Speech by SEC Staff:
|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 in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.|
Good morning. It is a pleasure to be here this morning at this Symposium on Investment Adviser Regulation. As outlined by the Co-Chairs of the conference, we can look forward to discussions regarding some of the hot topics and key developments in the area of investment adviser regulation. The conference includes sessions on the new Form ADV and the Investment Adviser Registration Depository, personal trading issues, performance advertising, portfolio trading issues, issues raised by the proliferation of alternative investments such as hedge funds, the priorities of the SEC's Office of Compliance Inspections and Examinations and recent SEC enforcement proceedings involving investment advisers. I thought this morning that you might find it useful if I shared some of my thoughts on some recent actions taken by the Commission and several other major issues in the investment adviser area. But as you know, I am required by Commission policy to state that the views I express are my own, and do not necessarily reflect the views of the Commission, the individual Commissioners, or other members of the Commission's staff.
Clearly, the investment management area is a tremendously important part of the Commission's responsibilities. At the end of last month, there were over 7,000 investment advisers registered with the Commission, with combined assets under management totaling over $20 trillion. Millions of Americans have entrusted their financial futures to these advisers.
Our new Chairman, Harvey L. Pitt, observed in his confirmation hearings that "our securities laws are, in the main, nearly seventy years old. They reflect a time, and a state of technology, that's light years away from where we are today." While the Commission has made significant strides towards modernization in the past few years, there is much left to be done, and I expect that the pace will quicken towards reconciling the Commission's regulations with the realties of how advisers conduct their business and meet the needs of today's advisory clients.
II. Investment Adviser Registration Depository
A major step in modernizing the advisory regulatory regime has been the introduction of the Investment Adviser Registration Depository (IARD) and revisions to Form ADV, the investment adviser registration form.
A primary goal of the Commission in developing the new system was to use modern Internet technology to streamline the process by which advisers make certain requisite filings with the Commission and state securities agencies, replacing a cumbersome, outdated paper-based system. Another important goal was to allow advisory clients, and prospective advisory clients, easier access to important information about advisers, so they can make informed judgments about advisers. Finally, it was hoped that the new system would enable the Commission to better oversee, monitor and regulate investment adviser registrants. I am pleased to say that the Commission is well on the way to realizing these goals.
All SEC-registered investment advisers were required to submit Part I of Form ADV using the IARD, between January and April of this year. IARD has now completed eight months of operation and, by all accounts, has been successful, with virtually all advisers having completed the transition to the new system. We have had an extremely positive reaction to the relative ease with which the Form can be completed on-line. The system was designed as a one-stop filing system for investment advisers to satisfy not only SEC filing requirements, but state filing requirements as well.
Data obtained from the initial IARD filings provide interesting information about the current state of the investment advisory industry as detailed in a recent report by the Investment Counsel Association of America and National Regulatory Services entitled "Evolution/Revolution - A Profile of the U.S. Investment Advisory Profession". The data reveals that one-half of all registered advisers have discretionary assets under management of less than $100 million and that 5% of the firms manage 82% of all discretionary assets reported, demonstrating that a small percentage of the firms manage the lion's share of discretionary assets under management. Summary IARD information also shows that most investment advisory firms are relatively small in size, with 66% reporting that they have ten or fewer employees. On the other hand, 3.6% of investment advisory firms employ more than 250 persons.
While 72% of advisers indicated that they are engaged in business solely as an investment adviser, IARD data also highlights the extent to which investment advisers are engaged in other businesses or are affiliated with entities engaged in other businesses:
Given the proliferation of alternative type of investments, such as hedge funds in recent years, 32% of advisers reported that they or their related persons are general partners in an investment-related limited partnership or managers of an investment-related limited liability company.
It is also interesting to note that 38% of investment advisers have no retail clients, 21% advise registered investment companies and 9.5% have no institutional clients.
Finally, 81% of registered advisers reported no disciplinary history at all, while 19% reported at least one answer in the affirmative to the disciplinary questions related to them or to an advisory affiliate.
Clearly, the information from IARD will enable the Commission to better monitor trends and developments in the investment adviser area and factor them into its decision-making.
Soon the Commission will be ready to launch the investment adviser public disclosure website (IAPD). By visiting the IAPD website, prospective clients and others will be able to retrieve the current Form ADV filed by an adviser registered through IARD. Potential advisory clients will be able to review advisers' disciplinary information, as well as information about their advisory services, client base and assets under management. The IAPD will give investors a powerful tool to help them make informed judgments when selecting an investment adviser. We also believe that the substantial revamping of Form ADV will make the information regarding advisers more relevant and understandable for investors.
After release of the public disclosure system, the next phase of the system to be launched will be the state investment adviser representative licensing system. The final phase of the system will be to eventually accommodate electronic filing of Part 2 of Form ADV, the investment adviser brochure. As part of the effort to improve information that investment advisers provide to existing and prospective clients, the SEC proposed that advisory firms be required to provide clients with a narrative brochure, in plain English, describing their practices, policies and procedures.
Commenters overwhelmingly supported the new narrative format as an improvement over the current format. They believed a narrative format would facilitate more effective communication to clients. ICAA supported the new format as "a logical and meaningful step toward improving disclosure for clients." Another commenter supported the proposed format "wholeheartedly," and stated it believes clients would find the brochure more useful, as would an adviser who would have "sufficient flexibility to present and explain its business practices in a meaningful way" and be able to "describe itself and its services in a way that is most relevant to the types of clients it seeks."
Most commenters also supported the scope of the disclosure requirements contained in the proposed brochure. Some were concerned that some of the new items would lead to lengthy and detailed disclosures, but they may have misunderstood the intent of the proposal. It was never expected that an adviser would reproduce all of its practices and procedures in the brochure.
While there appears to be a consensus on the proposed narrative approach, as well as the content of the brochures, there was disagreement on the proposed updating requirements, and the requirement that advisers provide clients with a supplement containing information about supervised persons. Let me address each of these in turn.
Updating. The Commission proposed that advisers update their brochures whenever a material change occurs (a current Form ADV requirement) and provide the information to clients in the form of a "sticker." The requirement to update investors is not currently a rule requirement-the only rule requirement is that an adviser must annually offer to deliver an updated brochure. Rather, the duty to update is inherent in an adviser's fiduciary obligations to its clients. An adviser cannot continue providing advice to clients based on stale disclosure.
Some commenters embraced the stickering proposal as a way to assure that advisers are fulfilling their fiduciary obligations. Others argued that it would be too expensive and burdensome. They argued that there are other ways to communicate developments to clients. Some, including the ICAA, argued that the annual offer should be replaced with annual delivery of the brochure.
Brochure Supplements. The Commission also proposed to require that advisers deliver a brochure supplement. It was concerned that, with the growth of some advisory firms, the firm brochure didn't provide useful information about the advisory professionals with whom the clients would be working. The supplements would be less than a page in length and provide information about investment adviser representatives. A client would only receive a supplement for the person servicing her account. Advisers could, if they wanted to, combine the supplement and the brochure and deliver a single document.
Again, commenters were divided on the brochure supplement. The Financial Planning Association strongly supported the supplement as "a highly practical disclosure piece." Others, particularly, the Securities Industry Association, objected strongly, arguing that clients didn't want this information, and that it would be burdensome and expensive to deliver. The ICAA suggested that the obligation to deliver the brochure be limited to "retail" clients, because institutional clients generally have access to the sort of information that would be in the supplement.
I believe that it is hard to argue against the intent and goals of the brochure and brochure supplement requirements -- affording advisory clients an opportunity to stay abreast of changes in an adviser's operations, preventing them from relying on stale information and allowing clients or prospective clients to assess the background of the investment advisory personnel that they rely on or are considering relying on. But clearly, the Commission has to be mindful of the costs and burdens that accompany various approaches to achieving these goals. As in much of what the Commission does, balancing costs and benefits is necessary. I can assure you that the concerns raised by the commenters regarding the updating and delivery requirements of the brochure and brochure supplement will be given careful consideration as we formulate our recommendation to the Commission. In any event, I think we can all look forward to the benefits of a modernized investment adviser registration process and the enhanced information that advisers will be able to provide to their existing and prospective clients in a clear and straightforward format.
III. Electronic Recordkeeping
Another area where the Commission has taken steps to modernize its rules is in the area of recordkeeping. The Commission recently adopted amendments to the investment adviser recordkeeping rules expanding the ability of advisers to use electronic media to maintain and preserve required records. This rule amendment responded to the enactment of the Electronic Signatures in Global and National Commerce Act ("E-Sign"), which encouraged federal agencies to accommodate electronic recordkeeping.
Prior to the recent amendments to Rule 204-2 under the Advisers Act, advisers could keep records on electronic storage media only if the records were originally created or received in electronic format. The Commission staff had issued no-action letters to conditionally permit funds and advisers to convert records into an electronic format and retain them electronically. The amendments incorporate these no-action letters into Rule 204-2, eliminating many of the conditions in the letters, and permit advisers to maintain all of their records in an electronic format. Under the revised rule, advisers are permitted to maintain records electronically if they establish and maintain procedures to: (i) safeguard the records from loss, alteration, or destruction; (ii) limit access to the records to authorized personnel and the Commission and its staff; and (iii) ensure that electronic copies of non-electronic originals are complete, true and legible. The standard adopted for advisers is different from rules adopted for broker-dealers, in which required brokerage records must be preserved in a non-rewritable, non-erasable ("WORM") format. Based on considerations of costs and benefits, and the fact that the Commission had not experienced significant problems with advisers altering stored records, the Commission determined that it was unnecessary to require advisers to invest in new electronic recordkeeping technology to adopt the WORM format. Moreover, the rule has been deliberately crafted to be technologically neutral, leaving advisers free to adopt any combination of technological and manual protocols that meet the requirements of the rule.
The rule amendments also clarify the obligation of advisers to provide copies of their records to Commission examiners. The amendments make clear that advisers may be requested to promptly provide legible, true and complete copies of records in the medium and format in which they are stored and printouts of such records, as well as the means to access, view and print the records. The Commission did not adopt the proposed amendment that would have stated that records are to be provided in no case more than one business day after a request. While the Commission stated that the "promptly" standard imposes no specific time limit, it stated that it was expected that an adviser would be permitted to delay furnishing electronically stored records for more than 24 hours only in unusual circumstances.
Finally, the Commission in adopting the amendments to Rule 204-2 made it clear that advisers can comply with the requirements of E-Sign only by complying with Rule 204-2. Accordingly, Rule 204-2 is the exclusive method by which advisers can comply with E-Sign's standards of accuracy and accessibility.
IV. Portfolio Investment Programs
The Internet has spurred a flurry of new products and ways of offering and delivering investment advisory services. Indeed, it is probably an understatement to say that the Internet is a fundamental development affecting all aspects of the investment management business. One development facilitated by the Internet are so-called "portfolio investment programs", sponsored by broker-dealers and investment advisers. Investors participating in these programs typically use the sponsor's web site to create personalized portfolios (also referred to as baskets) of securities.
The development of these products has caused some concern in the mutual fund industry, with the Investment Company Institute ("ICI") asserting that certain of these products are also unregistered investment companies, prompting a rulemaking petition to regulate these products under the Investment Company Act. On August 23, 2001, the Commission denied the ICI's rulemaking petition, stating that the programs described in the petition did not at this time appear to raise interpretive issues that warranted the Commission undertaking rulemaking. In the denial letter, the Commission juxtaposed the characteristics of an investment company with those of the portfolio investment programs described in the rulemaking petition.
The Commission noted that an investment company, or typically an external adviser, invests and manages the investment company's securities portfolio and that investors have no ability to direct the specific investment decisions made with respect to the investment company's portfolio. It further noted that investment company investors hold shares that represent an undivided interest in the pool of securities in which the investment company invests and that they have no beneficial ownership interest in the individual securities comprising the pool.
In contrast, the Commission stated that the programs described in the petition provide investors with the opportunity to make their own investment decisions and to create and manage portfolios of securities based on each investor's individual needs and objectives. It was further noted that each investor in the programs described in the petition is the beneficial owner of the securities in his or her portfolio, does not hold an undivided interest in a pool of securities, and has all of the rights of ownership with respect to such securities, including the right to vote, receive dividends, confirmations, proxy statements and other documents required by law to be provided to security holders.
The Commission further pointed out that sponsors of portfolio investment programs generally are subject to regulation and oversight under the federal securities laws, including the Securities Exchange Act of 1934, as sponsors of the programs have generally registered as broker-dealers, and in some cases, are required to be registered as investment advisers regulated under the Investment Advisers Act.
Finally, the Commission noted that it was aware that there are few such programs in existence and that they had not been in operation for a significant period of time. The Commission stated that it intends to monitor the development of these programs for compliance with the federal securities laws, and consider taking further action, if necessary. Consequently, through the inspection process and otherwise, the evolution of these products will be scrutinized carefully to assure that they are appropriately regulated under the federal securities laws.
V. Research Analysts and Investment Advisers
A significant amount of attention has been devoted recently to the issue of analyst conflicts. The controversy centers around the conflicts sell-side analysts may have as a result of their firm's investment banking, underwriting and market making activities. On June 28, 2001, the Commission issued an investor alert urging investors not to rely solely on analyst recommendations when deciding to buy, hold or sell stock. The alert explains the relationship between securities analysts and the investment banking and brokerage firms that employ them and cautions investors about potential conflicts of interest analysts may face. The House Financial Services Subcommittee on Capital Markets, chaired by Rep. Richard Baker, has held hearings to explore whether investors are receiving unbiased research from analysts. Rep. Baker also established a review board to examine various industry association proposals governing the standards and practices of research analysts. The Securities Industry Association ("SIA"), for example, has issued best practices guidelines for analyst research, dealing with conflicts of interest and the integrity of research. NASD Regulation, Inc. has sought public comment on proposed rule amendments that would require analysts and other brokerage employees to disclose potential conflicts of interest when they recommend a security during a public appearance or in written advertisements and sales literature, including analyst research reports.
As proposed, the NASDR rule amendment would require the person making, or responsible for making, the recommendations to disclose, if applicable, whether:
In a footnote to its proposal, NASDR clearly states that the rule is designed to apply to "NASD members" who are portfolio managers of an investment company or discretionary accounts. NASDR has urged the Commission to develop similar rules for investment advisers so that investors will have the same disclosure whether the analyst works for a brokerage firm or is associated with an investment advisory firm. Both the SIA and the Investment Company Institute, in comments to NASDR, oppose the application of the proposed rule change to portfolio managers.
I believe the Commission clearly has authority to adopt a rule similar to the NASDR's proposal under Section 206(4) of the Advisers Act. Section 206(4) gives the Commission authority to "prescribe means reasonably designed to prevent such acts, practices, and courses of business [by advisers] as are fraudulent, deceptive or manipulative."
The ICI contends in its comment letter that the proposal does not consider the differences in the potential conflicts of interest presented by "sell-side" analyst recommendations and statements made by portfolio managers. The ICI argues that the proposal fails to recognize that, at least in a great majority of cases, any potential conflicts of interest for portfolio managers are greatly attenuated. They assert that it is difficult to understand how a portfolio manager discussing a security held in a fund's portfolio during a public appearance would have a significant impact on the performance of a fund, when mutual fund portfolios are generally comprised of a relatively large number of securities. They also argue that it is less likely that a conflict of interest arises in this situation, since by previously purchasing the security and holding the security in the account of his clients, a portfolio manager presumably believes that the recommended security is a desirable investment. Indeed, the ICI contends that a favorable comment by a portfolio manager during a public appearance regarding a security that is part of his fund's portfolio holdings should not be considered a recommendation for purposes of the NASDR proposal.
The SIA contends that discussion by portfolio managers of specific securities holdings in public appearances are not intended to promote the acquisition of securities, but rather to explain investment strategies or objectives. Moreover, the SIA asserts that because asset management functions are generally conducted either through separate affiliates or a separate business line of a dually registered broker dealer, portfolio managers generally do not have access to, or knowledge of, ongoing investment banking activities of the broker-dealer. Additionally, both the SIA and the ICI assert that the oversight of investment advisory activities is the responsibility of the Commission.
The NASDR rule proposal would affect a large number of advisers in some very odd ways. For example, some advisers are dually registered and thus all of their portfolio managers would be covered under the rule. However, many advisers are not registered broker-dealers, but some of the portfolio managers are former broker representatives who hold Series 7 licenses and would be covered under the rule. In many firms, some portfolio managers are associated persons of a broker-dealer to participate in fund marketing activities and are associated with the fund group's distributor, who typically do not effect transactions in securities other than mutual fund shares. Adoption of the NASDR rule amendment could lead to an arbitrary application of the amended rule to many advisory personnel. This is why a number of commenters on the rule proposal have urged the NASDR to recognize that the nature of the conflicts faced by analysts and portfolio managers differ.
Accordingly, it will be necessary for the Commission to consider whether portfolio managers have similar conflicts as sell-side analysts, whether the conflicts are as severe as those faced by sell-side analysts and whether the proposed disclosures will be effective in addressing the conflicts. Once the NASDR rulemaking proceeding is concluded, it will be necessary for the Commission to consider, in light of the scope and terms of the NASDR rule, whether an Advisers Act rule is necessary.
VI. Investment Adviser Enforcement Actions
In his confirmation hearing, Chairman Pitt outlined several goals that he would pursue. Among them was the pursuit of "vigilant enforcement of sound rules that protect all investors against fraudulent, deceptive and manipulative misconduct." Unfortunately, there are circumstances that dictate that the Commission bring enforcement actions involving investment advisers. Although many of the recent cases involve non-controversial antifraud charges, such as out-and-out theft of client's assets, the Commission has also targeted various fraudulent practices peculiar to the operations of investment advisers, including fraudulent marketing and advertising. Fraudulent advertising may take many forms, including use of inflated and/or selective performance results, misleading use of back tested data, misleading use of model or hypothetical data, submission of false or misleading information to publications and consultants, and use of false information about compliance with AIMR standards.
The Commission and staff have also devoted significant enforcement and examination efforts to individual conflicts of interest and personal trading by investment advisers. Recent enforcement actions have involved front running and other abusive trading practices by which insiders unlawfully benefit from their positions. For example, in a case involving Nicholas-Applegate Capital Management, the Commission instituted administrative and cease and desist proceedings against an adviser in which a portfolio manager engaged in a day trading strategy in which he fraudulently allocated profitable equity day trades to his personal account rather than to the pension plan he was managing. The firm's procedures gave the portfolio manager the opportunity to allocate a buy or sell of the same security within the same day to the pension plan or to one of his personal accounts without anyone's knowledge or consent. The federal district court entered a judgment of permanent injunction and other relief against the portfolio manager. Following the entry of the judgment, the Commission settled the administrative proceeding against the portfolio manager, barring him from association with any investment adviser and ordered the portfolio manager to disgorge his ill-gotten gains. The Commission found that the advisory firm failed to reasonably supervise the portfolio manager and the firm was required to pay a civil money penalty of $250,000 and maintain and implement corrective compliance procedures.
On August 10, 2001, the Commission filed a similar enforcement action to freeze the assets of Alan Bond and his investment advisory firm, Albriond Capital Management, LLC. Bond was a frequent guest on PBS's WALL STREET WEEK WITH LOUIS RUKEYSER and CNBC. The Commission alleges in this action that Bond orchestrated a trade allocation scheme that resulted in his clients losing nearly $57 million and Bond reaping an investment return of almost 5,500% in his personal account. In this action, the Commission alleges that beginning in March 2000, while trading for his own personal account and the accounts of three institutional clients, Bond "cherry-picked" the best trades for himself. It is alleged that Bond called in trades to purchase securities to a brokerage firm without designating whether the trade was for his own account or the account of his clients. If the securities purchased increased in price during the day, Bond generally sold the shares and gave the profit to his own account. If the securities declined in value, Bond generally placed the securities in the accounts of three of his clients. Consequently, during a 17 month period, it is alleged that Bond's clients lost nearly $57 million, suffering negative rates of return ranging from 65% to 74%, while he personally gained nearly $6.6 million on an initial investment of approximately $260,000. In a parallel criminal case, the U.S. Attorney's office for the Southern District of New York, arrested Bond and seized assets of Bond and his firm.
The Commission has also continued to consider the appropriateness of other trading practices by investment advisers. A number of enforcement actions have addressed the practice by which investment advisers favor one or more clients over other clients in the allocation of trades. For example, the Commission has brought actions involving situations in which investment advisers have favored its performance fee-paying clients over its other clients in the allocation of hot IPOs and other equity trades, and in situations in which hot IPOs were disproportionately allocated to certain clients to boost performance records for marketing purposes.
The Commission has instituted a number of enforcement actions in recent years concerning the best execution and soft dollar practices of investment advisers. These cases have involved the improper use of soft dollars to pay for certain undisclosed expenses, including personal travel, marketing and other non-research administrative expenses of the adviser, as well as undisclosed soft dollar arrangements directing client brokerage in exchange for client referrals, including the payment of excessive commission rates for these referrals.
Earlier this year, the Commission filed suit against investment adviser Gordon J. Rollert of Wellesley, Massachusetts, alleging that he defrauded one of his clients, a church in Auburn, Massachusetts, of approximately $900,000. In the complaint, the Commission alleges that Rollert used his investment advisory firm to misappropriate hundreds of thousands of dollars in soft dollar credits generated by securities transactions made on the church's behalf. The complaint further alleges that as part of the scheme to misappropriate soft dollar credits, Rollert submitted over a hundred invoices to the broker-dealer for payments with soft dollars that had been generated by trading in the church's account. Many of the invoices that were submitted were in the name of a shell entity that Rollert controlled, and indicated that the entity had provided services to the advisory firm. It is alleged that Rollert personally picked up these payments from the broker-dealer and deposited them into bank accounts that he controlled and then withdrew the majority of the funds for his personal use. The Commission also alleges that Rollert violated his fiduciary duty of best execution for his client's securities trades by fraudulently setting the commissions paid by the church at a rate that was approximately five times higher than the average rate charged for soft dollar transactions at the time. The Complaint also alleges that Rollert churned the church's account to generate the soft dollar credits.
In another case, the Commission sued the same Alan Bond that I mentioned earlier, alleging that he fraudulently received over $6.9 million in kickbacks from brokerage firms in connection with his management of pension and investment funds of such notable clients as the National Basketball Association Player's Pension Plan, the Washington Metropolitan Transit Authority Retirement Fund and the City University of New York.
The Commission's complaint alleges that Bond received commission kickbacks from three brokerage firms through trades directed to these firms by his money management business. It is alleged that the kickbacks he received were siphoned off the investment returns of his clients in the form of mark-ups on principal trades in the over-the-counter market. According to the complaint, Bond dictated to the brokerage firms the amount of the mark-up on each trade and the firms, in turn, kicked back 57 - 80% of the mark-up to Bond. The Commission's complaint alleges that most of the money in this scheme went to finance Bond's lavish personal lifestyle. In addition to 75 cars (luxury and antique) and two real estate properties in Florida, Bond frequently went on shopping sprees running up American Express bills of $200,000 to $470,000 a month. It is also alleged that Bond used some of the illicit payments to purchase gratuities for the trustees and employees of his pension fund clients, including limousine service, overnight stays in posh hotels, expensive clothing and tickets to sporting events. In February of this year, the heads of two now defunct broker-dealer firms were fined and sanctioned in conjunction with this alleged kickback scheme.
Another area where there have been several recent cases relates to "portfolio pumping", the practice of increasing a stake in portfolio securities at the end of a financial period solely for the purpose of fraudulently driving up the value of the securities. The Commission filed securities fraud charges again Burton Friedlander, a hedge fund manager, two investment management entities he controls, and three hedge funds that he manages. The defendants are charged with market manipulation and with fraudulently inflating and misrepresenting the value of one of the funds. Among other things, the Commission charges that Friedlander manipulated the common stock of a company in which the hedge fund held an interest at the end of each month during the last five months of 2000. The Commission alleges that Friedlander caused approximately $2.4 million in fund redemptions to be made at the inflated fund net asset values for his and his entities' benefit, to the detriment of the fund's other investors. The Commission also alleges that Friedlander assigned arbitrary values to warrants in the fund's portfolio that were higher even than the price of the underlying common stock and caused additional investors to subscribe to the fund at inflated net asset values.
Also, on August 10, 2001, the Commission instituted and settled four separate but related administrative proceedings against a registered investment adviser, a portfolio manager formerly employed by the adviser, a registered broker-dealer and the former head of the broker-dealer's international equity trading desk. These proceedings resulted from a trading strategy in which the portfolio manager and the trader placed purchase orders in five securities heavily owned by the portfolio manager's advisory clients shortly before the close of the market with the purpose of increasing the closing price of those securities.
Using trading records and tapes of contemporaneous telephone conversations, the Commission found that the portfolio manager and the trader attempted to "mark or marked the close" of several securities in violation of the federal securities laws. The order states that the portfolio manager and the trader discussed which stocks to purchase, focusing on stocks in which the portfolio manager held large positions and chose target closing prices for these stocks. In some cases, the trading resulted in short-term increases in the overall value of certain securities held in the accounts managed by the portfolio manager when performance results were reported to advisory clients at the end of various quarters. The Commission found that the trading strategy was not disclosed to clients and was not authorized under investment guidelines that applied to the accounts. As a result, the Commission found that the portfolio manager willfully violated Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder, and willfully aided and abetted violations of Sections 206(1) and (2) of the Advisers Act.
The Commission also found that the investment adviser failed reasonably to supervise the portfolio manager with a view to preventing these securities law violations. The Commission found that although the adviser had in place written policies and procedures regarding trade processing, portfolio compliance and other issues, the adviser failed to adequately implement its policies that prohibited manipulative trading. While the portfolio manager's trades were reviewed on a daily basis, his trading methods were not effectively reviewed for compliance with this aspect of the adviser's policies. Similarly, the Commission found that the broker-dealer failed reasonably to supervise the trader, indicating that the trader's activities were not effectively reviewed for compliance with the firm's policies and procedures, which would have barred such trading activity.
I think it is significant that in the Commission orders against the adviser and the broker-dealer, the Commission noted that in accepting each firm's Offer of Settlement, it took into account the firm's remedial acts and its cooperation with the Commission staff. The adviser undertook an internal investigation of the portfolio manager's trading after receiving an inquiry from a foreign exchange, and the investigation led to the portfolio manager being placed on administrative leave and subsequently resigning. In addition, the adviser voluntarily compensated clients for any possible adverse effects of the portfolio manager's trading. Finally, the adviser implemented a series of reforms, including enhancing its segregation of functions and requiring that all equity trades be initiated and monitored by the trading department and not by portfolio managers. The broker-dealer likewise conducted an internal investigation in response to a foreign exchange inquiry, placed the trader on administrative leave and eventually terminated him for cause, and enhanced its compliance procedures by requiring review and approval by a supervisor, other than the securities trader, of any significant size order received for execution in the final 30 minutes of a trading day and review of any such order taken directly by the head trader by his or her supervisor.
While the great majority of investment advisers are ethical, responsible and maintain a compliance culture, unfortunately there are a few who engage in practices that merit enforcement action by the Commission.
VII. Best Execution
Short of actual fraud, many advisers need to pay more attention to seeking the best execution for their clients' trades. If an adviser is in a position to direct brokerage transactions, the adviser's fiduciary duty includes the requirement to seek the best execution for clients' securities transactions.
In this connection, the Commission in its 1986 interpretative release on soft dollars addressed an adviser's execution responsibilities as follows:
The [Adviser] must execute securities transactions for clients in such a manner that the client's total cost or proceeds in each transaction is the most favorable under the circumstances. [An Adviser] should consider the full range and quality of a broker's services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the money manager. The Commission wishes to remind [Advisers] that the determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account. In this connection, [Advisers] should periodically and systematically evaluate the execution performance of broker-dealers executing their transactions.
Commission staff has spent quite a lot of time in examinations recently looking at how advisers fulfill their duty of best execution. The staff no longer examines only commission rates and trade prices, but has expanded its review to focus on the process by which an adviser seeks to achieve best execution. While our Office of Compliance Inspections and Examinations ("OCIE") is currently working on a report of its findings, I wanted to share with you some of their observations. First, not 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, 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 should 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 make client referrals to the adviser, and using commissions to pay for research or other services. OCIE has observed some practices that should be considered by advisers:
The Founders Asset Management administrative proceeding demonstrates the importance of full disclosure of practices involving conflicts of interest. In that case, an investment adviser was alleged to have directed brokerage from small private accounts in return for client referrals and specifically altered its aggregation trade policies to provide that orders for small accounts would be executed separately from orders for large private accounts and mutual funds, with orders for the small accounts, executed after the orders for the large accounts and funds. The Commission found that these practices violated Section 206(1) and (2) of the Advisers Act because they were not disclosed to clients and were contrary to the firm's ADV disclosure that it was the firm's policy "to seek best execution of orders at the most favorable prices." Without admitting or denying the Commission findings, the former president and sole owner of the adviser consented to pay $590,000 in disgorgement and interest plus a civil money penalty of $150,000.
It should be clear to all advisers that in inspections, the staff will be looking for diligent and focused attention on execution practices, designed to maximize the value of the firm's investment decisions.
In closing, under a new Chairman, the Commission will establish the Division's priorities in the investment management area. But I am sure that there will be a continuing commitment to modernizing and improving the investment adviser regulatory framework. We have an obligation to stay abreast of and adapt to innovation and changing circumstances. We welcome your input as we strive for sound regulation to make the investment adviser regulatory regime the best that it can be for advisory clients and advisory firms. But oversight by the SEC is but one component of safeguarding the reputation of, and maintaining investor confidence in, the investment adviser industry. Ultimately, it is the integrity of the advisory firms that will solidify the future of the investment management business. It is in all our interests that there continue to be a vigorous commitment to maintaining the trust of the investing public.
I thank you for your attention and I hope you enjoy the remainder of this Symposium.
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