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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Luncheon Address at IA Week/IA Watch's 9th Annual IA Compliance Fall Conference 2009


Andrew J. Donohue

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

Philadelphia, Pennsylvania
September 21, 2009

Today's Market Environment: Challenges Facing the Investment Advisory Industry

I. Introduction

Good afternoon and thank you for the kind introduction. It is a pleasure to be here. Before I begin, it is my obligation to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I was very pleased that IA Week and IA Watch kindly asked me to speak with you today. I always appreciate the opportunity to speak with compliance professionals. In fact, of the many groups that I interact with, I believe and understand that you are among the most critical that we rely on to ensure that the laws and Commission's rules are complied with.

Along with my appreciation for what you do, I also appreciate the challenges that you are facing in today's market environment. While I believe that good effective compliance is good for business, especially the business of investment advice, that can be lost on some people, especially in stressful times. With declining assets under management, investor uncertainty, and the rapidly changing nature of the advisory business, maintaining a culture of compliance within your firms may often not be easy these days. On top of this, with the Commission having brought a number of enforcement actions alleging violations by investment advisers, the public's perception of compliance at advisory firms may not fully reflect the fact that most firms want to be compliant, and that you understand it is in yours and everyone's interests that they are. Indeed, one thing these cases may bring to light is how difficult your jobs have become. You must successfully navigate the naturally competing interests of business motivations with adherence to regulatory rules and constraints. Furthermore, with investment products, trading processes and the general advisory business becoming increasingly complex, and new regulatory challenges being identified, the expectations placed on you are even greater. As they should be.

However, I don't mean to place all the responsibility for compliance on the shoulders of the CCO. In fact, I believe compliance is the responsibility of the firm, not just the CCO. My approach has been that CCOs are there to assist management of the firm in developing and implementing a compliance program properly tailored to the firm and its activities. The CCO also evaluates and monitors the system. Firm management, and the supervisory personnel are, however, primarily responsible for compliance and certainly for properly supervising those below.

With this in mind, today I would like to highlight some of these and other challenges you and your firms are facing in the advisory industry. As you go through the excellent agenda prepared for you today and discuss how to best implement different aspects of your compliance programs, I hope that the discussion of the challenges you face in doing so will provide a beneficial backdrop as to how you might approach your responsibilities in the current market environment.

In addition, as I mentioned, I view you as a key component of the regulatory regime governing investment advisers. But the Commission must also do its part. For this reason, in addition to outlining the challenges you face, I would also like to highlight what we are doing in the Division of Investment Management to address these current challenges.

II. Current Challenges in the Investment Adviser Industry

A. The Changing Investment Advisory Landscape

I am afraid that discussing the challenges facing the investment management industry has become a favorite theme of mine. I have been working in this industry a long time — over 30 years — and I never cease to be amazed at how complex and intertwined our markets have become. In light of this complexity, over the years I have become increasingly concerned how our markets could withstand inordinate stress in one part without unraveling throughout. Unfortunately, my fears were somewhat realized over the past year and a half as the effects of the Lehman bankruptcy and subprime loans rippled through the markets and adversely affected firms and investors. However, I was also reassured by the markets' resiliency and, in general, investors' faith in the safety of their investments. I attribute this partly to a compliance culture and system that has been built up over time in the investment management industry. This culture is what you are tasked with nurturing and maintaining in your compliance roles, and as a result of the various events we have seen in our markets, a mix of significant challenges face you in doing so.

First, some of the events that occurred have called into question core understandings of how our markets function and left us questioning basic tenets that have always been assumed to be true. For example, in extreme market conditions, we saw certain strategies that were long considered the basis for sound investing begin to fail. Take diversification. In times of crisis, normally uncorrelated or negatively correlated investments appeared to correlate with each other as we saw "a flight to quality" and a movement to hold cash and treasury bills. Just when the need for the benefits of diversification was at its highest, it seemed to fail. If virtually all markets move together, normally uncorrelated or negatively correlated assets become correlated, and investment strategies developed around more traditional correlations inevitably fail. In addition, some reports showed that actively managed funds have failed to outperform major market indices over long periods of time. In fact, one report showed the indice benchmarks outperformed fund managers in at least 70 per cent of cases and in almost all categories, and that is before considering the higher fees generally associated with active management. With this type of uncertainty in our markets, and in our knowledge of markets, advisers face increased pressures to perform and alleviate clients' legitimate concerns for the safety of their investments.

Next, we see further pressures on advisers as asset values declined and the advisory landscape adjusted to the new market environment. The downturn in the markets over the past year impacted the SEC-registered investment adviser community in many ways. First, the number of registered investment advisers was virtually unchanged and, at around the beginning of 2009, the number of advisers was actually decreasing. Furthermore, the Commission experienced approximately 20 percent more withdrawals from registration than usual (about 100 more) with about half of this increase (about 50) resulted from advisers switching from being federally registered to state registration. Seeing this trend, it appears that smaller advisers with 10 or fewer clients were among the hardest hit and affected by the market events.

Second, the assets under management by SEC-registered advisers drop $9.4 trillion or 22 percent. The median assets under management reported dropped from $126 million to $97 million. However, the top 10 percent of advisers that have the most assets under management still manage 92 percent of all assets under management, this has not changed over the last year, but these 1,140 advisers did report a 22 percent, or $8.5 trillion, reduction in assets under management. The other 90 percent of advisers with less assets under management reported a higher reduction of 27 percent in the assets under management. Again, it appears the smaller advisers were impacted the most.

Finally, as over 95 percent of advisers did and still do charge at least some of their clients fees based on a percentage of assets under management, the income for the majority of advisers has declined in correlation with the market downturn. And I have seen reports that advisory fee rates are also under increasing pressure.

With these trends occurring within the advisory industry, the pressures on advisers to perform well and with less cost becomes even greater. For this reason, I implore you today to review your compliance programs with an eye toward the unexpected, and to be aware of the importance of your programs, especially during periods of uncertainty. I also encourage you to embrace the culture where the question is "is this the right thing to do for the client" and not "where does it say I can't do this to the client?"

B. Sophisticated Products

Another challenge the investment management industry faces, and one that I have been concerned about for some time, is the increasing use of derivatives and sophisticated financial instruments. I have concerns on multiple levels in this area, including those from a compliance perspective. Not only is it imperative that all relevant parts of an adviser's operations understand a portfolio instrument and appreciate its use, characteristics and implications, and, of course, the portfolio manager and investment officers will generally be involved in the decision to use a new type of financial instrument, but it is also imperative that you and your team, as well as the legal and accounting groups, truly understand the instrument as well; and that you have implemented the proper legal, accounting and compliance techniques and controls. I also worry because I believe that many firms' systems, particularly the compliance and accounting systems, may not be sophisticated enough to effectively handle synthetic instruments.

Furthermore, as you are aware, many investment mandates have sought to align the management of the client assets with the client's investment risk and performance expectations by limiting the use of explicit leverage, the percentage of client assets invested in a particular security, issuer or sectors and the prohibition of certain practices. The use of derivative instruments in managing client portfolios can provide benefits but also pose certain challenges. Among these challenges, three major ones are (1) that the potential impact of derivatives on a portfolio are not related to the amount invested in the derivatives; (2) derivatives can offset the benefits that a portfolio might be expected to derive from the quantitatively mandated requirements; and (3) derivatives frequently have implicit leverage which can result in technical compliance with limitations on explicit leverage but expose the portfolio to precisely some of the risks associated with leverage that clients sought to avoid. What to do? My suggestion to you is that you develop the expertise and systems necessary to (1) insure technical compliance with the client's mandates; as you have traditionally done; and (2) insure that the actual exposures that the portfolio represents comply with that which the client would expect. Conceptually this is, of course, correct. I recognize, however, that the quest is not easy. Hence my concern.

In addition to increasingly complicated products, advisers are also using increasingly complicated processes in their securities trading practices. Developments in client commission practices, evolving technologies both in the advisory and the brokerage industries have led to dramatic changes in how securities are traded. For example, advisory firms are using their own or broker-sponsored execution systems, such as algorithms, new unbundling and commission sharing arrangements, and dark pools. With all this, you and your compliance programs must somehow keep up. I encourage you to keep up with these developments and their implications.

C. Enforcement Cases

With the pressures on firms to perform in light of declining asset values, coupled with increasingly complicated investment products and processes, ensuring that your firms are acting in the best interests of its clients takes on a new dimension as firms may seek, knowingly or unknowingly, to push the compliance envelop. As compliance professionals, you must identify and deal with the conflicts of interest ever present within advisory firms every day. These conflicts have of course always been there, and the Investment Advisers Act is based on the premise that advisers are fiduciaries and must act in the best interests of their clients. This concept is fairly simple and straightforward. However, from your perspective, that does not mean it is. This is clear from recent enforcement actions against advisers, several of which involve allegations that advisers engaged in fraudulent activity intended to boost their performance or profits. For example, in a recent case, the Commission alleged that an adviser to pension funds recommended certain money managers to its clients based potentially on the brokerage commissions and fees received from those managers, rather than strictly on the basis of which manager would be best for the client.1 In another case, an adviser allegedly engaged in "undisclosed kickback arrangements" or "side agreements" requiring a fund administrator to pay a portion of its fee as a quid pro quo for the adviser to continue to recommend that the administrator continue to provide services for the adviser's funds.2 In yet another matter, the Commission alleged that an adviser failed to disclose the conflicts of interest involved in an adviser's mother receiving a referral fee for a subadviser.3 Other enforcement actions have involved allegations that advisers fraudulently allocated trades. In one case, the Commission alleged an adviser allocated IPO shares in exchange for cash kickbacks,4 and, in another case, the Commission alleged that an adviser allocated profitable trades to the adviser's personal accounts and unprofitable ones to the adviser's clients.5

In light of recent enforcement actions, including those that are receiving considerable public attention, investors, both individuals and institutions, seem to me less willing to take management's word on their disclosures and compliance with regulatory requirements — they are more demanding and questioning more. In many ways, this is a good development, but even more reason to be vigilant in your compliance programs to ensure your clients have confidence in those managing their money.

III. Regulatory Developments

Now that we have discussed some of the challenges you face in your work, I would like to turn to discussing our role in the compliance arena and review what we are doing in the Division of Investment to Management to address these new challenges.

A. Adviser Custody Rule

First, in May, the Commission proposed amendments to the adviser custody rule. The proposal would require all registered advisers with custody of client assets to engage, through a written agreement, an independent public accountant to conduct an annual "surprise exam." This would also include an exam of privately offered securities, which are not covered under the current custody rule. The proposal would also require registered advisers, or their affiliates, that hold client assets directly, to obtain an annual internal control report prepared by a PCAOB-registered and inspected accountant. The report would include the accountant's opinion with respect to the custody controls in place and the tests conducted of their operating effectiveness. If the adviser finds any material discrepancies in the audit exam, it would be required to report it to the Commission within one day. Advisers with custody would also need to have reasonable belief that the qualified custodian sends quarterly account statements to their clients and instruct clients to compare the account statements of the custodian with those of the adviser. Furthermore, the proposal includes certain reporting requirements.

The comment period for the proposal closed on July 28th. The Commission has received a significant number of comments on the rule — over 1300 — which the Division staff is currently evaluating. In addition, I also ask all of you to redouble your efforts in confirming appropriate custody of client assets and constantly asking yourselves 1) how do I know? and 2) what am I missing?

B. Adviser "Pay to Play" Proposal

Next, in July, the Commission proposed the so called "pay to play" rule. The proposal would apply to investment advisers that manage public funds that fund state and municipal pension plans. These pension plans have over $2.2 trillion of assets and represent one-third of all U.S. pension assets. Public pension plan assets are held, administered and managed by elected officials who often are responsible for selecting advisers to manage the funds they oversee. Pay to play practices undermine the fairness of the selection process when advisers seeking to do business with the governments of states and municipalities make political contributions to elected officials or candidates, hoping to influence the selection process. Political contributions may also be solicited from advisers, or it is simply understood that only contributors will be considered for selection. Although contributions in this circumstance may not always guarantee an award of business, the failure to contribute will guarantee that another is selected. Hence the term "pay to play."

Elected officials who allow political contributions to play a role in the management of these assets violate the public trust by rewarding those who make political contributions. Similarly, investment advisers that seek to influence the award of advisory contracts by public entities through political contributions to officials who are in a position to influence the awards, compromise their fiduciary obligations. Pay to play practices can distort the process by which advisers are selected and can harm advisers' public pension plan clients, and the pension plan beneficiaries, which may receive inferior advisory services and pay higher fees because, for example, contract negotiations are not handled on an arm's-length basis. These practices also create an uneven playing field among advisers and hurt smaller advisers that cannot afford the contributions. As the Commission stated, it believes that advisers' participation in pay to play practices is inconsistent with the high standards of ethical conduct required of them under the Advisers Act.

The Commission's proposal, modeled after MSRB rules G-37 and G-38, would work to curb this activity by prohibiting an adviser from providing advisory services for compensation to a state or local government client for two years after the adviser or certain of its employees make a contribution to an elected official or candidate who is in a position to award advisory business.

The proposal would not ban or limit political contributions advisers may make, but rather would impose a time-out on advisers receiving compensation for providing advisory services after such a contribution is made. The proposal would also provide a de minimus exception of $250, which an adviser's employees would be able to contribute to a political candidate that they can vote for without triggering the "time-out." The proposal would apply to SEC-registered investment advisers as well as those other advisers that are not so registered in reliance on the exemption under the Advisers Act available to advisers to private investment companies.

In addition, the proposal would prevent advisers from circumventing the rule by using third parties to exert influence over public officials on the adviser's behalf in a number of ways. This was a particular concern as third party solicitors have played a central role in many of the Commission's recent enforcement actions against investment advisers in this area. The proposal would thus prohibit an adviser from paying third parties, including placement agents and consultants, which solicit business from government entities on the adviser's behalf. It also would prohibit an adviser to do anything indirectly which, if done directly, would result in a violation of the rule. This would prevent advisers from funding contributions through other parties, such as attorneys, family member or affiliated companies. In this same vein, the proposal would prohibit advisers from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business. Finally, under the proposal, registered advisers would be subject to certain record-keeping requirements of their political contributions.

The Comment period on this proposal closes October 6th. As with all the Commission's rule proposals, the Commission very much appreciates your input. In particular, it looks to you to assist it in determining what will work, and what won't — you are the front lines when it comes to the practical aspect of implementing the Commission's regulations. Particularly in that regard, I truly value your perspective.

C. Rule 2a-7 Amendments

Next, the past two years has been an especially challenging period for money market funds. Money market funds are subject to a strict regulatory scheme under the federal securities laws that has worked for almost 30 years. However, with recent events, it became clear that the Commission may need to revise these rules to make money market funds more resilient to liquidity and other risks in the short-term securities markets and to better protect investors, by tightening up the risk-limiting conditions of the rule.

On June 24th, the Commission proposed amendments to rule 2a-7, the principle rule governing money market funds, to focus more on tightening the credit quality, maturity and liquidity standards for these funds. In doing so, the Commission was looking to make money funds, which collectively hold almost $4 trillion, less susceptible to a run by diminishing the chance that a money market fund will break a dollar and if one does, provide a means for the fund to orderly liquidate its assets.

The Commission's proposal would, among other things, require money market funds to keep a portion of their assets in highly liquid securities that could be used to meet significant demands for redemptions, limit the funds to investing in the highest quality securities, shorten the weighted average maturity of money market fund portfolios, and limit the ability of money funds to invest in longer-term floating rate securities. The proposal would also require funds periodically to "stress test" portfolios against market events, such as an increase in interest rates, to determine the capacity of the fund to withstand redemptions, as well as require money market funds to report their portfolio holdings monthly to the Commission and post their holdings on their Web sites. In addition, the proposal would permit a money market fund that has "broken the buck" to suspend redemptions to allow for the orderly liquidation of fund assets.

The Commission also asked in the proposal for comments on further changes to the regulation of money market funds, such as whether to require that money market funds have a "floating" price rather than the stable $1.00 per share price that is prevalent under current rules, as well as the role of credit rating agencies and the use of asset-backed securities in money market funds. Comments on this proposal were due on September 8th, and the Division staff is currently reviewing them. This proposal is an important initiative of the Commission and I anticipate that the Division may make a recommendation to the Commission in this area by the end of the year.

D. Other Matters to Look Out For

Finally, in addition to these rulemakings, I just want to mention briefly some of the other initiatives that may be on your mind. The Division is still working on a recommendation to the Commission that it adopt ADV Part 2, which we hope to have to the Commission soon. Updating adviser books and records requirements also remains an important initiative, however, in light of the recent market events and the Division's heavy rulemaking agenda, we will need to turn to this project at a later time. Additionally, with the issuance of the Administration's White Paper on financial reform in June, I am also anticipating what may happen with respect to the harmonization of the regulatory schemes governing investment advisers and broker dealers and the possible registration of advisers to hedge funds and other private funds with the Commission. Both these issues are the subjects of bills pending in Congress. Stay tuned on these matters.

IV. Conclusion

I want to thank you for listening this afternoon. Although we seem to be emerging out of a period of crisis, unfortunately it is my nature to always be concerned about what may be around the corner. As you encounter challenges in your very important work, I ask that you approach your compliance responsibilities with the view that maintaining the confidence of investors in the advisory industry is an important goal that we mutually share and, as I know you understand, is in the best interests of all of us. I hope that you will view the Commission as a resource in this regard and contact the staff with any concerns or any suggestions as to how we may make your work easier. We are in this together after all. I hope you enjoy the conference.



Modified: 09/21/2009