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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before the Investment Company Institute, Securities Law Developments Conference


Stephen M. Cutler

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

Washington, D.C.

December 6, 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 afternoon. It's a pleasure to be here with you this year. This Conference provides an excellent opportunity to update you on current developments at the Commission. It's an exciting time to be part of the SEC. Our new Chairman, as you know, brings an extraordinarily keen intellect and unparalleled energy to his job. Of course, Chairman Pitt's work ethic puts pressure on the rest of us to keep up. So, I have taken to searching for inspiration anywhere I can find it. Those of you with kids, like me, may already have seen the blockbuster "Harry Potter" movie. It's the story of a young boy who goes off to a remarkable school of wizardry and witchcraft. It prompted me to set up a meeting with Chairman Pitt to explain some exciting new ideas for Enforcement. You can understand my disappointment, then, when the Chairman took me aside and said that, though he appreciated my eagerness to "think outside the box," authorizing the staff to use Sorting Hats and Invisibility Cloaks wasn't exactly what he had in mind when he announced his new real-time enforcement initiative.

Some of you may have heard Paul Roye speak recently of how the events of September 11 affected the industry, and the steps that the SEC and the industry took together in response to that crisis. Now that we've had some time to step back and reflect on those events and their aftermath, I, for one, am astonished at how quickly and efficiently your industry has been able to recover. It is clear that you have been hard at work during these difficult months. I commend your efforts and your resilience.

Now, more than ever, it will be worth your while to expend the energy to maintain investor confidence. The unraveling of Enron highlights for us all the value and necessity of shareholder trust. Shareholders need to trust that their savings are adequately guarded in mutual funds. You are the providers of that steadying reassurance, and it is a critical role.

Today I would like to share with you some of my views, and they are only my views and not necessarily those of the Commission or its staff, on several issues that I group loosely under the title "potential pitfalls - how to avoid them, and what to do when you don't." The potential pitfalls I will cover, though not necessarily new, are ones that we've recently seen can have very serious consequences. The reason I describe them as potential pitfalls is that there are steps you can take to avoid winding up in one of these quagmires. Of course, in the real world, even the best-intentioned corporate citizens sometimes find themselves in trouble, so I'll also discuss steps you can take to make the best of such a situation, a subject explored in a recent Commission 21(a) report.

As professionals who work with or for regulated entities, you know that a subject that always requires attention is supervision. Wallis Simpson, the Duchess of Windsor, reportedly said, one can never be too rich or too thin. A sound corollary might be that regulated entities can never be too well supervised. So what do recent enforcement actions tell you about what it means to be well supervised?

Supervision Lesson Number One is that a firm — if it's not careful — can outgrow its supervisory procedures.

Our settled action against Dawson-Samberg Capital Management, Inc. and its Treasurer illustrates the point.1 From 1990 to 1996, Dawson-Samberg's assets under management more than quintupled, growing from approximately $350 million to over $2 billion. Although the firm had disclosed to its clients certain categories of products and services it might obtain using soft dollar credits, it failed to disclose that it would use soft dollars for personal and non-research business travel, marketing expenses and other administrative expenses.

Dawson's soft dollar program was administered by its Treasurer. Dawson gave her sole responsibility for the program without giving her any training and without creating a system of follow-up or review to ensure that soft dollar payments were properly monitored.

Based on these facts, the Commission found that, among other things, Dawson failed - and the Treasurer aided and abetted the failure — to disclose material information about the firm's use of soft dollars.

Dawson was also charged with failure to supervise. While the Treasurer's on-the-job training and lack of any follow-up procedures may have been adequate when Dawson had only a few soft dollar relationships, those became problems as the firm's size and its use of soft dollar credits increased. Supervisory and compliance procedures, training, and resources must grow with an investment advisory firm. It is critical that you not assume that what was once adequate will still be so if your firm expands.

The same point can be made about changes in the type of business a firm does or the investment approach a firm takes. If a firm's investment strategy changes, its supervisory procedures may need to follow suit. A firm must consider what opportunities for misconduct are specifically presented by the investment strategy it pursues and ensure it has compliance procedures to monitor conduct in that area.

Our case against Oechsle International Advisors drives this point home.2 In that case, we found that a senior portfolio manager at Oechsle, Andrew Parlin, arranged with ABN Amro sales trader Angelo Iannone to purchase securities in client accounts before the close of the market for the purpose of increasing the closing price of those securities. This is a practice known as marking the close. We allege that by intentionally paying a higher price at the end of the day and the end of the reporting period, Parlin and Iannone sought to cause a short-term increase in the value of securities. In certain instances, the closing price increases coincided with fiscal period ends, so that Oechsle could report increased returns.

Let me give you a flavor for the discussions that Parlin and Ianonne had about marking the close. With respect to the stock of a company called British Biotech, Parlin told Iannone: "[T]he main objective is the end of the month . . ." and the "strategy on [the stock], it's a two day, it's a two day 40 [pence] strategy." On another occasion, regarding another stock, Parlin complained to Iannone that "it's hard to do uh, this window dressing when markets suck." Let me pause here to say, I love tapes.

Notwithstanding the colorful, illegal activities of its portfolio manager, Oechsle in fact, had policies and procedures in place that prohibited manipulative trading. Yet, Oechsle failed to adequately implement these procedures. Specifically, the daily review of Parlin's trading did not effectively consider whether his particular trading methods, which included managing accounts with high concentrations of a small number of securities, were in compliance with the firm's anti-manipulation policies. In situations like this, where marking the close would have a particularly profound effect on the managed accounts' perceived performance, it is essential that a firm implement surveillance procedures designed specifically to guard against such conduct.

As I said, the logic of this case dictates that if a firm changes its investment strategy, it should examine its supervisory policies and procedures to determine whether they should be revised to address the particular risks associated with the new strategy. So be vigilant in ensuring that your firm does not outgrow its supervisory procedures, whether because of increasing size or a shift in its investment focus.

The Oechsle case points out an important corollary to Lesson 1: No employee ever outgrows the need for supervision. Andrew Parlin was a senior portfolio manager, managing principal, and member of Oechsle's executive committee. As such, his actions were not closely scrutinized by the firm and he was able to engage in a portfolio-pumping scheme. The moral of the story is that adequate supervisory policies, and enforcement of those policies, must extend to even the most experienced employees.

Supervision Lesson Two: Be mindful of market conditions and the market environment you're in when evaluating supervisory procedures.

Two significant cases from the last couple years illustrate the necessity of supervising specifically for risks associated with an up market. Our action against The Dreyfus Corporation and its portfolio manager, Michael Schonberg, in 2000,3 and our action against the Van Kampen Investment Advisory Corp. in 1999,4 involved failures on the part of the respondents to disclose the degree to which the success of certain of their mutual funds was dependent on difficult-to-replicate investments in hot IPOs. Dreyfus involved a portfolio manager of several funds who preferentially allocated investments in hot IPOs to one of the funds he managed. During the fund's first fiscal year, these IPO investments accounted for a whopping 86 percent of the fund's total return. Dreyfus touted its results, 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.

The Van Kampen matter involved similar facts. In that case, 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.

Because market conditions - for example, the hot IPO market - can have such a pronounced effect on the performance of particular mutual funds, it is essential that funds' and advisers' supervisory procedures be designed to address risks associated with prevailing market conditions. This holds true in a down market scenario as well.

In a down market, an area that presents supervisory and internal controls challenges is pricing of portfolio securities. Particularly in an environment that may create incentives for mispricing, it is essential that firms have carefully designed and diligently monitored policies and procedures governing pricing of portfolio securities. The situation involving several Heartland Group funds illustrates just how critical circumstances can become when there is a failure in pricing procedures. Earlier this year, Heartland so hopelessly lost track of the value of the portfolios of three of its funds that its auditors refused to opine on the valuations of the funds' securities. As a result, neither shareholders of the funds nor the Commission were able to assess the financial status of the funds. To address the situation, in March of this year, the Commission obtained an injunction, and an order freezing the funds' assets and appointing a receiver. We were pleased that two weeks ago, the receiver made a court-approved partial distribution of cash to shareholders in the affected Heartland funds.5

Our recent settled action against Western Asset Management Co. and Legg Mason Fund Adviser, Inc.6 provides a more transparent view into how pricing procedures can be circumvented. It also forms a good backdrop for Supervision Lesson Number 3: Good supervision requires functional separation so that the person conducting the business function is not the sole person responsible for supervision of that function; in other words, you need checks and balances. You may recall this lesson was vividly illustrated six years ago by the situation Barings found itself in, courtesy of rogue trader Nicholas Leeson. He was performing back office functions for Barings while serving as a trader.

The Legg/Western matter arose from the efforts of a portfolio manager to defraud two funds - one a mutual fund and the other an offshore hedge fund — from 1996 to 1998. The portfolio manager, an employee of the sub-adviser, concealed from the funds and their investment adviser the fact that issuers of securities held by the funds were suffering severe financial problems. The portfolio manager also inflated the value of the troubled securities, which caused the mutual fund to overstate its net asset value.

The portfolio manager at Western had practically unfettered freedom when it came to pricing these securities. Specifically, with respect to securities that were not publicly traded, like the ones at issue in this case, she was supposed to obtain two broker quotes. However, she was solely responsible for obtaining them, and, without detection, was able to provide the funds' accountants with two fictional quotes for each of the securities. As the value of these securities dropped, these fictional quotes overstated the value of the securities by ever increasing amounts.

So how was the portfolio manager able to get away with submitting fantasy prices to the funds' accountants? And whose job was it to prevent and detect this misconduct?

First, the how: Western had no policy or procedure to ensure that the portfolio manager was, in fact, monitoring the securities and then properly reporting and acting on any defaults. Moreover, with respect to pricing, while the funds required that securities with no readily available market quotations be valued based on quotes from two recognized broker-dealers, Western did not have adequate policies and procedures to ensure that the funds' securities were priced in compliance with this policy. Instead, the firm relied on a party who had a vested interest in seeing that the securities' prices were high — the portfolio manager. And, as a result, the portfolio manager was able to price the troubled notes at inflated prices.

Western's procedures in this area clearly would have been strengthened by functional separation. That is, by having a supervisor without a direct interest in the performance of the funds check whether the portfolio manager was properly following the firm's rules governing the monitoring and pricing of portfolio securities. The absence of any check and balance made it far easier for the portfolio manager to conduct her scheme without detection for two years.

That brings me to the question of who was responsible. The answer may surprise you. The culpability of the sub-adviser for the actions of its own employee is hardly novel. However, the buck didn't stop there. We also charged Legg, the fund's adviser, with failure to supervise the sub-adviser's portfolio manager. And so we come to Lesson Number 4: Supervision doesn't necessarily stop at organizational boundaries.

In this case, the relationship between the adviser and the sub-adviser was governed by a written agreement. That agreement specifically stated that Western's provision of those investment advisory services was subject to the supervision of Legg. So Legg clearly assumed supervisory responsibility for the portfolio manager. Nevertheless, Legg failed to adequately follow up on numerous red flags concerning the portfolio manager's handling of the problem notes. More than once, Legg became aware of the use of stale pricing data, but did not act on this information. Legg failed to have adequate policies and procedures to respond adequately to indications that the portfolio manager was overstating the value of the funds' securities. Indeed, Legg had not established or implemented procedures requiring follow-up or review of irregularities it detected.

Before you get the idea that an adviser's supervisory exposure for the wrong-doing of a sub can essentially be done away with by modifying contractual language, let me caution you otherwise. Apart from the written acceptance of supervisory responsibility, the nature of the relationship between Legg and the portfolio manager established that Legg was a supervisor. Legg was involved in the portfolio manager's appointment, and the portfolio manager, when dissatisfied with the resources she received from Western, complained to Legg. Such indicia of a mutually recognized supervisory relationship can establish liability even absent a written reservation of supervisory authority.

One other postscript for those of you who already have read this case closely, and noted that the adviser, Legg, and the sub-adviser, Western, are related entities. I do not believe that fact was integral to the finding of a supervisory relationship. In my view, an adviser - sub-adviser relationship between two unrelated entities is equally likely to result in a supervisory relationship.

This news may lead you to ask, in light of the responsibilities advisers take on for the actions of their sub-advisers, what should an adviser do to protect itself? What policies and procedures should it consider adopting to supervise a sub-adviser? Here are a few ideas for your consideration. And, let me emphasize, this list is in no way intended to be exhaustive:

  • One, obtain from employees of the sub annual certifications of compliance with the substantive policies and procedures governing the sub's responsibilities and with the federal securities laws.
  • Two, conduct periodic meetings with compliance personnel at the sub.
  • Three, require the sub to provide notice of regulatory examinations and provide copies of any exam reports; then, implement procedures for follow-up on any troubling findings contained in the reports; and
  • Finally, periodically reassess supervisory procedures applicable to the sub in light of:
    • Changes in a fund's investment strategy or portfolio manager,
    • Significant changes in the sub's business,
    • Dramatic changes in market conditions, or
    • Any other event likely to have a significant impact on the sub's operations.

When weighing the costs and benefits of putting greater resources into supervision and internal controls, you should harbor no doubts that Chairman Pitt believes in vigorous enforcement of the federal securities laws. As I mentioned earlier, his innovation in this area is the introduction of "real-time" enforcement. The goal of achieving real-time enforcement cuts across programmatic areas, so you are likely to feel its effects if you have reason to deal with the Enforcement Division - no matter what the type of case.

Some have asked what this means. A real-time enforcement program is one that seeks to respond quickly, effectively, and efficiently to wrongdoing. And this doesn't mean (some of you will be surprised to hear) simply imposing tight deadlines and refusing to grant extensions on subpoenas or Wells submissions, although I suspect you will see more determination on our part when it comes to those items. Indeed, I can warrant that we will be quicker to seek enforcement of our subpoenas in court when we're faced with non-compliance. (It's an area where I have delegated authority from the Commission.) But more fundamentally, real-time enforcement means:

  • Taking actions to stop fraud or other investor harm expeditiously, even if our investigation will continue,
  • Bringing cases in pieces (e.g., issuer, then officers, then auditors), and
  • Obtaining TROs and orders freezing assets.

But it also means, rewarding meaningful cooperation — because doing so will enable us to bring more cases faster.

Which brings me to the topic I promised I would discuss in my opening: how you can put yourself in the best position if misconduct does occur at your firm. In October, the Commission issued a 21(a) Report of Investigation and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions.7 The Report sets forth a framework for evaluating a company's cooperation in determining whether and how to charge the company with violations of the federal securities laws. Credit for cooperative behavior may range from the extraordinary step of taking no enforcement action at all to bringing reduced charges, seeking lighter sanctions, or including mitigating language in documents the Commission uses to announce and resolve enforcement actions. The Report identifies four broad measures of a company's cooperation:

  • Self-policing prior to the discovery of the misconduct, including establishing effective compliance procedures and an appropriate tone at the top;
  • Self-reporting of misconduct when it is discovered, including conducting a thorough review of the nature, extent, origins and consequences of the misconduct, and promptly, completely, and effectively disclosing the misconduct to the public, to regulators, and to self-regulators;
  • Remediation, including dismissing or appropriately disciplining wrongdoers, modifying and improving internal controls and procedures to prevent recurrence of the misconduct, and appropriately compensating those adversely affected; and
  • Cooperation with law enforcement authorities, including providing the Commission staff with all information relevant to the underlying violations and the company's remedial efforts.

Some commentators appear to be under the mistaken impression that the 21(a) Report foretells that we will be less than vigorous in enforcing the securities laws. I can tell you categorically: That is not the case. It does not create an amnesty program, as some have described it, which will enable any issuer to violate the law without repercussions, so long as after the fact the company self-reports. What it represents in my mind is an effort to maintain a wide spectrum of enforcement outcomes, so that there are meaningful differences in how we treat different respondents. That doesn't only mean giving "credit" to someone who cooperates; it also means being tougher on those who aren't good corporate citizens, including seeking stiff sanctions against and encouraging more criminal prosecutions of:

  • Deliberate wrongdoers,
  • Recidivists, and
  • Those who interfere with Commission processes.

Moreover, even in situations where credit for cooperation may be appropriate, the Report makes clear that self-reporting is not the only prerequisite. We will look to the company's actions both before and after discovery of misconduct, including the rigor of its compliance and/or internal audit program and the tone set by senior management. In my view, too little attention has been paid to this part of the 21(a) Report. If you start thinking about the 21(a) Report only after you receive a subpoena, you're too late.

Although I believe the 21(a) Report is very significant, as many of you know, the policy of rewarding cooperation is not a new one. It is a time-honored approach employed by numerous law enforcement authorities, including the Commission. In that regard, the 21(a) Report does not lay down new law. The Commission has always, to varying degrees, recognized the value of and rewarded cooperation. What is new is this Commission's willingness to articulate publicly the framework it will use for analyzing a firm's cooperation — to give transparency to its thought process. There hardly could be clearer evidence of the Commission's commitment to rewarding cooperation and its view that doing so is effective law enforcement.

As I drone on about the rewards of self-reporting and cooperating, you may be thinking to yourself, "been there, done that." If you are, you're right. The investment adviser community has a history of self-reporting and cooperating that frequently has warranted substantial credit by the Commission, and certainly has contributed to its good reputation. For instance, in 1993, the Commission brought an action against an adviser's Chief Investment Officer who failed to timely allocate transactions in mortgage-backed securities to particular client accounts.8 Specifically, he did not allocate the purchases of securities until after he had sold out the positions. The CIO also violated the adviser's procedures governing cross trades between advisory accounts. When the adviser discovered the CIO's conduct, it brought the matter to the Commission's attention and cooperated with our investigation. Ultimately, the Commission did not charge the adviser with any violations.

More recently, the Commission brought an action against a senior manager of an adviser who failed to comply with the adviser's procedures requiring employees to submit quarterly reports of their personal trading to the adviser's compliance officer.9 Instead of reporting his actual personal trades, the manager submitted personal trading reports containing fictitious transactions. As a result, accounts over which the manager had investment discretion engaged in several hundred transactions in securities in which he had a personal interest. Although no client accounts were adversely affected, the adviser failed to make and keep true, accurate, and current records. The violations were reported to the Commission staff - this time during a routine examination of the adviser — and the firm's personal trading reports were corrected. In settling this action against the manager with a cease-and-desist order, the Commission considered these remedial acts and the cooperation afforded the Commission staff. And again, the Commission did not charge the adviser.


If you boil today's message down to one sentence, it would be hope for the best, but plan for the worst. Particularly when it comes to supervision, there is much to gain from living by this rule. The Commission's recent statement on cooperation makes clear that good supervisory procedures can yield dual benefits. They will, of course, help keep your firm out of trouble; but they also will be of real value if and when your firm gets into trouble. The mutual fund community has a long history of good supervision as well as cooperation in the broad sense of that term. I encourage you to continue to build on and nurture that reputation, because it will reap benefits now more than ever.

Thank you.


1 In re Dawson-Samberg Capital Management, Inc. Now Known As Dawson-Giammalva Capital Management, Inc. and Judith A. Mack, Advisers Act Rel. No. 1889 (Aug. 3, 2000).

2 In re Oechsle International Advisors, L.L.C., Advisers Act Rel. No. 1966 (Aug. 10, 2001).

3 In re The Dreyfus Corp. and Michael L. Schonberg, Advisers Act Rel. No. 1870 (May 10, 2000).

4 In re Van Kampen Investment Advisory Corp., Advisers Act Rel. No. 1819 (Sept. 8, 1999).

5 Securities and Exchange Commission v. Heartland Group, Inc., Civil Action No. 01-C-1984 (Northern District of Illinois), Litigation Release No. 17247 (Nov. 27, 2001).

6 In re Western Asset Management Co. and Legg Mason Fund Adviser, Inc., Advisers Act Rel. No. 1980 (Sept. 28, 2001).

7 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 and Commission Statement on the Relationship of Cooperation to Agency Enforcement Decisions, Exchange Act Rel. No. 44969 (Oct. 23, 2001).

8 See In re Matter of Michael L. Smirlock, Advisers Act Rel. No. 1393, 1993 SEC Lexis 3313 (Nov. 29, 1993).

9 See In the Matter of David F. Bellet, Advisers Act Rel. No. 1979, 2001 SEC Lexis 2009 (Sept. 28, 2001).



Modified: 12/07/2001