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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Meeting the Compliance Challenge

Remarks by

by Paul F. Roye1

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

Before the Investment Counsel Association of America
Scottsdale, Arizona

April 23, 1999

Thank you and good morning. It is a pleasure to be at the Annual Conference of The Investment Counsel Association of America.

As all of you know, the investment management industry has experienced tremendous growth in recent years. From 1988 to 1998, total assets under management by federally registered advisers grew from $4.4 trillion to $15 trillion, an increase of over 240%.2 Just from 1996 to 1998, assets under management increased 40%. Much of this growth, of course, has been fueled by the longest bull market in history. I do think, however, that this growth is a reflection of investor satisfaction, and confidence, in the investment management industry and no doubt the efforts of your organization over the last 63 years have contributed to this confidence level.

I. Good Compliance is Vital to Continued Success of the Industry

The theme of this yearís conference is "Meeting the Challenge of the New Millennium." I believe the challenge for the investment management industry will be continuing the level of success achieved in the 20th century -- into the 21st century. Since none of us know where the market will be a few months from now (or even next week for that matter), the question is how can the industry continue its success into the next century? I believe that the only sure-fire method is by maintaining the integrity and professionalism that the investment management industry has demonstrated in the past.

Now, I bet youíre thinking, "of course you think adherence to high standards and sound practices is the answer -- youíre from the SEC." Okay, youíve got me there. But I really do believe that compliance with the law, and the high standards it imposes on investment advisers, is vital for the long-term success of the industry, as well as individual firms. As advisers devote more and more resources to new product development and marketing, it is essential that they devote substantial resources to compliance. Do not misunderstand -- I am not suggesting that advisers are not making this commitment today. I do believe that the industry recognizes the importance of compliance, and I know that many compliance departments have a prominent place within investment management firms. (Believe me, if the number of SEC staff members leaving the SEC to join investment management firms is any indication, your commitment is quite impressive!) I am here today only to caution the industry not to become complacent, and not to become a victim of your own success.

As you know, investment advisers are subject to the highest standards in the financial services field. In a case involving the Investment Advisers Act of 1940, the Supreme Court noted that the Act reflects "the delicate fiduciary nature of an investment advisory relationship," and that the standard for fiduciaries under the Advisers Act includes "an affirmative duty of Ďutmost good faith, and full and fair disclosure of all material facts,í as well as an affirmative obligation Ďto employ reasonable care to avoid misleadingí . . . clients."3 As the choices available to investors multiply daily, I believe that adherence to these standards is the best marketing tool available to investment advisers. In short, I believe good compliance just makes good business sense.

And thatís why I am here today -- to talk about why good compliance is good for your firm, the industry, and investors alike. I also will talk about what I think are the basics of an effective compliance system. I also plan to take some time to talk about some regulatory developments, including principal transactions and pay-to-play.

In the eyes of many, complying with SEC regulations, and establishing a compliance program, is just another cost of doing business. I am not one that subscribes to this view. Of course I realize that there are costs associated with the establishment and upkeep of a compliance program. And I also realize that even with the best compliance system, an adviser that fails to meet its clientsí financial goals probably will not be able to retain those clients. However, I am of the view that good compliance is a vitally important business asset, as well as a competitive advantage. In this day and age when investors can choose among an amazing array of financial professionals and investment opportunities, and have access to alternative trading systems and information technology, advisers need to be able to distinguish themselves in a very crowded field. In this competitive environment, it is vitally important for advisers to demonstrate that the fundamental business of advisers has not changed. It must still be based on a relationship of trust and integrity between a fiduciary and a client. When this trust is violated, it cannot be regained, and the adviser ultimately will lose its clients to other firms that recognize their fiduciary obligations.

As I was reviewing the conference materials, I noticed that one of the talks yesterday was titled the "Asset Managersí Perpetual Quest for the Investor $." While embarking on this "perpetual quest for dollars," it is important not to lose sight of your fiduciary obligations. I caution advisers not to "look the other way" when an employee responsible for generating sizable advisory accounts acts in an unethical manner. On this same note, former SEC Commissioner Bevis Longstreth once told the story of a chief compliance officer of a major brokerage firm describing the problem posed by large producers. The chief compliance officer asked the firmís branch manager "if he reviewed the monthly statements that were sent to him [by the big producer.] . . . [T]he branch manager said, ĎYes, I just sign them and pray.í"4

When telling this story, Commissioner Longstreth noted that praying did not help firms avoid paying out millions of dollars to settle customer complaints. I also donít think it will help when the SEC comes knocking on your door. Instead, I would recommend devoting adequate resources to compliance before the SEC is at your door. Of course, praying can never hurt for extra insurance.

II. The Costs of Non-Compliance -- Pay Now or Pay A Lot More Later

Now, I do not think compliance is important just to avoid an SEC enforcement action. Whether or not you expect an SEC visit anytime soon, I believe a strong compliance system should be an important business goal of any adviser. Clients expect that their advisers are complying with the law, and assume they have instituted policies and procedures to prevent violations by employees. For this reason alone, strong internal controls make good business sense.

No matter how you look at it, the price of compliance is minimal compared to the potential costs of non-compliance. As the saying goes, "pay now, or pay a lot more later." Devoting resources to compliance is simply the right business decision. If a firm does not have a strong compliance ethic, if it places the interests of the firm before its clients, it is only a matter of time before it loses the confidence of its clients. A compliance failure can lead to bad publicity and embarrassment, which can permanently damage a firmís reputation and ultimately lead to erosion of its client base. The end result will be lower profitability and private lawsuits. In short, a weak and ineffective compliance system can spell disaster for an adviser.

I think Chairman Levitt made this point well recently when he compared a firmís compliance department to "the Internal Affairs division of a police department. Both absolutely necessary, but not exactly appreciated."5 He noted that "saying no, pointing out problems, assessing responsibility is not for the fainthearted. But, if internal controls are not strong and are not driven by accomplished, smart and courageous people, a firmís future hangs in the balance. All it takes is one incident to destroy a reputation and eviscerate trust."6 I couldnít agree with him more.

And at the SEC, we appreciate good compliance. When the inspection staff visits an adviser and sees strong internal control systems, that adequate resources are devoted to compliance and surveillance functions, the staff will feel more comfortable that the adviser is able to detect problems and fix them. On the other hand, if we go in, and see weak controls, the staff may perceive this as a "red flag" requiring closer inquiry. Believe me, we want advisers to make compliance a top priority. We believe that a firmís compliance program is the first line of defense in protecting the interests of investors.

In recognition of the important function of self-regulation, several provisions of the federal securities laws require a firm to maintain a compliance system. These provisions are violated if a firm fails to maintain these procedures, whether or not any violations of the law occurs. For example, the Advisers Act requires advisers to maintain written procedures to prevent insider trading. If the adviser manages a registered investment company, it is required to have a code of ethics to prevent advisory personnel from defrauding the fund. Finally, the SEC has the enforcement authority to institute administrative proceedings against an adviser for failing to supervise an employee. You should note that the Advisers Act specifically provides a defense to an adviser for failing to supervise an employee who violates the law if the adviser established procedures reasonably designed to prevent and detect such violations, and the procedures were reasonably enforced. In the end, a top-notch compliance system can provide an adviser with important legal protections when a rogue employee engages in misconduct.

Recent SEC Enforcement Actions Against Advisers

Speaking of rogue employees, I would like to turn to some of the recurrent themes we have seen in enforcement actions involving investment advisers. These cases highlight some of the problems we are seeing in the industry and also illustrate the end result of poor compliance.

Recently, we have brought several cases involving investment advisersí undisclosed conflicts of interest and personal trading. These enforcement actions have involved abusive trading practices in which advisers or their employees improperly benefit from their positions. For example, we settled a failure to supervise case against an investment adviser in which a senior trader and portfolio manager for the firmís employee plan engaged in a day trading strategy in which he allocated profitable equity day trades to his personal accounts rather than to the firmís employee plan.7 The Commission found that under the adviserís policies and procedures then in effect, there was no oversight of the senior traderís investment decisions prior to his executing an order for the employee plan or for his personal accounts. These procedures gave the trader the opportunity to allocate a buy and sell of the same security within the same day to the employee plan or to one of his personal accounts without anyoneís knowledge or consent. In another case, the Commission has alleged that a principal of an investment adviser and the adviserís parent company, (a) recommended to the adviserís clients the securities of the parent company without disclosing that companyís financial condition, and (b) directed brokerage of the advisory clients to a broker without disclosing that commissions were being used to repay the principalís personally guaranteed debt to that broker.8

The Commission has also recently charged investment advisers with failing to reasonably supervise their employees, in cases involving millions of dollars in losses. We recently settled a failure to supervise case against an investment adviser for failing to supervise employees who fraudulently marketed and priced an offshore fund.9 The Commission found that one of the adviserís salesman repeatedly misled investors about the content, size and number of investors in the fund. The settled order further notes that the salesman falsely assured an investor that invested a total of $850 million in the offshore fund that its investment would be guaranteed. Meanwhile, contrary to the fundís investment policies, the adviserís portfolio manager invested the fundís assets in risky derivative securities. The Commission found that the portfolio manager also inflated the value of risky derivative securities held by the fund without detection. As a result, the adviser and the fundís investors were not aware of a $24 million net loss in the fund. The Commissionís order makes clear that the adviser did not have proper supervisory procedures, thus allowing the fundís portfolio manager to supply price quotes to the fundís administrator for calculating the fundís net asset value. In this case, the settlement included a $500,000 penalty. Another failure to supervise case involved the loss of $162 million in two pension accounts managed by an adviser.10 In this administrative proceeding, the SEC charged the adviser and its president with failing to supervise its chief investment officer who engaged in unauthorized options trading and concealed losses of $162 million, including losses of $150 million in one pension account. The Commission found that the CIO was able to place unauthorized trades because the adviser failed to respond to "red flags," and did not have procedures to monitor the CIOís trading or his reporting of performance. The order further notes that the adviser had no policies or procedures designed to detect unauthorized trading in the clientsí options accounts, and the adviserís president allowed the CIO to exercise complete control over all aspects of the firmís options trading program, including calculating and reporting the accountsí performance. According to our order, the president relied exclusively on unverified oral reports from the CIO to monitor the program.

We are also seeing problems relating to investment adviser soft dollar practices as well as advertising. As you are probably aware, we have devoted significant enforcement and examination efforts to investment adviser brokerage and soft dollar practices. We recently instituted enforcement actions against advisers, in which we charged the advisers with failing to provide adequate disclosure to clients about their soft dollar arrangements.11

This past year, we also brought several false advertising cases against investment advisers, involving advisers overstating their performance results or the amount of assets under management in advertising materials. In one settled case, an adviser claimed to have $118 million under management when it had less than $14 million.12 In another, an adviser overstated its assets by up to 2500%, and reported assets ranging from $175 million to $250 million when it never had more than $10 million under management.13 Another case involved an adviser that disseminated misleading performance information in advertisements by failing to disclose that the returns were based on a model portfolio, and not actual results.14 Another adviser distributed marketing materials which falsely claimed that its performance results were net of fees, when in fact they were not.15 Along with cease and desist orders and hefty penalties, you should note that as part of its settlements, the Commission has required advisers in many cases to send a copy of the Commissionís order to clients to inform them of their advisersí conduct. Advisers also have been required in certain cases to hire independent consultants to review their compliance procedures, and make recommendations, which the advisers must generally follow.

The one clear message to take from all of these cases is that the time to address compliance issues is before the SECís inspection or enforcement staff come to your door. I realize that no compliance system is completely fool-proof but it is the best insurance an investment adviser can get.

III. Setting up an Effective Compliance System

Now that I have mentioned the problems we have seen, the question now becomes how to set up an effective compliance system.

I think the first step in creating an effective compliance system is selecting and empowering the right people. For a firm to have a strong compliance culture, it must start at the top. If not, why should lower level employees take compliance seriously?

Next, compliance officers must be accorded proper respect within the organization and have sufficient authority to do their jobs, and to remedy inappropriate conduct. Ask your compliance personnel whether they feel they have this authority. Do they feel that they still have this authority when it comes to "top portfolio managers" in the firm? Do your compliance personnel feel comfortable going straight to top management, if necessary? Are there both formal and informal lines of communication between the compliance department and top management? This open line of communication will allow management to take corrective action early on.

Of course, the most important step for an adviser is tailoring policies and procedures to its own operations. Make sure the polices and procedures address the specific issues faced by the adviser. This is a commonly overlooked point. Many firms try to use form policies and procedures, without determining whether they fit the firmís operations. The problem is that a compliance manual cannot just sit on a shelf, it must be used and enforced. Thatís why it is not a smart move for a firm with five employees to try to copy procedures designed for a 1,000 person organization. Remember, the adviser will be held to the standards in its compliance manual. Thatís why an adviser must make sure the procedures fit its operations. Also, make sure the policies and procedures are workable when considering the firmís corporate culture.

Your procedures also can become an important education and training tool for employees. Education and training beyond procedures is also vital. While training new and current employees about marketing and new products, take some time to educate them on their obligations to their clients. Also, be sure to keep employees updated on regulatory developments.

Remember, in order to counter failure to supervise charges, an adviser must have established procedures and have a system for applying the procedures that reasonably can be expected to prevent and detect securities law violations by supervised persons. Also, supervisors must reasonably discharge their obligation under the procedures. When they see "red flags" and suggestions of irregularities, they must make inquiries and conduct adequate follow-up. Also, once these issues reach those in authority, they should take decisive corrective action.

You should make sure your firm has procedures in place to avoid common compliance failures, in addition to insider trading procedures, which are mandatory under the Advisers Act. Your compliance procedures should address the specific issues your firm faces. For example:

  • Did you obtain the best execution on behalf of the client?
  • If the firm participates in soft dollar arrangements, do the transactions fit within the 28(e) safe harbor? Are these arrangement adequately disclosed to clients?
  • Do you have trade allocation procedures and are investment opportunities allocated among clients in an equitable and timely manner?
  • Are your clientsí assets being valued accurately and fairly?
  • Did you make appropriate disclosure and obtain your clientsí consent to principal and agency cross transactions?
  • Is your advertising being reviewed before publication? If it includes performance results, is it net of advisory fees and other expenses?
  • Are you keeping records of your employees personal securities transactions?

Even with these procedures, proper resources must be made available to compliance personnel. Remember, whatever procedures are adopted, we expect advisers to follow them. Once the procedures are established, make sure the procedures are being enforced and kept up-to-date to take into account any new products or services. Also, newly merged firms should make sure their compliance programs are merged along with everything else. Failure to do so can lead to compliance problems which can be a bad start to what is supposed to be a new beginning.

IV. Current Regulatory Developments

Before concluding my remarks, I would like to switch gears, and spend a few minutes to talk about two regulatory developments on the horizon -- principal transactions and pay-to-play.

A. Advisers Act Section 206(3) -- Principal Transactions

The first new development involves principal transactions between advisers and their clients. Chairman Levitt recently asked the Division to focus on this issue. As you know, under the Advisers Act, an investment advisory firm must make disclosure of the capacity in which it is acting and obtain the clientís consent before selling him or her securities out of the inventory of an affiliated broker-dealer. But getting the explicit consent to do so can delay a transaction unreasonably. Many firms do business over the phone and it can be quite cumbersome to secure timely consent. So, transactions that could have been good for the client and the firm may never take place because people just donít want to bother.

Due to the changing structure of the markets and its effect on business, I agree with the Chairman that this is the right time to consider whether it might be appropriate to provide an exemption from the restrictions on principal trading. I caution that while we want to open new opportunities to firms and their customers, there are real risks to allowing principal trading in certain situations -- such as in illiquid securities or large, market-moving orders where it is very difficult to know whether the client paid a fair price. Thus, in developing flexibility in this area, we want to fashion an exemption that preserves investor protection.

B. Pay-to-Play

The second development is pay-to-play. Over the past several months the Division also has been examining the role of political contributions in the selection of investment advisers to manage public pension funds. We have concluded that the use of contributions to obtain government business, or "pay to play," is not an uncommon practice among advisers seeking contracts with public pension plans. We will soon be recommending that the Commission propose a rule addressing this practice.

Our recommended rule will extend the principles of MSRB rule G-37 to advisers with government clients. As you know, the Commission approved rule G-37 in 1994 to prohibit municipal securities underwriters from doing business with state and municipal issuers for two years after making certain political contributions. Our recommended rule would prohibit pay to play among advisers by imposing similar business restrictions on advisers, with some changes to reflect the differences between municipal underwriting and asset management. The rule will be drafted under the Investment Advisers Act of 1940, and would be administered by the Commission, rather than the MSRB.

C. Year 2000

Of course, I could not speak to you today without mentioning the first challenge of the new millennium -- Y2K.

Year 2000 is an important compliance and business issue for the advisory community. Advisers and their service providers, in particular the brokers they deal with, are very dependent upon computer systems. If those systems are not Y2K compliant, advisers may face problems valuing accounts, producing account statements for clients, and communicating with brokers.

At the SEC, we are very focused on the Y2K issue, and have taken several steps to make sure the securities industry is also focused. Right now, we are reviewing reports filed by investment advisers on their Y2K readiness. These reports -- Form ADV-Y2K -- are now available on our website and are being used by the staff to obtain a more complete picture of the industryís Y2K readiness, and to identify firm-specific problems for follow-up inspections. Currently, we are conducting Y2K cause exams of these firms whose Y2K reports raised "red flags" in order to evaluate the situation and to determine whether the adviserís disclosure to its clients is consistent with its state of readiness. The next Y2K report is due on June 7th, and we will be examining these reports to monitor the progress being made by the industry and individual firms.

Of course, it is difficult to monitor the Y2K-readiness of the industry if advisers required to file the form fail to do so. I caution any non-filers out there that the Commission takes these reports seriously. Non-filers should note that the Commission recently took enforcement action against several broker-dealers and transfer agents that failed to file similar Y2K reports. I also want to remind advisers that the SEC has issued guidance to advisers on their Y2K disclosure obligations and has established a task force to monitor compliance.

You may have heard that we made an unexpected discovery as we reviewed these reports. We discovered that many advisers registered with the SEC have failed to file Schedule I, the annual update to their Form ADV registration. Of course, I am sure that this issue does not involve anyone in this room. But -- in case it does --- please file your update.

V. Conclusion

I started out this morning highlighting the tremendous growth of the investment management industry. The industry should be proud of its achievements, but at the same time it should be mindful of the key ingredients of its success -- investor trust and confidence. As the industry looks towards the new millennium, I believe that good compliance and adherence to the highest professional standards, will serve as the most valuable assets in assuring the continued success of the investment management industry.

Thank you.

1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues upon the staff of the Commission.

2 SEC, Budget Estimate Fiscal 2000, at IV-13; SEC, Budget Estimate Fiscal 1998, at IV-12; SEC, Budget Estimate Fiscal 1990 at IV-14.

3 SEC v. Capital Gains Research Bureau, 375 U.S. 180, 194 (1963).

4 Bevis Longstreth, Commissioner, U.S. Securities and Exchange Commission, The Duty to Supervise: Self- Discipline Within the Securities Firm, Remarks to the Fifteenth Annual Rocky Mountain State-Federal-Provincial Cooperative Securities Conference (Oct. 29, 1982) in 1982 Speeches by SEC Officials (available in SEC library).

5 Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Remarks to the Securities Industry Association's Legal and Compliance Seminar (Apr. 13, 1999) (http://www.sec.gov/news/speech/speecharchive/1999/spch266.htm). 6 Id.

7 In the Matter of Nicholas-Applegate Capital Management, Advisers Act Release No. 1741 (Aug. 12, 1998).

8 In the Matter of Feeley & Willcox Asset Management Corp., Advisers Act Release No. 1711 (Mar. 27, 1998) (pending).

9 In the Matter of CS First Boston Investment Management Corp., Advisers Act Release No. 1754 (Sept. 23, 1998).

10 In the Matter of Rhumbline Advisers, Advisers Act Release No. 1765 (Sept. 29, 1998).

11 See, e.g., In the Matter of Schuylkill Capital Management, Ltd. and Howard A. Trauger, Advisers Act Release No. 1766 (Sept. 30, 1998); SEC v. Sweeney Capital Management, Inc., Timothy Charles Sweeney, and Susan Mary Gorski, Litigation Release No. 15664 (Mar. 11, 1998) (pending).

12 In the Matter of Paul J. Jackson D/B/A Paul J. Jackson & Associates, Ltd., Advisers Act Release No. 1762 (Sept. 29, 1998).

13 In the Matter of Reservoir Capital Management, Inc., Advisers Act Release No. 1717 (Apr. 24, 1998).

14 In the Matter of Brack Stanford and Associates, Inc. and Brack Stanford, Advisers Act Release No. 1734 (July 17, 1998).

15 In the Matter of Meridian Asset Management Corp., Advisers Act Release No. 1779 (Dec. 28, 1998).