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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Investment Management Enforcement in the 21st Century

by Richard H. Walker

Director, Division of Enforcement,
U.S. Securities & Exchange Commission

D.C. Bar Association
Washington, D.C.

October 18, 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 Mr. Walker and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Good afternoon. I am very pleased to join you here today and talk, from an enforcement perspective, about some of the current issues facing the investment management industry. This is an industry that we can all be proud of. It has avoided many of the large scandals that have surfaced over the years in other areas of the financial services industry. The participants in this segment of the industry deserve credit for their responsible efforts to promote fairness and a culture of compliance.

Two weeks ago, the Commission celebrated the 60th anniversary of the two 1940 Acts. Those who attended received a copy of an August 24, 1940 New York Times article announcing President Roosevelt's signing of the two Acts into law. As I read the article, I was struck by the following statement: the President "commended private business for a new attitude that he said was manifested in this new legislation by the fact that the investment industry asked for, and received, a grant of wider discretion to the SEC than was contemplated when the legislation was originated."

Of course, you all didn't pay to attend this lunch just to hear me say nice things about the investment management industry. It would be out of character for an Enforcement Director not to identify some of the areas where we have seen problems, while at the same time commending the industry overall for its responsible conduct. So what I plan to do today is stick to what I know best and give some perspectives based on recent enforcement actions we've brought in the investment management area. Ten months into the 21st century, we have seen cases that mix the traditional with the uniquely post-modern - namely those involving hot IPOs and the Internet. A discussion of these cases should give some insights into my enforcement philosophy in the `40 Act area and serve as notice of the types of cases we will continue to bring. Of course the comments that I make today represent my own views and are not necessarily shared by the Commission or my colleagues on the staff.

Every year roughly 10% of our cases focus on investment advisers and investment companies. This percentage has been steady for a number of years. Fifty of the 525 cases we brought in 1999 fall into this category, the vast majority of which involve advisors that are not affiliated with funds. While 50 cases may not sound like a lot, there are several reasons why we must continue to be very watchful of activities in the investment management area.

First, cases that we bring in this area tend to be "big ticket" cases. They often involve numerous harmed investors, be they clients of the same adviser or investors in the same fund charged with wrongdoing.

Second, each of these cases tends to get its fair share of publicity - publicity that does the industry as a whole no good and may cause investor confidence to one day wane.

And, finally, I was alarmed to learn that of the 1,400 advisory firms we examined in 1999, fully 90% received a deficiency letter from our examination staff. This compares unfavorably to 50% for the broker-dealers we examined. Although the rate of enforcement referrals from broker-dealer examinations is considerably higher than those from advisor exams, 19% as compared to 4% in 1999, we cannot let our guard down simply because the fund and adviser communities have avoided any major debacles.

We just ended our fiscal year 2000 on September 30 so the final tallies of the cases we brought aren't in yet. But quantity aside, in terms of quality, we brought some very important cases. The themes were several:

  • First, we continued our strong focus on performance advertising by both investment advisers and mutual funds, with a spotlight remaining on advertising by so-called incubator funds. In today's highly competitive market, it is not surprising that fraudulent advertising is the most frequent serious problem OCIE detects during its investment adviser examinations, and the most frequent type of enforcement case the Commission brings against investment advisers. I know that some industry commentators have been particularly concerned about certain problematic practices here - in particular, portfolio pumping and window dressing. I'll comment on these practices in a few moments.

  • A second theme of our cases is that we continue to make the prosecution of sales practice violations a top priority, especially in the area of mutual fund and variable annuity "switching."

  • Third, we are concerned with investment advisers who enter into undisclosed soft dollar arrangements with broker-dealers, involving the broker-dealers' referral of customers to the adviser and execution of transactions at inflated commission rates. Broker-dealers will sometimes provide advisers, who direct client brokerage to them, with "services" that benefit the adviser, rather than the adviser's clients accounts. We also remain on the lookout for fund directors who put their interests above those of fund investors.

  • The fourth theme addresses conduct by hedge funds. While many have mistakenly concluded that hedge funds are beyond our reach because they are not subject to registration or reporting requirements, they are subject to antifraud provisions, and we have brought several cases involving fraudulent practices by hedge funds and their advisers this past year to drive this point home.

  • And finally, we will have zero tolerance for fraud by those entrusted to invest retirement dollars in pension funds. Cases involving pension funds tend to center on frauds arising in connection with the selection of investments.

I'll begin by discussing this last point because it highlights an important case we brought just last Tuesday. We sued Paul Silvester, the former Treasurer of Connecticut, and others, for their role in a fraudulent kickback scheme in connection with the investment of state pension fund money. We allege that the scheme worked as follows: Silvester solicited two private equity firms to pay substantial fees to Silvester's close friends and political associates in return for investing hundreds of millions of dollars from the state pension fund with those private equity firms. The firms agreed to pay the fees in order to secure the investments. Our complaint alleges that Silvester then demanded and received kickbacks of a portion of these fees from his friends. A criminal action was also filed in this matter.

The harm to investors in this case is not unlike the harm suffered in municipal finance "pay-to-play" cases. While we did not allege that the pension fund lost money, the process of selecting investments for the fund was corrupted.

Similarly, this past year, we made clear that investment adviser pay-to-play will not be tolerated. In June, we charged William Stephens, the Chief Investment Strategist of a large San Francisco-based investment adviser with participating in a kickback and bribery scheme concerning the investment assets of certain labor union pension funds. We alleged that in order to land the pension funds as advisory clients, Stephens agreed in advance to channel a portion of the funds' assets into rigged investment vehicles from which a portion of the funds' assets would then be siphoned off to trustees of the funds as kickbacks.

Turning to the lessons of some of the other cases, we see a continued focus on sales practice violations. Sales practice abuses occur at an investor's point of entry to the market. If investors are defrauded at the door, aside from suffering losses, they are likely to leave and not return. As a result, the Commission has long regarded such abuses -- in all areas of the securities industry -- as among the most serious violations that we deal with.

In recent years, the Commission has meted out tough sanctions in the sales practice area. These include stiff monetary penalties and industry bars for securities professionals. The kinds of cases we will continue to be on the lookout for include those involving misrepresentations about the risks of investing in, or the characteristics of, a particular fund. In addition to traditional sales practice abuses involving misrepresentations of risk and rewards or the characteristics of particular investment vehicles, we will be focusing increasingly on situations involving conflicts of interest. This is an area of increasing concern now that funds are offering multiple classes of shares with different fees, and sales charge structures. A fraud can occur when a salesperson puts a customer into a B share, for example, that may pay a higher commission, when an A share would be more suited to the investor's needs. Fraud can also occur when a salesperson switches a customer from one fund to another fund, or from one variable annuity into another, in order to generate commissions.

Just last month, we brought our first action against a financial adviser for "switching" variable annuities. We charged Raymond A. Parkins, Jr., in Orlando, Florida, with inducing his investment advisory clients to switch their variable annuity investments by providing them with unfounded, false and misleading justifications for the switches. We alleged that he drew false and misleading comparisons of the performance of certain variable annuities and made false assurances that the switches would increase the diversification of his clients' portfolios. We also allege that he misled clients as to the sales charges associated with the switches.

As we've learned, switching cases can be very difficult because customers sometimes have a hard time understanding that they have been defrauded if they are not losing money in their underlying investment. We lost one switching case before an ALJ, FSC, in part because the victims of the switching did not understand that they had paid excessive fees and therefore stood by their broker. This will not, however, deter us from bringing these kinds of cases in the future. In fact, on August 28, we brought a settled administrative proceeding charging that Dean Witter had failed reasonably to supervise a broker who engaged in at least 48 violative mutual fund switches, including circular switches, in seven different accounts.

The cases that garnered the most attention over the past year came in the area of advertising. The phenomenon of "hot IPOs" has not been lost on mutual funds. Many have enjoyed highly profitable runs due to IPO investments. In boasting of their returns, some of these mutual funds have neglected to disclose that their eye-catching performance was, in fact, highly dependent on IPOs and, more importantly, that as the fund grew, the impact of such hot IPOs on the fund's overall performance would diminish. The Commission has brought two cases in this area within the past year.1Last fall, the Commission instituted proceedings against Van Kampen Investment Advisory Corp. in connection with its failure to disclose, both in Commission filings and in advertisements, that more than one-half of the Van Kampen Growth Fund's record 61.9% return was attributable to the impact of hot IPOs. The Growth Fund operated as an incubator fund for the first 13 months of its existence, during which it invested in 31 hot IPOs. Because the fund was so small in its early stages, even a handful of shares from each IPO had a dramatic effect on the growth of the fund's assets.

When the Growth Fund opened to the public in its second year of operation, Van Kampen promoted the fund by reference to its first-year performance, and the fund's net assets quickly increased from $1.1 million to $110.1 million. It was questionable, to say the least, that the fund

could continue to generate such returns through investing in IPOs, given the increase in the fund's assets. Under these circumstances, the failure to inform potential investors of the substantial impact of IPO shares on the Growth Fund's first year performance made Van Kampen's touting of the Fund's first year performance materially misleading.

In a case filed in May of this year against Dreyfus Corporation and one of its portfolio managers, the Commission came to virtually the same conclusion as in Van Kampen. Dreyfus involved a portfolio manager to several funds who preferentially allocated investments in hot IPOs to one of the funds he managed -- the Dreyfus Aggressive Growth Fund. During the fund's first fiscal year, these IPO investments accounted for a whopping 86 percent of the fund's 82 percent total return. Dreyfus touted these returns, and the fund's resulting number one ranking by Lipper in advertisements, without reference to the fund's reliance on hot IPOs to generate its return. In its semi-annual report, Dreyfus stated only that the fund had invested "in a number of initial public offerings," and that its return since inception "should not be regarded as routine." It did not, however, explain that the fund's results as of the date of the report were almost entirely due to its IPO investments - investments that could not reasonably be expected to grow at the same pace as the growth of the fund. The failure to disclose that the fund's total return during its first fiscal year was overwhelmingly attributable to investments in IPOs was material because it was doubtful, in light of the growth in the fund's assets, that the fund could expect to enjoy similar performance, even if it continued to invest in IPOs.2

Van Kampen and Dreyfus make clear that funds, and brokers discussing fund performance with their customers should bear in mind that disclosures regarding IPO investments, or other material events that may not repeat themselves, may be necessary to make performance results not misleading.

Van Kampen leads me to the topic of "portfolio pumping." This practice takes place when a fund increases its stake in portfolio securities at the end of the financial period for the purpose of fraudulently driving up the price of the fund. We have not yet brought a case in this area, but it is something we are paying close attention to. Earlier this year, our formed a task force to look into the practice. The task force is carefully evaluating trading data of fund securities that would indicate manipulation. And this concern extends beyond our borders - our colleagues in Canada, the Ontario Securities Commission, recently brought a case of this sort against Royal Bank of Canada's investment management arm.

I am also concerned about the misleading practice known as "window dressing." Here, advisers buy or sell portfolio securities at the end of a reporting period for the purpose of misleading investors as to the securities held by the fund, the strategies engaged in by the advisers or the source of the fund's performance. For example, an adviser may cause the fund to hold significant positions in securities that are not permitted under the fund's disclosed investment objectives. As the reporting period draws near, the adviser liquidates these positions to come into compliance with its stated objectives. OCIE is examining trading patterns to detect violations in this area. Let me be clear today - I view this as an antifraud violation. Investors are misled if they are told that the fund is investing consistent with prospectus disclosure when it is not.

Window dressing may also occur when an adviser replaces investments in otherwise permissible securities with investments in high performers just before the end of the reporting period to make it appear as though the adviser has a winning hand.

Another pitfall for those making representations concerning mutual fund performance has arisen as extreme volatility has replaced the parade of IPOs. As described in a Wall Street Journal article earlier this year, because of the drop in the market since March, performance results from

the first quarter of 2000 may be substantially better than performance since that time.3 The NASD, in particular, has focused on this issue, issuing a Notice to Members in April that reminds members "that if they choose to present extraordinary recent fund performance information, they should do so in a manner designed to lessen the possibility that investors will have unreasonable expectations concerning future performance.4A final word on advertising. The explosive growth of the Internet and the movement of investors and advisers online does not mean that our statutes don't apply in an online environment. The same rules apply to advertisements whether they are in print or on the web -- a lie about performance is a lie regardless of the medium in which it is transmitted.

On this point, in January of this year, we filed a case against Yun Soo Oh Park, better known as "Tokyo Joe." Mr. Park, formerly the manager of a burrito restaurant, had become an online celebrity first giving stock picks away for free in chat rooms and then selling them to subscribers to a web site he created. Among other violations, we alleged that Tokyo Joe posted false effusive testimonials on his web site and also computed his advertised returns using winning trades he did not actually make.

Another area in which you can expect continued scrutiny is fraudulent conduct involving hedge funds. While cases in this area are more difficult to detect, given the absence of registration and reporting requirements, it is significant that we brought four cases against hedge fund managers this past year.

The cases are all similar. They involve managers who lost or stole investor funds. Investors were kept in the dark about their losses through doctored performance reports. We brought a case of this nature just yesterday. We filed an emergency action against a hedge fund, Ashbury Capital Partners, and its manager, Mark Yagalla. We allege that Yagalla misappropriated for his own use a substantial portion of the several million dollars raised. We also allege that Yagalla provided investors falsified monthly statements significantly overstating the fund's holdings and returns.

Another area of enforcement priority is ensuring that fund directors properly fulfill their fiduciary duties. Like any corporation, the board of a mutual fund is generally responsible for overseeing the management of the company. But the board is responsible for much more. As the Supreme Court has stated, "directors serve primarily as `watchdogs' over an investment company to protect the interests of shareholders against abuses by investment advisers and others in a position to profit illegally from the company." They are effectively the shareholders representatives, who by virtue of their statutory role must approve fund management contracts, other service arrangements, monitor brokerage allocations, approve 12b-1 plans and generally safeguard shareholder interests.

Well-trained watchdogs can help to keep "attack dogs" -- as I've unfairly heard my staff referred to on occasion -- at bay. Investors must be able to depend on vigilant and well-informed directors to "keep their fund's house in order." Recent cases make plain that we will hold directors responsible when they breach their fiduciary duties.

One case confirming this point is our action against Monetta Financial Services. We allege that Monetta received profitable short term trading opportunities in hot IPOs from certain broker-dealers. The allocations were made based on business Monetta had directed to the broker-dealers, principally on behalf of the funds. We alleged that Monetta allocated portions of the IPOs to certain fund directors even though the funds were legally and financially able to invest in the IPOs. We also alleged that the Monetta directors who received preferential IPO allocations without making disclosure and obtaining the consent of disinterested representatives of the funds breached their fiduciary duty of loyalty.

In March of this year, the Administrative Law Judge issued an initial decision. We won. The ALJ found that that the undisclosed allocations of IPOs constituted antifraud violations. The sanctions were stiff, including disgorgement, and civil penalties ranging from $10,000 to $100,000 for the directors and $200,000 for Monetta.

No discussion of enforcement priorities would be complete without brief mention of our soft dollars cases. This continues to be an area of concern. In the Dawson-Samberg case we found that a registered adviser improperly used soft dollar credits to pay for certain undisclosed expenses, including its employees personal travel expenses, other travel expenses not related to research, and administrative and marketing expenses. And in Founders Asset Management, we charged the firm and its president with failing to disclose to their advisory clients a directed brokerage arrangement, pursuant to which the firm agreed to route client trade orders to a registered rep in order to compensate him for referring clients to Founders. We also charged Founders with failing to obtain best execution for its customers.

And, finally, it goes without saying that we will always prosecute fraud in its most primitive form - stealing, in particular, stealing by money managers. You are all no doubt familiar with our recent case against Dana Giacchetto, otherwise known as the "adviser to the stars." In April of this year, we filed a case alleging that Giacchetto was engaged in a scheme to divert at least $20 million in client funds to, among other things, support his lavish lifestyle. Giacchetto targeted prospective clients from the arts and entertainment industries, and his clients included Matt Damon, Leonardo DiCaprio, and Cameron Diaz. Then to conceal his diversion of funds, he had to make a variety of misrepresentations to his clients. Just last month, United States District Judge Lawrence McKenna entered a partial judgment of permanent injunction by consent against Giacchetto. He is also facing possible jail time in a related criminal prosecution; sentencing is set for December 6.

I've covered a lot of ground this afternoon about a variety of investment management enforcement issues. In closing, let me repeat what I said earlier - my hope going forward is to bring fewer - not more - investment management cases. The reputation of the industry is best safeguarded not by the oversight of the SEC but by the professionalism and integrity of its participants. I hope that the future will bring a continued, perhaps even more vigorous, commitment to maintaining the trust of the investing public. Thank you.

1   See In re The Dreyfus Corp. and Michael L. Schonberg, Advisers Act Rel. No. 1870 (May 10, 2000); In re Van Kampen Investment Advisory Corp., Advisers Act Rel. No. 1819 (Sept. 8, 1999).

2   In re The Dreyfus Corp. and Michael L. Schonberg, Advisers Act Rel. No. 1870, May 10, 2000, at 6.

3   Aaron Lucchetti and Pui-Wing Tam, "What's the Date? It's Key in Funds' Ads," Wall Street Journal, April 26, 2000, at C1.

4   NASD Notice to Members 00-21, April 2000.