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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Luncheon Address at IA Week's 7th Annual Fall Compliance Conference


Andrew J. Donohue1

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

Philadelphia, Pennsylvania
October 1, 2007

Good afternoon. It is a pleasure to be here and I very much appreciate IAWeek's role in sponsoring this conference and inviting me to speak with you. This afternoon I would like to review with you some of the latest developments in the area of investment adviser regulation. In addition, I want to let you know the initiatives that will likely be coming down the pike shortly in this area. Before I begin, however, I need to state clearly that my remarks here today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

Being in Washington, it is interesting how the annual cycle of professional life seems to really start, not in January, but rather now, in September, after the incredible heat and humidity that is summer down there has subsided. Members of Congress come back to town, and you can actually feel it come back alive. Of course life in New York also got down to business after the summer ended, but certainly Washington has a flavor of its own in this regard. For us in the Division of Investment Management, not only did life start up once again this fall, but it has started with a bang. In fact, just this past month, the Commission considered and approved an important regulatory initiative under the Investment Advisers Act concerning principal trading relief for non-discretionary advisory accounts. I would like to discuss this initiative in detail this afternoon. The staff also expects to recommend that the Commission consider the re-proposal of Form ADV Part 2 in the very near future. As compliance professionals, I am sure you are aware of the importance of Form ADV and the significance of this development. The Division also will be recommending to the Commission a number of other very significant matters before the year-end, which I would also like to discuss with you today.

I am particularly pleased to be discussing some of these developments here with you at this time. As compliance professionals, these developments will impact your work, potentially to a significant degree. It is for this reason that it is very important that we hear from you as the Commission proposes new initiatives and requests public comment. The Commission needs to know the compliance implications of regulatory actions. Will certain actions cause compliance difficulties? Will they increase costs beyond what the Commission has anticipated? I encourage you to respond to the Commission's requests for comment and let us know how these initiatives will impact your compliance programs.

Response to the FPA Decision — Principal Trade Relief and Interpretive Rulemaking

I would now like to turn to two rulemaking initiatives that respond to the decision by the Court of Appeals for the DC Circuit in Financial Planning Association v. SEC. One sets out an alternative means for investment advisers who also are registered broker-dealers to comply with the principal trading procedures established under the Advisers Act. The other is a proposal to re-codify several of the Commission's interpretive positions dealing with how the Advisers Act applies to broker-dealers.

Principal Trading Rule

As you all know, the court vacated the Commission's rule that provided that fee-based brokerage accounts were not advisory accounts and thus were not subject to the Investment Advisers Act. The court's decision takes effect today, which means that the Advisers Act now applies to broker-dealers offering those accounts.

As we began discussing the effect of the FPA decision with interested parties, two things became clear. First, for operational reasons, many broker-dealers (though not all) structured their fee-based brokerage accounts in a way that did not allow them simply to apply the Advisers Act to those accounts. For this reason, many firms have asked their fee-based brokerage customers to convert their accounts either to advisory accounts or to traditional commission-based brokerage accounts. Before the FPA decision, there were about one million fee-based brokerage accounts, holding about 300 billion dollars, so this conversion process has been a large undertaking.

Second, broker-dealers argued that the requirements of section 206(3) of the Advisers Act makes it impractical for the firms to offer their advisory clients transactions in certain securities which frequently trade on a principal basis. These include many kinds of debt obligations, including municipal bonds. These broker-dealers represented to us that many of the fee-based brokerage customers, as a practical matter, may be unable or unwilling to transition to an advisory account, and thus may be unable to maintain a fee-based account with the additional protections of the Advisers Act.

Section 206(3) prohibits an investment adviser from knowingly engaging in a transaction with its client for its own account — that is trading as principal — without disclosing in writing to the client the capacity in which it is acting, and obtaining the consent of the client. Congress enacted section 206(3) to address concerns that an adviser might engage in principal transactions to benefit itself or its affiliates, rather than the client. In particular, Congress appears to have been concerned that advisers might use advisory accounts to "dump" unmarketable securities or those they fear may decline in value.

Congress's concerns were, and continue to be, significant. Self-dealing by investment advisers involves serious conflicts of interest and a substantial risk that the proprietary interests of the adviser will prevail over those of its clients. Significantly, however, Congress chose not to prohibit advisers from engaging in principal trades with their clients, but rather established a means by which an adviser must disclose and obtain the consent of its client to the conflicts of interest involved.

In an effort to allow fee-based brokerage customers who convert to advisory accounts to continue to have access to a firm's inventory of securities, the Commission adopted, on a temporary basis, a new rule that establishes an alternative means for a firm to comply with Section 206(3). New rule 206(3)-3T permits an adviser that also is a registered broker-dealer to give oral disclosure prior to each principal trade rather than the written disclosure otherwise required by section 206(3). The rule applies only to non-discretionary accounts — where there already is client involvement in every transaction.

It also has a number of other conditions designed to prevent overreaching by advisers. An investment adviser taking advantage of the oral transaction-by-transaction disclosure permitted by the rule must:

  • Make prospective disclosure to the client in writing of the conflicts arising from principal trades — this disclosure is likely to occur at the beginning of the advisory relationship;
  • Obtain from the client written, revocable consent prospectively authorizing the adviser to enter into principal trades;
  • Make oral or written disclosure and obtain the client's consent before each principal trade;
  • Send to the client a confirmation statement disclosing the capacity in which the adviser has acted and indicating that the client authorized the transaction; and
  • Deliver to the client an annual report itemizing the principal transactions.

The rule also requires that the investment adviser be registered as a broker-dealer and that, in addition to the protections of the Advisers Act, the protections of the Exchange Act and the conduct rules of relevant self-regulatory organizations also apply to each account for which the adviser relies on this rule.

The rule contains a sunset provision. Absent further action by the Commission, the temporary rule will expire on December 31, 2009. This gives the Commission and the staff an opportunity to observe how firms comply with their disclosure obligations under the rule, and whether, when they conduct principal trades with their clients, they put their clients' interests first.

Finally, the rule makes clear that it does not relieve an adviser from its fiduciary duties under sections 206(1) and (2) of the Act. In other words, compliance with the rule does not relieve an investment adviser from its fiduciary obligations imposed by the Advisers Act, or by other applicable provisions of federal law. These obligations include fulfilling the duty to seek best execution of client transactions, as well as the duty to disclose material facts necessary to alert clients to the adviser's potential conflicts of interest.

The Commission has requested comment on all aspects of the temporary rule, with the comment period closing on November 30, 2007.

Interpretive Rule Proposal

As I mentioned earlier, the second rulemaking initiative is a proposal to reinstate several important Commission interpretative provisions of a rule regarding exemptions for broker-dealers that were vacated as part of the FPA decision, although the Court did not question their validity. The Commission proposed to reinstate them in order to avoid doubt about their status.

First, a broker-dealer that separately contracts with a customer for, or separately charges a fee for, investment advisory services is providing advice that is not "solely incidental" to its business as a broker-dealer. Similarly, a broker-dealer's exercise of investment discretion with respect to an account is providing advice that is not "solely incidental" to its business as a broker-dealer.

Second, a broker-dealer does not receive "special compensation" for purposes of section 202(a)(11)(C) under the Advisers Act solely because it charges a commission, mark-up, mark-down, or similar fee for brokerage services that is greater or less than one it charges another customer. In other words, a brokerage firm does not receive "special compensation" solely because it charges a commission for discount brokerage services that is less than it charges for full-service brokerage.

Third, broker-dealers that are also registered as investment advisers under the Advisers Act are investment advisers solely with respect to those accounts for which they provide services or receive compensation that subject the broker-dealers to the Advisers Act.

The Commission did not re-propose a provision regarding broker-dealers' financial planning services. Instead, the Commission plans to wait until it has had a chance to review the study by the RAND Corporation of the brokerage and advisory industries before taking further action on that interpretation.

Comments on this rulemaking initiative are due by November 2, 2007.

IA/BD Study

In regard to the Rand study, following the FPA decision, Chairman Cox approved additional emergency funding to accelerate this study so that it will be delivered to the Commission no later than December this year, which is several months ahead of schedule. We expect the resulting study to provide us with useful data about the ways in which broker-dealers and investment advisers market, sell, and deliver financial products, accounts, programs, and services to individual investors. The study also should help us to more fully evaluate how we can improve investor protection by updating our regulations to deal with the realities of today's marketplace.

ADV Part 2

Another very important initiative from the Division of Investment Management that I expect the Commission will soon be considering is the re-proposal of Part 2 of Form ADV.

As you know, Form ADV is the primary disclosure document that investment advisers provide to clients and prospective clients. It contains information about the adviser's business, backgrounds of advisory personnel, disciplinary information and conflicts of interest. Although the revision of Part 2 has taken some time, with the original proposal in 2000, this development is truly a major event in the regulation of the advisory industry as the importance of Form ADV cannot be understated.

As established under the Investment Advisers Act, the hallmark of regulation of the advisory industry is the assumption that advisers are fiduciaries and therefore must act in the best interests of their clients. Accordingly, unlike other countries that regulate advisers by imposing qualification and other requirements on advisers, here in the US we allow clients to make their own determinations when selecting advisers and evaluating any conflicts an adviser may have. However, this process only works if clients and prospective clients have the information necessary to allow them to make informed decisions regarding the advisers they choose to hire. This is where Form ADV comes in.

The Commission's substantial amendments to Part 1 of Form ADV in 2000, along with the institution of the IARD electronic registration system and the establishment of the Investment Adviser Public Disclosure website, was the first step in revolutionizing, not only the content of advisers' disclosures, but also the process by which investors, regulators and the general public could access information about investment advisers. We have seen major benefits from these amendments in terms of enhanced disclosure and transparency and ease of access to information. Advisers can now amend their Form ADV Part 1 information more efficiently and the changes also have greatly assisted the public's ability to access information about investment advisers.

In the original Part 2 proposal, the Commission proposed changing Part 2 from a check-the-box format with continuation sheets to a free-form text, plain English, narrative document. In 2000, the Commission delayed adopting the amendments to Part 2 to allow us time to fully consider the comments on our proposed revisions to Part 2. Although commenters strongly supported the proposed narrative format, many had expressed significant concerns with certain aspects of the proposal. In particular, commenters generally criticized the proposal's requirement for brochure supplements containing information about the individuals that clients rely on for advice — in many cases the advisory personnel that the client is actually interacting with. Some commenters argued that, as proposed, this requirement would be too costly and burdensome. Commenters also objected to a requirement that advisers deliver an updated brochure, or a "sticker" identifying any information that had become stale or incorrect and including updated information whenever information in the brochure became materially incorrect during the year.

In developing our recommendation to the Commission for Part 2, we are seeking to respond to these and other comments on the original proposal. Our goal with these revisions is to provide advisory clients and prospective clients clear, current, and more meaningful disclosure of the adviser's business practices, conflicts of interest, and background of advisory personnel. Following the success of Part 1 and the public disclosure website, we also intend to recommend that advisers be able to electronically file their brochures with the Commission and they would be available to the public through the Commission's website, which would greatly enhance access to this important information.

The revisions to Part 2 of Form ADV would represent a significant shift in the disclosure regime for investment advisers. For this reason, we plan to recommend that the Commission re-propose Part 2 so that we can obtain a fresh set of comments on this initiative. As Form ADV plays such an important role in the regulation and compliance programs of advisers, I strongly encourage you to let us know your thoughts on the proposal and how you believe it will impact your work within your firms.

Soft Dollars

Another very important initiative that the Division is developing concerns soft dollars. In 2006, the Commission issued an interpretive release that, among other things, provided guidance with respect to what qualifies as execution and research services that may be purchased using soft dollars under section 28(e) of the Securities Exchange Act. As a next step, the Division staff is currently working to provide a recommendation to the Commission that will provide guidance to assist mutual fund boards in their oversight responsibilities in this area.

One of the interesting aspects of soft dollars is how technology has impacted how this area is evolving. For example, firms are increasingly employing new technologies in their brokerage practices including broker-sponsored execution systems, such as algorithms, new unbundling and commission sharing arrangements, dark pools and brokerage consolidation. These new technologies are making it easier for advisers to more precisely value the worth of the research and brokerage services obtained with soft dollars. Additionally, the use of new technologies has created increased transparencies and is allowing greater opportunities for "virtual unbundling" of research and execution services. We are also seeing potentially favorable current market trends such as an overall decline in commission rates and increased internal reporting of meaningful information on trading practices to fund boards.

In addition, U.S. firms are reacting to new regulatory requirements in other jurisdictions, such as the FSA's requirements in the UK that research and execution be unbundled. Thus, the area of soft dollars has become a fast moving target. In order to get the lay of the land in this area, we are speaking with advisers of all sizes, independent directors and directors' counsels to make sure we get our recommendation right. Our goal is to provide fund boards and you, the compliance professionals, helpful guidance to assist you in monitoring the conflicts of interest inherent in soft dollar arrangements, while being careful to avoid recommending guidance that will adversely affect the evolution of the trading markets in an unintended way.

Additionally, as I have mentioned before, I do not believe that soft dollars can be considered in isolation. Rather, I believe, the dialogue between advisers and fund boards should instead focus on how soft dollar arrangements influence the overall practice of how an adviser places trades and whether that adviser is meeting its best execution obligations. Because brokerage commissions (and spreads and markups) are an asset of the client — and not an asset of the adviser — you as compliance professionals should be focused on the conflicts involved, monitoring the way this asset is used and the way that brokerage and other trade practices are described to clients. Your inquiry should not be limited to commissions on equity trades. There are best execution challenges in other asset classes as well, including fixed income. In addition, best execution inquiries should be made across all accounts and products, each of which may have its own best execution issues and challenges.

We expect to provide the Commission with a recommendation in this area by the end of the year and, again, I hope that you will provide your thoughts and comments as this project moves forward.

Books and Records

The final area I would like to discuss this afternoon, which I suspect is of great interest to this group, is the revision of the rules requiring investment advisers to keep certain books and records. Although technology is affecting many of our current initiatives in the investment adviser regulatory arena, I don't think the impact of technology is any more obvious than how it relates to books and records. The rules governing investment adviser recordkeeping requirements have not been updated in a comprehensive fashion since they were adopted in the 1960s. At that time, paper records were the norm and electronic records were the exception. Of course, the reverse is clearly true today. For this reason, the Division is taking a fresh, comprehensive look at the books and records requirements under both the Advisers Act and the Investment Company Act.

In developing our recommendation in this area, the Division is actively exploring how to reconcile the rules with the desire for electronic record retention. This includes the extent of advisers' obligations to retain electronic communications such as e-mails and text messages. In addition, we are examining the possibilities for better harmonizing the adviser rules with the broker-dealer rules.

Finally, we have been told that some advisers do not always understand their obligations to produce records to the Commission's exam staff, that some firms may be confused by the distinctions between what records they must create, what records they must retain if they create them, and what records they must provide to examiners if they retain them. Part of our goal in developing our books and records recommendation is to offer significant guidance in this area.


I want to thank IA Week again for inviting me to speak with you today — this conference could not have been more timely. With such important initiatives being considered by the Commission and the Division, I am grateful to have had the chance to discuss them with you today. As compliance professionals, your comments on these initiatives are crucial — our goal in the Division of Investment Management is to make you more effective in your important compliance functions. In addition, the Division wants to avoid unnecessary regulatory complications to your compliance programs. I strongly encourage you to let the Commission know your thoughts on these initiatives; I look forward to hearing them. In fact, I also have a selfish reason for this request — with the almost revolutionary aspect to some of the current initiatives in the investment adviser area, if I know what you, the compliance professionals, think about a regulation, more than anyone else, I will have a sense of whether it is a workable and meaningful protection. I will then be able to rest easier at night. And, with the schedule at the Commission this fall, I certainly could use the sleep! Thank you very much and enjoy the conference.



Modified: 10/12/2007