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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Compliance Issues for Investment Advisers Today

Remarks by:

Lori A. Richards

Director, Office of Compliance Inspections and Examinations
Securities and Exchange Commission

Remarks at Investment Counsel Association/IA Week
Investment Adviser Compliance Summit
April 28, 2003

As a matter of policy, the SEC disclaims responsibility for any private statement by an employee. The views expressed here today are my own, and do not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

Thank you and good morning.

I'm very pleased to be here today. IA Week and the ICAA have again teamed up for this conference, and I'm pleased to again address this group as you consider compliance issues of the day. Both the ICAA and IA Week actively seek to educate advisory firms about compliance issues, trends and techniques, and I think that sharing this kind of information is simply invaluable - so much can be gained by understanding the goals of any given compliance obligation, and then by getting a sense from other industry participants and practitioners about ways to implement specific techniques to achieve that compliance goal. So, forums that allow this kind of learning and interaction can be really helpful for individual compliance staff as you take stock of your firm's own compliance programs.

At the SEC, and certainly in the inspection program, our goal is to enhance compliance in the industry. That's right -- we are not simply focused on finding fraud and other violations of the securities laws, though that surely is part of our mission -- but we also want to reduce the incidence of violations and deficiencies among the firms we inspect. It's much better for investors if small problems don't become large problems, and better for investors if firms' own compliance programs stave off compliance problems altogether. That's what all of you in this room aim to do every day.

Since it is both your goal, and ours, to ensure that compliance programs are effective, I thought today I would share with you the areas where your attention may be needed the most. These are the particular areas within advisers that seem to be perennial compliance challenges -- or at least we think so, because they are the areas where we find the most deficiencies in our examinations of investment advisers. These are areas where you will want to focus your attention. My goal in sharing these compliance "problem areas" with you today is to inform you, so that you can make sure that your firm does not run afoul of compliance in these areas. And, to further our goal of enhancing compliance, I also want to share with you some examples of effective compliance controls in each area.

Before I talk about specific compliance topics, however, let me step back a bit. As you know, we have been extremely busy at the SEC in the last year. The incidents of corporate fraud, failures by market participants, and diminished investor confidence have been met by the SEC with a real focus on what we can do to restore investor faith in the markets, and what we can do to more proactively ensure that problems and failures do not occur. The SEC has proposed or adopted a number of new rules recently, including rules to implement the new Sarbanes-Oxley law, and to provide for disclosure of mutual funds' proxy voting practices. As I am sure you know, the Commission has also proposed new rules that would require advisers and funds to have written policies and procedures, and designated compliance officers, and we also issued a concept release asking for input on options for other ways to supplement government oversight, such as an SRO for advisers, fidelity bonding, and a greater role for the firm's independent accountant, or for outside compliance experts. These proposals all have at their heart the goal of enhancing compliance, taking a proactive approach to reduce the possibility of problems down the road, and restoring investor faith in our markets. I know that you will be discussing these rules and proposals in some detail during the next few days.

And, according to the program for this conference, you will hear about a "new" SEC inspection program -- a description with which I somewhat disagree! I would, instead, describe our inspection process as "evolving." While we have been performing risk-based inspections for some time, we are now refining and formalizing our approach to identify, and examine more frequently, those firms that present the potential for greater harm to the investing public. An adviser with a strong compliance program, generally, will present a lessened risk to clients; while an adviser with few or ineffective compliance controls presents a much higher risk. Hopefully, our "new" examination approach will encourage you to develop -- or refine -- your own compliance procedures and controls. Your success in doing so will not only protect your customers and your firm, but also the investing public and the health of your industry. And, it may also lead to a longer time between examinations!

Let me now turn to my topic -- the compliance problems we find most frequently in our examinations of investment advisers, and some of the sound compliance practices we have observed in these areas as well. Some of these areas may be familiar to many of you. In May of 2000, I issued an open letter to the advisory industry describing twelve areas where our examiners had found the highest number of compliance violations. That letter is on our website at http://www.sec.gov/divisions/ocie/advltr.htm. I think that many advisers took notice of that letter, took a hard look at their compliance programs and instituted better controls in many of the "problem areas" as a result. But the fact that we continue to find these same violations in our examinations today, is evidence that many advisers did not institute compliance controls in these area, or have not adopted and implemented effective compliance controls in these areas. Simply adopting policies and procedures is not enough. An adviser must put those policies and procedures into practice, clearly designate someone to be responsible for their implementation, and then test them and tweak them to ensure they are working and working effectively. During this conference, I urge you to reflect on this list of deficiencies, and think about the steps your firms can take to adopt and implement effective compliance controls in these areas.

Because I am so often asked by industry professionals to not just talk about the violations, problems and deficiencies that our examiners find, but also to describe the compliance techniques that have seemed to us to have been effective in preventing those violations, problems and deficiencies, I am going to share some of these with you today as well. One caveat -- these compliance controls are not mandated or required, and indeed, there may be others out there that are just as effective as these seem to be for the firms that have adopted them. But, these examples may get you thinking about what specific compliance controls would be most effective for your particular firm.

Let's start with, what are the most common problems that we see in our examinations of investment advisers? They are:

  1. Failure to Disclose Material Facts;

  2. Failure to Have Effective Internal Controls;

  3. Failure to Maintain Adequate Books and Records;

  4. Failure to Comply with Custody Rules;

  5. Failure to Accurately State Past Performance Results;

  6. Brokerage Problems, including with respect to Soft Dollars and Best Execution;

  7. Improper Personal Securities Transactions;

  8. Problems with Advisory Agreements;

  9. Failure to Compute Fees in Accordance with Contractual Terms; and

  10. Failure to Supervise Employees and Service Providers (Sub-Advisers too).

Let me describe each problem area, and give you some examples of pitfalls to avoid.

1. Duty to Disclose

Still heading our top ten most frequent problems are deficiencies in disclosures -- particularly in Form ADV, Parts I and II. Under the Investment Advisers Act of 1940, every investment adviser has a fiduciary duty to act in the best interests of its clients.1 A central tenet of this duty is full and fair disclosure of all material facts to clients. You've all heard this many times, yet, we find disclosure deficiencies in seventy percent of our exams!

What you tell your clients about your business -- and whether you conduct your business consistent with the disclosures you make to your clients -- goes to the heart of your fiduciary duty. We take your disclosure statements very seriously. So, at the start of every exam, examiners review materials -- in particular, an adviser's ADV -- to see how you describe your business, and especially those business practices that create potential conflicts of interest between you and your clients. Your description provides threshold insight into your business and those aspects of your business that present the highest risks to clients. As the exam progresses, examiners will continue to work to understand how you conduct your business and what advisory services you provide to your clients. Any discrepancies between the written disclosure and actual practice, or any inaccurate, incomplete, or untimely materials, indicate weak internal control processes and will heighten scrutiny by examination staff. This is fundamental stuff -- that what you tell your clients is, in fact, how you conduct your business. Let me give you some examples of disclosure problems that should never be found by examiners:

  • an adviser who does not discuss its current business practices in its brochure, such how it allocates bunched orders, or that shares of hot IPOs will be allocated only to clients with an "aggressive" investment style;

  • an adviser who fails to disclose to all potential and actual clients that it waives or negotiates fees; or

  • an adviser who fails to disclose that it places trades with an affiliated broker or places trades with a broker in exchange for client referrals.

And really, now that the IARD system is well underway, is there any excuse for an adviser who fails to file or update its ADV?

How might an adviser avoid these problems? Here's one way that some firms seem to have ensured that their disclosure is timely and accurate -- we have seen firms that require an annual in-depth review of the adviser's ADV and any other written material provided clients and the public. This review is conducted well before yearly amendments are filed with IARD, and is conducted by a group of firm employees who are familiar with all areas of the firm, with representatives from compliance, portfolio management, the trading desk, business operations, and back office operations. By including all of these business areas, the adviser not only sends a message that this review is important, but the adviser also ensures that all aspects of its business practices are accurately and fully disclosed. Then, following up on the yearly review, the adviser keeps records of the comments submitted by all reviewers, and verifies that any needed changes to its disclosure are made.

2. Internal Controls

Our examination experience shows that advisers with an effective system of compliance controls are much less likely to violate the federal securities laws. And, if violations do occur, they are found quickly and 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, with a higher risk to investors. With greater emphasis on risk-based exams, examiners' primary focus will be on an adviser's controls and procedures and, more importantly, to perform an evaluation of the effectiveness of those controls. Where those controls are found to be weak and ineffective, or non-existent, an adviser will be considered high-risk, and will have more frequent and in-depth exams. So, this is an important area for you to focus on now.

Some of the recurring deficiencies examiners see with respect to internal controls include the following:

  • an adviser has not adopted any effective or relevant compliance policies and procedures (e.g., an adviser simply adopts policies and procedures created by another firm);

  • an adviser has adopted policies, but there are no procedures to implement the policies, or the procedures are not being followed;

  • policies and procedures have been adopted, but no one tests to see if they are effective, or the results of testing are not used as a basis for strengthening any weaknesses or gaps found.

How might an adviser avoid such problems? In the best of circumstances, before drafting policies and procedures, an adviser will identify the statutory and regulatory requirements it must meet, and also identify where its business operations pose the greatest risk to clients. Only then, armed with its assessment of which areas present the greatest risk, should the adviser draft policies and procedures. But the process doesn't stop there. Once adopted, the adviser needs to monitor what's going on in its business - to test whether the procedures are working and the policies are being carried out. These tests alert the adviser whether the policies and procedures need to be tweaked or revised. We have found that the best practice among firms is to make sure that there is a clear delineation of duties and that there is independent oversight that these duties are being performed.

3. Books and Records Deficiencies

The Advisers Act and rules under the Advisers Act specify the books and records that each registered adviser must maintain. Records need to maintained not only for good management purposes, but also to allow the SEC to fully understand your business and whether you are in compliance with the Advisers Act. The obligation to maintain these books and records is one that you took on when you registered with the SEC as an adviser. The Advisers Act also requires advisers to produce those books and records for examiners "promptly." The failure to produce records promptly is a continuing complaint of examination staff! Those firms who fail to produce records, or do not produce them in a timely manner, do themselves a great disservice. In a risk-based examination environment, an adviser who reluctantly or slowly produces requested materials will likely be deemed high-risk, and face the prospect of more frequent and in-depth exams.

Other failures in the books and records category include:

  • an adviser's accounting records do not reconcile;

  • an adviser's financial statements are not current; or

  • an adviser fails to maintain certain records, such as cash receipts and disbursement journals, correspondence with clients, or backup materials for performance advertising.

These compliance problems would not occur if an adviser had given serious thought to the SEC regulations concerning maintenance of books and records. SEC rules provide a very specific list of all those records each adviser is expected to maintain. Learn it, know it! That list should form the basis for policies and procedures that govern the creation, updating, and maintenance of the documents examiners will expect an adviser to have on hand during an examination.

4. Failure to Comply with Custody Rules

The risk of an adviser misappropriating client funds and assets is highest when the adviser has custody -- that is, when the adviser can put his or her hands on those funds and assets. Accordingly, examiners are very careful in identifying whether an adviser has custody and, when an adviser is found to have custody, to review the controls and procedures the adviser has in place to minimize the risk to clients.

The Commission last year proposed amendments to the custody rules that: (1) better define custody; and (2) require advisers with custody to place client assets with a qualified custodian. Changes to the custody rule would make it easier to determine when an adviser has custody, and must thus comply with custody requirements.

Here are some examples of problems that examiners see with respect to custody:

  • An adviser that sponsors and manages a limited partnership investing in securities in which client funds are invested has custody of client funds and assets and does not have an annual surprise audit as required by the custody rule; or

  • An adviser with custody of client funds and assets that has not put in place some "third party" checks and balances to assure client funds are not misappropriated.

The best practices we have observed in this area are to have independent verification of client assets -- by the custodian of the assets or an independent auditor -- and a process to ensure that the custodian transmits statements directly to the client. We have also found that firms that avoid problems in this area document their reconciliation of custodian and advisory records, investigate all discrepancies, and make sure they supervise those activities where employees have the greatest chance to misuse or misappropriate client assets.

5. Failure to Accurately State Performance Results

Still high on the list of recurring problems are inaccurate performance claims and advertising violations. The Advisers Act prohibits advisers from making misleading statements or omitting material facts in connection with conducting an investment advisory business. Here are some examples of false advertising or other misrepresentations found during examinations:

  • Making a representation that the adviser has been endorsed, approved or passed upon in any manner by the Commission, which is prohibited by the Advisers Act. In addition, SEC staff has taken the position that the use of the initials "R.I.A." --for "registered investment adviser" -- following a person's name on printed materials is misleading because, among other things, it implies that the person has some level of expertise or special training, when in fact there are no specific qualifications for becoming a registered investment adviser;

  • Advertising only the adviser's profitable past, specific recommendations. Past specific recommendations can be disclosed only if the advertisement sets out a list of all recommendations made by the adviser within, at minimum, the immediate preceding twelve months;

  • Making inflated claims of performance;

  • Failing to disclose material information about how the adviser's performance results were calculated;

  • Comparing performance to an inappropriate index;

  • Using testimonials, that include statements of a client's experience with or endorsement of the adviser; and

  • Failing to maintain adequate supporting documentation for all performance claims.

Once again, this area requires on-going and careful review of advertising materials -- by a representative group from the adviser's business, not just by the marketing staff! At the least, compliance personnel, along with business and marketing representatives, should conduct this review. One best practice is to have procedures to ensure that all of the comments made in this process flow upward to those ultimately responsible for making necessary changes to advertising materials.

6. Brokerage Problems, including with respect to Soft Dollars and Best Execution

An adviser, as a fiduciary, must use client assets for the benefit of clients. Money spent on brokerage expenses is client money. As part of its duty to act in the best interests of clients, an adviser must seek best execution when executing client trades.

We continue to find such violative brokerage activities as:

  • An adviser who causes clients to pay excessive commission rates in exchange for client referrals from a broker-dealer, and fails to disclose this to clients;

  • An adviser who places trades with a broker in return for research, but fails to disclose this to clients; and

  • An adviser who fails to periodically and systematically review its brokerage arrangements to ensure it is obtaining best execution for its clients.

I can't emphasize this enough: advisers must review their brokerage arrangements periodically, and review the quality of execution that it is receiving against the quality likely to be received from alternative venues. Then, advisers should also compare those arrangements to its disclosure of its brokerage arrangements, and should catch any errors or discrepancies. We also expect firms to document the information reviewed during these periodic reviews and their conclusions regarding whether clients received the best executions possible during the period.

Given the importance of brokerage execution, and the conflicts of interest inherent in using client commissions to pay for soft dollar products, we expect firms to pay special attention to best execution when they are using client money to purchase research and other products along with execution. If you are also getting client referrals from the brokers who are executing your clients' trades, or the brokers executing your clients' trades also sell your funds' shares, you can expect to be asked some hard questions. We expect advisers to demonstrate to examiners why they are receiving quality trade execution, given these other products and services they are also getting. Documents that would be reflective of this may include execution quality analyses, including an analysis of competing market centers, documents evidencing the adviser's periodic review of the products and services the firm receives from brokers, including a breakdown of the costs of execution and of these other products and services in commissions and spreads. Finally, a best practice in this area is to have a committee of traders, portfolio managers and compliance staff ensure that the firm's disclosure of its brokerage practices is accurate, and in plain English.

7. Personal Securities Transactions

Another area in which we find problems is with respect to the personal securities transactions of advisers and advisory employees. Examiners will closely review compliance policies and procedures for personal trading because of the conflicts of interest and potential for abuse. Here are some examples of personal trading that violates the Advisers Act:

  • Failing to have any procedures to prevent the misuse of nonpublic information;

  • Trading in securities for personal accounts, or accounts of family members or affiliates, shortly before trading the same securities for clients (i.e., front running) and getting a better price; and

  • Placing trades for clients in securities in which the adviser has an undisclosed interest.

We expect advisers to have policies and procedures in place to monitor the personal securities trading of the adviser and its advisory representatives. These policies and procedures should provide for the timely collection of brokerage records of personal securities transactions, and for the review of those records in relation to trading in client accounts. Compliance personnel should also periodically analyze personal trading for deviations from any internal restrictions the adviser has placed on such trading, such as black-out periods around clients' trading in a security, and to search for patterns of activity that may suggest advisory personnel are gaming the restrictions -- such as by placing personal trades on the day before or the day after blackout periods begin or end. Then, once any questionable trades or patterns of trades are identified, we would expect appropriate follow-up action to investigate and sanction the employee if problems are found.

8. Problems with Advisory Agreements

The adviser's contract with its clients defines the relationship between the adviser and the clients and sets forth the parameters of the adviser's authority. The contract also serves as a critical test, really, of a firm's own compliance controls -- we look to see whether the adviser is complying with its own representations and with the expectations of its clients as set forth in the advisory contract. We will cite an adviser for, among other things, failing to fulfill contractual obligations when:

  • The adviser calculates fees differently than agreed to in the contract; or

  • The adviser fails to comply with client mandates, and causes clients to invest in securities that are inconsistent with the client's risk-level.

An adviser's approach to internal controls and record-keeping is important, here too. We would expect an adviser to keep records of conversations with and promises made to clients. And, we expect the adviser to have a means by which client mandates are communicated to portfolio managers who must comply with them, and some means to periodically test to ensure that the clients' portfolios in fact reflect the investment strategy selected by the client.

9. Client Fees

Closely aligned with disclosure and advisory contract problems, client fees also draw scrutiny of examiners, in large part because we continue to find situations where the adviser is charging client fees that do not correspond to the contract or disclosures made by the adviser. As evidence of weak controls, we continue to see instances where:

  • An adviser does not calculate the fee in accordance with the advisory contract - either because of errors or using a percentage basis not consistent with the contract; or

  • An adviser does not return to clients a pro-rata refund of the fees the client paid when the client terminates the contract.

How much confidence will you inspire in your clients if you overcharge them for you advice? When billing a client, advisers must ensure that the charges are consistent with the contract. One control that may be useful is to have an employee periodically verify billings for accuracy -- whether bills are calculated manually or by a computer program.

10. Supervision, Including of Sub-Advisers

Every adviser should do its utmost to ensure that its advisory representatives are conducting themselves in a manner that fulfills the adviser's statutory, regulatory, and fiduciary duties to its clients. Exemplary conduct consistent with high ethical principles reflects well on the firm, and conversely, well, you know. And, advisers have an affirmative duty to supervise under the Adviser's Act. Unfortunately, we continue to find circumstances in which an adviser has failed to adequately supervise its employees, to the detriment of clients. In egregious cases, the Commission will take enforcement action against an adviser for failure to supervise.

I also wanted to mention one area where I believe some less-than-meticulous care has been given: the supervision of service providers and, in particular, sub-advisers. I doubt anyone questions the need for an adviser, before contracting with a sub-adviser, to conduct an initial due diligence review into the qualifications and suitability of the sub-adviser. What is important in reviewing a potential sub-adviser though, is not just its performance "track record," but also the compliance controls that the sub-adviser has in place in all areas of its business that will affect clients of the primary adviser. And, after the contract is signed, the adviser needs to perform due diligence on a continuing basis. On a continuing basis, the adviser must concern itself with whether the sub-adviser is, in fact, providing the level of fiduciary care that the adviser itself provides to its clients. One practice that may be effective is for the adviser to conduct compliance audits of the sub-adviser, or for the sub-adviser to provide the adviser with copies of its internal or external compliance audit reports.

* * * * * * * * *

I want to end today where I began this morning, and reiterate that I strongly believe that talking about compliance issues and ways that compliance can be enhanced is tremendously valuable, because it will help you, when you return to the office, to implement compliance controls that work effectively. Industry and regulator alike, we must do all we can to proactively prevent compliance stumbles and failures and improve controls that result in better long-term compliance. I hope I have added value this morning to your thinking about compliance, particularly in these ten areas of most frequent compliance problems.

Thank you.

1 See S.E.C. v. Capital Gains Research Bureau, 375 U.S. 180, 191-192.


Modified: 05/29/2003