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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Guest Speech at IA Compliance Best Practices Summit


Paul F. Roye1

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

IA Week and the Investment Counsel Association of America
Washington, DC
February 28, 2005

I. Introduction

Good afternoon, I am very happy to be here today. I would like to thank Dennis Sullivan and David Tittsworth for including me on the program and providing an opportunity to discuss current issues in the investment adviser area. As you know, I must give the standard SEC disclaimer: “my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.” As many of you may know, I will shortly be leaving my position at the Commission, so my views will not count for much anyway. So I will understand if some of you may want to take a nap during lunch.

This year there have been a number of regulatory initiatives under the Investment Advisers Act that make, or propose to make, significant changes in the regulatory landscape. Therefore, it is an opportune time to take a step back and look at how this area of law is evolving and changing.

This afternoon I would like to take a break from the nuts and bolts of compliance issues that you are looking at over these two days, and review some of the Commission’s major investment adviser initiatives from a broader perspective. The Commission’s agenda in this area is particularly interesting because, while some initiatives have been responses to concerns arising out of industry scandals, others have generally resulted from the need to adapt a regulatory scheme established under a decades-old statute to a rapidly changing industry environment. For this reason, many of the Commission’s initiatives reflect concerns as to how to address new issues presented by the modern advisory industry in order to ensure that advisory clients receive the protections they are entitled to under the Investment Advisers Act.

II. Who Should be Covered by the Investment Advisers Act?

One of the ways the investment advisory business has grown is through an influx of new industry participants whose activities have traditionally fallen outside the statutory definition of investment adviser or who were not subject to the Act’s registration requirements. However, as the lines have blurred among financial service providers, and as unregistered advisers began managing money for a larger and broader cross-section of investors, investor protection concerns have prompted the Commission to consider the overarching question of who should be subject to the Advisers Act’s registration requirements. In the past year, three of the Commission’s major investment adviser initiatives addressed this issue. This blurring has required the Commission to take steps to attempt to ensure both that the protections of the Act extend to advisory services that the Act was intended to reach and that the Act’s requirements not apply where Congress did not intend them to.

A. Hedge Fund Advisers

An important initiative that the Commission considered last year was the adoption in October of the requirement that hedge fund managers register as investment advisers under the Act.

Hedge funds traditionally have been organized by professional investment advisers in ways that avoid regulation as investment companies under the Investment Company Act, as well as the registration requirements of the Securities Act and the Securities Exchange Act. In addition, many hedge fund managers, although they are investment advisers, avoided registration under the Advisers Act by taking advantage of an exemption from registration for small investment advisers – those with fewer than 15 clients. Hedge fund advisers qualified for this exemption by pooling client assets and creating limited partnerships, business trusts or corporations in which clients invest. Because advisers were permitted under a rule adopted by the Commission in 1985 to count each partnership, trust or corporation as a single client, they avoided registration while maintaining, indirectly, a large number of investors.

The determination to extend the registration requirement to hedge fund advisers was not taken lightly – in fact, it followed one of the most extensive examinations of any regulatory initiative in which the Division has participated. Beginning in June 2002, at the direction of the Commission, the staff commenced a sweeping study of the hedge fund industry. The study involved meetings with hedge fund industry participants, a series of exams by the Commission’s Office of Compliance Inspections and Examinations, and review of documents and information from 67 different hedge fund managers representing $162 billion of assets under management. Highlighting the staff study was a two-day Hedge Fund Roundtable, held by the Commission, at which hedge fund managers, investors, prime brokers, consultants, regulators, industry observers and others shared their views on hedge funds and the appropriateness of the regulatory structure governing them.

In September 2003, the staff study culminated in the publication of a report “Implications of Hedge Fund Growth.” The primary recommendation in the report was hedge fund adviser registration under the Investment Advisers Act.

So why did we conclude hedge fund adviser registration was necessary?

1. Tremendous Growth and Great Potential Impact

Over the last few years we have seen major changes in the hedge fund industry. One of our primary concerns was the industry’s tremendous growth. While no one knows for certain, it is estimated that in the last five years, the industry has grown by 260 percent, with assets close to $1 trillion in approximately 7000 funds. In the last year alone, it is estimated that hedge fund assets have grown over 30 percent. When this explosive growth is coupled with the fact that hedge funds also tend to be very influential and active traders, it becomes clear that hedge funds have a great potential impact on our capital markets. Indeed, one report estimates that hedge funds represent approximately ten to twenty percent of US equity trading. Another report portrayed a single hedge fund adviser as being responsible for an average of five percent of the daily trading volume of the New York Stock Exchange, while another report indicated that hedge funds dominate the market for convertible bonds.

2. The Need for Reliable Industry Data

Yet in spite of hedge funds increasing prominence in our financial system, no government or regulatory agency has reliable data on the hedge fund industry, including the number of hedge funds or how much they have under management. At the Commission, we have been relying on information from third-parties, which often conflict and may be unreliable. Without meaningful information, our ability to fulfill our investor protection mandate by truly understanding the impact that hedge fund advisers have on our securities markets and the broad market of individual, institutional, and professional investors with which hedge funds trade, is severely compromised.

3. Broader Investor Demographic

Another concern was the increasingly broad investor demographic who may, directly or indirectly, be investing in hedge funds. Lower minimums and the rise of funds of hedge funds have permitted a growing number of smaller investors into hedge funds. Funds of hedge funds represent approximately twenty percent of hedge fund capital and are the fastest growing source of capital for hedge funds today. In developed markets outside the United States, hedge funds have sought to market themselves to smaller investors and we can expect similar market pressures to develop in the United States as more hedge funds enter our markets. The beneficiaries of private and public pension plans are also increasingly exposed to the risks of hedge funds as these entities are investing greater amounts in hedge funds. One study on this issue calculated a 450 percent increase in pension fund investments in hedge funds over the past seven years. This growth in the level of pension plan participation in hedge funds was simply too large to ignore. Losses resulting from hedge fund investing and hedge fund frauds could affect the ability of these entities to satisfy their obligations to their beneficiaries or pursue other intended purposes.

4. Increased Fraud

Finally, the growth in hedge funds has also been accompanied by an increased number of enforcement cases involving hedge funds and their advisers. In the last five years, the Commission has brought 51 cases involving hedge fund fraud, resulting in investor losses of more than $1.1 billion. As hedge fund adviser enforcement cases represented more than 10 percent of the cases against investment advisers over the same period, they provided a strong signal to us that we should be concerned about activity in this area. In fact, just this month, the Commission acted to halt alleged ongoing fraud by a hedge fund manager, Northshore Asset Management. In its complaint, the SEC alleges that Northshore diverted $37 million of assets from two hedge funds and invested them in illiquid securities of entities in which Northshore and its principals have interests, and also used the assets to make undisclosed loans to these entities.

In addition, we are seeing hedge funds used to defraud other market participants. Hedge fund advisers were key participants in the recent scandals involving mutual fund late trading and inappropriate market timing. We have identified almost 400 hedge funds and 87 hedge fund advisers involved in these cases and all too often hedge funds were the late traders and market timers.

Although the registration of hedge fund advisers represents a significant development with respect to the application of the Advisers Act, it also represents the least intrusive form of regulation available to address the concerns of the Commission about the hedge fund sector, including the need for reliable data and deterrence of unlawful conduct. Throughout the rulemaking process, the Commission remained aware of the benefits hedge funds provide through enhancing market liquidity and efficiency, and was sensitive to avoid unnecessary restrictions on hedge fund activities. For example, Advisers Act registration does not result in hedge funds having to register their offerings with the Commission, modify their organizational structures, or result in disclosure of proprietary trading strategies. Registration under the Advisers Act simply will not hamper the legitimate operations of hedge fund advisers.

Also, the Commission provided hedge fund advisers a long transition period -- until February 1, 2006 -- before they must be compliant with the rule. For those of you who are hedge fund advisers, the Division of Investment Management is committed to assisting with adviser registration and in the preparation for greater SEC oversight. Staff will be available to work with you in resolving technical questions to ensure a smooth and efficient transition throughout the coming months.

B. The Broker-Dealer Exception

Another important initiative the Commission recently acted on considers the question of when a broker-dealer’s activities trigger application of the Advisers Act. Again, this question arose as a result of the lines established long ago in a statute becoming outdated as a result of modern industry practices and developments.

Although full-service broker-dealers have always provided their customers with a certain amount of investment advice, under the Advisers Act, they are excepted from registration if these advisory services are “solely incidental” to their brokerage business and they receive no “special compensation” for performing them. Fee-based compensation could be viewed as special compensation because it was compensation other than broker’s typical transaction-based compensation of commissions and mark-ups and mark-downs. Additionally, the Commission had indicated that if a broker-dealer charged customers different commission rates, one with advice and one without, the difference between the two rates was special compensation because it represented a clearly definable charge for investment advice.

In the late 1990s, the use of compensation to delineate brokers from advisers became problematic. During this period, several large broker-dealers initiated asset-based brokerage programs for which customers pay fees based on the amount of assets in their account. These programs were directly responsive to recommendations in a report on brokerage best practices set forth by a group of industry representatives called the Tully Committee. The report noted that because broker-dealer compensation depended on the number of transactions or the size of mark-ups or mark-downs charged, it created incentives for brokers to churn accounts, recommend unsuitable securities or engage in high pressure sales tactics. A further development at this time was the introduction by full-service broker-dealers of discount brokerage services, such as online trading services, which allowed customers who did not want investment advice to trade at a reduced commission rate.

Questions arose regarding whether broker-dealers had to treat both asset-based and discount brokerage accounts as advisory accounts, and thus lose their exception under the Advisers Act. The Commission first took action to address this situation in 1999, when it issued a rule proposal to exclude broker-dealers that offer these programs from the Advisers Act if the advice provided these accounts is 1) on a non-discretionary basis, 2) the advice is solely incidental to the brokerage services provided, and 3) the broker-dealer disclosed to its customers that their accounts were brokerage accounts. Thus in defining the boundary between advisers and brokers, the proposal used a functional approach focusing on the nature of the services provided, rather than the form of compensation, and the relationship between the investor and his or her service provider.

This proposal incited a strong reaction by many in the financial planning and investment adviser communities and the Commission received more than 1700 comment letters. While broker-dealers viewed the new programs as providing the same services that broker-dealers have traditionally provided to their customers, investment advisers and financial planners saw the switch to a fee-based compensation scheme as a transformational event – no longer were customers paying for brokerage transactions, but for a client relationship in which advisory services predominate. They argued that the rule, if adopted, would deny the account holders important protections provided by the Advisers Act.

In August this past year, the Commission reopened the comment period on the rule proposal. After analyzing the comments received, the Commission took further action in December when it modified and re-proposed the rule. To minimize disruption to the businesses of those broker-dealers currently offering fee-based brokerage and discount brokerage programs, the Commission adopted a temporary rule pending consideration of a final rule in this area, and a no-action position set forth in the original proposing release was withdrawn.

The new proposal would substantially expand the required disclosures to address any confusion that exists regarding differences between brokerage and advisory accounts. The proposal would require that all advertisements for an account excepted under the rule and all agreements, contracts, applications and other forms governing the operation of such an account contain a prominent statement that it is a brokerage account and not an advisory account, and that, as a consequence, the investor’s rights and the firms’ duties and obligations to the investor, including the scope of the firm’s fiduciary obligations, may differ and that an appropriate person at the firm be identified with whom the customer can discuss these differences. The revised proposal also requests comment on a requirement that broker-dealers treat as advisory accounts all accounts for which they provide discretionary advice, without regard to the form of compensation. This interpretation would provide a bright line test for the availability of the broker-dealer exception based on the exercise of discretion as a reliable indicator of the services the Advisers Act was intended to reach. The Commission is also giving consideration to providing more guidance on when advice is solely incidental to brokerage services and has asked for comment on whether certain common broker-dealer practices are inconsistent with advice being offered solely incidental to brokerage services. For example, the Commission requests comment on the extent to which financial planning services should not be viewed as incidental to the brokerage business.

The comment period for the re-proposal closed on February 7th, and the Commission has set forth a self-imposed April 15th deadline for consideration of the final rule adoption.

Before I move-on to the next topic, I would like to say a few words regarding the comments that we received on the original broker-dealer proposal and the re-proposal. Although we received over 1700 comments, many of these were form letters sent simply to express a view for or against the proposal. While this is not an inappropriate use of the opportunity for notice and comment, I would like to express my appreciation for commenters, such as the ICAA, who took the time to provide thoughtful and helpful analysis and suggestions on this proposal. In fact, the re-proposal reflects a number of recommendations advocated by the ICAA. For example, the ICAA requested that we modify the test for the availability of the broker-dealer exception to treat discretionary brokerage accounts that charge commissions and those that are fee-based in the same manner, that we clarify that an account receiving discretionary advisory services is not “solely incidental” to a broker-dealer’s business, and that the rule should require more meaningful disclosure in advertisements and other marketing materials and governing documents to inform consumers of the significant legal and functional differences between advisory and brokerage accounts. Each of these are addressed in the re-proposal.

As I have always said – comment letters are a vital part of the rulemaking process and we encourage and appreciate the time you spend to prepare them and educate us on issues that are important to you.

C. The Thrift Rule

The Commission has acted to address another situation in which the Advisers Act may be inappropriately applied. This situation, which involves the status of thrift institutions under the Advisers Act, arose from a legislative change that resulted in a disparity between how the advisory activities of different financial service providers are regulated.

Banks and thrifts both maintain trust powers that permit them to engage in a wide variety of advisory activities that could trigger application of the Advisers Act. In 1940, when Glass-Steagall generally restricted banks from securities activities, Congress excepted banks from the definition of “investment adviser” and thus the entire Advisers Act. At the time, thrifts did not have these trust powers -- they obtained them in 1980 -- and an exception from the Advisers Act was unnecessary. When Congress addressed thrift securities activities in 1999 with enactment of the Gramm-Leach-Bliley Act, it did not except thrifts from the Advisers Act, although it specifically did except certain thrift activities from the Advisers Act’s sister legislation, the Investment Company Act.

This has caused a series of problems. The trust activities of banks and thrifts are essentially covered by the same laws and regulations, except that thrifts are subject to additional requirements under the Advisers Act. Additionally, the Advisers Act does not lend itself well to the regulation of trust activities. As you know, the Act is primarily an anti-fraud law, focusing on managing conflicts of interest through their disclosure to advisory clients. The Act thus presumes an identifiable client who can grant or withhold consent to conflicts that arise in the course of the advisory relationship. Trust relationships, however, often involve beneficiaries who are minors or who are otherwise unable to actively participate as clients under the Advisers Act. The Act is thus a poor fit compared to thrift and trust law, which protect the trust from conflicts by other means.

To resolve this issue, last April, the Commission proposed to except thrifts from the Advisers Act when they provide investment advice in their capacity as a trustee, executor, administrator, or guardian for trusts, estates, guardianships and other fiduciary accounts. Thrifts would also be excepted when they advise collective trust funds and accounts that invest exclusively in them. However, the exception extended only to these circumstances, and thrifts that provide, for example, retail advisory services, would be required to remain registered with the Commission, and would be subject to the Advisers Act only for accounts that fall outside the proposed exceptions.

III. Enhancing Compliance and Internal Controls

As the size and complexity of the investment management industry continues to grow, competitive and market pressures may work to compromise the fiduciary and ethical principles that form the bedrock of the advisory business. We have seen this in the last few years – first with the series of egregious wrongdoings among some of America’s largest corporations and most recently in the late trading and market timing scandals of the mutual fund industry.

In response to these events, Chairman Donaldson has adopted a proactive approach, stating that

[the Commission’s] commitment to investors must extend to anticipating the wrongdoing that often accompanies the constant change in our marketplace and remaining at least one step ahead. The investing public deserves nothing less.2

With this principle in mind, the Commission adopted two important initiatives to promote ethical standards and strengthen investment adviser compliance and oversight.

A. Investment Adviser Compliance Programs

First, in late 2003, the Commission adopted new requirements to strengthen investment adviser compliance programs. The rule 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. I know that Lori Richards focused on compliance issues this morning and discussed the role of the chief compliance officer.

I want to reiterate what I know Lori emphasized this morning -- we do not view chief compliance officers as adversaries, but rather as “our partners in the protection of investors.” We are hoping to be in a position to assist CCOs as they perform their compliance oversight function. At Chairman Donaldson’s direction, we are working with our colleagues in the Office of Compliance Inspections and Examinations to establish a CCO outreach program so that we can foster communications among chief compliance officers and between them and our staff.

B. Investment Adviser Codes of Ethics

Another important rule, adopted by the Commission this past year was the requirement that investment advisers adopt codes of ethics. The compliance date for this rule was February 1st.

Investment advisers are fiduciaries and as such must place their clients' interests before their own. This bedrock principle, which historically has been a core value of the money management business, again appears to have been lost on a number of advisers and advisory personnel.

The Commission believes that prevention of unethical conduct by advisory personnel is part of the answer to the problems we have encountered recently. In this regard, the code of ethics must set forth standards of conduct for advisory personnel that reflect the adviser's fiduciary duties, as well as codify requirements that an adviser's supervised persons comply with the federal securities laws and require that supervised persons receive and acknowledge receipt of a copy of the code of ethics.

The ethics code is also designed to address conflicts that arise from the personal trading of employees of advisers. A principal feature of the code of ethics rule is a requirement that certain advisory personnel, referred to as access persons, must report their personal securities holdings and transactions, including transactions in any mutual fund managed by the adviser or an affiliate. The rule closes a loophole under which investment adviser personnel have not been required to report trading in shares of funds they manage. This loophole became apparent when, unfortunately, adviser personnel were discovered market timing funds they manage.

While the rule provides certain requirements concerning codes of ethics, I strongly encourage you to step back and review the unique kinds of conflicts your employees may face, such as entertainment and the receipt of gifts, and tailor your codes of ethics to your firms’ particular circumstances. As Chairman Donaldson stated at the open meeting adopting the rule:

‘[o]pportunity may only knock once, but temptation leans on the doorbell.’ As much as we might wish to, we will never be able to set and enforce rules that govern every situation in which an investment adviser's employees might be tempted to exploit the adviser's clients for personal profit. We have no choice but to rely on the advisory firms themselves to step into the breach — establishing a culture where the highest standards of behavior are practiced and where that doorbell is never answered.3

To assist you with your Codes of Ethics, one resource I am greatly impressed with is the ICAA’s Best Practices for Investment Adviser Codes of Ethics. By providing advisers thorough and useful guidelines in developing codes of ethics to fit their unique situations, these Best Practices work to assist firms not only in fulfilling the rule’s technical requirements, but also its spirit by encouraging advisers to think creatively to establish ethical controls that go beyond mere compliance and create a culture of integrity throughout their firms as a whole. I commend the ICAA’s efforts in this area and hope that its members will follow its lead.

C. IA Task Force

In addition to new regulatory initiatives, I would like to mention a risk management and assessment initiative set forth by Chairman Donaldson to anticipate potential problems across the investment management industry. As part of this initiative, the staff has been working to develop an enhanced risk based approach to oversight and examination of investment advisers. Chairman Donaldson has specifically directed that members of the Commission's senior staff work together to develop risk assessment protocols which could be used to identify investment advisers whose activities are raising “red flags” that suggest a more focused, cause inspection may be in order. It is anticipated that this approach will allow the Commission to increase its surveillance capacity and better target the use of examination resources to high risk advisers.

IV. Form ADV Part II

Finally, the Commission is always working to make information disclosures more accessible and user-friendly to advisory clients. In this regard, I would like to mention that we want to move forward with Part II of Form ADV. As you know, the electronic filing of Part I of Form ADV is already in place and is working well. Under the current proposal to revise Part II, the format would become a plain English, narrative document that could, if desired, be formatted with charts, graphs and other illustrations. We are also working with the NASD to amend the current electronic system so that it can accept the electronic filing of Part II. Part II would then be made available to the public through the Commission’s website. This rulemaking is a top priority for the Division and we expect to recommend that the Commission adopt Part II within the coming months.

V. Conclusion

In conclusion, I would like to underscore an important point – the importance of your role in ensuring an appropriate, balanced and effective regulatory environment. As technological, market and other developments drive fast-paced change in the investment adviser industry, we will continue to work to adapt our regulations to avoid unnecessary hindrances on advisory activities created by outdated requirements, while at the same time providing investors with the protections needed to address new risks as they emerge. With each proposed initiative, we appreciate your comments and feedback – we are attentive to all of them, and encourage their submission. We also encourage you to work with the Commission staff after new initiatives have been adopted, as a smooth and workable transition is in everyone’s interest.

Finally, as I conclude my tenure at the Commission, I would like to thank the ICAA for its responsible and thoughtful approach to issues of importance to America’s investors and the investment management industry.

I thank you for listening and hope you enjoy the rest of the conference.

1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

2 Opening Statement by Chairman William H. Donaldson at December 3, 2004, Open Meeting of the U.S. Securities and Exchange Commission.

3 Opening Statement by Chairman William H. Donaldson at May 26, 2004, Open Meeting of the U.S. Securities and Exchange Commission.



Modified: 03/01/2005