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U.S. Securities and Exchange Commission

Speech by SEC Staff:
"Our Shared Responsibilities for Fund Compliance"

Remarks by

by Lori Richards1

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

Before the Investment Company Institute
1999 Mutual Fund Compliance Conference

June 10, 1999

Thank you. Itís a pleasure to be here today with so many compliance professionals from the mutual fund industry. The timing of todayís conference, however, worries me a bit. At the same time -- we have some 400 hundred fund compliance professionals away from their posts here at this conference, and today is also the annual office picnic for the SECís inspection staff. No inspectors and no compliance staff on the beat -- well you can see why this concurrence of events causes me some concern.

Aside from the timing of these events, you and I -- fund compliance and SEC inspections staff -- share common goals. We both want to ensure that the fund industry and those associated with it are in full and complete compliance with the law, and we want to see adequate resources and attention devoted to ensuring compliance on an ongoing basis. We both want fund compliance departments to be prominent within investment management firms and for the business lines to have a healthy respect for the important role that fund compliance plays in the organization. We both regard the 40 Act as our Constitution -- a living, breathing document thatís provided a wonderful framework for all that we do.

Our shared purpose and commitment means that we support each other in immeasurably important ways. Indeed, Matt Fink reaffirmed this notion at the General Membership Meeting last month when he said that for the fund industry, success means more than pursuing short-term business goals -- it means and has always meant supporting laws, regulations and professional standards that put shareholders first.

The Director of the SECís Division of Investment Management, Paul Roye, also said recently that the only sure fire way for the industry to continue its success into the 21st century is by maintaining the integrity and professionalism that this industry has demonstrated in the past. I couldnít agree with Matt and Paul more. Their comments make clear that the fund industry and the SEC share a common goal -- to ensure that the investors we both serve are protected and that their interests come first.

In meeting this goal, we place a lot of reliance on you as the guardians of fund compliance. You are the first line of defense against all 40 Act sins -- against aggressive portfolio managers who may try to inflate a fundís performance by buying inappropriate securities; against affiliates dumping securities into the fund, against the mispricing of securities, and against the use of portfolio brokerage for purposes that donít benefit the fund. The topics on the agenda for this conference speak to the range of your responsibilities. Youíre carrying on your shoulders the interests of your fundsí investors -- which is at the core of the securities laws that the SEC is charged with administering and enforcing.

In that vein, I want to share with you today three points: 1) some thoughts on how we at the SEC further our mutual goals in the inspection process; 2) some of my observations on what makes a good compliance system; and finally, 3) I want to speak frankly about some areas where weíve seen compliance weaknesses.

How does the SECís inspection process support fund compliance?

If thereís one thing Iíve learned and observed in my time at the SEC itís that when there is an absence of disciplined procedures, or meaningful surveillance, there will be undetected mistakes and errors, and there will also be those who capitalize on the void in compliance for their own benefit or reward. I hate to be cynical, and Iím not, because in fact, this is an industry whose compliance record beats any, but you canít rely solely on the integrity of individuals when financial incentives may be tempting them in the other direction. "All that is necessary for evil to flourish is for good men to do nothing." When you think about it, this concept underlies the whole system of securities regulation. Advisers have the first line duty to supervise, a duty so serious that it is enforceable in the breach. This duty to supervise requires firms to have [quoting] "established procedures, which would reasonably be expected to prevent and detect, insofar as practicable," a violation of the securities laws by an employee. Then, the duty requires that supervisors reasonably discharge their duties and obligations under the supervisory system. So you have to have good procedures, and they have to be implemented.

I regard the obligation of advisers to supervise as perhaps the most important part of the securities laws -- because it underpins all others. All the protections provided to investors by the securities laws are only made real when implemented by effective supervisory and compliance procedures.

Thatís why we spend most of our time in examinations talking to you about the systems you have set up to supervise employees and to ensure compliance. Our goal in examinations is to review the effectiveness of your firmís overall supervisory and compliance systems.

I always find that, once firmsí understand what our mission is, that it helps them understand why we do what we do. Let me describe briefly for you the most important aspect of what we do in an inspection -- thatís the entrance interview -- and why you should view it as important as well. During the entrance interview, weíll ask you lots of questions designed to get an understanding of how your firm is organized, how managers exercise their supervisory responsibility, the nature of the firmís business and its key controls. We will ask you to describe your firmís controls in various areas that appear relevant to the firm, and how those controls function from start to finish. Examiners are using this meeting to get a sense of your firmís control structure and based on that, to decide the scope of their examination. Therefore, it is to your distinct benefit to be prepared for this meeting, and to fully and candidly describe your firm and its control systems.

It wonít help you or us to be coy in this meeting -- youíve worked hard to develop your own systems of supervision and control, and we want to know about them. Our goal is to reach a level of comfort that your firm has good controls, and that they are being implemented so that we can then move on to the next fund and feel confident that we donít need to visit you again until the next routine exam -- in 4 years or so.

So, returning to the duty to supervise, every good compliance procedure must be designed both to prevent and to detect violations. Prevention is something that this industry has excelled at. I have been so impressed by the upfront compliance technology that many funds use to screen trades for concentration, liquidity and other issues. Preventative compliance also includes personal trading pre-review and approval procedures and other compliance systems that are designed to ensure that problem trades never occur. Sometimes though, you just canít prevent violations from occurring. You try your best, but sometimes problems occur anyway. Thatís a fact of life. Thatís the second part -- detection -- compliance procedures must be designed to detect problems when they do occur. Exception reports and other post-trade reports fall into this category. In evaluating the effectiveness of procedures designed to detect problems, you need to see that problems are being found. During examinations, we evaluate the effectiveness of systems based on both criteria -- do the systems appear to prevent problems, and do they actually detect problems once they occur? Thatís why we review internal compliance checklists and reports that indicate that problems were caught. We would consider assertions that a firm has not had any problems, with a high degree of skepticism.

Finally, examiners will ask, once problems are detected, were they corrected, and corrected in a reasonable way? This is the other critical aspect of the duty to supervise -- in order to discharge their supervisory duties, problems must be corrected once detected. So, during examinations, our goal is to help ensure that you have created the systems you need to deter, detect and correct problems.

What makes a good compliance system?

Changing tack a bit, I wanted to offer some of the things I have learned from viewing effective compliance programs during examinations:

  • First, have good supportive management. No compliance or legal staff can do a good job without management who values what they do.
  • If you work in a firm that has management that isnít as thoughtful about compliance as it should be -- educate them. Tell them about SEC enforcement cases, and the financial, reputational and personal pitfalls of violating the securities laws. Outside counsel do this well.
  • Make fund board members aware of the importance of and the need for strong compliance. They are your allies in protecting investors -- educate them to be able to do their jobs.
  • Donít skimp. Make sure that you have identified critical areas of the firmís operations and that compliance policies exist for each aspect of the firms operations and for all applicable laws.
  • Empower staff. Make sure that all people clearly know what their responsibilities are. Train new employees and have regular communication about how the policies work and what their role is in the overall compliance system.
  • Make sure that policies are in writing so that, if a critical person in the loop gets hit by a bus, the firmís system in a given area or areas is not endangered.
  • Regularly reassess and evaluate policies and procedures in light of growth, changes in firm operations, mergers and personnel changes. Also, make sure that your system is in sync with and up-to-date with changes in the law and Commission guidance.
  • Review exceptions. Exceptions to written policies are occasionally needed to accommodate unusual circumstances. Make sure all exceptions are documented, approved and are subject to special review by compliance staff.
  • Use technology. Itís a fact that it improves compliance, avoids human errors, and saves time. I know that some small complexes say they donít have the money to invest in good compliance technology, but frankly, I think that using technology is a part of doing business today. If youíre out spending money marketing to new investors, you should make sure that the dollars spent on compliance keep up with your growth. Technology, in the long run, saves expensive man-hours. Invest now, reap the benefits later.
  • Go where the money is. Pay special attention to high flying portfolio managers. Watch for and scrutinize transactions with affiliated persons and firms. Look at valuation procedures. Be involved in the firmís marketing and advertising.
  • Make sure your policies are enforced internally. Milquetoast enforcement weakens your overall system of compliance.
  • Be creative. Think up new ways to view the firm, its operations and its compliance systems. We always notice that immediately after a high profile enforcement case, the industryís compliance procedures in that area improve, which is good. However, donít wait for the next enforcement case or deficiency letter. Think of how procedures might be circumvented, how things might go wrong before the event occurs.
  • Make sure you view incidents in the aggregate, not just individually. Reflect back over time. Do patterns exist that warrant further scrutiny? That warrant tightening procedures? Has that portfolio manager inadvertently failed to submit quarterly personal trading reports several times in the last few years? Are IPO allocations fair when viewed, not just one by one, but over time?
  • Donít be complacent. This happens over time, when youíve built your firmís compliance systems, and are vested in them. Always be looking for the way to build the better mousetrap.
  • Finally, hire good, smart people to run your compliance system. They should be assertive and willing to voice their views, even when those views arenít popular.

Each of these elements is, I think, a necessary component for a good, sustainable compliance system.

Compliance Weaknesses

So with that, let me conclude with some of our recent findings from inspections indicating areas where fund compliance staff should focus now. These are:

  1. The Allocation of IPOs;
  2. Soft Dollars and Brokerage Allocation;
  3. The Role of the Board of Directors;
  4. Personal Trading; and
  5. Performance Advertising.

1. Allocation of IPOs

As you all know, "hot IPOs" can boost an accountís performance, and participation in certain IPOs is highly desirable. Weíve seen lots of problems in how fund groups allocate IPO shares internally, and weíve received complaints concerning the allocation of hot IPOs. Problems seem to range from the intentional to the sloppy. Intentional misallocations include allocating all or a disproportionate number of IPO shares to principals or favored clients without disclosure. You will recognize that this fact pattern has resulted in enforcement cases in the last several years. We also see sloppiness in procedures, and thatís the area I really want to focus on here.

Many or even most fund complexes have a procedure by which hot IPOs are allocated amongst managed accounts -- generally shares are allocated pro rata to the accounts requesting participation, based on the number of shares requested. Seems fine, seems fair. The problem comes when exceptions to this policy are made.

In allocating a limited number of hot IPO shares received, some complexes give greater weight to different accounts based on the type of portfolio and the size of the account or fund. This is where you need good, clear procedures, including oversight by compliance and legal staff. You will want to review the allocations not only individually, but over time, to ensure that they are consistent and fair. You should also ensure that your allocation procedure is consistent with your disclosure.

2. Soft Dollars and Brokerage Allocation

Weíve spent alot of time in the inspections program looking at soft dollar use by the industry (by advisers, funds and broker-dealers) and we issued an inspection report summarizing our findings and recommendations last fall.

Because of what we saw -- that many (mostly non-fund advisers) were purchasing goods and services outside the research safe harbor without adequate disclosure and lack of good compliance procedures, even at firms that did significant soft dollar business -- this area continues to be a focus for SEC examiners.

Related to soft dollars is the fundsí use of brokerage. Keeping in mind that brokerage is an asset of the client, weíve been conducting a series of inspections to learn how funds ensure that theyíre getting "best execution." Best execution is not easily quantifiable, because it encompasses lots of factors -- price of course, of both the securities and the commission, the speed of execution, confidentiality, the depth of the market, and commitment of capital. And, as new trading alternatives are being created, what was best execution in the past may not now be.

So, weíre visiting a number of funds, talking to traders and others, to try and get a sense of how they make order routing decisions -- what factors do they consider and how do they measure the quality of execution performance?

Based on our reviews to date, I have a couple of suggestions --

First, this is an area where fund compliance and legal staff have a role. While assessing whether the adviser has fulfilled its duty of best execution is not easy, itís an area that deserves your attention.

Second, fund boards will need to ensure that fund assets are being used appropriately. We compiled a list of information that some fund boards review and consider in this process and included it as an appendix to last fallís soft dollar report. Recommended reading.

3. Role of the Board of Directors

As you know, the Commission has undertaken a broad initiative to determine what problems mutual fund independent directors are encountering, and how their effectiveness can be enhanced. The Commission started with a Roundtable earlier this year, and has outlined several proposals designed to enhance the effectiveness of independent directors.

A critical part of this initiative is to ensure that directors are getting the information they need to do their jobs effectively. You know the panoply of responsibilities that investment company directors have under the Investment Company Act. To fulfill their responsibilities, they rely in large part, on the adviser for information, which the adviser has a duty to provide. Chairman Levitt has asked us to pay close attention to the quality and quantity of materials provided to the directors, with particular focus on their review of the advisory contract and distribution plans. So, in every fund inspection for the next few months, weíre gathering information about the materials provided to Boards and about Boardís oversight of their funds.

4. Personal Trading and Codes of Ethics

As you know, all funds are required to have codes of ethics containing provisions reasonably necessary to prevent its access persons from engaging in fraudulent or deceptive acts. Even given all of the attention in this area by the press, the industry, and by the Commission and the Enforcement Division, we still see problems in codes of ethics and compliance procedures in this area --

Some problems that we see include --

- Lack of policies designed to prevent the use of inside nonpublic information (no restricted list or watch list);

- Pre-clearance procedures exist, but the procedures not implemented, or not implemented effectively (donít appropriately identify access people, no review of securities holdersí transactions); and

- Fundsí boards were not actively involved in reviewing the appropriateness of, or enforcing codes, as required under the codes.

In light of some continuing problems in this area, the Commission will further tighten the rules on personal trading. In the meantime, you might review your own complexís 17j procedures and make sure they are being implemented. One of the best internal control weíve seen in this area is a procedure that requires access persons to place all personal trades through an affiliated broker, then the trades are checked against fund trades for conflicts prior to execution.

5. Performance Advertising

Almost twenty years ago, the SEC adopted a rule (Rule 156 under the Ď33 Act) that prohibits funds from using ads that are false or misleading. Generally, an ad is false or misleading if it contains untrue statements of material fact or omits material facts. As you know, if funds use performance numbers in ads, they must show a fundís 1, 5 and 10 year total return numbers, current as of the last quarter.

Recently weíve seen funds use total return numbers for odd one-year periods -- such as the one-year period ended April 13 or May 3, or June 10. These ads donít include additional disclosure as to why the odd one-year period was chosen or why the total returns for the odd period were significantly higher than the total return for the quarterís end.

Upon further review, we found that the dates chosen by these funds coincided with days on which the fundsí NAV reached a new high. We also found that the NAVís of these funds were very volatile and were significantly lower by the time the ads appeared in print. It seems that these funds were gerrymandering the one-year period to come up with the best performance figures. We question whether this is a fair presentation to potential investors. And, these ads may be materially misleading in that they donít disclose the more recent, lower performance of the fund.

So, these are areas where, based on what weíve seen in inspections, we think you should focus on now -- allocation of IPOs, soft dollars and brokerage allocation, the role of the board, personal trading and performance advertising.

* * *

I hope that my observations this morning on our mutual goals and on what makes a good compliance system have been helpful or at least thought-provoking. I think we all realize that there are as many different ways to ensure good compliance as there are funds. But the important thing is to agree with the central premise -- that the investors we both serve must be protected by good, strong fund compliance.

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.