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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Address at IAA/ACA Insight's Investment Adviser Compliance Forum 2010


Andrew J. Donohue1

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

Arlington, Virginia
February 25, 2010

The Regulatory Landscape for Investment Advisers in 2010

I. Introduction

Good morning and thank you [David] for the kind introduction. It is a pleasure to be here. Before I begin, I want to make clear 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 first want to commend the Investment Adviser Association and ACA Insight for putting together what promises to be a remarkable program. Over the next two days, you will be listening to a packed agenda covering issues that are confronting the investment advisory business today. Each panel consists of true experts on investment adviser regulation, including a number of representatives from the very capable staff of the Investment Management Division, which I am privileged to head. While today I would like to review for you some of the Commission's major regulatory initiatives, I am not going to steal the staff's thunder by going into the intricate details about these initiatives and compliance developments. Rather, I'd like to take this opportunity to take a longer view of what has happened to adviser regulation since Chairman Schapiro took office one year ago and what you might likely see in the future.

It should be clear to everyone by now that Chairman Schapiro is pursuing an aggressive and investor-focused reform agenda. And unlike in some past eras, investment adviser issues have been and likely will remain at the forefront. Not only are major advisory issues being considered by the Commission, [as you heard this morning from Commission Walter] there also is adviser legislation being considered on Capitol Hill. These reforms have the potential for additional mandatory rulemaking and studies that would require significant staffing and resources in my Division and at the Commission. Significantly, Congress appears poised to give the Commission more funding to protect investors' interests and additional authority to step up our oversight of advisers to hedge funds and other unregistered investment pools. My Division, in cooperation with others in the Commission, is already in the process of gearing up to meet these anticipated challenges.

Thinking of the increasing prominence of adviser regulatory issues, before I get into the issues of today, I would like to take a step back and put these issues into perspective and talk about how we got here. As compliance professionals, you know the foundation underlying the success of the advisory industry is an adviser's fiduciary obligation to its clients. The wisdom of the fiduciary model of course started long before Chairman Schapiro's tenure of one year ago. In fact, it goes back to biblical times. Specifically, in the book of Matthew we are told "no man can serve two masters." We then saw this concept develop over hundreds of years in the common law. As it did, we saw two streams of analysis emerge: one couched in the law of trusts, the other in the laws of agency.

The common law of trusts dictates that advisers, as fiduciaries, are subject to the duties of care and loyalty. These duties require advisers to act prudently and solely in their clients best interests — concepts that are the bedrock of the investment management industry. From common law, we then saw Congress incorporate these fiduciary concepts into modern legislation. In adopting the Investment Advisers Act of 1940, Congress provided a great example of how the codification of fiduciary principles can create a flexible system of regulation, while providing for necessary investor protections. The notion that an adviser is, and must act as, a fiduciary is fundamental to the Investment Advisers Act. However, the Act does not lay out a comprehensive regulatory regime for advisers. Rather, it imposes on advisers a broad fiduciary duty to act in the best interest of their clients. Over the years, we have seen this principle-based system at work as the advisory industry has grown and flourished.

Fiduciary duties flowing from agency relationships result from the consent by one person to allow another to act on his or her behalf. Broker-dealers, for example, generally act as an agent for their customers. Interestingly, we are seeing these two streams of fiduciary obligation come to a head as the Commission, and now Congress, grapple with the quest to reconcile and harmonize the regulatory schemes governing broker dealers and investment advisers. As Chairman Schapiro has recognized, the nature of the services that broker-dealers and investment advisers provide often are identical from the investor's perspective. In my view, it would therefore seem reasonable for retail investors to expect that all securities professionals providing them with advice should be subject to the same obligations, regardless of how we categorize them. Although people may approach this problem from different perspectives, it is this recognition that appears to be providing a common ground for discussion and a way to move towards a solution that best protects investors' interests.

Now that we are back in modern times, I would like to take stock of a development that may not be clear to everyone outside the SEC — and that is that the process of rulemaking and the approach we are taking to addressing regulatory issues is changing under Chairman Schapiro's leadership. There is a heightened focus on the need for, and benefits deriving from, collaboration between the Divisions and the importance of shared thinking.

Even more significantly, Chairman Schapiro has created and staffed a new Division — the first in 37 years. The Division of Risk, Strategy and Financial Innovation or "RiskFin" has attracted some renowned experts in their fields and is transforming how the Commission tracks and responds to financial innovation, trading practices and risks. One of RiskFin's key functions is to advise the other Divisions and make recommendations as to how financial innovations and developments might affect the agency's regulatory activities. By having a seat at the table, RiskFin will help to inform the rulemaking process and better enable the Commission to take into account the broader perspectives needed to address the risks in today's market environment.

II. Current Rulemaking Initiatives

A. Adviser Custody Rule

So now let's turn to the Commission's most recent initiatives affecting investment advisers. Last year, the Commission took important steps to provide greater protections to investors who entrust their assets to investment advisers. The changes that the Commission made to the adviser custody rule last December were part of a comprehensive review of the Commission's rules in connection with a series of enforcement cases the Commission brought against advisers and broker-dealers alleging fraudulent conduct and misappropriation of funds.

This was a challenging rulemaking and one that required the Commission to strike a balance between increased regulatory requirements on advisers and necessary investor protections. Under the rule amendments, all advisers who hold or control their clients' assets, except those who have custody solely because of their authority to deduct fees from their clients' accounts, will be subject to a surprise inspection to verify assets. In addition, custodians who are affiliated with an investment adviser will be subject to an annual custody controls review. You can look forward to a full discussion of all of the details of this significant rule change on the panel immediately following this one.

Although the rule becomes effective on March 12, 2010, you should note that advisers have until the end of this calendar year to obtain the first surprise exam. In addition, the Division's Office of Investment Adviser Regulation is working diligently to compile answers to a number of questions and concerns that advisers, their counsels, and accounting firms have raised with us regarding the compliance dates under the rule and how to comply with the rule's surprise exam and internal control report requirements. We intend to post updated Frequently Asked Questions or FAQs on the Commission's web site on a rolling basis as we work through these issues. As directed by the Commission, the Division will also be evaluating the impact of the surprise examination requirement on smaller advisers that have the authority to obtain possession of client funds or securities and whose client assets are maintained by an independent qualified custodian and their clients.

B. Adviser "Pay to Play" Proposal

I would next like to discuss the so-called "pay to play" proposal, which also concerns adviser's fiduciary obligations to its clients (or potential clients) — in this case public pension fund clients. The rule, proposed in July, is designed to prevent investment advisers from seeking to influence the award of advisory contracts to manage public pension plans by making political contributions to officials who are in a position to influence these awards.

The $2.2 trillion of assets held in municipal and state pension plans are administered by elected officials who often are responsible for selecting advisers to manage the funds that they oversee. When these officials allow political contributions to play a role in who they may select to manage these assets, rather than making a strictly meritorious selection, they violate the public trust. Similarly, investment advisers that seek to influence the award of advisory contracts by public entities through political contributions to officials, compromise their fiduciary obligations to the plans.

The proposed rule 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 minimis 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 from doing 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 proposal generated 250 comment letters, many of which were supportive of the rule's goals, but critical of the approach the Commission took, an approach that was modeled on MSRB rules G-37 and G-38, as well as a 1999 rule proposal by the Commission that was never adopted. At the time of the 1999 proposal, some of the commenters that objected to the rule claimed that pay to play was not a problem in the management of public funds and that State laws were adequate to address any concerns. Since then, it has become increasingly clear that pay to play is a significant problem in the management of public funds by investment advisers.

The Commission and criminal authorities have now brought a number of actions in this area. In addition, a recent case in Federal court charges former New York State officials, as well as a placement agent, with engaging in a fraudulent scheme to extract kickbacks from investment advisers seeking to manage assets of the New York State Common Retirement Fund.2 Here, investment advisers were alleged to have paid sham "placement agent" fees, portions of which were funneled to public officials, as a means of obtaining public pension fund investments in the funds those advisers managed. In light of these cases, and the harm pay to play practices cause in the management of public funds, the Commission decided it was time to act.

The staff is currently working through the comments and preparing a recommendation for the Commission for a final rule. As we do so, we are determining how to best address a number of criticisms, and recommended modifications, of various aspects of the proposal. This includes the proposal's ban on payment to third party placement agents, of which commenters were particularly critical. The Commission received numerous comments arguing that placement agents can provide important services to investment advisers seeking to compete for government business, as well as to pension plans, and requesting that the Commission reconsider its approach. Specifically, many commenters suggested that the rule provide an exception to a ban for regulated entities serving as legitimate placement agents that are subject to similar pay-to-play regulations. In this regard, I have indicated in a letter to FINRA that such an exception might be feasible if FINRA were to implement rules that would prohibit pay to play activities by registered broker-dealers. We hope to continue our dialogue with FINRA to determine if an alternative approach may work without compromising the important goals of the proposed rule.

C. ADV Part II

Another important rulemaking initiative that we are working on in the Division of Investment Management relates to disclosure, specifically Part 2 of Form ADV. This project has already spanned the better part of a decade, and most you have attended quite a few conferences that have gone through the details of the proposal and re-proposal of the adviser brochure rule.

It goes without saying that as a fiduciary, it is critical for you to provide enough information to prospective clients to enable them to make an informed decision about whether to engage an adviser and, having engaged an adviser, how to evaluate and manage that relationship. We received over 80 comment letters on the Commission's March 2008 proposal. Most supported the proposed narrative format that would replace today's check-the-box, fill-in-the-blank approach. Commenters were divided over two principal issues. The first is whether advisers should be required to deliver a full, updated brochure to their clients each year. Some have suggested that it should be sufficient to instead deliver an annual summary of material changes with an offer to deliver the complete brochure upon request. The second concerns whether advisers should be required to provide specific information regarding the key personnel with whom clients will deal directly.

I think it is important to get this project done. As I have said previously, the Division plans to have a recommendation to the Commission for adoption of these amendments during 2010.

III. Recent Enforcement Cases

The Commission has also brought a number of enforcement cases recently highlighting the importance of an adviser's fiduciary obligations.

One settled case involved the valuation of shares of a fund invested primarily in mortgage-backed securities.3 For most of 2007 through mid-2008, the Commission alleged that the fund overstated its per-share NAV by as much as 17% because the adviser did not properly take into account readily available information about the value of residential mortgage-backed securities held by the fund, or it withheld relevant negative information about the securities from the committee responsible for determining the fund's NAV. As a result, according to the Commission's order, some shareholders redeemed their shares at prices higher than they should have received to the detriment of remaining shareholders, while some shareholders also purchased shares at a higher price than they should have paid.

In addition, according to the Commission's order, due to the fund's overstated NAV, the Fund appeared to be performing better than it actually was as compared to similar mutual funds. The Commission alleged that the adviser thus defrauded and deceived the fund insofar as the adviser knew, or should have known, that the inaccurate disclosure would harm the fund by diluting the fund's assets (because those shareholders who received such information would likely redeem their shares before the fund had completed the process of re-pricing securities, and thus would receive a higher NAV than they should have) and the adviser failed to inform the board about these disclosures.

Furthermore, the Commission brought a settled injunctive action against the adviser's Chief Administrative Officer (and Sr. VP) in which the Commission alleged that he engaged in insider trading after he attended meetings concerning the pricing of the fund's shares and difficulties the fund was experiencing.4 The Commission alleged that, following the meeting, the CAO redeemed all his shares in the fund at a favorable NAV and, prior to doing so, the CAO had called his mother who then redeemed her shares two hours later.

The Commission brought another case against an adviser that held itself out as a hedge fund consultant and one of its two principals, in connection with adviser's recommendation to its clients that they invest in a hedge fund without the adviser conducting all of the promised due diligence into the fund's investment style, trading strategy and risk management, as well as the fund's relationship with an independent auditor.5 The Commission alleged that most of the clients' funds were ultimately lost and dissipated by the hedge fund's principals who defrauded their investors by falsely describing the fund's performance in client account statements, periodic newsletters, and year-end financial statements which also included a phony audit opinion issued by a sham accounting firm that one of the fund's principals had invented.

IV. Conclusion

In conclusion, I would like to say, that, although we see enforcement cases such as these at the Commission, I believe it is a testament to you and the hard work that you do, that investors have entrusted their savings — in the amount of trillions of dollars — to registered investment advisers to manage. They have faith in you, as do I. Together, let's not let them down.

Thank you and enjoy the conference.



Modified: 02/26/2010