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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Compliance Priorities for Investment Advisers

Remarks by

Lori Richards

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

Investment Adviser Compliance Summit
IA Week/Investment Counsel Association of America

May 1, 2000

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 Ms. Richards and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Good Morning. I'm glad to be with you today. IA Week and the ICAA have teamed up for this conference, and I must say, it couldn't be timelier. The landscape for investment advisers is changing and changing quickly. First, the investment management industry has experienced tremendous growth in recent years. From 1988 to 1999, total assets under management by federally-registered advisers grew from 4.4 trillion to 16 trillion, an increase of 275 percent – not as rapid a growth rate as the increase in stock values of some Internet companies, but perhaps more impressive given that there are real assets behind these numbers. In just the last two years alone, assets under management increased 40 percent. The second significant change is that much of this growth in managed assets is derived from individual investors – everyone, it seems, is in the markets, either through private portfolios or through pension funds and mutual funds.

But there has been an additional change affecting our markets – there's been a real explosion of information made available to investors about stocks. It's a truism today to state that the Internet has changed the way we work, live and certainly the way many of us invest. Information is available at investors' fingertips that used to be available only to market professionals. Investors can not only obtain top-notch research reports on-line, they can also participate in chat rooms and discuss companies' earnings reports real-time! If you have the time, you could easily prospect your own portfolio, use pretty sophisticated asset allocation software to balance it out, make your own trades on-line, and factor in the tax consequences of all of your securities and other holdings. While this information is available and accessible, an average investor would have to spend an enormous amount of time sifting through it all – the volume is simply so great and the quality of information so varied.

So many investors need assistance wading through the overwhelming myriad and varied information out there to separate the wheat from the chafe – that they need investment advice from a fiduciary they can trust. While many people have predicted that the growth of the do-it-yourself investor will ebb, I think that your challenge as investment advisers is to present investors with an alternative that they can have confidence in, and can continue to have confidence in. In a very large part, I believe that investors' confidence in investment advisers is founded on good compliance. Your clients' faith in you is based on the fact that you act in their best interests, and in compliance with the law. This trust is critical, and it must be well-founded.

Let me give you an example outside of the securities industry, to illustrate this point. Recently, the press reported that the FAA was investigating the safety and maintenance record of a particular U.S. airline. This airline generally had, before this press report, an excellent reputation, and was known for its customer service. Indeed, I know some people who flew this airline for the quality of their food, which if you do any air traveling at all, you know is pretty darn unusual. All this good will and good repute was, on one day, swept aside with the announcement that there were concerns with the airline's compliance with safety rules. Suddenly, their bookings dropped. Flyers didn't wait for an explanation or a defense – they just shifted their business elsewhere. Similar examples exist in other industries - and serve the point well - your reputation for compliance is one that you should guard ferociously. It is that reputation for doing right when no one is looking, as well as when people are, that is the underpinning of your clients' trust. And that's what this whole conference is about - to give you the latest information, to keep you on top of all the changes, to help you keep your compliance programs proactive and aggressive.

And speaking of changes, the Commission announced recently that it intends to modernize and improve the regulatory scheme for advisers. The Commission has already proposed a new Form ADV and one-stop electronic filing and a fresh approach at functionally dividing advisers and broker-dealers, and is taking steps to curb pay-to-play by advisers. Other areas under consideration for change are rules relating to adviser advertising and performance claims, books and records, custody, suitability and codes of ethics. Paul Roye outlined these plans in an excellent speech to the ICAA's general membership just last month, and I understand that Bob Plaze and other Commission staff will discuss some of those plans today. Given all the change underway, now is also the time for you to ensure that you are prepared to retain clients' trust and confidence by ensuring that you have top-notch internal controls in every area of your organization.

This morning I want to help you do that. I will share with you some of my thoughts on some fundamental principles underlying a good internal control system, and outline the contents of a letter that we are releasing today to all investment advisers that describes some areas where we've seen compliance problems in our recent examinations of advisers (www.sec.gov/offices/ocie/advltr.htm). Finally, I want to talk with you about performance advertising – the most common type of serious compliance failure that we're seeing in our exams of advisers today.

I. The Need for Strong Internal Controls

I fully believe that everyone in this room is committed to ensuring compliance, or you wouldn't be here at this conference today. But for a good compliance system to work and work effectively, it's got to be part of a strong system of internal controls.

Q: What do I mean by internal controls?
A: A process designed to provide assurances that objectives are being met. This process should include the following compliance controls:

  • written procedures;

  • a clear delineation of responsibilities; and

  • independent oversight.

Before I turn to the main focus of my remarks about internal controls, I want to say something to some individuals who are not in the room this morning - your senior management, the owners of your firm, your board of directors. Any effective system of internal controls must be effected by and supported at the top of the organization. And by "support" I mean several things – first you, as compliance professionals, have got to have the tools you need to do your job, and to do it well, compliance must be well-funded. That means paying good people good money, and acquiring the technological tools that more and more are critical to a good internal controls infrastructure. While many smaller firms may be able to get by on manual-intensive review of documents, I think that for most larger advisers (that description includes all SEC-registered advisers), technology is a part of doing business today. If you're spending money marketing to new investors, you should make sure that the dollars spent on internal controls keep up with your growth. Second, "support" for internal controls is in tone and attitude. The overall culture is set at the top of the organization by senior management and is implemented by internal controls. Having good internal controls keeps you out of trouble. Are you a firm that's going to cut it right close to the line or are you a firm that's going to do the right thing – even when clients or the SEC or the press aren't looking? To make a finer point - are you going to ensure that you are detecting and resolving issues in a way that, while technically or arguably legal, may not be in the best interests of clients? Does your business model shortsightedly emphasize profits over long-term client satisfaction? These are not idle questions, we see firms of both types and they're both large and small, new and established, and invariably, the firm's commitment to compliance is revealed by senior management's support for strong internal controls. No compliance or legal staff can do a good job without management who values what they do.

If you have the unfortunate lot to work in a firm that has management that isn't as thoughtful about internal controls as they should be, educate them. Tell them about SEC enforcement cases and deficiency letters, and about the financial, reputational and personal pitfalls of violating the securities laws. Your job, and its not an easy one, is often to convince business people of the benefits to the business of good, aggressive compliance. I have often said that in this we have a common mission – we both want to ensure that investment advisers are in full compliance with the law, and even more than that, so we can sleep at night, we both want to make sure that advisers have internal control and compliance systems to ensure that they stay within the law when we're not around.

This is the precept, I suppose, of the legal duty that advisers have to supervise. Advisers have the first line duty to supervise, a duty so serious that it is enforceable in the breach. This duty to supervise requires firms to have [quoting] "established procedures, which would reasonably be expected to prevent and detect, insofar as practicable," a violation of the securities laws by an employee. Then, the duty requires that supervisors reasonably discharge their duties and obligations under the supervisory system. So you have to have good procedures, and they have to be implemented.

I regard the obligation of advisers to supervise as perhaps the most important part of the securities laws – because it underpins all others. All the protections provided to investors by the securities laws are only made real when implemented by effective internal control and compliance procedures.

That's why we spend much of our time in examinations talking to you about the systems you have set up to supervise employees and to ensure compliance. One of our goals in examinations is to review the effectiveness of your firm's overall supervisory and compliance systems.

Every good compliance procedure must be designed both to prevent and to detect violations. Preventative compliance includes personal trading pre-clearance and procedures for the allocation of hot IPOs and other compliance checks that are designed to ensure that problem trades never occur. Sometimes though, you just can't prevent violations from happening. You try your best, but sometimes problems occur anyway. That's a fact of life. That's the second part – detection – compliance procedures must be designed to detect problems when they do occur. Exception reports, internal audits and other post-transaction reports fall into this category. In evaluating the effectiveness of procedures designed to detect problems, you need to see that problems are being found. During examinations, we evaluate the effectiveness of systems based on both criteria – do the systems appear to prevent problems, and do they actually detect problems once they occur? That's why we review internal compliance checklists and reports that indicate that problems were caught. When firms tell us that they had no problems at all, we're pretty skeptical, and we wonder about their systems for detecting problems.

Finally, examiners will ask, once problems are detected, were they corrected, and corrected in a reasonable way? This is the other critical aspect of the duty to supervise – in order to discharge your supervisory duties; problems must be corrected once detected. So, during examinations, our goal is to help ensure that you have created the systems you need to deter, detect and correct problems.

How do you create the supervisory systems you need to help us both sleep at night? Well, I was asked this morning to provide you with practical tips, and as much "take home value" as possible, so, I will offer you some things to think about as minimum elements from my experience at the SEC in viewing both effective (and ineffective) compliance programs.

What makes a good compliance system?

  • First, don't skimp. Make sure that you have identified critical areas of the firm's operations and that internal controls exist for all aspects of the firms operations and for all applicable laws.

  • Make sure that every activity within the firm is supervised by someone.

  • Empower staff. Make sure that all people clearly know what their responsibilities are. Train new employees and have regular communication about how the policies work and what their role is in the overall compliance system.

  • Make sure that policies are in writing so that, if a critical person in the loop takes a long vacation, the firm's system in a given area or areas is not endangered.

  • Regularly reassess and evaluate policies and procedures in light of growth, changes in firm operations, mergers and personnel changes. Also, make sure that your system is in sync with and up-to-date with changes in the law and Commission guidance.

  • Review exceptions. Exceptions to written policies are occasionally needed to accommodate unusual circumstances. Make sure all exceptions are documented, approved and are subject to special review by compliance staff.

  • As I said earlier, use technology. It's a fact that it improves compliance, avoids human errors, and saves time. Technology, in the long run, saves expensive man-hours. Invest now, reap the benefits later.

  • Go where the money is. Pay special attention to areas of the business that generate revenue, focus on the high-flying portfolio managers. Watch for and scrutinize transactions with affiliated persons and firms. Look at valuation procedures. Be involved in the firm's marketing and advertising.

  • Make sure your policies are enforced internally. Milquetoast enforcement weakens your overall system of compliance.

  • Be creative. Think up new ways to view the firm, its operations and its compliance systems. We always notice that immediately after a high profile enforcement case, the industry's compliance procedures in that area improve, which is good. However, don't wait for the next enforcement case or deficiency letter. Think of how procedures might be circumvented, how things might go wrong before the event occurs.

  • Make sure you view incidents in the aggregate, not just individually. Reflect back over time. Do patterns exist that warrant further scrutiny? That warrant tightening procedures? Has that portfolio manager inadvertently failed to submit quarterly personal trading reports several times in the last few years? Are IPO allocations fair when viewed, not just one by one, but over time?

  • Don't be complacent. This happens over time, when you've built your firm's compliance systems, and are vested in them. Always be looking for the way to build the better mousetrap.

  • Finally, hire good, smart people to run your compliance system. They should be assertive and willing to voice their views, even when those views aren't popular.

Each of these elements is, I think, a necessary component for a really good, sustainable compliance system.

II. Common Compliance Problems

I want now to turn and outline for you some of the most common compliance problems that we're seeing in our examinations of investment advisers. These are things I think you should be mindful of in your own organizations. Also, because these are areas where we have seen problems, you can be sure that these are areas where SEC examiners are going to focus their attention in upcoming examinations. Because we are often asked about the compliance problems and issues that we see in examinations, we are today providing an open letter to all SEC registered investment advisers that outlines some of the violations of the Advisers Act that we find during examinations. It's available on the SEC's website at www.sec.gov/offices/ocie/advltr.htm. Our intent in preparing this letter is to educate investment advisers about these practices and to encourage strong internal control procedures to ensure compliance with the Advisers Act. Our goal is to point out some common pitfalls so that you can focus efforts on ensuring that your firm avoids these missteps. We also want to help improve compliance practices, not just one-on-one through examinations every five years or so, but through a broader communication that hopefully, will allow you time and notice to correct any of these compliance problems before examiners arrive on your doorstep.

Our compliance letter describes twelve areas where we see violations and compliance weaknesses during examinations - let's call them the "SEC's 12 Not Wanted Compliance Problems." They are:

1. Failures to Disclose Material Facts;
2. Unfair Trade Allocations;
3. Advertising Violations;
4. Inaccurate Performance Claims;
5. Personal Trading Violations;
6. Problems with Advisory Agreements;
7. Books and Records Deficiencies;
8. Problems with Referral Arrangements;
9. Problems in the use of Brokerage, including Soft Dollar and Best Execution Concerns;
10. Failures to Comply with Custody Rules;
11. Recidivism; and
12. Inadequate Internal Controls and Supervisory Procedures.

I'm going to refer to you our letter for a full description of all twelve, and I note that several of these topics are on the agenda for discussion at this conference. Many of the compliance problems that we see in these areas are not due to intricate, incomprehensible, or difficult to apply law. To be sure, there are laws fitting that description, even in our Advisers Act. But the most common violations we see are not due to difficult interpretation or application. The violations we most often see are caused by lapses in supervision and controls. And make no mistake, we see these types of lapses at all organizations, large, small, new and established. So read the letter, and review your own compliance in these areas.

III. Performance Claims

I do want to discuss one area noted in our letter as a common violation-performance claims. I want today to sound an alarm about performance claims - we see far too many problems in this area. In fact, the most common type of serious problem that we find in our examinations of investment advisers is fraudulent advertising. It is also the leading type of enforcement case that we bring against investment advisers. In the last three years, the Commission has brought 16 actions against advisers and individuals for fraudulent performance and other claims. Fraudulent advertising can take many forms, but in common, all fraudulent ads contain material misrepresentations, or omissions of material fact necessary to make the statements made not misleading.

In today's competitive environment, many advisers need an edge, right? "Accentuate the Positive" is their motto. They need a catchy ad and certainly, given the bull market over the last years, they need not just average performance, but stellar performance to really stand out. Beauty contests are won by the adviser with the best performance. Unfortunately, too often advisers cross over the line between simply accentuating the positive facts and making up a better story.

Some of the different types of fraudulent advertising we have seen include:

  • the use of inflated or selective performance results;

  • the use of backtested and model performance data misrepresented as real performance;

  • the use of testimonials;

  • the use of selective recommendations;

  • the use of false information about the number or type of clients, the amount of assets under management, the length of time the adviser has been operating, and the advisers' expertise; and

  • the use of false statements about compliance with AIMR's performance presentation standards.
To give you a sense of the problem, let me give you several examples:

  • one adviser distributed an advertising circular stating that the adviser managed about $280 million when it managed just $30 million; stating that it had 522 accounts when it had just 100; and not content with actual returns of 15-30%, this adviser apparently stated that his total annual returns were 54%!

  • another adviser represented that its 27% average ten-year return was its actual performance, when in fact, it was based on a hypothetical model.

  • another adviser created a marketing brochure that stressed its conservative investment philosophy. In reality, their investment strategy was to short sell high-tech stocks in a bull market!

  • another adviser who was consistently ranked in the top of Nelson's "World's Best Money Managers" allegedly reported performance returns for two years before it was even formed, and reported substantial growth in its assets under management when its assets remained flat. This adviser also exaggerated individual client account sizes by amounts larger than the advisers' total assets under management!

  • finally, in order to create a respectable track record, another adviser completely fabricated its performance returns, its assets under management and its number of clients in order to lure solicitors into referring clients to the adviser.

It's clear from these examples that these advisers were trying to appear larger, and more profitable than they really were. Now the Division of Investment Management has announced that it plans to review the rules governing advertising by advisers, and in particular, to reconsider whether testimonials and partial lists of recommendations ought to continue to be considered "per se" fraudulent. None of the examples of ads that I just provided included just testimonials or partial recommendations - all of these advisers went further and lied to their clients about their performance records. This type of ad will always be considered fraudulent.

Aside from advertising that is just out-and-out fraudulent like the examples I've just noted, we also see other problems in advertising that we are quite concerned about. Most fundamentally, we are troubled by advisers that advertise performance figures, but then can't support those performance claims with supporting documentation. We suspect a good number of advisers who advertise performance well above their peers, but can't show us support for how they reached these numbers, are just simply making it up. We remind advisers that Rule 204-2(a)(16) under the Advisers Act requires advisers to maintain all records that are necessary to demonstrate the calculation of advertised performance returns. Because of all of the problems that we have seen with made-up or gerrymandered performance advertising, examiners will ask advisers to support their performance claims with third-party records – brokerage or custodial records and statements. Because of the possibility of fraud, internal documentation prepared by the adviser may not be adequate alone to substantiate performance claims. In today's technologically sophisticated world, it's relatively easy for an adviser to artificially create internal statements supporting false performance returns. We have seen this scenario too often. In today's technologically sophisticated world, it should also be relatively easy for advisers to maintain independent records substantiating returns.

If you are today advertising performance that you cannot independently support, you should start collecting documents now from your brokerage firms or custodians, so that you can prove your performance is genuine. Consider also having your outside auditor audit your performance. Is this an extra step? Yes. Is it time consuming? Yes. Is it worth it? Well again, if you think advertising your performance is worth it, then taking extra steps to ensure that your performance is accurately calculated is surely worth it. If examiners are not comfortable that you can substantiate your performance claims, with reliable documentation, they may either note this in a deficiency letter, or where your performance claims seem to be extraordinary, they may refer the examination to our Division of Enforcement for a more complete investigation of the basis for your claims.

Another type of performance claim problem that we see is the use of composites that seem to "cherry pick" accounts in order to reach the most profitable aggregate performance number. We've seen advisers who create composites that only include accounts that achieve the best actual results, excluding accounts that performed poorly. Or composites that only include accounts for the time periods they were profitable. Or composites that purport to include only high-quality conservative portfolios, but that also include some small-cap high-tech portfolios. Because there are so many ways for an adviser to distort performance in creating composites, I could go on and on with examples, but you get the point. Composites must fairly and accurately represent what they say they represent.

Another common problem is the use of performance results that don't exclude fees – so potential customers cannot understand what the advisers' rate of return would be after paying fees. As you know, advisers can advertise gross-of-fee performance, only if the ads also contain net-of-fee results too.

Finally, we often see advisers who claim that their performance presentations comport with the standards adopted by the Association of Investment Management and Research for calculating performance. These standards apply to the creation and maintenance of composites, the calculation of returns, the presentation of results, and disclosures. As you know, so many clients ask that advisers calculate performance using AIMR standards that are fast - becoming the standard in the industry. One reason that AIMR standards have become so important is that they provide a means for clients and potential clients to evaluate and compare advisers. As you know, the Commission does not require advisers to comply with AIMR standards but if an adviser claims AIMR compliance and has in fact not complied with the standards, the adviser may have made a material misrepresentation. False claims of AIMR compliance can be particularly misleading when a client selects an adviser from among advisers, based on the incorrect belief that the advisers' performance complied with the standards.

Based on the importance of these standards to clients, when we see an adviser inaccurately claim AIMR compliance, we'll cite this in a deficiency letter and we may ask the adviser to notify all clients, consultants and others who received the materials containing the misrepresentation. If we see an adviser fraudulently claim AIMR compliance and overstate returns, we're likely to refer the adviser to our enforcement staff.

So, given the importance of performance claims, I urge you to redouble your efforts at ensuring that you are providing an accurate picture of your firm to the world. Compliance and legal staff must be involved in this effort – you should be a key part of your firms' marketing efforts. Don't let the marketing staff take over here. There is almost no risk greater than the risk of overstating profits. Your firm's integrity, reputation and client base depend on honesty and integrity in your performance claims.

There is a lot going on in your industry.

We've covered a lot of ground this morning, and yet I feel we've only scratched the surface. This conference is a great opportunity to dig deeply into the compliance issues you face every day. I applaud both the sponsors, and the participants.

But as you focus in on specific issues, I want to leave you with one final thought. Good compliance is not a recipe - it is a way of thinking. Your attitude, your approach, your sense of professionalism, will determine the quality of your work.

You can see this in all of the issues we've been talking about: inspiring a commitment to compliance in your senior management; building a good compliance system; and avoiding common errors. All of these things start with your own personal commitment to producing only top quality compliance. As long as that commitment is in place, I have no worries about the fast pace of change in your industry.

Thank you.