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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks at the IA Watch Annual IA Compliance Best Practices Seminar


Carlo V. di Florio1

Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

Omni Shoreham Hotel
Washington, D.C.
March 21, 2011

Thank you for inviting me to speak to you today on these important topics. We have shared objectives when it comes to protecting investors, market integrity and capital formation. I appreciate the hard work you do in your institutions each day to promote good governance, risk management, compliance and ethics. My door is always open and I welcome the dialogue and collaboration as we work together to prevent fraud, improve compliance, monitor risk and inform policy.

Today I would like to cover the following four topics: First, I would like to give you an overview of the exciting changes in our National Exam Program and across the SEC more broadly. Second, I will talk about the provisions of Dodd-Frank that are of particular interest to advisers, and what the Commission staff and the National Exam Program has been doing to get ready for these challenges. Third, I will talk about key exam focus areas for investment advisers. Finally, I will discuss some recent enforcement cases that have important lessons for the adviser community. As you know, the views that I express here today are my own and do not necessarily reflect the views of the Commission or of my colleagues on the staff of the Commission.

SEC-Wide Reforms

Since Chairman Schapiro’s arrival at the SEC in 2009, the Commission has taken significant steps to reform its procedures, revamp its systems, bring more complex enforcement actions, better target its examination efforts and adopt a series of rules intended to protect investors and promote fairness in the markets. In addition, it has done significant work to fulfill its obligations under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

As part of our effort to become a more effective regulator and create a strong culture of teamwork and collaboration, Chairman Schapiro has brought on new leadership in virtually every office and division at the Commission. The Commission created an entirely new division of Risk, Strategy and Financial Innovation, which has been a great partner for my office, by raising our knowledge and awareness around new and emerging risks, how they impact our strategies and our programmatic areas and how we can become more risk-focused in our efforts. Like all of you in the industry, we are trying to allocate precious, limited resources to their highest and best use by taking a risk-focused strategy.

The Commission has also been raising its own standards internally in the same way that it place expectations on all of you as registrants. For example, for the first time the Commission has its own Chief Operating Officer who is seeking greater operational efficiency and effectiveness. It has a new CFO who is focused on new controls and systems around financial management. It also has a new Director of IT to bring critical technology to the agency so we can modernize and execute our regulatory mission and mandate more effectively. A lot of tremendous change is happening which will make the Commission more efficient and effective in executing its mission.

Investor-focused rulemaking. The SEC has also been very investor-focused and productive with regard to new rule making. The Commission has:

  • adopted new custody rules designed to improve protections for investors who entrust their assets to investment advisers
  • updated Form ADV and related rules requiring advisers to provide clients with brochures that plainly disclose such things as the advisers’ business practices, fees, conflicts of interest and disciplinary information
  • adopted a number of rule changes to strengthen money market funds, such as additional risk-limiting conditions and new stress testing requirements, and additional disclosure to improve our oversight capabilities.
  • addressed potential conflicts of interest in the public space, particularly the new pay to play rules that apply to advisers to pension funds and other government clients.
  • Adopted new rules that provide investors and other market participants with more meaningful and more timely ongoing information regarding municipal securities
  • Proposed rules to create a more equitable framework governing the way in which investors pay the costs for mutual funds to be marketed and sold
  • Proposed a new rule that would require SROs to establish a consolidated audit trail system that would enable regulators to track information related to trading orders receives and executed across the securities markets.

Market Structure. I have heard concern that, with all the new rules and studies called for by Dodd-Frank, the Commission may not be able to turn its attention to the critical market structure issues that it was focused on before Dodd-Frank. Chairman Schapiro has made clear that market structure is going to remain a priority. In January 2010 the Commission issued a concept release addressing current equity market structure issues, including trading centers, linkages, and trading strategies, and requesting public comment. The May 6th 2010 “flash crash” highlighted the importance of this topic. Commission staff continues to work on recommendations for further initiatives to moderate excessive volatility, such as a limit up-limit down mechanism for individual stocks and updated market-wide circuit breakers.

The Commission’s broader market structure agenda is concerned with a wide range of issues relating to high-frequency trading, undisplayed or “dark” liquidity, and the overall quality of the equity markets. Proposals currently are pending that target unfair practices with regard to topics like flash orders or dark pools. The Commission is also seeking to strengthen its ability to have a consolidated view across the equity markets – for example the large trader reporting requirement and the proposed consolidated audit trail would allow the Commission to track trading activity across the securities markets in a consolidated fashion. Market access issues are another important topic that the Commission recently addressed through a new rule that will become effective in July. So whether it is fairness and timeliness in data feeds, sponsored access, co-location – those are all issues that Chairman Schapiro has stated the Commission will continue to scrutinize on its market structure agenda.

Building a National Exam Program

The National Exam Program examines investment advisers, investment companies, broker-dealers, transfer agents, credit rating agencies, exchanges and other SROs such as clearing agencies, FINRA, and the MSRB. In addition to new regulation affecting these registrants, the Dodd-Frank Act introduces new regulation of hedge fund advisers and derivatives and municipal advisors, which will significantly increase examination responsibilities.

To address these new requirements, OCIE has developed a more risk-based approach to the examination program that will enable us to use our resources more effectively. This approach is necessary, given that the exam program is only able to cover a very small portion of the individuals and entities that register with the Commission, and the disparity between resources and responsibilities is growing as a result of the new requirements of the Dodd-Frank Act.

One of the benefits of a wider use of a risk-based approach should be an ability to identify fraudulent conduct at an earlier stage. A recent illustration of the fruits of a risk-based approach is the case filed in January and recently expanded in an amended complaint against a Stamford, Connecticut-based investment adviser and its principal, Francisco Illarramendi. The Commission alleged that Illarramendi engaged in a multi-year Ponzi scheme involving hundreds of millions of dollars. According to the Commission’s amended complaint, Illarramendi allegedly misappropriated assets and used two hedge funds for Ponzi-like activities in which they used new investor money to pay off earlier investors. The case has also produced criminal charges by the United States Attorney for the District of Connecticut.2 As described in a press conference by Commission staff, the fraud was first unveiled by Commission examiners during a risk-based exam of an SEC-registered adviser with which Illarramendi was affiliated. Despite efforts by Illarramendi to allegedly obstruct the examination and mislead the staff – conduct that led to a criminal charge of obstruction of justice – the examiners and their colleagues in the Enforcement Division obtained evidence of the fraud.3

Recent Reforms

Over the past year, OCIE has undertaken a broad self-assessment of its strategy, structure, people, processes and technology. This has resulted in a comprehensive improvement plan to break down silos and promote a high-performance culture. Below is an outline of key program improvement initiatives.

Strategy – Strengthening Our Mission and Risk-Focusing our National Exam Program. OCIE is implementing many reforms toward an integrated National Exam Program designed to improve consistency, effectiveness and efficiency. The cornerstone is a national governance model and enhanced risk-focused exam strategy to better allocate and leverage limited resources to their highest and best use. Four key objectives support our overall mission to protect investors, maintain market integrity and facilitate capital formation:

  • Improve industry compliance with the securities laws as well as industry risk management and compliance practices through exams and communication with industry.
  • Identify and prevent fraud through risk-targeted exams and better coordination with the Division of Enforcement in identifying, investigating and preventing fraud.
  • Monitor new and emerging risks to investor protection and market integrity through joint initiatives with our policy divisions and the Division of Risk, Strategy and Financial Innovation. This includes the development of new risk assessment and surveillance models and risk analytics so we can target the highest risk firms, practices and trends.
  • Inform policy as the eyes and ears of the SEC in the field, through involvement in the rule-making process, and with dedicated policy support teams on key initiatives.

Structure – Strengthening Expertise in Critical Risk Areas. OCIE is implementing significant structural enhancements to support the National Exam Program and a risk-focused exam strategy. This restructuring will strengthen expertise and facilitate teamwork, while driving greater consistency, effectiveness and accountability. For example:

  • We have a new national governance model that includes regional leadership in key strategic planning, policy setting and performance management decisions.
  • We have a new Risk Analysis and Surveillance Unit to enhance our ability to identify the highest risk firms we should be examining and the highest risk issues to focus on in our exams of those firms.
  • We have launched new Specialization Working Groups dedicated to enhancing our ability to identify, understand and proactively examine new and complex industry developments, in areas such as structured products, valuation, high-frequency trading and municipal securities.
  • We are also looking at how best to staff exams with examiners whose skills sets most effectively address the specific risks in an exam profile. This includes deploying joint IA/BD teams to address issues regarding dual broker-dealer and investment adviser registrants.

While these structural improvements are comprehensive, they are also designed to achieve specific outcomes. For instance, these changes will facilitate better teamwork and collaboration with the policy divisions and also speed alerts, information hand offs, and referrals from OCIE exam staff to the Enforcement Division.

People – Recruiting Specialists, Improving Training and Strengthening Culture. In the past year, before the Continuing Resolution necessitated that we suspend recruiting, OCIE was able to recruit people with new skill sets that are critical to supervising our modern capital markets. We have also been building a leading practice training program, introducing mentoring, and building a culture of high-performance, teamwork and accountability. Here are some specific examples:

  • We have recruited a limited number of new Senior Specialized Examiners to strengthen our expertise and skills sets in key risk areas, including complex products, risk management, business areas and quantitative analytics.
  • We are working to implement a new Certified Examiner Training program that establishes consistent baseline technical training and certification standards across the country.
  • We are strengthening management skills and practices through new management and leadership training programs.
  • We are launching a mentoring program to support the professional development of our examiners and leverage the expertise and experience of our most seasoned examiners.

Process – Streamlining Processes to Drive Consistency, Effectiveness and Efficiency. We have re-engineered our exam process end-to-end. This has enabled us to target more risk-focused examinations, enhance pre-exam preparation, improve multidisciplinary staffing, and increase field supervision. We have become more risk-focused in allocating resources effectively and efficiently. In addition, we have introduced new mechanisms to drive consistency and accountability across our National Exam Program. Here are some examples:

  • A National Exam Manual that sets forth updated policies and procedures governing examinations nationwide.
  • A standardized National Exam Workbook to drive consistency in the exam process nationwide.
  • OCIE’s first Chief Compliance Officer to enhance and monitor compliance with our own policies and procedures, as we expect of our registrants.
  • Regular meetings between home office and regional offices to coordinate and monitor performance and compliance.
  • Increased use of supervisors in the field and involvement of senior staff on exams.

Technology – Automating the Exam Process to Keep Pace with New Developments. We are focusing our technology strategy on moving from a manual to an automated exam process where possible. This includes automating risk assessment and surveillance; exam preparation; all key activities associated with exam execution, such as trade analysis; work paper management and data analytics and reporting. Other technology initiatives include:

  • We created a Technology Committee to oversee our technology resources and strategy.
  • We have a dedicated Senior Technology Officer who is developing a comprehensive technology strategy, technology architecture and implementation plan to automate and strengthen our exam program.
  • We are piloting new risk assessment and trade analysis technologies that will make the program more efficient and effective in identifying risks and wrongdoing throughout the capital markets.

Governance, Enterprise Risk Management and Internal Controls. The financial crisis revealed just how dramatically risk management failures can harm investors, jeopardize market integrity and hinder capital formation. It also revealed the need for better oversight of risk at the board and senior management levels, and the need for stronger independence, standing and authority among a firm’s internal risk management, control and compliance functions. As a result, we are focusing in our exams on the risk management as it pertains to the corporate governance and enterprise risk management framework of a firm so we can assess the firm’s system of checks and balances.

Investment Advisers and ERM. For investment advisers as a group what does this mean? This is a business that has seen a significant degree of growth and consolidation within the industry in recent years, and this gives rise to particular enterprise risk issues such as

  • consolidating disparate technological platforms, systems and controls,
  • familiarizing risk management, internal audit and compliance functions with new business units
  • revising business continuity planning
  • managing differences in firm cultures that may complicate merger of procedures, processes, controls, etc.

These are all issues that go beyond just chief compliance or risk officers, and require senior management attention in order to ensure that the appropriate resources, senior management and business unit attention are being invested.

Dodd-Frank Issues for Advisers and the National Exam Program

Let me now highlight some key provisions of the Dodd-Frank Act for investment advisers and what the Commission staff is doing to respond to these changes.

1. Shifting Responsibilities for Advisers. Section 410 of the Dodd-Frank Act raises the asset threshold for SEC registration from $25 million in assets under management to $100 million (subject to certain other provisions). This section provides an exception that permits (but does not require) such mid-sized investment advisers to register as investment advisers with the SEC if they would be required to register with 15 or more states. OCIE is working with the SEC’s Division of Investment Management and state securities regulators on the transition of these investment advisers from federal to state oversight. As a result of this change, we expect that approximately 4,100 investment advisers will switch from SEC to state registration. As noted in the Commission staff report to Congress on the need for enhanced resources for investment adviser examinations,4

“[t]he amount of any potential increase in examination frequency, however, may be offset by the need to divert examination resources to fulfill new examination obligations that the Commission was given by the Dodd-Frank Act. Moreover, the Staff expects the number of registered investment advisers to grow in subsequent years. While the Commission’s resources and the number of OCIE staff may increase in the next several years, the number of OCIE staff is unlikely to keep pace with the growth of registered investment advisers.”5

These new examination obligations include the increase in more complex hedge fund and private equity registrants, and other provisions of the Dodd-Frank Act that give us new responsibilities in a range of areas, such as in examining municipal advisors, credit rating agencies, and various participants in the securities swaps markets. As this study notes, the expected continued long-term growth in the number of registered investment advisers and cumulative assets under management is also a likely source of additional demand on examination resources.

2. Regulation of Private Funds. One area regarding private funds that we are already thinking about concerns how private equity firms and their advisers manage conflicts of interest. The Technical Committee of IOSCO has a report out that describes a number of potential conflicts of interest in the private equity arena, and the Institutional Limited Partners Association has issued a set of Private Equity Principles recently that are designed to address many of these conflicts. When we conduct a risk-focused examination, such as of fund advisers to large private equity funds, we will be looking for conflicts such as these, and for evidence that advisers have been vigilant in identifying such potential conflicts and putting in place effective plans or controls to address them.

3. Regulation of Securities-Based Swaps and Market Participants. Title VII of the Dodd-Frank Act creates a new regulatory regime for key participants in the securities-based swaps markets. The Commission has already published for comment ten rulemaking proposals in this area, namely, proposed rules regarding:

  • Anti-fraud and anti-manipulation measures regarding security-based swaps;
  • Reporting and real-time public dissemination of trade information for security-based swaps;
  • Obligations of security-based swap data repositories;
  • Mandatory clearing of security-based swaps;
  • Exceptions to the mandatory clearing requirement for hedging by end users;
  • Standards for the operation and governance of clearing agencies;
  • Registration and regulation of security-based swap execution facilities;
  • Definitions of swap and security-based swap dealers, and major swap and security-based swap participants, done jointly with the CFTC;
  • Trade acknowledgements for security-based swaps; and
  • Conflicts of interest at security-based swap clearing agencies, security-based swap execution facilities, and exchanges that trade security-based swaps.

OCIE is working closely with the Division of Trading and Markets on these rule proposals, in anticipation of having to examine all of these new entities for compliance with the new regulatory regime.

4. Regulation of Municipal Advisors. The Dodd-Frank Act also establishes a new registration regime for municipal advisors. Last September, the Commission adopted an interim final rule establishing a temporary registration regime for municipal advisors. In December, the Commission proposed a rule to create a permanent registration process.

5. 913 and 914 Studies. The Commission recently released several staff studies mandated by Dodd-Frank. These staff studies related to improving the investment adviser and broker-dealer regulatory frameworks. Of particular note, the Commission published a staff study on enhancing investment adviser examinations. The study, required by Section 914 of the Dodd-Frank Act (the “914 Study”), concludes that the Commission’s investment adviser examination program requires a source of funding sufficiently stable to prevent examination resources from being outstripped by future growth in the number of registered advisers (i.e., that the resources are scalable to any future increase — or decrease — in the number of registered investment advisers). The 914 Study identified three options for Congress to consider:

  • Impose “user fees” on SEC-registered investment advisers that could be retained by the Commission to fund the investment adviser examination program;
  • Authorize one or more SROs to examine, subject to SEC oversight, all SEC-registered investment advisers; or
  • Authorize FINRA to examine dual registrants for compliance with the Advisers Act.

In addition, pursuant to Section 913 of the Dodd-Frank Act, the Commission published a staff study on the obligations of investment advisers and broker-dealers (the “913 Study”). More particularly, the 913 Study required an evaluation of the effectiveness of the legal and regulatory standards of care applicable to investment advisers and broker-dealers providing personalized investment advice and recommendations about securities to retail customers. In that study, the staff made several recommendations, including: that the Commission (1) exercise its rulemaking authority under the Act to implement a uniform fiduciary standard of conduct for broker-dealers and investment advisers when they are providing personalized investment advice about securities to retail customers (specifically, “to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”; and (2) consider harmonizing broker-dealer and investment adviser regulations when (a) broker-dealers and investment advisers provide the same or substantially similar services to retail customers, and (b) such harmonization adds meaningfully to investor protection. Section 913 of the Dodd-Frank Act further provides that if the Commission promulgates such a standard of conduct, that standard shall be “no less stringent” than the standard applicable to investment advisers under Sections 206(1) and (2) of the Advisers Act.

6. Improved Disclosure and Corporate Governance Rules. The Dodd Frank Act directs the Commission to take action on a number of corporate governance and executive compensation topics, including, among others:

  • “Say-on-Pay” and “Golden Parachute.” In January 2011, the Commission adopted rules to implement the provisions of the Dodd-Frank Act that require public companies subject to the federal proxy rules to provide their shareholders with an advisory vote on executive compensation, as well as an advisory vote on compensation arrangements and understandings in connection with merger transactions.
  • Compensation Committees and Compensation Consultants. The Commission is required by Section 952 of the Dodd-Frank Act to mandate new listing standards relating to the independence of compensation committees and to establish new disclosure requirements and conflict of interest standards that boards must observe when retaining compensation consultants.
  • Recovery of Erroneously Awarded Compensation. Section 954 of the Dodd-Frank Act requires the Commission to adopt rules mandating new listing standards relating to specified executive compensation “clawback” policies.
  • Pay versus Performance and Pay Ratios. Under Section 953 of the Dodd-Frank Act, the Commission must adopt rules requiring new disclosures about the relationship between executive compensation and company performance, and the ratio between the median of the annual total compensation of an issuer’s employees and the annual total compensation of the issuer’s chief executive officer.
  • Employee and Director Hedging. Section 955 of the Dodd-Frank Act requires the Commission to adopt rules requiring disclosure by issuers of their policies relating to certain employee and director hedging activities.

7. Whistleblowers. Section 922 of the Dodd-Frank Act requires the SEC, under regulations prescribed by the Commission, to pay awards to individuals who voluntarily provide the Commission with original information that leads to the successful enforcement of (1) an SEC action that results in monetary sanctions exceeding $1 million or (2) certain related actions.

This provision substantially expands the agency’s authority to compensate individuals who provide the SEC with information about violations of the federal securities laws. Prior to the Act, the agency’s bounty program was limited to insider trading cases, and the amount of an award was capped at 10 percent of the penalties collected in the action.

Last November, the Commission proposed rules mapping out the procedure for would-be whistleblowers to provide critical information to the agency. The proposed rules convey how eligible whistleblowers can qualify for an award through a transparent process that provides them an opportunity to assert their claim to an award. It also defines and interprets key terms in the statute.

The Commission staff is currently reviewing comment letters and working on a recommendation to the Commission for final rules implementing the whistleblower provisions of the Act. In addition, the Enforcement Division recently hired a head of the SEC Whistleblower Office (Sean McKessy). Pending the adoption of final rules, Enforcement staff has been processing and tracking whistleblower complaints submitted to the Commission and sharing information with our office for purposes of informing our risk-based examination program. The SEC Investor Protection Fund, which will be used to pay awards to qualifying whistleblowers, is fully funded with $452 million (funding source is unrelated to our appropriation).

Exam Focus Areas for Investment Advisers

1. Valuation: Advisers’ valuation practices are a top priority, particularly when the adviser manages difficult to value instruments, such as derivative-based investment products that do not routinely trade on exchanges or in other established markets. We are also looking for situations where advisers mark positions up to collect higher fees. Accordingly, the exam will look at valuations and review the auditor’s scope and verification reviews. The exam will also check processes, policies and procedures and oversight in this area.

2. Conflicts of Interest: This entails a review of procedures in place that identify, disclose and manage conflicts. For instance, allocations have proven to be a persistent problem as managers allocate few expenses or assign better trades or opportunities to funds where they own larger stakes or to favored clients. This focus area will also include analysis of insider trading, side letters, best execution, directed brokerage and soft dollar issues. In addition, this area includes a review of compliance with pay to play rules and conflicts associated with advisory services provided to governmental entities, such as public pension funds.

The amendments adopted by the Commission to Part 2 of Form ADV should be helpful. Among other improvements to the Form, contained in these amendments are the more robust requirements for disclosing and explaining conflicts of interests advisers have and how these conflicts may impact their clients.

3. Portfolio Management: This area includes testing whether the strategy presented to investors is actually being carried out by the advisers. Divergence of portfolio management from an advertised style is a risk indicator of additional control deficiencies and issues.

4. Performance and Advertising Issues: Examiners will review both performance calculation and the presentation of that performance in offering materials. Aberrational performance is a great risk indicator and part of our risk assessment and surveillance models.

5. Asset verification: We continue to place emphasis on verifying customer assets and controls with respect to safeguarding of customer assets. The custody rule is critical here and we will leverage the work of the auditors. We will pay particular attention to advisers that have access to clients’ assets (e.g., check writing authority, power of attorney, and/or general partner to hedge fund). The staff will verify the existence of client assets and to evaluate the strength of the safeguards within the custodial arrangements that cover such assets, the exam will focus on the adviser’s processes for: confirming and reconciling trades, receiving and disbursing clients’ assets, and confirming the accuracy of the periodic statements to clients. In as many processes as possible, the staff will validate information with third-party sources, such as DTCC.

6. Risk governance: We will look at risk management practices and ask the following questions about five levels of risk governance:

  • First, how do the business units of an entity ensure they are taking and managing risk effectively at the product and asset class level in accordance with the risk appetite and tolerances set by the board and senior management of the whole organization?
  • Second, how are key risk management, control and compliance functions structured and resourced to ensure they are effectively embedded in the business process, while having the necessary independence, standing and authority to be effective in helping the organization identify, manage and mitigate risk?
  • Third, how is senior management ensuring effective oversight of enterprise risk management and embedding risk management in key business processes, including strategic planning, capital allocation, performance management and compensation incentives?
  • Fourth, how does the internal audit process independently verify and provide the board and senior management with assurance regarding the operating effectiveness of risk management, compliance and control functions?
  • Finally, how is the board of directors (if one exists in the organization) staffed and structured to ensure it can effectively set risk parameters, foster an effective risk management culture, oversee risk-based compensation systems and effectively oversee the risk profile of the firm?

7. Business Continuity/ Disaster Recovery: Business continuity and disaster recovery planning has always been an important part of our overall examination program, including for investment advisers. The recent natural disasters in Japan and New Zealand highlight the continued importance of this for firms and markets.

8. Additional issues we are monitoring:

  • Use of social media (websites, blogs, twitter, etc). Certain functionalities on these sites, such as stock picks, links to other products and services, difficulties in providing proper disclosures, and offerings, raise the need to consider compliance risks.
  • Small niche mutual funds, ETFs (exposed to certain countries, products, markets, etc.) are subject to unusual or obscure risks (currency devaluation, weather, political instability, etc.) Otherwise small events can have huge effects. Risk management for such products should emphasize making sure that the business side understands these risks fully and explains them clearly to clients. Stress testing these types of products may also be an important consideration for risk management.

Recent Enforcement Cases of Note

Let me now turn to a couple of recent settled enforcement matters that should be of keen interest to the adviser community, and that illustrate some of the points that I have been making.

The first case that I want to discuss is a recent settled enforcement administrative proceeding brought by the Commission against three AXA Rosenberg entities (collectively, “AXA”), charging them with defrauding advisory clients and compliance rule violations for concealing a significant error in the computer code of the quantitative investment model that they use to manage client assets. The press release announcing the proceeding noted that this case was the result of joint efforts by San Francisco examination staff, Los Angeles enforcement staff and the Enforcement Division’s Asset Management Unit.

The Commission alleged that a senior executive at ARG, the holding company of the two SEC-registered investment advisers, and BRCC, the investment adviser that developed the code, learned in June 2009 of a material error in the model's code, dating back to April 2007, that disabled one of the key components for managing risk. The Commission alleged that instead of disclosing and fixing the error immediately, the senior ARG official, who was also a BRRC official, directed others to keep quiet about the error and declined to fix the error at that time. ARG disclosed the error to SEC examination staff in late March 2010 after being informed of an impending SEC examination. AXA disclosed the error to clients on April 15, 2010. The error caused $217 million in investor losses. AXA agreed to settle the SEC's charges by paying $217 million to harmed clients plus a $25 million penalty, and hiring an independent consultant with expertise in quantitative investment techniques who will review disclosures and enhance the role of compliance personnel.

This is an excellent case study of a breakdown in enterprise risk management on several levels. While computer coding errors will sometimes occur, a mindset among senior managers to sweep a problem under the rug rather than to deal with it forthrightly is obviously not the approach to risk management that anyone wants to see. This case could be a teachable opportunity for many of you to take back to your firms, as an illustration of the need, among other things, for a tone at the top that encourages everyone, from senior managers and risk officers to lower level employees, to identify and address problems as they occur, escalating issues as needed.

Second, I would like to refer to a case from 2010, in which the Commission staff brought an administrative action against Morgan Keegan, a registered broker-dealer and investment adviser, and one of its officers and a portfolio manager, as well as an investment adviser affiliate of Morgan Keegan.6 Morgan Keegan underwrote and distributed shares of several affiliated investment companies that invested in investment securities backed by subprime mortgages, many of which lacked market quotations. Pursuant to Section 2(a)(41)(B) of the Investment Company Act, these securities for which market quotations are not readily available must be priced at fair market value as determined in good faith by the funds’ boards of directors. In the Order the staff alleged that both Morgan Keegan and its officer failed to fulfill Morgan Keegan’s responsibilities delegated to it by contract by the funds’ boards to price the funds’ securities in accordance with their valuation policies and procedures as set forth in the funds’ prospectuses. For example, the staff alleged that Morgan Keegan accepted unsubstantiated price adjustments made by the funds’ portfolio manager that inaccurately inflated the price of certain securities, contrary to the funds’ policies and procedures. The staff alleged that the portfolio manager actively screened and manipulated dealer quotes from at least one broker-dealer, and that he also failed to advise Morgan Keegan or the fund’s board when he received information that prices for certain securities should be reduced. The staff alleged that his actions resulted in a fraudulent forestalling of declines in the published NAVs of the funds that would have otherwise occurred in a declining market. The staff also alleged that Morgan Keegen fraudulently published NAVs for the funds without following procedures reasonably designed to determine that the NAVs were accurate. The facts alleged in this matter are similar to another administrative action that the Commission brought in 2008 against Heartland Advisors Inc. and several of its officers, which involved a mispricing of municipal bonds.7

These cases are cautionary warnings as to the problems that can arise when advisers have weak controls over valuation of complex and/or illiquid instruments. In the Morgan Keegan case the facts alleged suggest that there were insufficient controls in place to ensure that policies and procedures were followed that could have prevented what the staff alleges was fraudulent conduct by at least one individual. In the Heartland case, the Order issued as to the settling parties suggests a similar lack of controls. For example, the Order indicates that, despite representations in a fund prospectus that the Fund had “intensive credit research” following the Fund’s proprietary method, in reality the Fixed Income Department was understaffed and only performing “catch up research” on its portfolios.

Finally, I would like to briefly mention the “Expert Network” insider trading cases that the Commission and the Department of Justice have recently brought, and that have received much recent press coverage. There are many interesting dimensions to this line of cases, and they seem to have spawned some urban legends and misunderstandings about what I believe is the staff’s intent. Contrary to some reports that I have seen, I believe these cases do not represent some inherent hostility by the Commission toward expert networks, nor do they indicate that the Commission is seeking to undermine the mosaic theory, under which analysts and investors are free to develop market insights through assembly of information from different public and private sources, so long as that information is not material nonpublic information obtained in breach of or by virtue of a duty or relationship of trust and confidence.

One aspect of these cases that I want to highlight is how it underscores the need for advisers to have reasonable policies to prevent insider trading. Information networks when properly designed are just another type of research and hiring them is consistent with what institutional investors should do. I am not suggesting that advisers must avoid using expert networks, but that they should address any increase to their compliance risks that expert networks may pose, and build appropriate controls around information obtained from expert networks, at both the front end and the back end.

Front-end controls could include such things as reviewing the terms of agreements with expert network firms, having adviser staff read and acknowledge the adviser’s insider trading policies, and pre-approving every conversation with an expert. It might mean having, at least occasionally, “chaperoned” conversations -- that is, a compliance person is a silent listener to the conversation between the expert and the adviser’s money manager/analyst. The adviser might also want to conduct an evaluation of the controls that are in place at expert networks with which the adviser does business. The adviser might also want to either avoid being involved with an expert who is an employee of a public company, or having extra controls in place.

Back-end controls could include obtaining certifications from adviser employees who use expert networks that they are not trading in on insider information. It could also include testing trading -- see what trades the adviser staff makes after the expert conversation; and test at least some of the trades in specific companies against press releases, earnings announcements and 8-k filings. These might also include policies and procedures to monitor personal trading of employees or agents who may have access to material nonpublic information.


Thank you again for inviting me to speak to you today. I look forward to continuing to work together with you to achieve our common goal of preventing fraud, improving compliance, monitoring risk and informing policy. I am now happy to answer your questions.


1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private statements by its employees.

2 Litigation Release 21875, March 7, 2011, available at http://www.sec.gov/litigation/litreleases/2011/lr21875.htm.

3 Remarks of David Bergers at News Conference on the Case Against Francisco Illarramendi, (March 7, 2011), available at http://www.sec.gov/news/speech/2011/spch030711db.htm.

4 Study on Enhancing Investment Adviser Examinations as Required by Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, (January 2011), available at http://www.sec.gov/news/studies/2011/914studyfinal.pdf..

5 Id. at 3.

6 In the matter of Morgan Asset Management, Inc., et al., Sec. Act Rel. No. 9116, Exch. Act Rel. No. 61856, Admin. Proceeding File No. 3-13847 (April 7, 2010).

7 In the Matter of Heartland Advisors, Inc., et al., Sec. Act Rel. No. 8884, Exch. Act Rel. No. 57206, Admin. File No. 3-12936 (Jan. 25, 2008).



Modified: 03/21/2011