Remarks to the 2014 IAA Investment Adviser Compliance Conference
Director, Division of Investment Management
March 7, 2014
Good morning and thank you for the kind introduction. David Tittsworth has been a tireless advocate on behalf of the Investment Adviser Association for almost twenty years, confronting some of the most pressing and difficult issues facing the investment management industry. I suspect that in your time at the IAA you have been witness to more change in the business and regulation of investment advisers than took place in the sixty years prior - back to when the IAA’s predecessor, the ICAA was educating and lobbying Congress on what would become the Investment Advisers Act of 1940. I personally have enjoyed working with you on a number of interesting issues during my tenure at the Commission, and offer a hearty congratulations on your upcoming retirement.
Today, I would like to provide an update on some developments within the Division of Investment Management and discuss some rulemaking and other Division initiatives, including our efforts to provide more guidance to the investment management industry. I also would like to discuss a rule that is of particular importance to this audience — Rule 206(4)-7, the Advisers Act compliance program rule. Although perhaps not so surprising to a room full of investment adviser legal and compliance officers, the compliance program rule took effect ten years ago last month. I’ll focus my remarks on a few of the important lessons we have learned since the rule’s adoption. Before I begin, let me remind you that the views I express today are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.
Division of Investment Management Developments
Given the reality of budgetary constraints and our significant new mandates under the Dodd-Frank and JOBS Acts, the Division is working to become smarter, more strategic and more targeted in meeting the challenges of an evolving investment landscape. In 2013, the Division undertook a process to better understand our key strengths and areas in which we could improve. We gathered input from inside the Division as well as from our colleagues throughout the Commission. We identified and prioritized issues confronting the Division and have implemented a number of initiatives, which are designed to accomplish three goals.
First, encourage an inclusive collaborative working environment within the Division, across the Commission, and with outside stakeholders such as yourself. Second, increase information and knowledge sharing. And third, improve transparency into our work processes.
One of the most important initiatives resulting from this process has been the restructuring of the Division into four groups reflecting our key functions: (1) disclosure; (2) guidance; (3) rulemaking; and (4) business operations, which includes risk monitoring and analysis. We have already seen evidence that this restructuring will enhance our efficiency and our communications with you, among other important goals. For example, a request for guidance historically may have been submitted to multiple offices within the Division, depending upon the form of relief requested or type of registrant. Now, exemptive applications and no-action and interpretive letters are under one umbrella — guidance — making it much easier for you to contact us with questions and requests, and for us to be consistent in our responses. The new organizational structure has permitted us to adopt a more flexible staffing model in our investment company and investment adviser rulemaking offices as well — allowing the Division to devote greater resources to front-burner rulemaking initiatives.
No discussion of this reorganization would be complete without highlighting our newly created Risk and Examinations Office, or “REO.” REO is a multi-disciplinary office staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers, and accountants. REO maintains an industry monitoring program that provides ongoing financial analysis of the investment management industry, with a particular focus on strategically important investment advisers and funds. The REO monitoring program’s work includes analysis of the information the industry provides through various regulatory reports, as well as industry information from third party providers, and has already shown results. The recent Enforcement action against Ambassador Capital Management that you may have seen in the press stemmed from REO’s ongoing analysis of money market fund data, in this case a review of the gross yield of funds as a marker of risk. The performance of the Ambassador Money Market Fund was identified by REO as consistently different from the rest of the market.
In addition to financial analysis, REO conducts an examination program that gathers information from the investment management industry to inform the Division’s policy making. Although REO may conduct its own exams, where practical, REO will join examiners from the Office of Compliance Inspections and Examinations (“OCIE”) on their examinations of firms. REO’s work will inform the initiatives to which the Division devotes resources and will help inform the rules we recommend.
I am excited at the prospect that REO can help the staff to be proactive and get out in front of new industry trends, rather than reacting to past practices. We hope to use the work of REO to make our oversight more efficient and effective. REO represents a new area of focus for the Division of Investment Management, and I expect REO to complement the work of the SEC as a whole.
Rulemaking and Other Division Initiatives
In 2013, we spent a lot of time focusing on how we most efficiently approach our rulemaking initiatives. To ensure that we are allocating our resources wisely, we have taken a fresh look at policy initiatives and analyzed those matters based on four factors: first, the risk to be mitigated; second, the urgency associated with a particular initiative; third, the potential impact of an initiative on investors, registrants, capital formation, efficient markets, and the Division’s and the Commission’s operational efficiency; and fourth, the resources associated with a policy initiative.
I would like to turn now to a few of the rulemakings that we’ve accomplished during the past year incorporating this approach. First, in April, the Commission, together with the CFTC, adopted the “Identity Theft Red Flags Rules” -- rules designed to detect and prevent theft of the identities of mutual fund investors and clients of asset managers.
Second, as I’m sure you are aware, the Commission proposed additional money market fund reforms in June. The proposal includes two principal alternative reforms that could be adopted alone or in combination. One alternative would require a floating net asset value for prime institutional money market funds. The other alternative would allow the use of liquidity fees and redemption gates in times of stress. The comment period officially closed on September 17. The staff is currently reviewing and analyzing the more than 1400 letters we have received to date with a view toward making a recommendation to the Commission. As Chair White has said, adopting a final rule on money market mutual funds is a critical priority for the Commission in the relatively near term of 2014.
Third, the Commission adopted a new rule to implement the JOBS Act requirement to lift the ban on general solicitation and general advertising for certain offerings, including hedge fund offerings, in July. In connection with this new rule, the Commission also issued a proposal designed to, among other things, enhance the agency’s ability to evaluate the development of market practices in Rule 506 offerings. The proposed measures include expanding the information that issuers must include on Form D, requiring issuers to file the Form D before general solicitation begins and when an offering is completed, and requiring legends in written general solicitation materials. The comment period for these proposals closed on November 4. IM staff and our colleagues in the Division of Corporation Finance are currently reviewing and analyzing the more than 450 comments letters we have received to date which will help inform a recommendation to the Commission.
Finally, in collaboration with four other agencies and other Divisions, IM staff helped to develop the Volcker Rule. The rule, which implements Dodd-Frank Act restrictions on proprietary trading and investments in and sponsorship of hedge funds and private equity funds by banks and their affiliates, was adopted by the Commission and each of the other agencies on December 10, 2013. Commission staff, along with staff from the banking regulators and the CFTC, continue to participate in interagency working group meetings so that staff from each of the agencies can communicate on a regular basis on questions from market participants, on technical issues, and on supervision and examination approaches.
This year promises to be a busy one on the rulemaking front as well. In addition to working toward the adoption of a money market fund rule and the Reg. D amendments, we will focus on the few remaining IM-specific Dodd-Frank Act mandated rulemakings, which include removing the remaining references to credit ratings in our rules and the “say-on-pay” rulemaking addressing reporting of certain proxy votes by institutional investment managers.
We also expect 2014 to be an important year in our efforts to enhance the Commission’s ability to collect and analyze data. Form N-MFP data on money market fund holdings has been beneficial for the Commission. We hope to similarly benefit from improvements to the information the Commission receives about other mutual funds, closed-end funds and ETFs. Accordingly, staff is reviewing the frequency and format of fund portfolio holdings information, including the merits of receiving that information in a tagged format, as we do with the money market fund information, and is considering making a recommendation to the Commission. Our goals in this initiative are to improve the quality of the data we receive and to reduce unnecessary burdens.
Target date funds are also on the priority list for 2014. At Chair White’s direction, we are preparing a request soliciting additional comment on standardized risk-based glide path illustrations for target date funds, as recommended by the Investor Advisory Committee. In addition, we are assessing next steps with respect to the Advisers Act temporary principal trading rule that will sunset at the end of this year.
As you know, rulemaking is an important component of the Division’s work, but the Division’s work encompasses much more. Staff in the Division regularly review exemptive applications, fund disclosures, enforcement actions, and requests for no-action and interpretative guidance, among other things. Of particular interest to the members of this audience whose firms manage private funds is a no-action letter issued by the Division last month that provided guidance regarding the definition of “knowledgeable employee” under the Investment Company Act. This letter, which arose as part of the initiative I mentioned last year at this conference to engage in a regulatory review as a result of the required registration of advisers to private funds, updates and modernizes views of the Division that date back to when David began his career at the IAA on what a firm’s principal business units may be and what it means to participate in the investment activities of an adviser for the purposes of advisory staff investing alongside other private fund investors.
We also regularly collaborate with our colleagues throughout the Commission in connection with major initiatives or in response to questions from outside stakeholders implicating multiple divisions or offices. For example, IM staff recently collaborated with the Office of Municipal Securities to respond to questions from the IAA, SIFMA and others regarding the registered investment adviser exclusion from the definition of municipal advisor. The guidance, which took the form of answers to frequently asked questions, expressed the staff’s view that an SEC-registered investment adviser may provide advice on municipal derivatives in an investment portfolio for municipal entity clients without registering with the Commission as a municipal advisor under certain circumstances. IM staff also continues to work with colleagues across the Commission to consider the duties of investment advisers and broker-dealers. In addition to the Dodd Frank Act required report to Congress, the Commission issued a request for data this time last year, and, recently Chair White indicated that the Commission will intensify its consideration of these issues with the goal of enhancing investor protection.
We have been working to enhance our communications with the public as well. To further this goal, we have begun issuing guidance updates to supplement our traditional no-action and interpretive letters. Guidance updates set forth the staff’s views on particular matters in a transparent way. Division staff issued 14 guidance updates during 2013 and three so far in 2014. Just last month, the staff issued a guidance update clarifying that changes to advisory contracts that result in an increase in the aggregate advisory fee rate paid by a mutual fund remain subject to shareholder approval under multi-manager exemptive orders. Another recent example that may be of interest to you suggests steps that fund advisers may consider with respect to risk management and disclosure relating to changing market conditions. We also issued a guidance update last year regarding the Custody Rule in response to numerous questions we received from private fund advisers. The guidance expressed the staff’s view that an adviser to an audited pooled investment fund is not required to maintain private company, non-transferable stock certificates that evidence the fund’s ownership with a qualified custodian, so long as certain conditions are met. I encourage you to read these and other updates, which are posted on the Division’s recently redesigned website.
In addition to enhancing the way we communicate with you, we are also seeking ways to learn more from outside stakeholders about industry developments and investors’ experiences. As part of this process, we have met with senior management at fund and advisory firms and fund boards. In these discussions, we have learned a great deal about the identification and management of risk — risks specific to certain firms or funds, as well as critical risks to the industry as a whole. These meetings allow us to obtain a first-hand view of the systems, controls, personnel, and a sense of culture of an individual firm. We will be better regulators to the extent that we better understand the workings of the industry we regulate.
One issue of concern that we have identified from a number of sources, including the discussions noted above with senior management at advisers, is the migration of individual investors from brokerage accounts to advisory accounts. We will continue to monitor this trend, with a keen interest in evaluating the impact of this migration on investors. Indeed, our colleagues in OCIE’s National Exam Program have indicated that as part of their examination priorities for 2014 that they will examine the significant risks to investors presented by dual registrants’ conflicts, including risks from migration of accounts for the purpose of generating fees with little benefit to clients. To those of you that work for a dual registrant, I think you should consider whether the recommendation to move from a brokerage account to an advisory account is consistent with fiduciary obligations and whether the move is in the client’s best interests.
Ten Years of the Compliance Rule
I would now like to discuss the tenth anniversary of the compliance program rule. Anniversaries are always a good time to look back and look ahead - a time to ask what we have learned and how to apply those lessons going forward. As you are no doubt aware, Rule 206(4)-7 requires advisers to adopt, implement and annually review compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and also requires that advisers designate a chief compliance officer. The rule, which was adopted against the backdrop of the late trading and market timing scandals, stresses the importance of strong compliance programs in preventing violations of law as well as the important role that compliance professionals play in ensuring a strong culture of compliance.
When proposing Rule 206(4)-7, the Commission stated that “Our experience is that funds and advisers with effective internal compliance programs administered by competent compliance personnel are much less likely to violate the federal securities laws. If violations do occur, they are much less likely to result in harm to investors. In contrast, we have learned to regard weak controls as an indicator that undetected (and uncorrected) violations may have occurred, and we have assumed that, until improved controls are implemented, investors are at risk.” I believe those words are as true today as they were ten years ago.
Compliance policies and procedures must be specifically tailored to your firm’s advisory business, and a few recent enforcement cases confirm this point. Last March, the Commission charged two investment advisers with misleading investors about the valuation policies and performance of a private equity fund they managed. In connection with these misleading statements, the Commission’s order found that the adviser’s written policies and procedures were not reasonably designed to ensure that valuations provided to prospective and existing investors were presented in a manner consistent with written representations. Similarly, just last month, the Commission charged an investment adviser with issuing false and misleading advertisements. The Commission noted that the firm’s policies and procedures only parroted the Commission’s rule, and were not specifically tailored to prevent advertisements from violating the advertising rules.
It is crucial that policies and procedures be reviewed and updated as your business changes, as regulations change, as new guidance is issued. Compliance policies and procedures should evolve and grow with your business.
Another recent enforcement action in this area resulted in a Colorado portfolio manager being banned from the securities industry for five years for misleading and obstructing a chief compliance officer. This case should send a clear message to the industry that professionals have an obligation to adhere to compliance policies, and that the Commission will not tolerate interference with CCOs who enforce those policies.
Many of you in the audience today stand on the front lines of upholding the compliance rule. You are key to the success of our mission to protect investors, and we value and respect the work that you do. We want you to have the tools, resources and support that you need to do it within your firms. I believe that the compliance rule has been a win for clients, the Commission and for the investment management industry as a whole in bringing attention and resources to this important function.
Thank you for the opportunity to share my thoughts with you today. I hope I have been able to convey a sense of the dynamism currently at work in the Division of Investment Management, and the serious commitment the staff of the Division has to the important work we do in the service of the investing public. In all the Division’s initiatives, we work to meet the Division’s mission to protect investors and to promote informed investment decisions on their part. At the same time, we seek to facilitate appropriate innovation in investment products and services. As always, the staff welcomes your input and your cooperation with us in this important work. Thank you.
 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.
 Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 30551 (June 5, 2013), 78 FR 36834 (June 19, 2013), available at http://www.sec.gov/rules/proposed/2013/33-9408.pdf.
 Eliminating the Prohibition Against General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 9415 (July 10, 2013), 78 FR 44771 (July 24, 2013), available at http://www.sec.gov/rules/final/2013/33-9415.pdf.
 Amendments to Regulation D, Form D and Rule 156 under the Securities Act, Securities Act Release No. 9416 (July 10, 2013), 78 FR 44806 (July 24, 2013), available at http://www.sec.gov/rules/proposed/2013/33-9416.pdf.
 Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, Bank Holding Company Act Release No. 1 (Dec. 10, 2013), 79 FR 5535 (Jan. 31, 2014), available at http://www.sec.gov/rules/final/2013/bhca-1.pdf.
 Risk Management in Changing Fixed Income Market Conditions, IM Guidance Update No. 2014-01 (Jan. 2014), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf.
 Privately Offered Securities under the Investment Advisers Act Custody Rule, IM Guidance Update No. 2013-04 (August 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-04.pdf.
 Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003), 68 FR 74714 (Dec. 24, 2003), available at http://www.sec.gov/rules/final/ia-2204.htm.
 Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2107 (Feb. 5, 2003), 63 FR 7038 (Feb. 11, 2003), available at http://www.sec.gov/rules/proposed/ic-25925.htm.
 In the Matter of Oppenheimer Asset Management Inc. and Oppenheimer Alternative Investment Management, LLC, Investment Advisers Act Release No. 3566 (March 11, 2013), available at http://www.sec.gov/litigation/admin/2013/33-9390.pdf.
 In the Matter of Navigator Money Management, Inc. and Mark A. Grimaldi, Investment Advisers Act Release No. 3767 (Jan. 30, 2014), available at http://www.sec.gov/litigation/admin/2014/33-9521.pdf.
 In the Matter of Carl D. Johns, Investment Advisers Act Release No. 3655 (Aug. 27, 2013), available at http://www.sec.gov/litigation/admin/2013/ia-3655.pdf.