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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the IA Week and the Investment Adviser Association 10th Annual IA Compliance Best Practices Summit 2008


Andrew J. Donohue1

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

Washington, D.C.
March 21, 2008

Good afternoon. It is always a pleasure to speak at this conference and I'd like to thank IA Week and the Investment Advisers Association for inviting me to speak with you today. Before I begin, I of course must note that my remarks today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I wanted to offer my congratulations to IA Week and the IAA as I see that we are now at the tenth anniversary of this conference. A lot has changed in the compliance world in the last 10 years. Part 1 of Form ADV is now electronically filed, and advisory firms are now required to have a code of ethics, to adopt compliance policies and procedures and to appoint a Chief Compliance Officer. The Commission has proposed amendments to Part 2 of Form ADV not once but twice — OK, so certain things haven't changed in 10 years.

It is not just some of the compliance rules that have changed. As compliance professionals, you witness first hand a business that is constantly innovating and introducing new products and services. You have the tough responsibility of ensuring that, in your firms, healthy change and improvement does not advance at the expense of sound risk management and compliance with the law. I appreciate that this can be a difficult task to achieve when your business people are anxious to get new services to market or to establish a new client relationship.

As a regulator, the Commission also strives to keep pace with developments in the marketplace and to maintain regulations that both allow beneficial industry innovation and ensure that, regardless of such changes, interests of investors are protected. Yesterday, Lori Richards spoke about the Office of Compliance Inspections and Examination's risk-based examination program and disciplined approach to risk assessment. Lori also passed on her top compliance issues, which focused on ensuring that advisers are living up to the fiduciary duties that they owe their clients.

Today, I would like to share with you some of the top regulatory initiatives that the Investment Management staff is working on. Like OCIE, we in the Division of Investment Management are looking hard at advisers' fiduciary duties, with the goal of helping you understand your fiduciary obligations in light of changing markets, and therefore better serve your clients.

I know from my decades working in the private sector that industry often fears any change in regulation. They fear it will simply result in more regulation, increasing the burden on compliance personnel like yourselves. They also fear that any new regulation will harm their business or at least impact their business in ways they cannot predict. The staff's goal in reaching out to industry — whether it is through this conference, our CCOutreach seminars, invitations to comment on the Commission's rulemaking, or industry meetings and roundtables — is to dispel that fear. We want to understand your concerns so that any recommendation we make to the Commission to change regulations advances investor protection but does not hamper beneficial industry change and unnecessarily increase regulatory burdens. I hope you and your firms will continue to engage with us in this dialogue and continue to let us know your thoughts and concerns. And now let's turn to those regulatory initiatives.

Form ADV Part 2

I will start with the Commission's proposal to substantially improve advisers' disclosure to clients in Part 2 of Form ADV. As you know, Part 2 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. The goal of Part 2 is to allow investors to make an informed choice in selecting an investment adviser and to evaluate any conflicts an adviser may have.

This document is especially important because the U.S. federal securities laws do not prescribe minimum experience or qualification requirements for persons providing investment advice. They do not establish maximum fees that advisers may charge. They generally do not prohibit advisers from having substantial conflicts of interest that might adversely affect the objectivity of the advice they provide. Instead, investors have the responsibility in selecting their adviser to negotiate their own fee arrangements and evaluate their adviser's conflicts. As a result, it is critical that clients and prospective clients receive sufficient information about the adviser and its personnel to permit them to make an informed decision about whether to engage an adviser, and having engaged the adviser, how to manage that relationship.

As you heard at yesterday's panel on Part 2, the proposed amendments are intended to get clients disclosure that is more meaningful, more effective, and easier to understand. Because Part 2 plays such an important role in the regulation and compliance programs of advisers, and because the proposal is intended to result in more client-friendly disclosures, I strongly encourage you to let the Commission know your thoughts on the proposal. Comments on the Part 2 proposal are due by May 16, 2008.

RAND Report

Next I will turn to the RAND report. Many of you work for firms that are dually registered as an investment adviser and a broker-dealer. You face the task of establishing procedures for compliance with the Exchange Act and the Investment Advisers Act on an ongoing basis, and you have been witnessing the convergence of the brokerage and investment advisory industries first hand.

Of course, the intersection between these two industries is not new. But the wide-ranging scope of services provided by today's financial service providers and their rapid growth and evolution over the last 70 years has certainly changed these industries since the statutes were enacted. On the broker-dealer side, brokerage commissions have been unfixed and discount brokerage services are now common in the marketplace. These changes have helped open up the markets to retail investors and lower the costs of investment.

The asset management world has experienced similar change. At the time the Investment Advisers Act was enacted, firms acting as "investment counsel" numbered in the hundreds and assets under management were only a few billion dollars. Today, there are over 11,000 investment advisory firms registered with the SEC alone and over thirty trillion dollars worth of assets under management — and that is not counting the many investment advisers registered solely with state regulators. The asset management industry also has seen great changes in its business models. Just witness the rapid growth in recent years in separately managed accounts and unified managed accounts. Advisers are recommending investment in increasingly complex products such as derivatives and are using sophisticated computer models to manage client assets. At the same time as these significant changes are transforming the activities of broker-dealers and investment advisers, the number of investors participating in the market and seeking advice, and therefore impacted by these industries, has been experiencing dramatic growth as well.

A fortunate effect of the principles-based regulation embodied in the Investment Advisers Act is that it has within it a certain amount of flexibility to accommodate change in industry practices. But to be truly effective in protecting investors, all regulation must be periodically evaluated, and even principles-based regulation may from time to time need adjustment.

In December 2007, the RAND report on the current state of the retail investment adviser and broker-dealer industries was delivered to the Commission. This report will provide an important resource to the Commission as it evaluates the current and future regulation of those industries. Chairman Cox has directed Erik Sirri, the Director of the Division of Trading and Markets, and me to review the empirical data and analysis contained in the RAND report and prepare a range of options for Chairman Cox's consideration by May 5. We are busy working on that task and this certainly is an area to watch in the coming months.

Temporary Principal Trading Rule

A clear area where the regulation of broker-dealers and investment advisers differ is principal trading. Under Section 206(3) of the Investment Advisers Act, an investment adviser is not permitted to engage in principal trading without disclosing in writing the capacity in which it is acting and obtaining consent from the client prior to each trade. This restriction is in recognition of the fact that principal trading represents a significant conflict of interest between the adviser and its client — one that clients should be aware of and consent to before allowing an adviser to place trades on their behalf. But broker-dealers engage in principal trading as a regular part of their market-making activities. The dramatic changes in industry practices have begun to highlight this difference in regulation as well.

Many of you are aware of how this issue came to light. Over 10 years ago, the "Tully Report" recommended ways to minimize the conflicts between broker-dealers and their customers. One conclusion of the Tully Report was that fee-based compensation in some cases might better align the interests of broker-dealers and their clients. Soon thereafter, broker-dealers began offering fee-based accounts.

These accounts put in the spotlight the blurring of the traditional statutory line between investment advisers and broker-dealers. In response, the Commission adopted a rule providing that fee-based brokerage accounts were not advisory accounts and thus were not subject to the Advisers Act. In 2007, the Court of Appeals for the DC Circuit vacated that rule in the FPA decision. As a result, starting on October 1, 2007, broker-dealers offering fee-based brokerage accounts became subject to the Advisers Act with respect to those accounts.

It was not long after the FPA decision that interested parties began telling the staff the operational difficulties broker-dealers would face both in applying the Advisers Act to the fee-based brokerage accounts and in transitioning those accounts to either traditional advisory accounts or traditional brokerage accounts. Recognizing those concerns, the Commission adopted Temporary Rule 206(3)-3T permitting 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 temporary rule contains a number of other conditions intended to highlight for clients the conflicts associated with principal trades.

The Commission also has proposed to reinstate several important Commission interpretive provisions regarding the application of the Advisers Act to certain activities of broker-dealers that were vacated as part of the FPA decision, although the Court did not question their validity.

The Commission has received several comments on the temporary rule and the proposed interpretive positions, and the Division plans to make recommendations to the Commission on these matters in the next several months.

In the aftermath of the FPA decision, there are a few matters that you may see examiners focusing on if your firm is a dual registrant. They may look into how your firm is conducting principal trades and what compliance procedures are in place to ensure that those trades are in the client's best interest. Examiners also may be looking at how firms advise clients about what type of account is appropriate for them.


One area that interests us is the rapid development of managed accounts. Managed accounts have been an innovative way for firms to meet client demands for more unified portfolio management and possibly provide cost savings through the bundling of advice, brokerage, and custody.

But managed accounts also create challenges for compliance personnel and the firm's regulators. First, the separation of those providing the foundational advice or investment models from those with discretion to determine the trades and asset allocation requires careful disclosure to ensure that clients understand how the advice is provided and where the decision-making is centered. This disclosure is particularly important when the originator of the advice has no direct contact with the client.

Second, firms providing managed accounts should be attuned to how they are meeting their best execution obligations. If client trades will be placed with the managed account's sponsor, the adviser should be comfortable that this arrangement achieves best execution and that the client is informed of this arrangement and why it achieves best execution.

I also have previously expressed concerns with whether firms were complying with rule 3a-4 of the Investment Company Act, which allows managed accounts to operate outside the jurisdiction of the Investment Company Act, and whether firms were meeting all the conditions contained in this rule in their managed account programs. In addition, in line with the Division's goal of periodically re-evaluating regulations, I believe it is important that we review the conditions in rule 3a-4 to consider whether they continue to provide an appropriate level of individualized treatment to support an exception from the definition of investment company for certain types of managed accounts or investment advisory programs.

Finally, the Division staff would be interested in learning about your experience in placing clients in managed accounts. For example, we are interested in how firms determine that a managed account is the appropriate account for a client and how firms determine that clients are receiving the full value of these accounts and particularly of the "bundled" brokerage services. We also are interested in learning what brokerage services clients typically use in these accounts and how frequently they use them.

Soft Dollars

I have been speaking frequently today of the dramatic changes in the marketplace in recent years, and the corresponding need for the Commission's regulations to be frequently re-evaluated to ensure the maintenance of investor protection.

Soft dollars and trading practices in general are certainly areas where rapid evolution has become the norm. In recent years, developments in client commission practices, evolving technologies, and market place developments have led to dramatic changes in the brokerage industry and in securities trading practices. For example, firms are using broker-sponsored execution systems, such as algorithms, new unbundling and commission sharing arrangements, and dark pools. The increased use of electronic methods to order, track and analyze securities trading has increased transparency of the costs associated with execution. This development is allowing advisers to determine with greater certainty the expense of research funded by client assets and "virtually unbundle" research and execution services. The use of "commission sharing arrangements" may enable a clearer determination of the actual amount of commission dollars used to pay for research and those used to pay for execution. We are also seeing potentially favorable market trends such as an overall decline in commission rates and increased internal reporting of meaningful information on trading practices to fund boards.

In light of these changes in the marketplace, the Division recognizes the need to provide additional guidance to assist mutual fund boards in their oversight responsibilities with respect to soft dollars. In preparing recommendations for guidance, the Commission staff has met with industry representatives, including investment advisers, independent fund directors and directors' counsel. We are seeking to ensure that our guidance reflects actual market practices and is based on actual industry experience.

When emphasizing today the need for the Commission's regulations to be re-evaluated in light of changes in the marketplace, I also have been careful to stress that regulators should strive to avoid unnecessarily hindering beneficial changes in industry practices. Accordingly, we also are taking into consideration the fact that regulatory requirements need to be flexible enough to accommodate rapidly evolving market conditions and practices in the area of soft dollars. To this end, it may be more helpful for fund boards and compliance professionals to have a framework for properly fulfilling responsibilities, while maintaining flexibility for firms and fund directors to oversee trading operations in a manner they determine appropriate in light of their particular circumstances.

We expect to provide the Commission with recommended guidance in the coming months and, again, I hope that you will provide your thoughts and comments as this project moves forward. But, I would hasten to add that the Division's activities regarding soft dollars are not limited to guidance to fund directors. The proposed revisions to Form ADV Part 2 also would require advisers to discuss the conflicts of interest inherent in an adviser's soft dollar practices.

Books and Records

Technology is not only reshaping how industry and the Commission look at soft dollar practices. Technology has fundamentally changed how all firms in all industries create and maintain 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. Emails and instant messaging did not exist. Compliance professionals like yourselves also are surely using technology to enhance your ability to monitor the firm's activities and compliance with various laws and regulations. We are looking into how the Commission's books and records rules for advisers may be updated to work together with the technologies and processes that you are already using to do your jobs.

Of course, we are taking a comprehensive look at the books and records rules, and are planning to recommend that the Commission propose amendments that go beyond the role of current technology. The Division staff is looking at the purpose of each requirement to determine whether it can be satisfied in a better or less burdensome manner. We also are seeking to clarify the books and records requirements so that it would be clearer to you what records advisers must create, what records advisers must retain, and what records advisers must produce to examination staff. We also are planning to recommend guidance on outsourcing and under what conditions advisers can use a third party to create or store records. Finally, we are exploring whether it would be useful to have more uniform recordkeeping standards across financial service firms. I also want to note that we have continued our outreach efforts in this area, talking — and more importantly listening — to advisers, counsel, trade associations and compliance consultants to learn what works, what doesn't and why.

We hope to recommend to the Commission this year amendments to the books and records rules.

Derivatives and New Investment Products

In addressing compliance professionals, I feel I'd be remiss if I didn't spend at least a little time speaking about risk management. In particular, I'd like to focus on advisory firms increasingly recommending investment in complex investment products, such as derivatives, and the expected capability of its compliance and back office functions in this area.

As an initial matter, before determining to advise clients to invest in any new investment product, it is critical that an investment advisory firm is confident that it has the resources in place to appropriately administer those investments. For example, is the adviser comfortable that it has full access to relevant information to understand and assess the risks involved in such instruments? Is there a sufficient due diligence process in place and is compliance appropriately involved in this process? As part of its risk management function, is the firm able to adequately monitor and supervise any investment strategy involving such instruments? Also, has the adviser made appropriate disclosures to its clients about investments in derivatives or other complex investment products and the risks involved?

Finally, the firm's back office functions should be sufficiently robust to provide effective and timely service regarding these instruments, including when unexpected events occur that cause spikes in activity. Firms must be able to operationally manage the documentation, settlement, valuation and confirmation processes for these products in a timely manner and ensure that any service providers have effective procedures to handle and clear these trades, including in times of high trading volume. You, as compliance professionals, should be thinking through these issues to be sure that the front office, in their eagerness to generate returns and satisfy clients, does not get ahead of the back office capabilities.

Other Regulatory Initiatives

In addition to the topics I've discussed today, the Division is continuing its work in a number of other areas. The Division is in the process of re-evaluating Rule 12b-1 in light of the over 1000 comment letters that the Commission received after the roundtable on that rule. The Commission also proposed amendments to introduce a new plain English summary prospectus for mutual funds. The Commission is in the process of reviewing the comment letters received.

Earlier this month the Commission proposed two new rules under the Investment Company Act that would codify the exemptive relief exchange traded funds require to operate. Comments on the new ETF rules will be due by mid-May.


Again, I appreciate your inviting me here today to discuss current initiatives in the Division of Investment Management. As you can see, the Division has a full plate in attempting to modernize the provisions of the Investment Advisers Act to keep pace with today's rapidly changing marketplace. I'd be happy to take any questions.



Modified: 03/21/2008