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U.S. Securities and Exchange Commission

"Current Examination and Enforcement Issues"
15th Annual Conference on the Securities Industry
AICPA and the Financial Management Division of the Securities Industry Association


Lori A. Richards

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

New York City
October 29, 2003

Thank you. I'm glad to be here. The views I'm about to express are my own and not necessarily those of the Commission or my colleagues on the Commission's staff.

This is an exciting time to regulate securities firms. I imagine it is also an exciting time to audit them. New issues and concerns arise continuously, demanding our attention. At the same time, of course, the old issues do not go away. Every time we walk into a firm, to conduct an examination, and you walk into a firm, to conduct an audit, we both confront the risk that we are about to encounter a new compliance issue.

In the examination program, we pride ourselves on our ability to respond quickly when new and significant compliance issues suddenly appear. We have worked to reduce the turn-around time between first warning, and full regulatory response. Our goals are to move quickly to determine the scope of a problem, identify participants, make recommendations to the Division of Enforcement for possible follow-up action, and work with the Commission and the rule-writing Divisions on possible regulatory enhancements. We also have, as a broader part of our mission, an obligation to try to identify possible compliance issues before they blossom into full-blown problems, crises, and frauds. Thus, a very significant part of our program is to identify weaknesses, or "deficiencies" in examination parlance, and to ensure that firms correct them and implement sound internal controls to ensure that they do not reoccur or become larger violations or failures. In this way, we hope that we help ensure that violations are prevented.

The audit community faces similar challenges. You must quickly devise effective audit strategies to address new compliance issues, as they become known, and also help ensure that firms have implemented effective internal controls to ensure against compliance and other failures. My goal here today is to identify some issues that should be on your list of potential risk areas. These issues have our attention in the examination program. Some have also generated enforcement actions. I raise them with you today not just because we're interested, but because I think you should be interested as well.

You should note that any list, any effort to pick out a few key issues, necessarily involves a lot of selection. We're looking at a lot of other issues. I'm sure you are too. I've selected these topics because they cut across the securities industry, raise significant compliance and regulatory concerns, and are matters that auditors should think about as they prepare their own risk assessments. They are: late trading and timing in mutual fund shares; creation and marketing of structured finance products; risk management and internal controls; and the accuracy and reliability of books and records and computations.

1. Late Trading and Timing in Mutual Fund Shares

The first issue is late trading and market timing in mutual fund shares. This should have your attention whether your clients are mutual funds, broker-dealers, advisers, transfer agents or any other entity that processes mutual fund share transactions. These issues have received a lot of attention recently, and that attention is well deserved. Along with our colleagues in the Division of Enforcement and throughout the country, as well as in coordination with the New York Attorney General's Office, we are actively examining and investigating firms industry-wide to determine the extent of this conduct. Let me begin with late trading.

Late trading takes place when an investor is allowed to place orders in mutual fund shares after the fund calculates its net asset value, usually 4 pm ET. If investors are allowed to place orders after the close, they can take advantage of information that was not known at the time of the close. Late breaking news about portfolio securities, about the U.S or foreign markets, even natural disasters, can have an impact on share prices, and can tip off the late trader that the information used to calculate a fund's NAV is stale. If the trader has to wait until the next calculated NAV, as the law requires, the new NAV can be expected to take account of these developments. But, by trading late, and obtaining the obsolete NAV, the late trader can lock in quick and easy profits. Of course, those profits come out of the other shareholders in the fund.

We are actively reviewing funds, broker-dealers, advisers and transfer agents' policies, procedures and controls for preventing late trading, including time stamping of orders and supervisory controls. Late trading has also generated enforcement actions.

Earlier this month, the Commission, along with the New York Attorney General's Office, brought an action against Steven B. Markovitz, a hedge fund trader at Millennium Partners, L.P. In its order, the Commission stated that Markovitz engaged in late trading on behalf of Millennium on a regular basis. Certain broker-dealers permitted Markovitz to buy and sell fund shares after the markets had closed, and to obtain that day's NAV. In some cases, Markovitz would send the order after the close, on other occasions he would send the order before the close, and then confirm, alter, or cancel it after the close. He understood that he was obtaining an advantage not available to other investors.

The Commission found that this violated the antifraud provisions of the Securities Act and the Exchange Act. It also found that Markovitz's conduct aided and abetted violations of Rule 22c-1(a) -- the rule requiring redemption of fund shares at the NAV next computed after receipt of an order to buy or redeem. Markovitz was barred from the adviser and the fund industry.

In addition to late trading, we are investigating mutual fund "market timing." Timing takes place when an investor engages in the short term trading of mutual fund shares to take advantage of inefficiencies in the fund's pricing. We are also looking at the related issue of funds' policies, procedures and practices for fair valuing their securities -- that is, for taking account of significant developments after the markets close. Since timing can dilute the value of fund shares and increase fund expenses, most funds discourage timing. The compliance risks in this area were demonstrated loud and clear by the SEC in two enforcement cases we brought recently. Just yesterday, the Commission brought an enforcement action against Putnam Investment Management, and two of its portfolio managers, Justin Scott and Omid Kamshad, in connection with the personal excessive short term trading in their own funds. The portfolio managers had access, of course, to the holdings, valuations and transactions in the funds they managed and used this information, it is alleged, to trade in their own fund shares. The SEC charged the two portfolio managers with fraud, and charged Putnam with fraud, failing to supervise, failing to have policies and procedures in place reasonably designed to prevent the misuse of non-public information, and failing to enforce its codes of ethics.

The Commission brought another case two weeks ago against James Connelly, a former Vice Chairman of Fred Alger Management, Inc. As Vice Chairman, Connelly was responsible for overseeing business strategy at Alger Management. As set forth in the Commission's order, he also authorized a complex timing scheme. Connelly regularly authorized select investors to time the Alger Fund. Specifically, the timers made substantially more exchanges than the six per year they were supposedly permitted. In return, these investors offered to commit additional assets to buy other funds in the Alger complex. These other investments were known as "buy and hold" assets, or "sticky" assets.

This was not a casual or spontaneous arrangement. As the Commission's order describes, this program was well organized --

  • Timing investors were generally expected to commit at least 20% of their investment in buy and hold positions.
  • Buy and hold assets were invested in funds that Connelly was seeking to grow, such as a small cap fund.
  • Connelly appointed a "timing police" who sought to identify investors who were timing without approval. Those who were timing without Connelly's approval were asked to redeem their shares.
  • At the program's peak, there were more than a dozen authorized timers with approximately $200 million in timing assets in Alger funds.

Importantly, all of this was done despite the fact that the Alger Fund's Prospectus and Statement of Additional Information --

  • Did not disclose that select investors were allowed to time the funds;
  • Did not disclose that they were allowed more than six exchanges a year;
  • Did not disclose that they were required to place certain assets in buy and hold positions to pay for their timing;
  • Did not disclose that investors would be treated differently depending on whether or not they had entered into timing arrangements; and finally,
  • Did not disclose that these timing arrangements would harm the other investors in the timed funds.

The Commission found that this conduct violated the antifraud provisions of the Securities Act, the Exchange Act, and the Investment Advisers Act. The Commission also found that Connelly violated the Investment Company Act by making untrue statements or material omissions in filings with the Commission. He settled the action, and was barred from the securities industry.

A clear message is to be had by these enforcement actions -- the Commission will not tolerate abusive activity with respect to mutual funds. We are concerned to see that this conduct appears to exist at other firms, and while our examinations and investigations continue, certainly this is an area of risk that should be on the auditor's priority list.

There is one other aspect of the Connelly case that deserves mention. At the same time that the Commission brought its settled administrative proceeding against Connelly, the New York Attorney General brought a criminal action charging him with the felony of tampering with physical evidence. According to the felony complaint, starting in early September 2003, less than two months ago, Connelly took a series of steps to thwart the investigation. He deceived his own lawyers to prevent them from producing documents in response to a subpoena. He tried to conceal some of the trading arrangements. He directed subordinates to delete e-mails and to falsely report facts. Connelly has admitted his conduct before a New York State judge.

Firms and individuals that attempt to thwart regulatory action through illegal conduct, such as tampering with evidence or obstruction, should expect a swift and effective response. In the examination program we expect registrants to be forthcoming and honest. We expect them to produce all of the records that are responsive to our requests. When they make representations to us, orally or in writing, we expect that they have looked into the matter and are speaking on the basis of established fact. In sum, we rely on their professionalism and integrity. I hope that instances to the contrary remain unusual and rare.

2. Creating and Marketing of Structured Finance Products

A second issue that has our attention, and should have yours, is the role of financial institutions in creating and marketing complex structured finance products. As you know, broker-dealers often play an important role in structured finance transactions. They develop them, market them, implement them, and often participate in them -- both for their own use and to address the needs of their customers. This can expose broker-dealers to significant credit, market, operational, legal, and reputational risk. Several members of Congress asked us to look into this area following hearings on the Enron disaster. We have worked closely with the bank regulators in these reviews.

Specifically, we examined eleven financial organizations that are major players in the structured finance market. We focused on products where the counter-party or client was a public company. We reviewed how the firms determined their business, accounting and tax strategies. We also looked at their assessment of credit, market, legal and reputational risks. The examinations have generally concluded and we are working with the banking agencies to analyze our findings.

Hopefully, after the Enron disaster, and the Commission's enforcement cases against broker-dealers for aiding and abetting Enron's securities fraud through the use of structured transactions, all of you understand why structured transactions must be fully incorporated into the firm's risk management structure. Based on our reviews, one control area that I would like to highlight is whether these transactions are reviewed and approved by someone independent of the sales and trading areas. These internal reviews can be conducted by independent control groups from: accounting, tax, legal, compliance, senior management, or committees combining some or all of these functions. Of course, these reviews must also be supported by appropriate policies and procedures.

3. Risk Management and Internal Controls

A third issue that has our attention is risk management and internal controls. They are playing an increasingly important role in our examinations. This development is having an impact on every part of our program.

We have placed the largest broker-dealers on a regular cycle of internal control reviews. For the largest firms, we will examine their internal control systems every other year. We are reviewing their risk management systems, their controls over trading risk, their process for granting or denying counter-party credit, operational risk, and a host of related topics. We are also working closely with the Federal Reserve staff to ensure that the largest firms in our functional jurisdiction have appropriate risk management systems in place.

We have also begun to conduct risk management-internal control type reviews of investment company complexes and advisers. In the fund and adviser community every examination is now risk-based. We have developed a protocol for examining the risks these organizations usually face. The protocol includes: consistency of portfolio decisions with client goals, valuation of portfolio securities, accuracy of performance claims, reconciliation procedures, both internally and between the firm and external service providers, and more. As with broker-dealers, our goal is to ensure that funds and advisers have appropriate controls in place. If we have concerns about a firm's controls, or we determine that the controls in place are ineffective, we will schedule the firm for frequent repeat control reviews. These reviews could be as frequent as every other year. Firms with better control environments may be examined once every four years.

Our internal control examinations during the last year revealed some troubling issues. Examples of weaknesses include:

  • We found firms that exceeded their product trading limits for extended periods of time, with no evidence of corrective action, such as temporary limit increases or unwinding.
  • We found problems with the extension of counter-party credit, including the failure to perform timely credit assessments, and at least one firm that had no written policies and procedures governing the minimum due diligence and documentation required for counter-party credit reviews.
  • We found problems with firms failing to follow their own internal controls, such as by failing to have pricing models reviewed by an independent control area.
  • We found weaknesses in internal audits, including the cancellation or indefinite deferral of audits that were scheduled on the audit plan, for no apparent reason.
  • Finally, we found some weaknesses in compliance oversight, including a firm that performed no surveillance of the fixed income sales and trading desks.

I don't mean to suggest that every firm suffers from these control weaknesses. Many firms had impressive systems in place, staffed by dedicated and highly motivated employees. However, our mission, and your mission, is to identify the firms that are not living up to that standard.

4. The Accuracy and Reliability of Books and Records and Computations

The final topic I would like to raise with you today is an old favorite. It should be on every auditor's list: the accuracy and reliability of the firm's books and records, including the accuracy of its accounting computations. This is not a new issue. It will not draw a lot of headlines. But it continues to be a matter for serious concern.

For example, last year, we discovered computational errors of one sort or another in fully a quarter of our broker-dealer examinations. In 26% of our broker-dealer examinations, we discovered that the firm's required books and records were inaccurate because of computational errors. In 16% of our examinations, we discovered that computational errors had an impact on the net capital calculation. Whether we focus exclusively on net capital, or on the larger issue of the overall accuracy of the firm's books and records, these percentages are far too high.

Problems with net capital computations, in particular, warrant careful attention. Recent examinations have revealed some significant weaknesses. We found firms that failed to accrue tax liabilities and arbitration settlements, to record unsecured debits of sizeable amounts, and to properly compute haircuts on open contractual commitments in firm commitment underwritings. We found other firms that erroneously included assets of affiliated companies or recorded cash deposits before the funds were received. These problems are very serious. Our Division of Enforcement is generally very interested in net capital problems. In fact, in the last year, the Commission has brought several enforcement actions alleging net capital violations, including one just two weeks ago.

On October 15, 2003, the Commission brought a settled administrative proceeding against Mid-Ohio Securities Corporation. Mid-Ohio's business primarily consists of maintaining IRA accounts for its customers. It failed to include and classify customer IRA funds held in bank escrow accounts as liabilities in its aggregate indebtedness computation, which resulted in a net capital deficiency of approximately $4 million. The firm was censured, ordered to cease and desist from its violations, and required to pay a penalty of $25,000.

As auditors, you understand the importance of accurate books and records, computations, and net capital. Moreover, as auditors, you understand that procedures exist to test and verify computations. Not surprisingly, in light of the availability of effective controls, when we find such errors, we also find weak controls or weak management.

For example, we are carefully reviewing the work of part-time financial officers, sometimes called "Rent-A-FinOps." These FinOps often devote less than their full attention to the condition of a particular broker-dealer. In fact, they sometimes try and exercise their responsibilities from locations several time zones away! In April of this year, the Commission brought a settled administrative proceeding against Daniel L. Springate. In its order, the Commission noted that if Springate had adequately reviewed the documentation supporting his broker-dealer's assets, he would have known that the net capital computation was inaccurate. I worry about the effectiveness of these part-timers, and urge you to review their work carefully.


In conclusion, all of us need to give our full attention to these issues: illicit trading and timing in mutual fund shares, controls over structured finance transactions, weaknesses in risk management and internal controls, and good-old-fashioned errors in the books and records and computations. An effective solution will require help from all of us, both public sector examiners and private sector auditors. I hope that in the coming months you will give these concerns your full attention. I appreciate your support.

Thank you.


Modified: 10/31/2003