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Speech by SEC Staff:
Valuation, Trading, and Disclosure: Three Compliance Imperatives

Remarks by

Lori A. Richards

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

2001 Mutual Fund Compliance Conference
Investment Company Institute

June 14, 2001

The SEC, 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 the author and do not necessarily reflect the views of the Commission or the staff of the Commission.

Good morning. It's a real pleasure to be with you, my colleagues in fund compliance. I want to say at the outset, how valuable I think this conference is and how much I think we all learn from meeting together to discuss issues and share ideas on fund compliance. Today, I want to talk with you about three compliance imperatives: valuation, trading, and disclosure.

Before I do however, let me say that, as fund compliance and legal officers, you and our staff at the SEC have a shared purpose and commitment -- we both want to ensure that the compliance component of the mutual fund business is strong, well-staffed, respected within the firm, and equipped to do the job. You are truly on the front lines of compliance every day, but you should know that we at the SEC are guarding your flank, and are very supportive of all of your efforts to keep your firm and its employees on the safe side of the law. Indeed, just last month Paul Roye, the Director of the SEC's Division of Investment Management, warned fund firms against making resource cuts to compliance that, while short-term expedient, could damage a firm's long term interests in ensuring clients' trust and confidence. It's certainly my recommendation that compliance be considered a "bread and butter" part of all firms' infrastructure, and that it be protected from business cycle cutbacks. Because whether the market's up or the market's down, the law and fund responsibilities to investors remain steadfast. Moreover, it's in every fund firm's best interest to ensure that its customers remain its customers -- and customers will only remain so when they have the kind of confidence and faith that come with strict compliance with the law.

More than just complying with the law however, striving to exceed the law's prohibitions and truly implementing "best practices" is the hallmark of many firms in the fund industry. Indeed, Matt Fink has often remarked on this, and said recently at the Mutual Funds and Investment Management Conference that the success of the fund industry has always depended on the public trust earned by individual mutual fund organizations. He said that the fund industry "must continue to educate [its] officers, employees, and directors to implement the spirit as well as the letter of the law." Importantly, he said that the industry "must continue to adhere to high business standards and voluntary practices that go beyond law and regulation." Well, I could not agree more.

I have seen, in my life as an examiner, many examples of firms that not only comply with the bare minimum requirements of the law, but go further to ensure that they are on the forefront of achieving truly best practices. There are many fund groups with truly outstanding compliance programs. To be sure, I've also seen advisers and fund groups whose guiding philosophy seems to be to shadow the compliance line as closely as possible -- and I always wonder how the compliance directors at these firms sleep at night. Why aren't they worrying about the legal and reputational risk of being so close to crossing that line? Why aren't they more worried about their customers' best interests? Why aren't they worried about what their boards of directors would say and think?

Let me tell you about how this contrast in compliance philosophies was made starkly clear to me one afternoon earlier this year. A staff member came in to my office and said that the general counsel and compliance director of a large adviser had just called and wished to discuss with us a violation of the law that an employee had committed, and that the adviser's compliance staff had recently discovered through its routine monitoring procedures. This adviser, let's call it Adviser A, called us to report the violation and describe what they knew about it, it took disciplinary action against the employee involved, and hired an outside law firm to conduct a full and expedited review. This is a firm with a very healthy compliance program and active use of compliance technology, who discovered the problem in its routine compliance monitoring. In contrast, later that same afternoon, I learned that another large adviser, let's call it Adviser B, who was in the middle of an SEC examination, was giving our examiners a difficult time -- not providing documents, not providing senior staff to answer questions, and just not answering critical questions -- being altogether recalcitrant and in my mind, acting like they had something to hide. This firm, while large in terms of assets under management, has a one-person compliance effort, apparently poor internal controls and makes very little use of technology in compliance. This is a firm that does not appear to invest in or to respect compliance controls.

The contrast between Adviser A and Adviser B was to me quite stark. Adviser A is an excellent fund citizen, ensuring that it has the compliance tools it needs to detect violations, taking steps to correct them promptly, and even informing their regulator of problems. Adviser B is lackadaisical at best, underfunding and underresourcing compliance, and evidencing a negative attitude towards their regulator.

Let me describe how our compliance risk assessment for these two advisers plays into our examinations. Adviser A engenders confidence, which will likely put this firm on the outer end of our exam cycle. We're also more likely to have confidence in their entire compliance infrastructure -- after all they are doing what they should be doing -- detecting problems and correcting them once detected. The scope of our examination of this firm will reflect our recognition of their already existing compliance controls. On the other hand, I'm worried about Adviser B's lack of compliance controls, and whether the lack of controls has resulted in violations of the law. In light of their compliance risk, we're likely to examine them very, very closely -- deeply and broadly. We're also likely to put this firm on the inner end of our exam cycle, and to visit them frequently.

With that example as a backdrop, I know that all of you aspire to work for firms that fall squarely within the philosophy of Adviser A -- with strong compliance and internal controls. And that's certainly our goal too. I want to do whatever I can to help you help your firms be on the right side of the

compliance line, and well beyond that line. I thought I'd spend some time today giving you my thoughts on areas I think you should focus on now and ensure that you have state-of-the-art compliance controls. And by the way, these are also areas that we'll be looking at closely in our examinations.

I want to focus this morning on three critical areas of fund compliance:

  • Valuation;

  • Portfolio Trading; and

  • Disclosure.

In each of these areas, I want to share with you some of the dangers and pitfalls that we've seen in examinations. Some were caused by a compliance system that wasn't up to snuff, that may have allowed violations to occur, or allowed violations to go undetected. I also want to share with you some of the compliance practices we have seen that really work. Keep in mind that any good compliance system must be designed both to prevent violations, and to detect violations if they do occur.


Let me start with valuation. In many ways, valuation and daily pricing are the hallmarks of a mutual fund. Accurate mark-to-market valuation and daily pricing allow investors to have confidence that the prices they pay and the money they receive when they sell a fund's shares are based on the real value of the fund's portfolio that day. What could be more fundamental to investors' trust and confidence than that?

Valuation is relatively easy when market prices are available, but what about when market prices are not available? What about when market prices are available, but suspect? What about when market prices are stale in light of a sudden change in the market for that stock?

Well as you know, fund boards are responsible for establishing procedures to "fair value" portfolio assets whenever market prices are not "readily available." Fair value is the amount a fund would expect to receive upon the current sale of the security.

Unfortunately, the Commission recently had to seek a receiver for three funds as a result of valuation issues, in SEC v. Heartland Group, Inc. I can't underemphasize the importance of strong internal controls with respect to valuation.

Based on our recent examinations, here are some practices you might think about in the valuation area:

  • Guard against a lack of oversight of valuation -- make sure that there are good checks and balances in the valuation process.

  • Because there is a degree of expertise needed to handle valuation and pricing issues, some fund boards have established valuation committees to focus specifically on valuation issues when they arise. The adviser may also have a valuation committee, and many funds have a director on call. These committees should have written policies, regular meetings, and keep minutes.

  • The more difficult a security is to value, the more the board should be involved in understanding the pricing methodology. The board needs to understand the pricing process -- and will want to review the process with the adviser -- including the criteria considered and the valuation methods used.

  • If you use a pricing service, understand exactly what services that pricing service provides. Pricing services vary: they may give you NASDAQ quotes; they may give you their best estimate of value based on communications with the underwriter or issuer; or they may spit back at you exactly the information that your portfolio manager has provided to them.

  • Some funds use more than one pricing service -- this allows the fund to obtain two independent pricing recommendations, and can provide a check for discrepancies.

  • The portfolio manager can be used as a reviewer of valuations of individual securities (he or she will have good knowledge of the market in that security, and could do an "end of the day check"). But, don't rely solely on the portfolio manager for valuations, he or she has a built-in conflict of interest.

  • Many advisers have an automated checking routine that searches for day-to-day price changes in individual securities over some threshold percentage and that kicks these out for review. Be sure that someone actually checks on the reasons for the increase or the decrease in the prices.

  • Sometimes prices that come in from external sources (e.g., a pricing service or broker-dealer) are overridden by the adviser. Have controls on pricing overrides. Make sure that there are policies outlining when overrides are allowed and that there are procedures to ensure supervisors' approval and documentation of all overrides.

  • Ensure that someone who is not involved in the pricing process, such as compliance staff, reviews all overrides to look for individual overrides that aren't supportable, and for patterns of overrides that suggest problems. Also consider providing a periodic report to the board on all overrides and the reasons for them.

  • Monitor for "stale pricing" (when the price of a security does not change). Is someone overriding incorrectly or is something wrong with the input?

  • If you're using fair value, compare any sales in the market to the fair value for accuracy. Also, review any differences that occur over time for any bias that suggests that the fair values being used are either consistently higher or lower than actual sales prices. Also consider providing this data to the board (e.g. quarterly) so that it can ensure it is overseeing the process.

  • Most money market funds use amortized cost to value their portfolios and compute their daily net asset values. Remember that these funds are also required to "shadow price." Shadow pricing is designed to gauge the difference between the cost value and the market value of the portfolio, and to act as a sentinel or early-warning of impending problems in the portfolio that could ultimately result in the fund having to reduce its net asset value. Take shadow pricing seriously. When there is deviation from cost, take appropriate action to bring these two values back in line.

Accurate pricing of portfolio securities and calculation of NAV are critical activities that are at the very heart of the "mutuality" in mutual funds. Each shareholder, whether coming, going, or continuing must receive his or her fair, pro-rata interest in the fund, every day. This goal can be reached only if the prices used are accurate and net asset values are calculated correctly.


Turning to portfolio trading, I want to talk with you about the legal duty to seek the best possible execution for fund transactions and some steps that you can take to help ensure that your firms are meeting this obligation. As you know, fund advisers have a fiduciary duty to seek the best execution for fund transactions. To understand this concept, think about the business of an advisory firm. An adviser is in business to make investment decisions that are profitable and suitable for its clients, and to implement those decisions, it places orders to execute securities transactions with broker-dealers. An adviser should place orders in ways that are designed to capture for its clients the maximum value of those investment decisions -- to seek the best possible execution of those trades. To ensure that advisers are fulfilling their duty of best execution, they are required to "periodically and systematically" evaluate the quality of execution services received from the broker-dealers that are used to execute fund trades. Many factors go into a "best execution" analysis, for example:

  • obtaining the best price (for large trades, this means getting the whole trade done with the least amount of market impact);

  • the speed of execution;

  • the certainty of execution; and

  • the commission rate or spread.

We've spent quite a lot of time in examinations recently looking at how advisers fulfill their duty of best execution, and while we are currently working on a report of our findings, I wanted to share with you some observations. First, it was not always clear to us that all advisers consider possible execution alternatives. Some advisers appear too comfortable with existing execution quality. Remember that advisers are required to perform a "periodic and systematic" review. One would think that this would lead to rerouting orders on occasion and not routing status quo. Second, we've found sometimes that advisers don't always identify those execution quality factors that they are relying on in routing order flow, and they don't always analyze these factors in a systematic way. In particular, advisers must consider the opportunity to obtain better executions for clients in light of the conflicts of interest in trade placement, including directing brokerage to broker-dealers that sell the fund's shares or make client referrals to the adviser, and using commissions to pay for research or other services.

In light of our exams to date, we've observed some practices that we think should be considered:

  • Some advisers have established a committee to review trade placement and best execution. This committee aids in identifying all factors that are important to the firm in routing trades.

  • Establish criteria to measure these factors. As part of this process, obtain and review a variety of quantitative as well as qualitative information. Apply these factors to actual results on a regular basis, at least quarterly. Collect and maintain complete documentation of what was considered during each review and the decisions reached.

  • Ensure that the fund's board has enough information to fulfill its oversight responsibilities. Have the "best execution" committee or the portfolio manager and trader for example, meet with the board periodically to discuss trade placement, costs, service quality factors, and alternative means of execution.

  • Identify, question, resolve and disclose conflicts of interest in trade placement.

In placing orders to implement your portfolio managers' investment decisions, it's important to do so in ways and with broker-dealers that are able to consistently capture the maximum value of those investment decisions. It makes no sense to try to make superior investment decisions and then lose or give away the value of these decisions through sloppy placement of orders for execution. Ensuring that all relevant information and attendant conflicts of interest regarding trade placement are periodically and systematically evaluated can help ensure that the adviser obtains the best execution and achieves the highest returns for fund shareholders.


Finally, the third critical fund compliance challenge is disclosure. The means by which an adviser describes its business to its clients and potential clients is one of the most important aspects of the advisory function. An adviser's goal should be to ensure no surprises -- that all information relevant to a client or a fund investor is provided, and provided in a timely, clear, and understandable way. That's real communication. This must be easier said than done, because while we see examples of clear, full, and accurate disclosure, we still see examples of muddled, obtuse, and non-descriptive disclosure by advisers. I think that too often marketing departments dull down and make disclosure language less precise. It's in your interests as compliance staff to ensure that you're at the table when disclosure and advertising language is being drafted and that disclosure is precise, accurate, and fullsome. You should know that when we discover a conflict of interest during an examination, our first question is -- how did they disclose it? And when the fund's disclosure is less than precise and the conflict is a significant one, we're much more likely to refer the matter to our Division of Enforcement for further review. Even more importantly, it's in the adviser's best interest to have clients who are as informed as possible -- they're more likely to remain long-term clients if they've had no disclosure surprises along the way.

Let me give you some examples of several situations where you should be careful to ensure that your disclosure is quite good:

  • Make sure that any use of performance numbers in advertisements or client presentations is accurate. Have a compliance review of all ads or presentations before they are used. In these volatile times, consider including in the ad statements that more current performance data is available by phone or on the adviser's website.

  • Make sure that disclosures about your policies for obtaining best execution are clear and accurate.

  • Make sure that, if you route fund portfolio orders to the broker-dealers that sell your fund's shares, you are disclosing this practice and any impact on execution costs.

  • Similarly, if you are an adviser and you route customer orders to broker-dealers in exchange for client referrals, your customers had better know about this and what they may be giving up by your routing practices. Too often advisers will say "that brokerage is directed" when there is no clear evidence of client direction.

  • If you allocate attractive investment opportunities among clients on other than a pro-rata or other basis that is fair to all clients, you should disclose your practices to clients.

  • If performance numbers in advertisements are derived in circumstances or conditions that are not likely to be repeated, the advertisements should disclose fully the factors that gave rise to the performance and the likelihood of repetition.

It's important both from a compliance standpoint, as well as from a client relationship standpoint, to make sure that your disclosure language in all communications with clients and potential clients is accurate, in plain English, and fullsome. As I said, the goal should be real communication with clients.


In conclusion, I want to thank you for your attention, and for attending this conference. I know that because you are here today, you care as much as I do about fund compliance. There are a lot of topics on the agenda for this conference that we too are quite interested in, in addition to valuation, portfolio trading and disclosure, these include paying for distribution expenses, anti-money laundering strategies, Regulation S-P and global compliance efforts. All are important and timely topics.

Let me close by encouraging you to implement good, strong fund compliance programs that meet and indeed exceed minimum requirements, and that maintain the public's confidence in you, your firm, and the fund industry.

Thank you. Have a good conference.


Modified: 06/14/2001