mr. Mistele:  My sense is that this issue is dissipating in a sense of being addressed in employment contracts, noncompete agreements with portfolio managers or research analysts recognizing this pattern that has emerged. Companies are recognizing this is an asset that they want to protect and they want to address up front. In some sense this issue is, I think, going to die of its own accord.

Ms. Quirk:  Maybe, except that it's kind of like the "pre-nup" negotiations, if you want somebody to come in and you say, "But by the way you can't take any. . ." It can get a little tricky. That would be nice, but I'm not entirely sure.

Mr. Caccese:  I would agree with what Katie has said on this thing. I can see in the very rare circumstance would one individual be responsible for the performance that's created so they can take it with them. The only other example I can think about, I think the SEC has addressed this, is when the whole shop leaves. Maybe the whole fixed-income department leaves. The managers, maybe even the traders, the analysts leave and goes to a new shop. It's almost like a change of ownership in a firm that you get in a new company, basically, it's bought by the new company. I think that situation you could take it with you as long as when you're in the new company, you're style and strategy and everything else is almost the same as it was in the old company. That's an important thing that the operating had to operate similarly in the new situation you have.

Moderator Scheidt:  I think there's at least two other factors that play into this, too. The first one is that there's a lot of self-policing going on. I know in the mutual fund context we've gotten a lot of comments from former employers when they hear that a former portfolio manger is claiming performance as their own. We get the word that the former employer disagrees. Sometimes we get that early in the process, sometimes we get that later in the process. Later in the process the information gets handed over to Lori and her people. Earlier in the process, we unfortunately play referee in the context of prefect of registration statements. Sometimes you are told whatever they think you want to hear. It's really hard to figure out what the truth is. To some extent in the fund context, the staff has just had to rely on the representations. If the representations are not true, then the portfolio mangers are taking that risk of having a false and misleading document. That's one element, and the second element as Lori mentioned, and as we'll speak to next, is the legal need to have documents substantiating your performance that you advertise. Frequently, when portfolio managers leave, they can't take the filing cabinet or the computer records of their former employer. That is an effective bar in many cases to portfolio managers being able to take their performance with them.

The fourth topic as I just indicated was substantiation. Before an adviser can advertise its performance, it must have documents that support that performance. The specific rule, Rule 204-2(a)(16) of the Advisers Act, provides for a safe harbor. That if the adviser retains all the account statements of their clients and the account statements show all debits and credits and other information, that retention of those documents will be in compliance with the Act. It's not the only way that advisers can comply with the Act, and we've issued a no-action letter and I can tell you we have another no-action letter in the works that will address what kinds of records advisers can maintain to satisfy the conditions of this rule.

The stated purpose of the rule is to assist the Commission's examiners in evaluating whether the ads are false or misleading. I'd like to ask, Lori you've already identified numerous instances in which advisers have advertised their performance information without having adequate records, I'd like to ask is additional guidance necessary or do most advisers seek to comply with the rule by maintaining account statements?

Ms. Richards:  I think additional guidance would be really helpful. We often see a lack of reliable supporting documentation. An adviser may be in compliance with the rule by maintaining copies of the account statements that it has created itself and provided to clients. We see situations where we're not convinced that those documents are reliable verification for the adviser's performance. We strongly believe that all advisers should maintain all documents that support advertised performance claims, and in particular, the most reliable verification are third-party records, brokerage statements, and statements from the adviser's custodian. We are taking the position in our examinations that the most reliable kind of documentation is this third-party documentation. Given the problems we've seen in this area and the possibility of fraud by advisers who misrepresent their performance, we are strongly urging investment advisers to start maintaining these third-party records. We don't think it's burdensome now that most records are maintained electronically, and that those kind of records provide the best kind of verification.

We've also kind of told the industry that if advisers don't maintain third-party records that are adequate for us to obtain some comfort that the performance claims are genuine. And where the adviser is advertising performance that seems extraordinary and above and beyond that of its peer group, rather than have SEC examiners perform a full verification audit based on limited books and records available of the adviser, that we're going to refer those advisers to our Division of Enforcement for a more complete verification on the adviser's performance claims. I think guidance in this area is helpful and also, speaking only for myself, think that the SEC's rule that allows advisers to comply with the document retention provisions of the rule by maintaining their own records, ought to be changed. Investment advisers ought to maintain all the records that are necessary to demonstrate that they've calculated their performance accurately, and those records would include, as I say, statements from brokers and statements from custodians.

I would also note if I have one more second, another area of where the books and records rules act to the disadvantage of SEC examiners when they are trying to verify compliance is performance records must be maintained for five years if the adviser uses those performance records to advertise its performance. In the area of composites where an adviser is selecting among some client accounts to include in the composite and not include other client accounts, the adviser does not need to maintain records for the accounts that were excluded. That's a problem for us when we try to ascertain whether the adviser has included all representative accounts if the adviser is only maintaining partial records. I think that's another area that the Commission may want to consider as it considers whether to provide guidance in this area.

Moderator Scheidt:  So, Lori, you would have the Commission adopt the rule that would require advisers to maintain records with respect to all of their clients in a particular year if the adviser was still advertising any performance from that year?

Ms. Richards:  Any performance during that year.

Mr. Mistele:  Are you saying that a self-generated appraisal is not sufficient to support a performance record? You need a third-party, let's say custodian or administrator to support the performance record, an appraisal you send out to a client, that you reconcile against custodial records each month, is not sufficient to support a performance?

Ms. Richards:  If you have the custodial records so that we can do the verification, that's optimum. Documents that are created only by the investment adviser, we feel can't be used always as verification of performance claims, particularly in situations where the performance claims really seem to be extraordinary. We're not content in those situations, we're not comfortable to rely solely on documents that have been created by the adviser. If the adviser has an outside audit performed of the performance claims, that obviously gives us much more comfort that there's been some independent verification of the calculation of the claims.

Mr. Mistele:  And the fact that it's available from the custodian is not sufficient? You actually have to have, and we do, I'll just add up front that we do, we have both, in case my mother is out there, you have to have both in your files?

Ms. Richards:  Most advisers, I think, do have both. It's very difficult for us to go to a custodian and a broker, and many advisers don't want us to do that. They don't want the SEC approaching a broker dealer and asking for the records of the investment adviser. But in situations where we need to do that, we will do that in order to verify an adviser's performance claims. In order for us to conduct a full audit of the adviser's books and records, we much prefer the adviser itself maintain third-party records demonstrating compliance.

Mr. Caccese:  I would agree with what Lori is saying especially her latter point about keeping records for accounts that you're not even advertising because you really can't determine if a composite is appropriately created if you don't have records of what accounts were excluded. They may have been excluded because of poor performance. They may have been excluded because they are nondiscretionary. They may have been excluded because it's a different strategy then what you're putting in that composite. So that's essential. I think also having adequate records, as most people know here, part of the AIMR Standards is verification which is optional. A complaint or comment we receive a lot from the verifiers out there is when they go in and hired by firms to do verification, one of the initial problems they have is they can't get the records or there are inadequate records for them to even start verifying some of the performance numbers. It's important to have the accuracy of the records.

Mr. Mistele:  But for firms who are moving towards electronic reconciliation, reconciling your general ledger system against the custodial records, I guess it's somewhat a wake-up call to say you better be preserving that electronic feeder, that database, that you're reconciling against. You're shaking your head yes?

Ms. Richards:  Yes, I hope so.

Moderator Scheidt:  How would the panelists feel about a SEC rule requiring advisers who advertise their performance to have those results verified by an independent auditor or other entity? Obviously, it would add to the expense.

Ms. Quirk:  It's a cost issue.

Mr. Mistele:  It depends, in my mind, which marketplace you're in. Certain markets, I think the large institutional market, the state governmental plans are looking towards verification, which is a mini-audit so to speak, at levels 1, 2, and 3. Some competitive pressures are, I think, nudging investment advisers in that direction, not willingly.

Mr. Caccese:  From the AIMR side, the AIMR PPS Standards, has always taken the position that verification should be mandatory because of the extra costs especially for the smaller firms. Also, the market will decide, and we have seen a continual increase of firms voluntarily getting their AIMR performance verified. What's happening around the world, where the gifts of the global investment performance standards sponsored by AIMR in the markets where there are not active regulatory oversight, verification is coming in as being mandatory as an extra protection to make sure the performance being shown is accurate.

Moderator Scheidt:  I could see the SEC proposing a rule like that, in part, to give the examiners a break. The examiners can come in and advisers could either show them their account statements in compliance with the rule or they could point to that big room in the back and say, "There are all our documents. Have fun." And Lori and her staff could be there for days and weeks attempting to verify the performance information which may on the surface look troublesome, but may at the end of the day, be perfectly fine. I think the Commission's, one of the Commission's interests in this would be an effective use of its resources, and it's limited examination resources and enforcement resources. If it were to give a safe harbor or some sort of provision that would encourage the use of verification by independent third parties, that would facilitate the staff's examination process. It would probably facilitate cleaner performance information in advertisements and we'd have to assess the costs involved.

Mr. Caccese:  Doug, my observation would be if the SEC decided to go down that route, however they define the verification, hopefully it would be similar to the AIMR Standards because the verification shouldn't be done as an audit. It shouldn't just be limited to accounting firms. There are consultants and other organizations out there that are much more familiar with the investment process which are a lot of how you determine your performance, how you create your composites. It's not an auditing function. It's an understanding of the investment process to make sure that that would be addressed in it.

Ms. Quirk:  Of course, depending on whether you've standardized performance that's going to be reported so that the verification process becomes a commodity that will control the costs. So these may be interconnected.

Mr. Aguilar:  I would concur with that, but I'd listen closer to the word "safe harbor." I would commend you that if you did such a rule, you should perhaps clarify who the verifiers could be. Who would be acceptable to you, and that you boldface the safe harbor provision.

Mr. Mistele:  I guess I'd be concerned what are you auditing against? If you don't claim AIMR compliance, what's the standard you're auditing against? How do you define what's discretionary account, how an account is included in a portfolio or composite? What standard would you use to measure by?

Moderator Scheidt:  The numbers presented there reflect, I'm trying to think of the standard language that auditors use when they review financial statements.

Mr. Aguilar:  I think the answer to that may be once they decide to the approved, they will make those definitions known to us.

Mr. Caccese:  I'm not sure you'd want the verifiers to define the standards. Even in the auditing area, they are auditing against standards created by the FASB and GAP and AICPA and SEC. So there are standards there.

Moderator Scheidt:  You might be sure they are doing a sufficient sampling to ensure the numbers are accurate, and that they do it fairly.

Mr. Caccese:  I would refer people to look for the requirements for a firm that's doing verification. The AIMR Standards goes through a lot of detail what has to be looked upon.

Moderator Scheidt:  Moving on to the fifth topic of today's panel is the testimonial rule. The Commission has a rule that prohibits the use of testimonials in advisory advertisements. It was adopted in 1961, and it's based on the Commission's view at that time, that testimonials are inherently misleading. They have a tendency to emphasize favorable comments and ignore those that are unfavorable. It was adopted pursuant to the Commission's authority under Section 206(4) of the Advisers Act in which the Commission has the authority to foreclose the use of advertisements that have a tendency to mislead. Not that the actual testimonial in this case is actually fraudulent, but that there's a practice that has a tendency to mislead.

This rule is currently under review by the Investment Adviser Task Force in the Division of Investment Management. Again, Lori, how prevalent is the use of testimonials by advisers? And how bad is it?

Ms. Richards:  We do occasionally see the use of testimonials by advisers. Since the use of testimonials is considered per se fraudulent, we don't see it that often. On occasion we do see that advisers use testimonials in exactly the ways that the anti-testimonial rule was designed to prohibit. We see testimonials by kind of folksy people talking about their wonderful experiences with the investment adviser. "Just ask Ward and June Cleaver what they thought about their experiences with the adviser."

We also see testimonials by people who command respect, public figures, people with some prominence in the community, doctors or lawyers talking about their faith in the adviser's abilities. In all these situations where we've seen testimonials, the adviser is seeking to portray these clients' experiences as representative of the experience that you, too, could have if you invested with this particular investment adviser. The adviser uses these clients to emphasize very positive experiences, of course. We've never seen any ads that use testimonials from individuals that have had just mediocre or unsatisfactory experiences with the investment adviser. I think there is something inherently not representative about the use of testimonials.

Moderator Scheidt:  Is the rule out of date? Is it archaic? Should advisers be permitted to use them because other professionals are allowed to use them?

Mr. Aguilar:  There was a lot of discussion in one of our earlier sessions about the similarities and differences between the broker/dealer community and the investment adviser community. For this purpose of this discussion, I think there's probably a lot of similarities. They're certainly allowed to use testimonials. So if you're going to adhere to an even playing field philosophy, you've got to step back and take a hard look at whether if "it's good for the goose, it's good for the gander."

Mr. Mistele:  In some sense I think we're in Superman's Bizarro world. In the sense that broker/dealers can use testimonials with retail investors, the proverbial "little old lady in tennis shoes," but an investment adviser can't use testimonials with a large institutional client or prospective client. That's kind of an odd position to be in.

Ms. Quirk:  I agree with that. The other thing, I guess, that I think needs to be thought about in this area is what the testimonial is for. It's one thing to say, you know, "all of my dreams came true because they've made me a millionaire," as opposed to these folks provide good service. They listen to me, whatever. It seems to me there are things about which testimonials ought to be representative or that there's no harm to people. If somebody says you provide good because you answer your phone regularly just to be silly about it, that seems to me to be far less problematic than having somebody say, they've become a millionaire in two months. Maybe those distinctions ought to be drawn in thinking about what this rule does and doesn't permit.

Mr. Caccese:  I think this rule has really passed its time. You have to go back to when this rule was originally enacted. It was inherently fraudulent for an investment advisory firm to even report any of its performance. Times have really changed since then.

Ms. Quirk:  We all live with the disclosure, you know, footnote that says, "this may not be representative." You would have to do something to make sure that what you are describing is more representative than not or things like that in order to have the claims be made. There are ways at getting at that, too.

Moderator Scheidt:  I think if we were to go to the more liberal approach, I'd want the Commission to go a little bit different from what I've seen in the broker/dealer area. There's one particular golfer who has done a lot of ads for a broker/dealer firm. There flashed on the screen for perhaps a half of a second, the fine print, and the disclaimer. That just can't work. I don't think disclaimers or footnote-type presentations are going to keep inherently misleading ads from being misleading, or inherently unrepresentative ads from being misleading. I'd have problems with that. I'd also wonder if this is really something the adviser industry wants to get into. Do they really want Michael Jackson or Michael Jordan or Tiger Woods advertising, making celebrity testimonials for their products? I question whether Michael Jordan eats Ball Park franks. They tell me that the FTC has rules against things like that, but I just don't know whether they're enforced.

Ms. Quirk:  I'm not sure that there's a huge clamoring, at least in my marketing department, but maybe you all have a different experience. I think it has to do with the fact that it has gotten, the testimonial covers everything that might be around. One client speaking to another, let's say. I'm not sure we want Michael Jordan, but I think we do want to be able to tell clients that 55% of our high net worth clients think that our phone service is the best or whatever. I think it's that kind of stuff where we need some flexibility. Not to mislead, but to give people a sense of what our service levels are like.

Mr. Caccese:  I'd like to meet Michael Jordan. We couldn't afford him, nor would we want to use testimonials. It does put a pall over the use of when a client calls and wants a reference, you now, a similarly situated account. You sit there and cringe a little bit. What kind of caveat should I read over the phone when they talk to this other client. So it does limit your flexibility really in an institutional marketplace.

Mr. Aguilar:  I don't have much to add, but I'd like to say that to those who have been watching television that just because you have a famous ex-ball player or tennis star doing your ads doesn't mean it's a testimonial. For those who have seen Bill Russell and Chris Everett lately and Mia Hamm, those are not testimonials on the record.

Moderator Scheidt:  It just depends on what they are saying. Tom, did the ICI make a suggestion a few years ago in this area on adviser advertisements and as to Rule 156?

Mr. Mistele:  They essentially made a proposal to the FCC, and I think it's July of 1998 which would in a sense adopt Rule 156 in an investment adviser context. I think that's one reason it would set us well in trying to interpret these types of issues as they come up.

Moderator Scheidt:  I think the idea is not a bad one. I question the adoption of a rule to do that. I think an interpretive release or staff legal bulletin could do the job just as well or better. I think Rule 156 is sort of an odd rule. It doesn't prohibit anything. It just says a few things and gets out of there, but warns people that they might violate 10b-5. I think the staff could do something like that in this area without too much trouble.

Our last topic of the day is a similar topic. It's the Commission's rule that prohibits the use of past specific recommendations. It, too, was adopted in 1961, and it, too, expressly prohibits advisers from engaging in this kind of conduct. Again, when the Commission adopted the rule, it determined that such ads were inherently misleading because they refer to only recommendations which were or would have been profitable and ignore those which or were would have been unprofitable. The rule has a proviso. Although it prohibits the use the past specific recommendations, it says, "ads can offer to provide a list of recommendations or ads can include every recommendation that the adviser gave in the last year." I would suggest that most advisers couldn't buy ads big enough to include all their ads for the last year. I don't know whether advisers are willing to provide a list of all their recommendations in the last year. I question whether the conditions of this rule are overly burdensome and whether others feel the same way, and whether others have a solution to the problem. I've heard from others that advisers want to be able to provide their clients or their clients want to be provided with information about past specific recommendations. And I'll also say that funds are permitted to refer to the stock picks they made in their management discussion analysis, and that's not prohibited. I will open up the idea to the panelists.

Mr. Mistele:  I can give you a practical example. We at Dodge & Cox work off a master buy-and-sell list. So the separate accounts most likely have the same securities as our mutual funds, and we'll prepare a mutual fund quarterly letter, and of course, we'd like to use that MD&A, at least a certain part of it to be used for institutional accounts. We have to sit there with a scissors and cut out all of the positions that have been profitable in the past year, and that seems to us kind of an absurd result. In the Franklin letter it says that you don't even have to identify it as being profitable, just has a stigma attached to it. That's per se a violation of the antifraud rules. We think it's reached kind of a conclusion, a point where it needs to go.

Moderator Scheidt:  Well there's no prohibition against referring to unprofitable recommendations.

Mr. Mistele:  And we do that. We have to give a balanced approach and we do discuss our "dogs" as well as our "wins."

Ms. Quirk:  To only talk about the dogs is a little punitive.

Mr. Mistele:  To only talk about the dogs would put you at a somewhat competitive disadvantage.

Mr. Caccese:  There are a lot of other things you have to talk about in mutual fund MD&A type of discussion. My concern I have about the testimonial, eliminating it. If you eliminate it, you have to make sure you're not enabling the adviser to basically cherry-pick the good recommendation. Just like you don't want them to use their representative account, because it's always the good account. You don't want them to say, "Well, I recommended the XYZ stocks or technologies because they were the best." It has to be a balanced approach, but maybe not a whole list of everything. I thought the MD&A sounds like a good approach for that.

Mr. Mistele:  The audience you're sending it to, though, is getting an appraisal each month, and they know what your gains and losses are. They're getting a semi-annual or annual gain/loss report. They know whether you're cherry-picking or not.

Moderator Scheidt:  That may work when you're providing that information to your existing clients who get account statements that show what's in their portfolio what traded out. In ads that go to prospective clients, they aren't going to have that kind of information. Maybe that's one distinction that the rule could draw.

Ms. Quirk:  But you still want to be in a position when you're doing a one-on-one presentation to a prospective client. You do want to be able to use stocks to illustrate the style that you use or the process that you use or your research picks. I think we can all live with the notion that it has to be balanced. I think the idea that you can't talk about anything if you don't talk about it all. It's just too hard to live with. There should be some balance.

Mr. Aguilar:  The gray place. If there's something their clients are actually asking, prospective clients for whom you are asking for this kind of information or most often to their consultant. And to not be able to provide them that information is counter intuitive.

Moderator Scheidt:  Is it a requirement that the presentation merely not be misleading, i.e., it must be balanced, sufficient for most people? Is it going to provide the guidance to go from an absolute prohibition today to no-holds barred and you're on your own. Is that going to be sufficient? Should the rule be amended to include some conditions to meet a happy balance?

Ms. Quirk:  I think you can amend the rule to simply say it can't be misleading. Then I think you need to provide some guidance around the issues of, you know, reminding people not to cherry-pick. You can remind people of the four or five cardinal sins in this area, and that ought to get everybody started.

Mr. Caccese:  I mean really be covered by a general antifraud provision, and through the release you can talk about what you mean it has to be balanced.

Ms. Quirk:  Similarly again, use Lori's experiences, use that as examples of good things and bad things you've seen as a way of giving people the flavor they need to get started.

Mr. Caccese:  I think you could stand on the fundamentals. I was talking to about all the other panels that advisers are fiduciaries. They have a high standard, an ethical standard to comply with, and based within that framework they're going to have to issue a balanced report.

Mr. Aguilar:  You have no credibility otherwise.

Mr. Caccese:  Exactly.

Ms. Richards:  I would agree that if there's any change in this area it ought to be accompanied by guidance. I think examiners will have a difficult time determining whether or not past specific recommendations or with respect to the use of testimonials, whether or not they truly are balanced and representative. I could imagine that examiners would have to analyze all of the adviser's accounts and all of the adviser's stock picks in order to determine whether or not these particular past specific recommendations were truly balanced. That's very difficult for the SEC to verify. If there is a change in this area it ought to be accompanied by really fulsome guidance. Not only for advisers, but also so there's some method of verifying that they truly are representative.

Moderator Scheidt:  Perhaps an approach, just off the top of my head, the rule could carve out communications with existing clients that are designed to deal with how the adviser managed the portfolio during a relevant period. It would still be subject to a balanced presentation minimal requirement, but because the client has been provided with or if the client has been provided with an account statement that shows all the positions, that's fine. There might have to be a higher standard for an ad because there's only so much room in an ad. You aren't going to be able to describe, probably very well, a representative sample of your recommendations. Perhaps that is an approach that could work.

We've just about run out of time. I would like to thank all the panelists for their time and efforts today. Thank you for your attention.

Mr. Roye:  We're going to proceed with the next panel without a break. It's our final panel on technology. Okay, we'll break for five minutes and then resume. Sorry about that.


VI. Technology and Investment Advisor Regulation

Moderator Plaze:  Thank you very much. Welcome to the last panel of our roundtable today. I'm sure you're getting tired of hearing from, but here I am again. No conference on any industry, I think, in America today or regulated industry at least, is complete without discussing the impact of technology on that industry. Technology is affecting this industry in a wide number of ways. It's affecting the way advice is delivered, new websites are being developed daily that offer an array of services. They are being developed by both startup organizations and well-established firms. These can be powerful devices to reach millions of investors, but they can present new challenges to the Commission and hazards to investors as the recent enforcement case against a website operator illustrates.

Technology is also affecting the back office services advisers provide. It has revolutionized the financial planning industry once tethered to broker/dealers to provide execution, settlement, and custodial services. More and more financial services are giving up their broker/dealer licenses and using the web-based services of brokers like Schwab for back office services. Technology is also affecting the way advisers deal with their regulators. For some time now, we've permitted broker/adviser's books and records to be kept electronically. Our examiners can come into your office during an inspection, download these records for review at his or her office. This practice saves you time and him time.

Finally, technology is making possible the Investment Adviser Registration Depository, the IARD, which will permit advisers to file with us and state regulators electronically. Here to discuss the impact of technology with us on the investment adviser regulations, we have a distinguished panel of members of the industry and experts. Jilaine Bauer, senior vice president and general counsel of Heartland Advisers, Inc. Scott Campbell to my left. He's vice president and general counsel of Financial Engines Advisers, LLC. Chip Jones is vice president of Securities Affairs Regulatory and Industry Affairs with the American Express Financial Advisers. Melanie Lubin, Chair of the Investment Adviser Section of NASAA, and Securities Commissioner of the state of Maryland. John Markese is president of the American Association of Individual Investors. And Craig Tyle, general counsel of the Investment Company Institute and all-around 40 Act scholar.

Mr. Tyle:  Thank you, Bob.

Moderator Plaze:  Craig, that's all you get from me, is this panel. We have today representatives of advisers who use technology in different ways and to different extents. What I'd like to ask them to do is to be on this panel. This is a little bit different from some of the other panels we've done today, is to explain what they're doing, how technology is affecting their business, and how that Advisers Act either facilitates or in some places, hopefully not too many, impedes the use of technology. Start off with Scott Campbell with Financial Engines Advisers, out in the West Coast. What you're doing is, it's a new world, you're delivering financial services through the web. Could you tell us a little bit about that and what your experience has been in terms of making it work under the Advisers Act.

Mr. Campbell:  Sure. What I'd like to do today is give you a little background on Financial Engines, and then what I also want to talk about is give you some insights on why the online investment advice phenomenon is starting to grow in the retirement plan market. Why the 401(k) space and then proceed to talk about the challenges.

For those of you who aren't familiar with Financial Engines, the company was founded by Bill Sharp in 1996. Bill is really well known for his work in Cap M theory. He got a Nobel prize for it in 1990. Really what he was doing was, he saw lots of very sophisticated institutional practices being developed in the pension consulting world and the defined-benefit world, which is the old retirement plan world where employers really had the full responsibility for investing funds of employees, and then when they would retire, you get your retirement paycheck from the employer.

He saw lots of these techniques being developed in that space but they really hadn't been brought over to the world of defined contribution plans, the 401(k) plans, which really are the predominant vehicle now in the private companies. That was really the genesis for the company to use the power of the web to take these techniques over to the world of 401(k). The company was founded in 1996, and we actually launched with our first corporate customer a company called Alsa Pharmaceuticals in 1998. That was in October. About a year later, we opened up our website to make our services direct to consumers. So any consumer who has a 401(k) plan out there that wants Financial Engines' investment advice can just come directly to our website, subscribe for our service, and the retail price is $14.95 per quarter. It's less than $60 a year, and they can get advice from us there.

More recently, this spring we are taking our advice outside of the 401(k) realm into IRA accounts. We've expanded our ability to give advice on pretty much any IRA that you might hold out there. If you have, let's say a Schwab account or an Ameritrade account or a Merrill Lynch account, and there's a supermarket of mutual funds out, we can give you advice on how to allocate your savings among those plans.

Moderator Plaze:  Scott, do you have an operator at the computer who responds to questions or does the advice come as a result of an algorithm?

Mr. Campbell:  The advice comes as a result of an algorithm, but all of our processes and it's an ongoing service as opposed to just a piece of software that sits on a PC, all of the services roll up under the supervision of our investment committee.

Moderator Plaze:  The algorithm itself is designed and the conclusions, the recommendations that are imbedded in the algorithm are by your committee.

Mr. Campbell:  That's correct. The team lead by our financial research and analyst specialists put together the algorithms to evaluate the funds. That's really how the advice is delivered. As I mentioned earlier, beyond the company, one of the reasons why advice is really starting in 401(k) and IRA, there's just a really huge demand. If you look at the trends in the pension world in the last, say 30 years, almost without exception all of the new plans coming on board are defined contribution plans as opposed to the defined benefit plans. Just to give you a sense of the numbers, there are approximately $2 trillion sitting out there in various defined contribution plans. This represents about 55 million Americans who are saving and this is becoming their primary vehicle. For 401(k), that's about 33 million participants.

The other thing that's interesting, although the responsibility has been transferred to individuals in these self-directed plans, they really haven't been given the tools to allocate among the plans. There was actually a recent study put out by Marshall & Eisley in Milwaukee. They said the number one reason, the number one way that people pick their plans today is they simply allocate among the choices in the plans equally. For example, if there are five accounts, let's say there are five fund choices in the plan, it's not unusual for participants to divide their choices 20 percent equally among each of the choices. So there's this huge demand for advice, and we're really moving in there to fill the need.

You asked earlier about the challenges, Bob. On books and records, in particular, we are taking advantage of the fact that you can store lots of these records electronically. We have an archival process where we archive our systems monthly and during each advice session that we have with our customers, we get an electronic communication from them, which we archive and log. We call that "sessions logging." We definitely take advantage of those provisions.

Moderator Plaze:  It's actually the nature of your advice, electronically making it easier to satisfy the recordkeeping requirements. No file cabinets.

Mr. Campbell:  That's correct. Although we do have strong boxes and other physical media so ultimately we do backups. We'll take the data off of the servers, and we'll burn it to magneto-optical disks.

Moderator Plaze:  Now there's a provision in the Advisers Act that recordkeeping requirements that requires a record of every advice, written advice provided to a client, which is, of course, electronically communicated would be picked up from that. As an issue, some electronic advisers have expressed to us that when a prospective client comes in and tries out different assumptions through the algorithm, runs different algorithms, it creates essentially different investment advice. It maybe on a session of 18 or 20 records of output of algorithm has to be kept. Have you found a problem with that? What do you do?

Mr. Campbell:  The way we've addressed the problem is we capture personal information and portfolio information from the user for each session. And then when this person gets to an actual action plan, an actual recommendation of which funds to buy and sell, that particular record will be captured and based on that data and the models that we have, we could recreate the whole session. That's how we satisfy the requirement.

Moderator Plaze:  I'm obviously fascinated by this. In your algorithm, one of the factors is how much will I have for retirement if I do Option A, Option B or Option C, how I allocate my 401(k). Do you have assumptions on rate of return on given for let's say, 20 or 25 years on given options built into your algorithms? Or do you ask a prospective client to draw assumptions for you?

Mr. Campbell:  We actually do all of that work for the consumer. One of the things that we do is we only ask investors to give us facts and give us information over which they have control so we don't ask them to estimate rates of inflation or rates of return. All that is really under the hood in our models.

Moderator Plaze:  Thanks. Jilaine, you're with a more traditional money management firm, Heartland. It's kind of hard not to be a more traditional firm. Aptly named Heartland Advisers in Wisconsin, I believe.

Ms. Bauer:  We're about as far apart as Milwaukee is from San Francisco.

Moderator Plaze:  I'm with you there. Would you like to spend a few minutes explaining how your firm is using developing technology and how that's contributing to your operations.

Ms. Bauer:  Sure. I think while we're very much the traditional investment adviser, nonetheless, our business has changed quite a bit in the past few years. The investment advisory profession emerged and we created our firm to provide unbiased investment information and guidance to our clients. However, technology has enabled the creation of new forms of organizing our relationships with our clients and with the securities markets allowing our clients to be networked and to exchange information directly in an open architecture that wasn't previously possible. At our firm, and others like ourselves, technology has affected us in varying degrees. Different firms with different business lines being impacted more than others. It's caused changes in our organization and management structure to be fundamentally altered. We have new strategic and tactical alliances with third parties, and our business processes have been re-engineered.

In the investment side of the house, investment information has become more of a commodity than in the past. Securities markets are globalized but segmented. Trading is moving towards 24 by 7. Investment decisions must be made more quickly. Time horizons are truncated. In the back office we find things like straight-through processing is automating our trade processing by and among the buy-and-sell sides, as well as our custodians. That is fundamentally changing what our back offices are doing. It's eliminating the duplicate trade entry and reconciliation functions allowing us to focus more of our time in a forward-looking fashion on trading and providing information and analytics to our trading desks and our portfolio managers.

In the front office, we find that the expectations of our customers are increasing. The service demands are greater. Information must be communicated more frequently and quickly. It's no longer enough to meet with them once a quarter. You find things like database marketing occurring in different segments of the market. The consumer market is segmenting, and you find the way that you deliver your products and services is changing. You've got electronic delivery and website content. Even the RFP process has changed and going online.

On the compliance side, technology is a tool, but it's certainly no substitute for strong internal controls, supervision, and training. It's allowed our compliance programs to be more comprehensive with front-end as well as back-end systems, but it's only as effective as we are able to make it by adapting it to our specific businesses. I think it's facilitated compliance monitoring in the soft dollar area, best execution, portfolio restriction monitoring, personal trade monitoring, licensing and registration, and our ability to communicate policies and procedures internally more effectively.

Moderator Plaze:  That's very interesting. Are you finding in all this sweep of change, problems in the regulatory structure that have created impediments to this change?

Ms. Bauer:  I think the business has become more complex and the skill sets that are required are different than it has been in the past. Traditionally, the most valued skill sets have been investment management and sales. I think you're finding that in order to maintain the appropriate compliance structure, you need better process, better discipline. You need people with skill sets that involve management, back office operations, broader band individuals that understand systems as well as the regulatory regime we operate in.

Moderator Plaze:  That's interesting. John, excuse me, Chip, American Express Financial Planners largest financial planning firm, in probably the world, why stop at this country? Eleven thousand reps, forty-two hundred offices, technology has to play a big role in the set of controls you have to keep that organization operating.

Mr. Jones:  It's been truly amazing for us the way technology has affected our business. If you go back just ten years ago, it used to be a financial adviser would go out and meet with a client. They would fill out a data form on the client to gather the information they needed in order to prepare the comprehensive financial plan. The adviser would then bring that back. Mail it into the home office, and so it was very dependent on the U.S. postal service. And the exchange of information and the amount of time that it took to get the information into the home office, where the information was entered into a mainframe computer, which prepared the financial plans, sent it back out to the adviser. The adviser would check the accuracy of the data. Send it back to the home office, and then eventually it would get back to the client, at which point they, too, would amend the document. So this whole process could go on for weeks or even a month. Now this can be done in really, if the adviser has the time, they can complete this whole process in a day. They can either take their laptop computers to a client's home and sit down with the clients and work through "what if" scenarios. Change the plan to where the customer or the client is comfortable that they are going to be able to achieve the goals that they want in the specified period of time. Or, the clients can come into the adviser's office, and they can sit down and they can work through the same process there in the adviser's office. From that perspective, it's just a much more user-friendly, client-friendly type of interaction that we now have with our clients.

The other ways that technology is benefiting our advisers, if you will, is through e-mail communications that say, used daily between advisers and clients in between our home office and our advisers. The advisers, we think, are now better informed. We have an intranet site where our advisers can go in, and we keep them updated on everything from market trends to compliance issues that they need to be aware of. Our advisers check this site daily to keep up with these trends. That's how it has affected American Express Financial Advisers from an adviser perspective.

From a consumer perspective, we also do something that's very unique. You can go into americanexpress.com and prepare a comprehensive financial plan for yourself. It's free. Our philosophy on doing this is that we sort of divided the consumer market up into three different classes. You have your do-it-yourselfers. You have your validators, and you have your delegators. What we hope to do through providing this online service for free and educating the consumers is hope to bring in the do-it-yourselfers and the validators. That they will get to a point in time where the financial plan may become too complicated, and they'll want to seek professional help. It just so happens we have a little icon that says, "contact an adviser." That's what we hope to do, but it's truly an amazing site. The amount of information we have on there is mind-boggling. I would encourage everyone to take a look at it. It's really interesting.

Moderator Plaze:  Thanks, Chip. John, from the investor's point of view -

Mr. Markese:  I think you're all probably individual investors, so I'm not telling you anything you don't know, but the individual investor is enchanted with this technology. Even the Beardstown ladies can go online now and get all of their calculations done, accounting and performance calculations. If you look at what we could do today, we can go online as individual investors, get real-time quotes, portfolio tracking, retirement planning, scenario building. We even have a former SEC commissioner, I think, building mutual funds for us. We have around the corner, and every time I say, "around the corner," someone nudges me and says, "No they are already doing that." We're going to be able to go online, for probably $10 a month. Say, give me Peter Lynch, his philosophy, give me the S&P 500 stock set, I want only dividend-paying stocks, I only want 20 stocks of this, and so forth. When I get this 20-stock portfolio, I can essentially buy it out of an e-basket for no cost. We're looking at the world that's changing dramatically, the quality of information, the consistency of it, and the availability. To go on a series of different sites, and ask the same question and look at and compare the answers.

I have to tell you I don't think individual investors are confused. I think they know it's not personalized information. If they punch in all their particulars, their income, their portfolio values, and so forth, then they answer the 20 questions about lotteries and risk and all that, and education level and time horizon, what comes out is they know they are falling into a box, a 16-box matrix. What comes out of that is a portfolio, and perhaps even attached to that are suggested investments. They realize that's not specialized, individualized help, but it is certainly helpful to them.

I think what we have, however, is the risk of technology. You're all aware of the chat rooms, but so are individual investors. They are going on it for more of the entertainment value, I believe, these days, than actual information. I think what we have to address is beyond all this power and the knowledge of investors, of what it's doing for them and what it means to them, is the issues of the Tokyo Joe situations. I think that is going to be so pervasive. It can now be from any corner of the earth, perhaps the galaxy, and that's what we're really going to have to fight. I think we don't really need to circumscribe the potential of the internet with too much regulation. I think individual investors are far brighter than you would imagine, as you all are, I'm sure. Thank you.

Moderator Plaze:  Thanks, John. Melanie, regulators perspective.

Ms. Lubin:  Well, I'm glad John has started to burst the bubble because I think I might completely bust it. I'm all for technology. I'm all for information. What scares me a little bit about the access to all this information is how investors are getting duped. And how they are not as smart as all of us want to think they are. I think getting all the information on the net, getting IARD online, getting the disclosure information out there, really getting the information out there about the qualifications of an adviser, how the adviser charges fees, what their conflicts are, and all those things, are wonderful. I think the investor needs that kind of information in order to figure out whether they are at a legitimate website. Are they at something where they are going to get advice that really suits their situation? Are they looking at a website where the website has been in business, where they have a track record, where they are regulated, whether they are registered with the SEC or registered with their state? Has that adviser gotten in trouble with the regulator? And is that information readily accessible so with another "click" off of that website? The potential client can go somewhere and make sure they are, in fact, looking at a legitimate investment adviser, and that they're not looking at a Ponzi scheme on the net. Out in the trenches in the states' securities divisions, we see all the cases where people get duped by people online. It looks very sophisticated, and it looks just as sophisticated as American Express or Merrill Lynch or anybody else. It's a facade often for advisers and for clients, and the clients and the investors just don't realize that they are dealing with someone who is illegitimate.

So I think our job is to make sure that the tools are there for people to recognize what's real and what isn't. And that they're educated enough to know how to access those tools and verify the information that they are looking at.

Moderator Plaze:  Craig, you've made some comments that have raised some concerns, not alarms, I think, in this area. My only suggestion, one thing, I think it was provocative, maybe you'd respond to the idea if an adviser had a website that you'd be required to have a hyperlink to your registration material, when we get it off on the IARD. So you'd have easy access to both eventually the brochure, as well as the disciplinary and other information there. How long you've been in business. Who controls your firm?

Mr. Tyle:  I think that that might be something that is definitely worth exploring. I think the issues I raised in the paper may come one step before that, which is the threshold issue of are you an investment adviser that's required to register under the Act. I think this goes back to the publisher's exception which we didn't have time in the first panel to cover, but it really turns on the issue, at least as its been interpreted under the courts, as to how personalized the advice is. I think the web really blurs that distinction. It may lead the Commission to want to take a more functional approach with some of the regulatory provisions under the Advisers Act. It may not be black or white. You may want to have some form of disclosure placed on the website, maybe it's not the complete ADV, not the complete brochure. Maybe you have to look case by case to see, "Gee, is this advice, for instance, particularized enough that we want to have rules like restrictions on principal transactions and the like." It may have to be applied on a more case-by-case basis.

Moderator Plaze:  Pretty hard to apply on a case-by-case basis websites that are changing on a daily basis where it can number in hundreds of thousands.

Mr. Tyle:  It could depend on how the website is characterizing the type of advice it's giving, for instance. John said when you're going through kind of a "click the box" type of format that investors generally probably view that not as individualized advice. There probably does not need to be the same scrutiny applied to that. Perhaps if the website holds itself out as being able to truly through technology be able to provide advice that's particularized to you, the investor, and then in turn makes specific security recommendations, that may very well call for a heightened regulatory regime, I think.

Moderator Plaze:  Maybe this is an opportunity to discuss the Tokyo Joe case. SEC versus Lowe, there's a publisher's exception to the Advisers Act, and that sets the exception which results in the major publications that you read everyday not being registered as an adviser even though there might be the equivalent of "Dear Investor" column. You know, where people write in and people actually do give advice, Wall Street Week in Review, publisher's exception. Question is how does that publisher's exception apply to a communication via any media, but the web makes it more convenient, which is essentially a piece of investment advice masquerading as the court. As in the Tokyo Joe case suggested, where is the line drawn? It was the holding of the Supreme Court a number or years ago in the SEC versus Lowe decision. Lowe, I think we can all agree, a bad actor. He had been criminally convicted of stealing from his clients, but worst of all stealing from a bank. It's gone. Anyway, we revoked his registration only to discover that he was continuing to publish newsletters. Then, went to court and got an injunction and he defending. It went all the way to the Supreme Court, and the court came down and concluded that he was, indeed, entitled to the publication exceptions. Now, the court in that decision had two choices to make. It could have held, as he alleged in his defense, that the registration provisions of the Investment Advisers Act as applied to investment newsletters violated first amendment considerations and actually amounted to a prior restraint. As a result, the registration provisions would have been struck down, but the fraud provisions would have prevailed. The court avoided the constitutional issue and held that it was not subject to the Act because of the publisher's exception from the definition of the Investment Adviser's Act. As a result, the Commission has no jurisdiction whatsoever over investment newsletters. Of course, if the adviser registers for some other reason, we assert our authority over their newsletter and any fraud that they may perpetrate through the newsletter.

It's been interesting, there have been two questions come up since then. One, what's personalized investment advice because the court in that decision held that he was provided impersonal advice and that it was of regular and general circulation. Those are the two issues. The personalized investment advice raised the question in the computer algorithm case. Is that personalized investment advice so that the exception applies. I think the Commission's staff has consistently held since Lowe that an algorithm that requires information of particulars, even though the information it spits out, the advice will be the same to any individual who provides the same information. That's still personalized investment advice and they're not entitled to the exception. Any thoughts on that view of the statute? We have no case law in this area at this point, but I offer the opportunity to the panel to comment on that thought.

Mr. Tyle:  I guess I'll reiterate what I said previously which is I think it is very, very hard in light of the new technologies to make that a black-or-white question. I think it has to be accepted that there are degrees of personalization, and there's going to be increasing levels within that. Perhaps the SEC is going to have to draw some sort of arbitrary line there. I think it will be very difficult to do. That's why I say that maybe another possible way of looking at it is how the website holds itself out. Is it purporting to provide advice that is tailored to an individual as opposed to generalized advice.

Moderator Plaze:  The other areas the court said if it was bona fide investment advice of general and regular circulation. That was the question at stake in Tokyo Joe.

Mr. Tyle:  I think it was very interesting. If you read, and the panelists here got in the materials the various papers filed in connection with Tokyo Joe including the Commission's brief, which I thought was very well done. At least currently that has been how the court has ruled. The Commission seems to be arguing that if your actions would constitute a violation of the Advisers Act, and there are numerous violations that are alleged of Tokyo Joe, then that kind of proves that it's not a bona fide publication. And therefore, you're not entitled for the exemption from the Advisers Act. Although at least if the facts are true, I can't really disagree with the outcome, but it does seem to be somewhat of a circular argument.

Moderator Plaze:  Doesn't that what Lowe necessarily leads to, a bona fide? If the issue is bona fide, and of course in the Tokyo Joe case, it was a Motion to Dismiss so the court was in the position of assuming the facts as the Commission alleged them.

Mr. Tyle:  If that's what bona fide means, again, I think you inherently have a circular argument. I wonder whether courts as they have to confront this issue down the road are going to accept that.

Moderator Plaze:  In my view at least, it's an issue that was presented and there's no way around as a result of the Lowe decision, those types of issues. It is a strange result. I think what happened was in Lowe, the court stretched to avoid that constitutional issue, and this is where you are today. As a regulator, I would have preferred they struck down the registration provisions as applied to impersonal advice because we would at least have the fraud provisions applicable to newsletter publishers. There's a great deal of fraud in that area, I think. John, do you follow that area at all, the investment newsletters?

Mr. Markese:  Yes, we do. I guess I think that most of the internet should be under that publisher's exclusion contrary to, I think, probably --

Moderator Plaze:  Not subject to the fraud provisions either?

Mr. Markese:  Well, fraud provisions, yes. The Tokyo Joe case is sort of a --

Moderator Plaze:  The publisher's exception, if you enter it, the whole statue simply does not apply. And that's the problem.

Mr. Markese:  Unfortunately, I'm not a lawyer. Or, fortunately, I'm not lawyer, but just let me make a simple statement. Tokyo Joe was a pump-and-dump scheme clearly. Forget about anything else and we should be able to go after that. Financial engines that generate, you know, put people in the matrix depending on their inputs, it's not personalized advice. I understand that the inputs are personalized, but the output is really standardized matrix sort of analysis. I really don't think that's financial adviser function, personally.

Mr. Campbell:  If I can respond, I don't ever want our company to be equated to a Tokyo Joe as a scenario. Actually, our advice is personalized. It is tailored to the individual. We do not slot people into say, one of twelve model portfolios, what you get is wholly unique to you. Part of the reason for that is we look at your personal holdings. For example, if you hold a concentrated position in a small cap stock sitting out in your brokerage account, we take that into account, into what we recommend and allocate going on in your tax-exempt account. Our company felt that what we wanted to do is we wanted to answer the questions that investors had. And that was to give them specific recommendations on exactly what to do. I think to our credit we just recognize that the best thing to do would be to register as an adviser and embrace the regulatory scheme as opposed to try to circumvent it.

I thought the opinions that you circulated in Tokyo Joe were kind of interesting in one respect. In the district court's opinion, they talk about this bona fide issue and sort of saying, "Hey, this really is not a publication because if you take into account the fact that Tokyo Joe is using A) e-mail and B) he was using web postings in chat rooms." Those are sort of indicia that what we're talking about here is a personalized communication. A one-on-one kind of communication, not a publication. I thought that was an interesting fact.

Although, I think it would be wrong to presume that anytime you have an e-mail or anytime you have a chat room posting that what is going up in that context is not a generalized publication. I think it depends really on the content, the nature of the communication. If you go into a chat room and you've got, let's say a newsletter, that you just wanted to post in the chat room, I think it's pretty clear under those facts that that would be a generalized communication. Same thing with an e-mail. If you want to send out a broadcast communication of a report or an analysis which is just for general consumption, I think it would be tough to argue that that is a personalized communication.

Moderator Plaze:  I agree with you and I think that the Lowe decision supports you on that. Lowe, himself received, had a telephone answering system where people could call and get updates, and the court dismissed that. That did not include that that involved personalized investment advice.

Got to move on. We're going to talk about the IARD which was briefly mentioned earlier. As you know, the Commission proposed amendments to Form ADV a few weeks ago. These are terribly important amendments. They will change the way we and the regulated community here, the investment advisers interact in major ways. People can file electronically. Prepare your Form ADV in your office, hit a button, send it to the NASDR, and have that information filed with the Commission and all the state regulators simultaneously, fund an account with the NASDR and have your licensing fees paid in all the states you have obligations to annually. We talked about this. I talked about it in terms of fulfilling the promises of NSMIA in 1996 of making regulation more efficient and indeed more effective from the perspective of the regulators.

Melanie, you've been deeply involved in the planning and soon-to-be the implementation of the IARD. Can you give us some perspectives you have as both the Chair of the NASAA Committee responsible for this project as well as Commissioner of Maryland.

Ms. Lubin:  I think IARD is great. I probably have spent more time in the past year working on that than I have the business of the Maryland Securities Division, but don't tell my boss. When IARD is up and running and all of its separate parts are on the system which is going to take a little bit of time because we're not rolling out the whole system at the same time. It really is going to be a giant leap forward for regulators in the industry and as well as for investors. The information investors need to know about the advisers, need to be able to access to comparison shop, to figure out what their adviser should be telling them about, is all going to be online. There will be Part 1 of the Form, Part 1B of the Form for the state advisers, and Part 2 which is the brochure and disclosure document, will all be online. It will be accessible to potential customers.

As far as the industry members go, it'll be at least initially a little more burdensome. Everybody is going to have to figure out how to use this new system and those kinds of things. We all figured out how to get online over the past couple of years so eventually they'll figure out how to fill out the Form. You know if they can order books from Amazon.com, this is a little more complicated, but they'll figure it out. They'll be able to put their information in. They'll be able to update their information in a very efficient manner. Nobody has to figure out anymore how to feed the form into a typewriter or even find a typewriter that they can feed the form into, and fill things out. You know, put little "X's" in the squares and type on the actual lines on the form. The form will be there. They will be able to put in as much information in most places as they need to give out to get the questions answered.

It'll also be a lot easier to update. The information will come up, and they'll be able to amend what needs to be amended. They will be forced to amend things that have to be updated on an annual basis. It'll give them one-stop filing. Their fees will be collected. If they're a federal adviser, the notice of filing fees will be collected through the system. It will be disseminated to all the states as well as the filing going electronically to the states. The same things will happen for the state advisers with the state registration fees.

As far as my position as a regulator, it's going to make my life when the whole system is up and running, a lot easier. We're going to be able to get rid a lot of file cabinets. We're going to be able to get rid of the hand processing of all the checks that come in for initial registrations and renewal registrations. We'll be able to process things much more efficiently. We'll be able to focus on areas we want to look at. We're going to know right away when things have been amended. We're going to be able to make the kinds of assessments about who has custody and who has disciplinary history and those kinds of things. The things we really want to look at and concentrate on much more readily than we can now.

It's also going to be a really good enforcement tool. We'll be able to keep track of when advisers are sanctioned by other regulators. If someone has been booted from another state. If the SEC has taken action. All that information will be on the system the way it's on CRD for broker/dealers. We'll be able to track that and figure out whether it's appropriate for us to put additional safeguards in place or perhaps revoke an adviser's registration is they've really crossed the line.

As I've said, it's really going to be a giant step forward particularly when the entire system is up and running. It's going to provide most of the benefits in about two or three years when we have both parts of Part 1, the disclosure part, the reps, and Part 2 on the form. We're looking forward to it.

Moderator Plaze:  Thanks, Melanie. Chip with all those reps and all those offices, you're registration process must be quite something. Are you looking forward to the IARD? What do you think?

Mr. Jones:  What I was going to say is I was going to echo Melanie regarding the IARD, and say that we're all for it and everything. When she said it's going to be an enforcement tool, I'm not reconsidering my position as to whether or not we like the IARD. No, I tell you, I've been involved with the IARD from the beginning. They have an industry council or something that provides input to the IARD system. It's truly been an amazing process to see the NASDR, the SEC, and NASAA work together to try to, uniformity is something that's actually taking hold and we're looking forward to it. It's been a very good process. The web CRD is the basis for the IARD. There were some problems with web CRD initially, and the SEC and the NASDR, and NASAA have worked closely together with the industry in order to get those worked out. So, I think that learning process through that is going to be extremely helpful. I have nothing but good things to say about the IARD.

I would like to make a couple of quick comments with regard to the ADV that's the vehicle for using the IARD. I have one word for the SEC and your group as you look at the proposal. Flexibility. Don't mandate a single method of complying with, take for instance the updating process for the brochures. One of the suggestions that was included in the proposal regarded stickering and sending stickers out to the clients every time there was a material change to the Form ADV. That information is already available online, not only through the IARD, but we at American Express may even put it on our own website in a user-friendly format, not that the IARD won't be user-friendly. The information is going to be out there for clients so maybe through the annual offer, you include an index of the amendments that have been made throughout the year. There are many ways that firms can comply with these things. I want to stress that you guys take flexibility into account when you adopt that.

Moderator Plaze:  Chip, you've walked your way into some thorny issues dealing with electronic delivery access versus delivery. Unfortunately, we don't have time to discuss it this afternoon, but maybe you give me a call in the office later this week and we can talk about it. I think we appreciate these issues. Comment period on Form ADV, by the way, ends June 13th. Yeah, I keep getting that date wrong, June 13th. We really look forward to your comments so keep those cards and letters coming.

In the remaining time that we have, we really need to talk about one other area of technology that's important to advisers. It's how technology affects the line between what advisers do and what mutual funds do and the different regulatory schemes we have for them. I'll give you an example, and this is one I like to use. If a mutual fund company got a big computer and decided to divide all the securities in the portfolio up and allocate them among all their investors and decided to call those clients, instead of investors, clients. Could they then de-register under the Investment Company Act and go along the way as an investment adviser? Does technology, which allows you to allocate, slice and dice, does that change the regulatory scheme? Does it give opportunities to engage in regulatory arbitrage between systems of regulation. Craig, you see I've been thinking about these issues lately.

Mr. Tyle:  Not lately, we've been thinking about them for sometime. I guess to put it into context, you have to step back and say, "Why is this an issue?" So you're under the Investment Company, Title 1, as opposed to the Investment Advisers Act, Title 2. What's really the difference? I think the most important difference is that if you come under the Investment Company regulatory scheme, you are subject to a series far more detailed, and in many cases, stricter provisions. Stricter provisions on affiliated transactions. Oversight by independent directors, including oversight of the fees that are charged to the customers. In addition, since mutual funds are issuing securities, they're subject to the Securities Act. You have prospectus liability and under that the SEC had adopted the standardized performance advertising rules. We will soon be faced with after-tax performance advertising, et cetera. So mutual funds are subject, in many cases, to stricter, at least more detailed regulation than simply advisers and advisory clients would be. Why is that the case? There are probably a lot of reasons. I think, ultimately, though, it almost comes back to the issue we were talking about with Tokyo Joe. The concept of the advisory relationship is a personalized, one-on-one relationship. I think at least in theory it allows the client to more closely monitor what the adviser is doing. Perhaps have the program tailored to his or her interests, et cetera. I think there's also some notion when you're investing in a pooled vehicle odds are that account is going to be smaller, the person is going to be less sophisticated, maybe needs a little more paternalistic regulation.

The issue however, the scenario that Bob poses is where do you draw the line? If you just formalistically draw it on whether it holds itself out as being a mutual fund, it would be fairly easy to engage in regulatory arbitrage and avoid some of these more detailed requirements. The SEC considered this for close to 20 years, and finally in 1997, adopted Rule 3a-4. What Rule 3a-4 essentially does is it sets forth various procedural tests. The advisers have to meet with the client at least once a year, has got to allow the client to alter the recommended program, the client has to maintain indicia of securities ownership, et cetera. I think the question posed, and it is simply a question at this point is have advances in technology made it much easier to comply with these somewhat mechanistic requirements of Rule 3a-4, and yet have the adviser not truly be providing individualized advice to clients. I think there are some indications that this maybe happening. Discretionary advisory programs are growing very rapidly. The investment minimums to participate in these accounts are coming down. And as I think John indicated earlier on this panel, there are new programs out there that are offering prepackaged portfolios to investors. They are essentially, at least they look at first blush, like virtual mutual funds. They're not registered under the Investment Company Act and the sponsors may not even be registered under the Investment Advisers Act. So it seems to warrant the SEC perhaps taking a step back and looking at whether further changes are necessary.

Another related issue in that regard is whether the SEC has the ability to monitor these programs. Rule 3a-4, as proposed, would have required a filing requirement so the SEC could kind of keep tabs on these programs. That was not ultimately adopted, but it might be something the Commission wants to look at. I guess I'll echo to some extent what I said when we were talking about the publisher's exclusion that I think really what the SEC has to do is perhaps not look at it completely, "Are you a mutual fund or are you not a mutual fund?" But step back and look at some of the individual investor protections and ask, "Should these be applied to clients of these programs?" For instance, should there be some sort of independent oversight a la an independent director of some aspects of how these programs are run? Should there be oversight, for instance, of the fees? Should there be stricter limits on affiliated transactions between the adviser under these discretionary programs and the client and disclosure as well.

The last panel talked about standardized performance. I think the general consensus was across the board for the investment advisory industry. That may not make sense, but if you're having basically similar investment allocations offered to a wide range of clients maybe those should be subject to something akin to Rule 482. Maybe they also ought to have to report those returns on an after-tax basis et cetera. I think those are issues the SEC really seriously needs to look at.

Moderator Plaze:  Craig, we did something like that in the wrap fee programs, which is the area we addressed in the mid-90s. There's somewhat of a cross between a traditional advisory service and a mutual fund. We didn't deal with the issues about whether they are an investment company or not, but yet they are somewhere between a financial product and a financial service. What we did is we created a disclosure document that's designed for those issues. So we addressed the issue not on a substantive regulatory basis, we left that under the Advisers Act, largely, subject to the 3a-4 constraints, but we focused on the disclosure aspect and we standardized them and made them more uniform, the disclosure under this area. In fact, what I'm saying is that I'm agreeing with you. There's a hybrid approach to hybrid products, and we've taken at least one step towards that direction.

Mr. Tyle:  Well, that may be a very good model, at least on the disclosure side. Again, as you know, the Investment Company Act was far more than a disclosure statute, and I think you need to look at some of the other provisions there as well. A couple other things that I think the Commission should bear in mind. One is the growth of technology may actually make it easier for some of these programs to comply with some of the provisions under the Investment Company Act or greater disclosure requirements as well. I think that needs to be looked at. And second, I think the fact that perhaps most of the participants in this market today are very reputable entities doesn't mean that there's not a need for regulation. Because as this market expands, you're going to get more marginal players entering and if the SEC has ceded, in effect, it's regulatory jurisdiction early on, my experience is and I suspect your experience as well, is that it's very, very difficult to get it back.

Moderator Plaze:  That was my concern in the discussion of personalized versus impersonalized advice. I'd prefer not to cede it, at least with our antifraud authority, the entire internet. I don't think that's the position, the approach the Commission is going to want to take in that area.

Any wrap-up thoughts, comments before we have to come to a close by any of our participants this afternoon? I want to thank you very much, and thank you for an audience. I appreciate your sitting through the day.

Paul Roye: Before you go, I'd just like to close by indicating that the Chairman called for this roundtable to elicit input and ideas on the direction the Commission should pursue in terms of updating and modernizing the Investment Advisers Act. I think it's fair to say that we've accomplished a lot with this roundtable and covered a lot of ground and got a lot of insights and ideas. I'd like to thank our panelists who took the time out to be here to prepare for the roundtable. I'd also like to thank finally the Division staff who helped put the roundtable together. Cindy Fornelli and Dave Fielder in the Office of the Director, Doug Scheidt and Brent Fields in our Chief Counsel's Office. And in our Investment Advisers Task Force headed up by Bob, Jennifer Sawin, Lori Price, Jeff Himstreet, Karen Goldstein, and then our administrative staff, Donna Hawkins, Victoria Gray, and Debra Abernethy. We appreciate your coming. We appreciate your attention. We look forward to your input in the days ahead. Thank you very much.

(Whereupon, at 5:34 p.m., the conference was adjourned.)


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