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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Priorities in Investment Adviser Regulation


Paul F. Roye

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Remarks Before the IA Compliance Summit and Best Practices Update

Washington, DC
April 8, 2002

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 Mr. Roye and do not necessarily reflect the views of the Commission or the staff of the Commission.

I. Introduction

Good morning, and thank you for inviting me to speak to you today. As always, I am pleased to be here-and also pleased to see that you have such a full and interesting agenda planned for your conference. From issues such as best execution, to adviser registration, to advertising, the conference will address a number of important regulatory topics currently attracting the attention of advisers, regulators and investors. Many of these issues are becoming increasingly important as investors in the midst of a difficult market environment, and faced with a vast array of investment choices, are turning to those with investment expertise to guide them in their efforts to prepare for retirement, save for college expenses and meet other financial goals.

I have been asked to speak today about priorities in the area of investment adviser regulation. But before I do that, I must state that my remarks represent my own views and not necessarily the views of the Commission, the individual commissioners or my colleagues on the Commission staff.

II. Part 2 of Form ADV

In the Investment Advisers area, one of our top priorities has been completion of the revamping of Form ADV with the adoption of amendments to Part 2 of the form. Amending Part 2 will complete the first major overhaul of the 17-year-old form, which greatly impacts the day-to-day operations of all investment advisers and also impacts advisers' relations with their clients and potential clients.

The Commission has proposed substantial amendments to Part 2 of Form ADV. The Commission adopted amendments to Part 1 of the form in September 2000 and at the same time instituted the IARD electronic registration system. The Commission delayed adoption of the amendments to Part 2 because commenters expressed more significant concerns with Part 2 than with Part 1 and because the Commission and the staff wanted to focus on the transition of Part 1 to electronic filing through IARD. As you are aware, SEC-registered advisers completed the transition to IARD last April, and the Commission and NASAA launched the IAPD public disclosure website in September 2001. Through that website, any member of the public can review the most recently filed Form ADV information of any SEC-registered adviser, and certain state-registered advisers, from their homes, on-line, around the clock, at no charge. Most recently, the investment adviser representative portion of IARD was launched, enabling firms to electronically register their investment adviser representatives with the various states.

Now that the transition to IARD, the launch of the public disclosure website and the implementation of electronic investment adviser representative registration are behind us, the Division staff is actively working on a recommendation to the Commission regarding adoption of Part 2. We also are coordinating with the states on final Part 2 amendments. As I said, Part 2 is a top priority.

As proposed, Part 2 would call for a plain English, narrative brochure. We believe that the proposed narrative approach would be much more useful, readable and helpful to advisory clients. Commenters agreed with us. The areas of the proposal that drew the most concern involved updating firm brochures and proposed "brochure supplements," which would contain background information about individuals who work for an adviser.

The overhaul of Part 2 is a large-scale project that will have a universal impact on the advisory industry. Few, if any, regulatory matters under the Advisers Act affect so many people so substantially. Therefore, we want to make sure we get it right. The Division staff is closely reviewing your comments while at the same time working to recommend a final version of Part 2 that remains true to the principle that advisory clients should receive meaningful and readable information about their investment advisers. Jennifer Sawin, Assistant Director in the Office of Investment Adviser Regulation, will be addressing Form ADV and electronic filing through IARD on a panel later in today's program.

III. Contingency Planning

Another matter of significant priority for the Division and the Office of Compliance Inspections and Examinations is disaster recovery planning. I was pleased to see that there is a conference panel devoted to this very important and timely topic. The tragic events of September 11th opened all our eyes to certain weaknesses in disaster recovery and contingency planning. As your agenda indicates, clients rely on you to maintain your operations and your ability to communicate with them, even in the wake of natural and other disasters. Therefore, during exams, our inspections staff will be asking for copies of your contingency plans and likely will ask questions about alternative physical facilities, back-up records storage and back-up communications systems. The staff also will focus on testing and internal evaluation of contingency preparedness. The staff understands that a "one size fits all" approach to contingency planning does not work. Each firm should thoughtfully assess what its own back-up and contingency needs are and institute procedures to meet those needs in a well thought out contingency plan. John Walsh, Chief Counsel of our compliance and inspections office, will be talking with you later today about additional priorities for the examinations staff.

IV. Anti-money Laundering

Following the tragedy of September 11th, Congress passed the USA Patriot Act, which imposes new anti-money laundering requirements on investment companies and broker-dealers. To the extent that advisers manage investment companies, they will be involved in ensuring that their investment companies comply with the new anti-money laundering requirements. In addition, pursuant to interim regulations issued by the Treasury Department in December, all persons engaged in a trade or business, including investment advisers, are required to file currency transaction reports for currency transactions over $10,000. We have been working with the Treasury Department to implement the USA Patriot Act, and there will be a panel later in your program discussing the responsibilities of the financial services industry in this very important effort to root out terrorist and criminal money laundering.

V. Internet Advisers

In terms of matters that are on the horizon, the Commission has announced that it will hold an open meeting this Thursday to consider whether to propose a new rule under the Advisers Act that would permit certain investment advisers that provide advisory services through interactive Internet websites to register with the Commission, even if they do not have $25 million in assets under management. The staff's recommendation is driven, in part, by the development of Internet technology that was not prevalent in 1997 when NSMIA was implemented. As Chairman Pitt has stated, the Commission is committed to reviewing and modernizing all of the federal securities regulations. This means that we have to analyze and revise our rules, as necessary, in the wake of technological developments in the marketplace.

VI. Adviser Advertising Rule

In light of the fact that we are conducting a full-scale effort to dust the cobwebs off our Advisers Act rules, various industry groups have made requests that we update particular rules. For instance, the ICAA has requested that the Commission revise the investment adviser advertising rule. I also believe that the advertising rule is in need of revision. The ICAA advocates modernizing the rule and eliminating its specific prohibitions in favor of a general anti-fraud standard. Tomorrow morning's panel will discuss the ICAA's advertising proposal in detail and will include as a panelist Bob Plaze, someone familiar to all of you as the Division's Associate Director in charge of investment adviser regulation.

VII. Principal Transactions Rule

Other rulemaking requests we have received include one from the Securities Industry Association. The SIA has requested that the Commission promulgate an exemptive rule to allow investment advisers to engage in principal transactions with clients without first obtaining client consent for each principal trade. The SIA recommends that advisers be able to obtain prior blanket written consent from their clients. In addition, the SIA has suggested that any new principal transactions relief be limited to circumstances where there is little or no likelihood of abuse, such as "riskless" principal transactions, high quality equity and fixed income securities that have readily available and liquid markets that significantly reduce the risk of dumping or unfair pricing, and principal transactions with sophisticated investors. We are considering such parameters as we work on a proposed rule to recommend to the Commission.

VIII. Exemption for Thrifts

We also have received requests from the thrift industry that the Commission exempt thrifts from the provisions of the Advisers Act. The thrifts have argued that this exemption would put thrifts on a level playing field with banks, which are excluded from the definition of investment adviser except to the extent that they advise registered investment companies. However, the ICAA and The Financial Planning Association on behalf of the advisory industry have argued that a thrift exemption would actually un-level the playing field between thrifts and other advisers. In a recent development, Representative Michael Oxley of Ohio introduced legislation endorsed by the Office of Thrift Supervision that, if enacted, would treat thrifts the same as banks under the Advisers Act.

IX. Broker-dealer Exemption

In addition to these projects, the Commission has outstanding a proposal to exempt from the definition of investment adviser certain broker-dealers that charge an asset-based fee, if those brokers make appropriate disclosures and do not have discretion over client funds. The proposal was precipitated by the development of new brokerage compensation systems and the development of on-line trading at reduced brokerage rates. The proposal contained a no-action position for brokers with asset-based compensation programs. The proposal generated over 250 comment letters. Brokers strongly supported the proposal, and advisers and financial planners strongly opposed it.

The rule proposal and its comment letters have highlighted certain broader, more fundamental issues regarding broker-dealers and adviser regulation. For instance, the Advisers Act excepts broker-dealers from the definition of investment adviser to the extent that the advice they provide is solely incidental to the conduct of their business as a broker or dealer. But what does it mean for advice to be "solely incidental"? Some contend that the Commission needs to provide additional guidance in this area.

Additionally, the exception creates some anomalous situations. For instance, it is seems odd that a broker-dealer with full discretion over client assets might not be an investment adviser. Under the Commission's broker-dealer rule proposal, a broker with discretion that charges an asset based fee would be an investment adviser, while a broker with discretion that charges only commissions might not be an investment adviser. From the client's perspective, however, those two brokers are performing exactly the same services. While there may have been clear lines between investment advisers and broker-dealers in 1940, the financial services industry has evolved to the point where the differences are not quite so clear. I believe that we need to consider how we can eliminate these anomalous situations.

X. Books and Records/Custody Requirements

The staff also is working on recommendations to the Commission regarding major overhauls of the adviser books and records rule and the custody rule. As you are aware, the books and records rule imposes obligations on every adviser registered with the Commission, and the custody rule has not been significantly re-worked since its adoption in 1962. Both are important projects.

XI. Proposed Analyst Rule

One issue that is now off the Division's priority list relates to the NASDR's proposed analyst rule. As you may recall, last summer NASDR proposed rule amendments to require additional conflicts disclosure from financial analysts and other brokerage personnel who make public statements about individual securities issuers. NASDR's original proposal would have applied to fund portfolio managers and other buy-side analysts that were registered as broker-dealer representatives or were employed by dual broker-dealers/investment advisers. The proposal raised concern among some that investment advisers would then be subject to different disclosure standards based on whether they were subject to the NASDR rule or not. However, in the proposed amendments submitted to the Commission in February, NASDR limited the application of its proposal to "research analysts," which are defined as persons principally responsible for the preparation of research reports. Consequently, NASDR's proposal states that a mutual fund portfolio manager generally would not be deemed to be a "research analyst" even if the portfolio manager is an associated person of a broker-dealer. The Division is continuing to monitor the proposal. At this point, however, it appears that there is not a threat of inconsistent regulation among investment advisers, and the Division currently does not plan to recommend action in this area.

XII. Compliance and Enforcement

As you can see, adviser regulation is in a state of flux, and I hope and believe that the outcome of this period of evolution will be an adviser regulatory system that is more usable and meaningful for both advisers and their clients. However, even during this period of change, one thing remains constant. And that is the importance of compliance and putting your clients' interests before your own. Advisers must establish effective and meaningful internal controls. And the supervisors who oversee these controls must be dedicated and vigilant. Lax internal controls signify an advisory firm that is not truly dedicated to its clients. Advisers that "put their clients first" will institute strong internal compliance systems to ensure that client interests, and client assets, are not put at risk. Year in and year out, compliance is a top regulatory priority for the Commission staff. We, and clients, expect that compliance is a top priority for advisers as well.

Advisers have various sources of assistance when it comes to instituting strong internal compliance systems. One very helpful source is the ICAA and the other various industry trade associations, which provide compliance assistance to their members. Along these lines, AIMR recently proposed trade management guidelines to assist advisers in their best execution obligations. I believe that industry efforts to establish standards and recommend best practices go a long way toward building strong compliance systems and toward strengthening the industry's reputation with its clients.

As becomes obvious all too often, weak compliance programs often lead to securities law violations. And a top priority for the entire Commission is enforcement of the securities laws and regulations. Chairman Pitt has instituted a program of "real-time" enforcement, and the enforcement staff is committed to detecting and stopping fraudulent activity before that activity results in significant losses to innocent investors.

One recent enforcement matter involved a portfolio manager who inflated the value of troubled securities in a mutual fund and a hedge fund. The Commission found that the funds' sub-adviser, who employed the portfolio manager, failed to adequately supervise the portfolio manager. Significantly, the Commission also found that the funds' adviser failed to adequately supervise the portfolio manager. In making its finding, the Commission noted that the contract between the adviser and the sub-adviser provided that the sub-adviser's services were subject to the adviser's supervision and that the adviser became aware of several "red flags" indicating potential problems, such as stale pricing of the troubled securities, but did not adequately follow up on these issues. Both the adviser and sub-adviser were censured and each ordered to pay a $50,000 civil money penalty. As the advisory industry moves more and more toward the use of sub-advisers, all must be mindful of advisers' duty to oversee those sub-advisers. Advisers cannot shirk their responsibilities to their clients simply because another entity is investing client money. If anything, advisers should be especially vigilant about compliance oversight when other parties are involved in managing client assets.

As a general matter, many of our recent advisory enforcement actions have involved soft dollar issues, brokerage kickbacks, false advertising, inflated performance results, misstatements regarding number of clients and assets under management and actual theft of client assets. John Reed Stark, Chief of the Commission's Office of Internet Enforcement and today's luncheon speaker, will provide you with additional details on the Commission's enforcement actions with respect to Internet fraud.

We also have seen an increased number of enforcement actions involving hedge funds. Hedge funds generally are referred to as unregulated investment pools. This may conjure up images of some maverick managers doing as they please. However, hedge fund managers who take this attitude do so at their peril. As we all know, hedge fund managers are investment advisers under the Advisers Act. And even though they may be exempt from registration in many cases, they still are subject to the Advisers Act's anti-fraud provisions, which provide the Commission the ability to attack abusive practices by advisers. Section 206 of the Advisers Act generally makes it unlawful for an investment adviser to engage in fraudulent, deceptive or manipulative conduct. Moreover, the Supreme Court in SEC v. Capital Gains Research Bureau, Inc.1 held that section 206 imposes a fiduciary duty on investment advisers. Therefore, an investment adviser--whether or not registered--has an affirmative duty to act in the best interests of its clients and to make full and fair disclosure of all material facts, particularly when the adviser's interests may conflict with clients' interests.

Section 206 prohibits, of course, misappropriating client funds. But it also prohibits a variety of other unscrupulous activities, such as overstating performance results, usurping investment opportunities that belong to clients, failing to disclose soft dollar practices, failing to seek best execution on client transactions, and favoring certain clients or proprietary accounts in allocating trades without disclosing the practice. Hedge fund managers always must keep in mind that, even though they consider themselves to be "unregulated," they have a fiduciary duty to their clients. The Commission and others are watching to make sure that hedge fund managers meet their fiduciary obligations.

In addition, hedge fund managers sell their hedge fund shares through private placements. Therefore, they must follow the disclosure and anti-fraud standards of the Securities Act and the Exchange Act. As part of these standards, hedge fund managers must prepare a private placement offering document, which in many ways is similar to a mutual fund prospectus. Most importantly, hedge fund managers must live by the disclosures made in their offering documents, just as mutual fund managers are bound by the language of their prospectuses.

The Division staff also has taken a regulatory action that may help to curb certain investment adviser fraud. In January, the staff issued a no-action letter to the NFL Players Association, which represents present and future professional football players in the NFL. The Players Association had become concerned about the rising number of NFL players being defrauded by those who invest player money or give players financial advice. The Players Association stated that, in the last three years alone, it was aware of at least 78 players who had been defrauded of over $42 million dollars. The Players Association noted that many of their members come from economically deprived backgrounds, are financially unsophisticated and have comparatively vast wealth thrust upon them at a relatively early age. These factors can work to exacerbate the possibility that a player may fall victim to fraudulent advisers. Some of these issues were highlighted in the case of "Tank" Black, a former professional sports agent who is now awaiting sentencing on a criminal conviction for conspiring to commit mail and wire fraud, defraud the United States and obstruct an SEC investigation. Mr. Black, who also is subject to a civil action filed by the SEC, is believed to have defrauded nearly two dozen client-athletes of approximately $5 million while acting as an unregistered investment adviser and unregistered broker-dealer.

Cases like this one caused the Players Association to take action to respond to the distressing amount of financial fraud perpetrated on its members. And the staff granted no action relief in response to the Players Association's request that they be permitted to provide their players a list of financial advisers, including investment advisers, broker-dealers, financial planners and others, that have passed certain screening requirements established by the Players Association. These screening requirements include whether a financial adviser has a history of certain disciplinary events. The no-action relief was necessary because financial advisers that appear on the list pay the Players Association a fee to cover the costs of completing the background checks and running the program. The Players Association requested assurance that the staff would not recommend taking enforcement action against them as an investment adviser or a solicitor. Of course, we hope that the Players Association's program has the intended effect of reducing financial fraud and further hope that other groups can take similar steps to protect their members.

XIII. Improvements in Financial Disclosure and Related Issues

Since the beginning of his chairmanship, Chairman Pitt has set improving financial disclosure as a top priority for the Commission. Recent high profile bankruptcies have highlighted to the investing public the importance of accurate and meaningful financial disclosure. Public scrutiny has also focused on related issues such as corporate governance, management conflicts and our accounting system.

Chairman Pitt has called for input on these issues, acknowledging that the Commission does not have a monopoly on wisdom. He has emphasized that the Commission is seeking to learn more on these issues and will not foreclose any valuable alternatives and suggestions. I believe that investment advisers are uniquely qualified to provide meaningful input on financial disclosure, corporate governance and related issues. We are at an important crossroads in the direction of corporate disclosure and accounting in America. And I believe that the advisory industry, as the trusted advisers of millions of American investors, has a responsibility to provide input on these significant issues.

XIV. Conclusion

Now is an exciting time to be involved in the regulation of investment advisers. Adviser regulation has entered the electronic age through the IARD; adviser registration information now is available to the public with just the click of a mouse-rather than a laborious search of microfiche; and adviser regulations currently are the subject of a top to bottom review. The adviser industry continues to grow, as investors seek guidance and direction for the investment of their savings. And the adviser industry, for the most part, continues to attract capable, principled and dedicated professionals who have a genuine desire to help others reach their investment goals. Those who do not meet this high standard exhibited by the advisory industry will be met by our compliance examiners and our enforcement staff, who continue to show a tireless commitment to protect investors and root out fraud.

Once again, I thank you for including me at your conference. It is always a pleasure to meet with you and to discuss the significant regulatory issues facing the advisory industry. I hope that you have an informative and productive conference and thank you for your attention.


1 375 U.S. 180 (1963).



Modified: 04/09/2002