Post by sandi66 on Oct 29, 2008 15:17:48 GMT -5
Speech by SEC Staff:
Keynote Address at the National Regulatory Services
Twenty-third Annual Fall Compliance Conference
by
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Scottsdale, Arizona
October 29, 2008
Thank you very much for your kind introduction. Although I have addressed many groups during my tenure as the Director of the Securities and Exchange Commission's Division of Investment Management, this is my first time speaking at an NRS compliance conference. When I arrived in Scottsdale yesterday, I immediately sensed that this audience, composed largely of compliance professionals, might have a slightly different focus than other industry groups that I have addressed. Although it is hard to put my finger on it, I suspect my perception may have something to do with the fact that in encounters with conference attendees, when I asked "how's it going" the response — invariably — was "no compliance problems, but the day's not over yet."
Given recent market events, what I would like to do in the limited amount of time that I have with you this morning is to talk a little about your role as compliance professionals and the heightened importance of your role in these challenging times. Thereafter, I will spend a few minutes highlighting some of the initiatives that are underway in my Division that may be relevant to your practice. Please keep in mind that these initiatives are ultimately for the Commission's consideration and may or may not come to fruition. Before I go any further, now is a good time to give the standard disclaimer that my remarks represent my own views and not necessarily the views of the Commission, individuals Commissioners or my colleagues on the Commission staff.
Let me begin with a general observation — I believe that in periods of market stress, such as we are experiencing today, compliance personnel have an enhanced role to monitor that their firm operates in compliance with established policies and procedures. After all, a firm that cannot even comply with its policies and procedures would seem more likely to run afoul of the securities laws. I do not mean to imply that in stressful situations a firm necessarily acts with ill intent. On the contrary, a firm may have the best intentions yet in its haste to react promptly to market events the firm may not take the time necessary to appreciate whether its intended course of action fully complies with securities laws or even its own policies and procedures. It is always important to do the right thing. It is equally important to do it the right way.
An example from recent events illuminates this point. Some money market funds, facing the prospect of holding a troubled security or facing liquidity challenges, may seek to have an affiliate infuse capital or sell to the affiliate the troubled securities that may be a drag on net asset value or liquidity. Any reliance on an affiliate, however well intended, must still conform to the securities laws. If a fund acts too swiftly, it may inadvertently violate the securities laws that make it unlawful for a fund and its affiliates to engage in certain transactions. In particular, absent Commission relief, a transaction involving an affiliate who infuses capital (other than by purchasing fund shares) or purchases securities from the fund may violate Investment Company Act Section 17(a) which generally makes unlawful the sale of securities between a fund and an affiliate, and/or Section 17(d) which generally makes it unlawful for an affiliate to effect any transaction in which the fund is a joint participant with the affiliate. As compliance personnel, you are an invaluable resource to enable your firm to act in compliance with its policies and procedures and, ultimately, the securities laws. This includes documenting that the firm timely seeks and obtains any Commission relief necessary for the firm to engage in the contemplated activity.
The Division is sensitive to these pressures. Specifically, the Division of Investment Management has repeatedly granted timely relief to fund sponsors to support money market funds and these efforts have been ongoing since last year when money market funds first started facing challenges primarily from their investment in structured investment vehicles (or SIVs). The Division has issued numerous no-action letters — in many cases over a period of just a few hours — to provide relief to funds always with a view of what is in the best interests of the fund and its investors. This relief has enabled affiliates to institute measures to support money market funds such as capital infusions and purchasing distressed securities from the funds. The Division posts these no-action letters on the Commission's website. I encourage those of you who are at firms that may face similar issues to review the letters prior to encountering difficulties, as they will likely provide helpful insight.
Recognizing the "ongoing dislocations in the financial markets," the Division also has recently issued no-action letters having nationwide effect that provide money market funds with temporary relief. Specifically, the Division has provided assurances that in the following three situations it will not recommend enforcement action against a money market fund: First, where an affiliated person of the money market fund, such as a bank holding company, purchases asset-backed commercial paper from the fund at the amortized cost value of the commercial paper to enable the fund to participate in the asset-backed commercial paper program of the Federal Reserve Bank of Boston.2 Second, with respect to "senior security" issues, where a money market fund participates in the U.S. Treasury's temporary guarantee program that guarantees fund shareholders will receive $1 per share.3 Third, where the money market funds uses "shadow pricing" procedures for certain portfolio securities by reference to their amortized cost value rather than using available market quotations for debt securities with remaining maturities of 60 days or less.4
In order to be effective, compliance personnel must work with legal and management, in advance of the intended course of conduct, to provide guidance so that the firm operates within its policies, procedures and the law. While I have used recent events involving money market funds to illustrate my point, your ability as compliance personnel to have a significant impact on your firm is much broader than this one area. Perhaps I am stating the obvious, nonetheless I believe it is important to emphasize that in situations where time and other pressures may be significant, your organization must not act so swiftly that it cuts compliance corners. Likewise, employees must not be driven to take actions that do not accord with the rules. In this regard, it is imperative for compliance and legal personnel within the organization to work together "hand in glove" — in order to avoid "foot in mouth." In the absence of such coordination, the odds increase significantly that something will fall through the cracks only to be discovered after it is too late to prevent a legal or compliance violation.
Another product of stressful times in the market is the urge for firms to downsize. This is understandable — if a decrease in business or asset values causes the firm's revenue and income to drop, the firm may quite properly look to reduce its expenses in order to maintain a profit or minimize its loss. Typically, the biggest expense of a firm is its payroll. Therefore, in a down market, to cut costs the firm may consider laying off employees — including compliance and legal personnel. The notion that a firm should include compliance and legal personnel among the group of employees to downsize can be in my view a serious mistake. This is because compliance and legal areas of responsibility, unlike other aspects of a firm's operations, are generally unrelated to the dollar value of the firm, assets under management, or the firm's revenues. Rather, compliance and legal operations are driven by the complexity of investments, the number of portfolios, and trading activity, not by the value of assets. As such, compliance and legal are necessary core elements for a firm to operate and must continue to function properly whether or not the firm downsizes. If anything, I submit that the value of compliance and legal personnel increases during a down market. This is because in periods of heightened scrutiny, investors, regulators and counterparties may be loath to give a firm the benefit of the doubt if there is any question regarding the firm's compliance with the rules if the firm has decreased its compliance or legal resources.
I recognize that with this audience I may be preaching to the choir about the necessity for adequate resources for compliance and legal. Moreover, you may be thinking that my remarks might have more impact if they were delivered to an audience composed largely of management rather than compliance personnel. What I hope you realize is that, as compliance personnel, you have the ability and the obligation to influence management. After all, compliance is really management's responsibility. Nonetheless, I imagine that some of you here this morning question your ability to do so effectively. As someone who was responsible for legal and compliance at a few firms, I thought I might share with you a true experience I had. Since I had these responsibilities at a few firms, I will not disclose the specific firm's name in order to provide plausible deniability to me and those involved.
Once upon a time there was a "star" portfolio manager. Although the portfolio manager operated fully within the firm's code of ethics and personal trading restrictions, the firm's compliance personnel detected a pattern evidencing that this particular manager always came close to the outer threshold of acceptable behavior. To the compliance personnel, this suggested that the manager knew exactly the firm's policy and was potentially gaming the system. The compliance personnel attempted to discuss with the portfolio manager their concerns. The response from the manager, however, was something along the lines of "pound sand, I'm not violating anything." At that point, I was contacted by the head of compliance. My response? I called the portfolio manager's supervisor and set up a meeting for the next day. At the meeting I informed the supervisor as follows: First, compliance had identified a potential issue with the portfolio manager's trading activity. Second, while the manager was operating within the firm's rules, the pattern of activity was troubling and suggested a need for heightened monitoring and scrutiny. Third, the legal and compliance personnel were reporting this information to the supervisor so that the supervisor was aware of it and so that the supervisor could monitor the situation. Fourth, and perhaps most important, the responsibility reasonably to supervise and oversee the portfolio manager rested with the supervisor — not with legal or compliance personnel.
This simple yet necessary course of action had an immediate effect. The supervisor was alerted to an issue — having been appropriately reminded of who bore the ultimate responsibility in the event of a problem. In case you are wondering, following my discussion with the supervisor the portfolio manager's potentially problematic trading activity immediately abated.
What I hope the foregoing tale demonstrates is that compliance is there to assist management in discharging compliance obligations, but ultimately it is management who bears these responsibilities. It is vitally important that this fundamental point not get lost, particularly where advances in technology allow firms to shift compliance from "back-end" to "front-end." Let me explain. Traditionally firms have often operated using "back end" compliance, meaning that a trading activity that occurred on any given day was then reviewed and processed at the end of the day or the next morning and any questions or concerns with specific trades dealt with after the fact. Under this system, firm personnel directing the trades clearly had the responsibility to comply with firm policies, procedures and portfolio restrictions, and the compliance personnel acted as a backstop to check that the firm was in compliance with its policies, procedures and portfolio restrictions. With advances in technology and increased complexity of operations, compliance has shifted to the "front-end," because firms are able to employ computer filters that craft parameters to catch potential compliance problems before they occur. This is generally a good development as it can enable firms to utilize technology to help prevent problems. Nonetheless, even the most sophisticated systems can still allow trades to go through that may violate the firm's established policies, procedures, or portfolio restrictions. This creates challenges for compliance personnel, because a firm may be tempted to fault compliance for an aberrant trade. However, just because a firm may use computer filters or other technology to catch potential compliance problems earlier does not shift the responsibility to make sure that a transaction complies with the firm's policies, procedures, and portfolio restrictions. Such responsibility remains where it has always been — on firm management. In my view, compliance should be there to assist management — not supplant it — in complying with this responsibility.
I would now like to spend a few minutes discussing some real life compliance issues and highlight for you an area where you may want to focus additional attention. Specifically, in two recent cases the Commission has brought charges against investment advisers for failure to disclose conflicts of interest. On May 1, 2008, the Commission settled an enforcement action against investment adviser Banc of America Investment Services and a successor entity for failing to disclose to clients that in selecting investments for discretionary mutual fund wrap fee accounts, Banc of America favored two mutual funds affiliated with it.5 In the absence of this disclosure, clients did not know that Banc of America had an interest in recommending to them the proprietary mutual funds over other alternatives and that Banc of America earned additional fees as a result. The adviser agreed to settle by paying nearly $10 million in disgorgement, interest and penalties.
On September 23, 2008, the Commission entered into a settlement with investment advisers AmSouth Bank and AmSouth Asset Management. This case involved the advisers defrauding the AmSouth mutual funds by secretly using for marketing and other unrelated expenses a portion of administrative fees paid by the funds and their shareholders which expenses should instead have been paid by the advisers. This was accomplished by the advisers entering into undisclosed side agreements with BISYS Fund Services, Inc., the administrator for the mutual funds. Under these agreements, in consideration for the advisers recommending that the mutual funds continue to use the administrator, the advisers received approximately $16 million in rebates of the total $49 million in administrative fees that the mutual funds paid to the administrator during the relevant period. After crediting the advisers with certain repayments to the mutual funds, the Commission agreed to accept from them an $11.4 million settlement representing disgorgement, interest and penalties.6
While the particulars of each case vary, both situations involve alleged undisclosed conflicts of interest. In each situation, had the adviser disclosed the conflict, this would have neutralized claims that the adviser misled investors and others. I would suggest that for those of you in the audience who are investment adviser compliance personnel, for purposes of the annual review of your compliance program as required by Advisers Act Rule 206(4)-7(b),7 you should spend some time reviewing with management and legal counsel your disclosure policy particularly regarding potential conflicts of interest. My takeaway from these examples is that it is critical that your compliance program includes appropriate review of conflicts and whether and how such conflicts are identified, disclosed and resolved.
More generally, current market events provide an opportunity for you to review certain assumptions that may (at least until recently) be embedded in the operations at your firm. Without providing an exhaustive list, examples that come to mind include assumptions on the behavior of various types of instruments, hedging techniques, portfolio diversification, and portfolio liquidity. In addition, you should probably take a look at sales materials and pertinent disclosures to see if the information continues to be accurate. I would also suggest that to the extent you have not already done so, you carefully review the ComplianceAlert newsletters published by the Commission's Office of Compliance Inspections and Examinations available on the Commission's website. In these newsletters, published in June 2007 and July 2008, OCIE identifies common deficiencies and weaknesses that examiners found during compliance examinations of investment advisers, mutual funds, broker-dealers, and transfer agents. The newsletters may be a helpful resource that you can use when conducting a review of your own compliance program.
I have just two additional points on this topic and then I will move on. First, as I mentioned, Rule 206(4)-7(b) requires an annual review of an investment adviser's compliance program. Although only an annual review is required, an astute compliance professional will engage in more frequent reviews, especially following any change in business activities (such as downsizing), markets, or regulatory developments (such as the Commission's recent requirement for institutional investment managers to file Form SH detailing short positions). Second, recognizing that the majority of funds operate pursuant to one or more exemptive orders that allow them to engage in otherwise prohibited activity, I believe that funds as part of their annual review should examine their outstanding exemptive orders and satisfy themselves that they continue to operate in accordance with any conditions required in those orders. As someone who has had responsibility for legal and compliance in complex organizations, I can suggest the following. Exemptive order requirements get embedded in a firm's policies and procedures — as they should. However, when the policies and procedures are revised, personnel do not always go back to the exemptive order to review whether the specific requirements have been correctly reflected in the firm's revised policies and procedures. You and legal counsel need to do so.
In the remaining minutes that I have with you this morning, let me briefly address two initiatives underway in my Division that may impact this audience. The first initiative that I would like to discuss — and which I suspect is particularly relevant for this audience — is the Division's examination of the investment adviser books and records rule and recommendations to the Commission for updating it. In order to provide an appreciation for our recommendations, some historical background may be helpful.
In 1940, when the Congress enacted the Advisers Act, no requirement existed for investment advisers to keep books and records of their activities.8 Another twenty years passed before Advisers Act Section 204 was amended in 1960 to require that advisers "make, keep and preserve for such periods, such accounts, correspondence, memorandums, papers, books, and other records, and make such reports, as the Commission by its rules and regulations may prescribe as necessary or appropriate in the public interest or for the protection of investors."9 In response, in 1961 the Commission adopted Rule 204-2.10 As originally adopted, the rule assumed that records would be retained in paper format. To put this in historical context, it might be enlightening to reflect on what else happened in 1961. Here are a few examples: I was eleven; then-president Kennedy, on his sixth day in office, conducted the first ever live presidential news conference; IBM introduced the Selectric typewriter; Fairchild Semiconductor marketed the first commercial integrated circuit; and the Beatles made their debut concert performance.
In the intervening 47 years since the Commission adopted Rule 204-2, the rule has undergone various amendments but very little substance in the rule text has changed. In contrast, I am now a grandfather. We have had many live presidential news conferences. Examples of the Selectric typewriter and first commercial integrated circuit can be found, if at all, on display in a museum. And the Beatles will not be touring any time soon.
What does this suggest? To me, it suggests that it is time we update Rule 204-2 to recognize that substantial changes have occurred in the industry and with technology since 1961. To this end the Division is contemplating recommending that the Commission amend Rule 204-2 to require advisers to maintain some records in electronic format (under the current rule electronic records are optional) and to generate and produce (on staff request) searchable and sortable electronic records of trading data for managed accounts, clients lists, and code of ethics breach logs. We are fine-tuning the proposed communications retention requirements, and looking at the current content-based approach. We may recommend that advisers keep additional categories of written communications, such as correspondence regarding clients, advice, performance, compliance, commissions, and audits as well as correspondence to or from clients, regulators, marketers and broker-dealers. Industry professionals have suggested we also explore alternative approaches, such as a "modified business as such" standard, which would require advisers to retain all correspondence relating to their advisory business but allow them to discard correspondence of certain employees who would be "carved out" because of their job functions. This type of alternative raises additional policy issues. There are many additional details of this initiative that must be carefully considered as part of any recommendation, and my staff is actively working on this initiative.
The second initiative is the "Director Outreach Initiative." This was a project that I started in early 2007 to examine the duties imposed on independent directors of mutual funds. Since launching this initiative, I have attended more than 25 mutual fund board meetings and have obtained insight directly from directors and other industry participants. Based on this feedback, my staff is assembling a variety of recommendations for the Commission's consideration for ways to increase the effectiveness of independent directors. The relevance for this audience is that as part of the staff's recommendations, we plan to recommend that the Commission issue interpretive guidance recognizing situations where independent directors, while maintaining ultimate responsibility for fund oversight, may delegate certain responsibilities consistent with the valid exercise of their business judgment. Although we do not contemplate specifying either the specific responsibilities or to whom they may be delegated, compliance personnel are clearly within the universe of persons directors mentioned that they rely upon. Accordingly, stay tuned for further developments.
You have a full program today and I have used up my allotted time. Thank you for allowing me the opportunity to participate this morning.
Endnotes
--------------------------------------------------------------------------------
1The 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 of the author's colleagues upon the staff of the Commission.
2See Division of Investment Management September 25, 2008 Letter to the Investment Company Institute available at www.sec.gov/divisions/investment/noaction/2008/ici092508.htm.
3See Division of Investment Management October 8, 2008 Letter to the Investment Company Institute available at www.sec.gov/divisions/investment/noaction/2008/ici100808.pdf.
4See Division of Investment Management October 10, 2008 Letter to the Investment Company Institute available at www.sec.gov/divisions/investment/noaction/2008/ici101008.htm.
5http://www.sec.gov/litigation/admin/2008/33-8913.pdf
6http://www.sec.gov/litigation/admin/2008/ia-2784a.pdf
717 USC 275.206(4)-7(b).
8Investment Advisers Act of 1940, ch. 686, 54 Stat. 789 (codified as amended at 15 U.S.C. §§ 80b-1 - 80b-18a).
9Pub. L. No. 86-750, 74 Stat. 885, 886 (1960).
10Investment Adviser Release No. 114 (May 25, 1961).
www.sec.gov/news/speech/2008/spch102908ajd.htm
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Home | Previous Page Modified: 10/29/2008
Keynote Address at the National Regulatory Services
Twenty-third Annual Fall Compliance Conference
by
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Scottsdale, Arizona
October 29, 2008
Thank you very much for your kind introduction. Although I have addressed many groups during my tenure as the Director of the Securities and Exchange Commission's Division of Investment Management, this is my first time speaking at an NRS compliance conference. When I arrived in Scottsdale yesterday, I immediately sensed that this audience, composed largely of compliance professionals, might have a slightly different focus than other industry groups that I have addressed. Although it is hard to put my finger on it, I suspect my perception may have something to do with the fact that in encounters with conference attendees, when I asked "how's it going" the response — invariably — was "no compliance problems, but the day's not over yet."
Given recent market events, what I would like to do in the limited amount of time that I have with you this morning is to talk a little about your role as compliance professionals and the heightened importance of your role in these challenging times. Thereafter, I will spend a few minutes highlighting some of the initiatives that are underway in my Division that may be relevant to your practice. Please keep in mind that these initiatives are ultimately for the Commission's consideration and may or may not come to fruition. Before I go any further, now is a good time to give the standard disclaimer that my remarks represent my own views and not necessarily the views of the Commission, individuals Commissioners or my colleagues on the Commission staff.
Let me begin with a general observation — I believe that in periods of market stress, such as we are experiencing today, compliance personnel have an enhanced role to monitor that their firm operates in compliance with established policies and procedures. After all, a firm that cannot even comply with its policies and procedures would seem more likely to run afoul of the securities laws. I do not mean to imply that in stressful situations a firm necessarily acts with ill intent. On the contrary, a firm may have the best intentions yet in its haste to react promptly to market events the firm may not take the time necessary to appreciate whether its intended course of action fully complies with securities laws or even its own policies and procedures. It is always important to do the right thing. It is equally important to do it the right way.
An example from recent events illuminates this point. Some money market funds, facing the prospect of holding a troubled security or facing liquidity challenges, may seek to have an affiliate infuse capital or sell to the affiliate the troubled securities that may be a drag on net asset value or liquidity. Any reliance on an affiliate, however well intended, must still conform to the securities laws. If a fund acts too swiftly, it may inadvertently violate the securities laws that make it unlawful for a fund and its affiliates to engage in certain transactions. In particular, absent Commission relief, a transaction involving an affiliate who infuses capital (other than by purchasing fund shares) or purchases securities from the fund may violate Investment Company Act Section 17(a) which generally makes unlawful the sale of securities between a fund and an affiliate, and/or Section 17(d) which generally makes it unlawful for an affiliate to effect any transaction in which the fund is a joint participant with the affiliate. As compliance personnel, you are an invaluable resource to enable your firm to act in compliance with its policies and procedures and, ultimately, the securities laws. This includes documenting that the firm timely seeks and obtains any Commission relief necessary for the firm to engage in the contemplated activity.
The Division is sensitive to these pressures. Specifically, the Division of Investment Management has repeatedly granted timely relief to fund sponsors to support money market funds and these efforts have been ongoing since last year when money market funds first started facing challenges primarily from their investment in structured investment vehicles (or SIVs). The Division has issued numerous no-action letters — in many cases over a period of just a few hours — to provide relief to funds always with a view of what is in the best interests of the fund and its investors. This relief has enabled affiliates to institute measures to support money market funds such as capital infusions and purchasing distressed securities from the funds. The Division posts these no-action letters on the Commission's website. I encourage those of you who are at firms that may face similar issues to review the letters prior to encountering difficulties, as they will likely provide helpful insight.
Recognizing the "ongoing dislocations in the financial markets," the Division also has recently issued no-action letters having nationwide effect that provide money market funds with temporary relief. Specifically, the Division has provided assurances that in the following three situations it will not recommend enforcement action against a money market fund: First, where an affiliated person of the money market fund, such as a bank holding company, purchases asset-backed commercial paper from the fund at the amortized cost value of the commercial paper to enable the fund to participate in the asset-backed commercial paper program of the Federal Reserve Bank of Boston.2 Second, with respect to "senior security" issues, where a money market fund participates in the U.S. Treasury's temporary guarantee program that guarantees fund shareholders will receive $1 per share.3 Third, where the money market funds uses "shadow pricing" procedures for certain portfolio securities by reference to their amortized cost value rather than using available market quotations for debt securities with remaining maturities of 60 days or less.4
In order to be effective, compliance personnel must work with legal and management, in advance of the intended course of conduct, to provide guidance so that the firm operates within its policies, procedures and the law. While I have used recent events involving money market funds to illustrate my point, your ability as compliance personnel to have a significant impact on your firm is much broader than this one area. Perhaps I am stating the obvious, nonetheless I believe it is important to emphasize that in situations where time and other pressures may be significant, your organization must not act so swiftly that it cuts compliance corners. Likewise, employees must not be driven to take actions that do not accord with the rules. In this regard, it is imperative for compliance and legal personnel within the organization to work together "hand in glove" — in order to avoid "foot in mouth." In the absence of such coordination, the odds increase significantly that something will fall through the cracks only to be discovered after it is too late to prevent a legal or compliance violation.
Another product of stressful times in the market is the urge for firms to downsize. This is understandable — if a decrease in business or asset values causes the firm's revenue and income to drop, the firm may quite properly look to reduce its expenses in order to maintain a profit or minimize its loss. Typically, the biggest expense of a firm is its payroll. Therefore, in a down market, to cut costs the firm may consider laying off employees — including compliance and legal personnel. The notion that a firm should include compliance and legal personnel among the group of employees to downsize can be in my view a serious mistake. This is because compliance and legal areas of responsibility, unlike other aspects of a firm's operations, are generally unrelated to the dollar value of the firm, assets under management, or the firm's revenues. Rather, compliance and legal operations are driven by the complexity of investments, the number of portfolios, and trading activity, not by the value of assets. As such, compliance and legal are necessary core elements for a firm to operate and must continue to function properly whether or not the firm downsizes. If anything, I submit that the value of compliance and legal personnel increases during a down market. This is because in periods of heightened scrutiny, investors, regulators and counterparties may be loath to give a firm the benefit of the doubt if there is any question regarding the firm's compliance with the rules if the firm has decreased its compliance or legal resources.
I recognize that with this audience I may be preaching to the choir about the necessity for adequate resources for compliance and legal. Moreover, you may be thinking that my remarks might have more impact if they were delivered to an audience composed largely of management rather than compliance personnel. What I hope you realize is that, as compliance personnel, you have the ability and the obligation to influence management. After all, compliance is really management's responsibility. Nonetheless, I imagine that some of you here this morning question your ability to do so effectively. As someone who was responsible for legal and compliance at a few firms, I thought I might share with you a true experience I had. Since I had these responsibilities at a few firms, I will not disclose the specific firm's name in order to provide plausible deniability to me and those involved.
Once upon a time there was a "star" portfolio manager. Although the portfolio manager operated fully within the firm's code of ethics and personal trading restrictions, the firm's compliance personnel detected a pattern evidencing that this particular manager always came close to the outer threshold of acceptable behavior. To the compliance personnel, this suggested that the manager knew exactly the firm's policy and was potentially gaming the system. The compliance personnel attempted to discuss with the portfolio manager their concerns. The response from the manager, however, was something along the lines of "pound sand, I'm not violating anything." At that point, I was contacted by the head of compliance. My response? I called the portfolio manager's supervisor and set up a meeting for the next day. At the meeting I informed the supervisor as follows: First, compliance had identified a potential issue with the portfolio manager's trading activity. Second, while the manager was operating within the firm's rules, the pattern of activity was troubling and suggested a need for heightened monitoring and scrutiny. Third, the legal and compliance personnel were reporting this information to the supervisor so that the supervisor was aware of it and so that the supervisor could monitor the situation. Fourth, and perhaps most important, the responsibility reasonably to supervise and oversee the portfolio manager rested with the supervisor — not with legal or compliance personnel.
This simple yet necessary course of action had an immediate effect. The supervisor was alerted to an issue — having been appropriately reminded of who bore the ultimate responsibility in the event of a problem. In case you are wondering, following my discussion with the supervisor the portfolio manager's potentially problematic trading activity immediately abated.
What I hope the foregoing tale demonstrates is that compliance is there to assist management in discharging compliance obligations, but ultimately it is management who bears these responsibilities. It is vitally important that this fundamental point not get lost, particularly where advances in technology allow firms to shift compliance from "back-end" to "front-end." Let me explain. Traditionally firms have often operated using "back end" compliance, meaning that a trading activity that occurred on any given day was then reviewed and processed at the end of the day or the next morning and any questions or concerns with specific trades dealt with after the fact. Under this system, firm personnel directing the trades clearly had the responsibility to comply with firm policies, procedures and portfolio restrictions, and the compliance personnel acted as a backstop to check that the firm was in compliance with its policies, procedures and portfolio restrictions. With advances in technology and increased complexity of operations, compliance has shifted to the "front-end," because firms are able to employ computer filters that craft parameters to catch potential compliance problems before they occur. This is generally a good development as it can enable firms to utilize technology to help prevent problems. Nonetheless, even the most sophisticated systems can still allow trades to go through that may violate the firm's established policies, procedures, or portfolio restrictions. This creates challenges for compliance personnel, because a firm may be tempted to fault compliance for an aberrant trade. However, just because a firm may use computer filters or other technology to catch potential compliance problems earlier does not shift the responsibility to make sure that a transaction complies with the firm's policies, procedures, and portfolio restrictions. Such responsibility remains where it has always been — on firm management. In my view, compliance should be there to assist management — not supplant it — in complying with this responsibility.
I would now like to spend a few minutes discussing some real life compliance issues and highlight for you an area where you may want to focus additional attention. Specifically, in two recent cases the Commission has brought charges against investment advisers for failure to disclose conflicts of interest. On May 1, 2008, the Commission settled an enforcement action against investment adviser Banc of America Investment Services and a successor entity for failing to disclose to clients that in selecting investments for discretionary mutual fund wrap fee accounts, Banc of America favored two mutual funds affiliated with it.5 In the absence of this disclosure, clients did not know that Banc of America had an interest in recommending to them the proprietary mutual funds over other alternatives and that Banc of America earned additional fees as a result. The adviser agreed to settle by paying nearly $10 million in disgorgement, interest and penalties.
On September 23, 2008, the Commission entered into a settlement with investment advisers AmSouth Bank and AmSouth Asset Management. This case involved the advisers defrauding the AmSouth mutual funds by secretly using for marketing and other unrelated expenses a portion of administrative fees paid by the funds and their shareholders which expenses should instead have been paid by the advisers. This was accomplished by the advisers entering into undisclosed side agreements with BISYS Fund Services, Inc., the administrator for the mutual funds. Under these agreements, in consideration for the advisers recommending that the mutual funds continue to use the administrator, the advisers received approximately $16 million in rebates of the total $49 million in administrative fees that the mutual funds paid to the administrator during the relevant period. After crediting the advisers with certain repayments to the mutual funds, the Commission agreed to accept from them an $11.4 million settlement representing disgorgement, interest and penalties.6
While the particulars of each case vary, both situations involve alleged undisclosed conflicts of interest. In each situation, had the adviser disclosed the conflict, this would have neutralized claims that the adviser misled investors and others. I would suggest that for those of you in the audience who are investment adviser compliance personnel, for purposes of the annual review of your compliance program as required by Advisers Act Rule 206(4)-7(b),7 you should spend some time reviewing with management and legal counsel your disclosure policy particularly regarding potential conflicts of interest. My takeaway from these examples is that it is critical that your compliance program includes appropriate review of conflicts and whether and how such conflicts are identified, disclosed and resolved.
More generally, current market events provide an opportunity for you to review certain assumptions that may (at least until recently) be embedded in the operations at your firm. Without providing an exhaustive list, examples that come to mind include assumptions on the behavior of various types of instruments, hedging techniques, portfolio diversification, and portfolio liquidity. In addition, you should probably take a look at sales materials and pertinent disclosures to see if the information continues to be accurate. I would also suggest that to the extent you have not already done so, you carefully review the ComplianceAlert newsletters published by the Commission's Office of Compliance Inspections and Examinations available on the Commission's website. In these newsletters, published in June 2007 and July 2008, OCIE identifies common deficiencies and weaknesses that examiners found during compliance examinations of investment advisers, mutual funds, broker-dealers, and transfer agents. The newsletters may be a helpful resource that you can use when conducting a review of your own compliance program.
I have just two additional points on this topic and then I will move on. First, as I mentioned, Rule 206(4)-7(b) requires an annual review of an investment adviser's compliance program. Although only an annual review is required, an astute compliance professional will engage in more frequent reviews, especially following any change in business activities (such as downsizing), markets, or regulatory developments (such as the Commission's recent requirement for institutional investment managers to file Form SH detailing short positions). Second, recognizing that the majority of funds operate pursuant to one or more exemptive orders that allow them to engage in otherwise prohibited activity, I believe that funds as part of their annual review should examine their outstanding exemptive orders and satisfy themselves that they continue to operate in accordance with any conditions required in those orders. As someone who has had responsibility for legal and compliance in complex organizations, I can suggest the following. Exemptive order requirements get embedded in a firm's policies and procedures — as they should. However, when the policies and procedures are revised, personnel do not always go back to the exemptive order to review whether the specific requirements have been correctly reflected in the firm's revised policies and procedures. You and legal counsel need to do so.
In the remaining minutes that I have with you this morning, let me briefly address two initiatives underway in my Division that may impact this audience. The first initiative that I would like to discuss — and which I suspect is particularly relevant for this audience — is the Division's examination of the investment adviser books and records rule and recommendations to the Commission for updating it. In order to provide an appreciation for our recommendations, some historical background may be helpful.
In 1940, when the Congress enacted the Advisers Act, no requirement existed for investment advisers to keep books and records of their activities.8 Another twenty years passed before Advisers Act Section 204 was amended in 1960 to require that advisers "make, keep and preserve for such periods, such accounts, correspondence, memorandums, papers, books, and other records, and make such reports, as the Commission by its rules and regulations may prescribe as necessary or appropriate in the public interest or for the protection of investors."9 In response, in 1961 the Commission adopted Rule 204-2.10 As originally adopted, the rule assumed that records would be retained in paper format. To put this in historical context, it might be enlightening to reflect on what else happened in 1961. Here are a few examples: I was eleven; then-president Kennedy, on his sixth day in office, conducted the first ever live presidential news conference; IBM introduced the Selectric typewriter; Fairchild Semiconductor marketed the first commercial integrated circuit; and the Beatles made their debut concert performance.
In the intervening 47 years since the Commission adopted Rule 204-2, the rule has undergone various amendments but very little substance in the rule text has changed. In contrast, I am now a grandfather. We have had many live presidential news conferences. Examples of the Selectric typewriter and first commercial integrated circuit can be found, if at all, on display in a museum. And the Beatles will not be touring any time soon.
What does this suggest? To me, it suggests that it is time we update Rule 204-2 to recognize that substantial changes have occurred in the industry and with technology since 1961. To this end the Division is contemplating recommending that the Commission amend Rule 204-2 to require advisers to maintain some records in electronic format (under the current rule electronic records are optional) and to generate and produce (on staff request) searchable and sortable electronic records of trading data for managed accounts, clients lists, and code of ethics breach logs. We are fine-tuning the proposed communications retention requirements, and looking at the current content-based approach. We may recommend that advisers keep additional categories of written communications, such as correspondence regarding clients, advice, performance, compliance, commissions, and audits as well as correspondence to or from clients, regulators, marketers and broker-dealers. Industry professionals have suggested we also explore alternative approaches, such as a "modified business as such" standard, which would require advisers to retain all correspondence relating to their advisory business but allow them to discard correspondence of certain employees who would be "carved out" because of their job functions. This type of alternative raises additional policy issues. There are many additional details of this initiative that must be carefully considered as part of any recommendation, and my staff is actively working on this initiative.
The second initiative is the "Director Outreach Initiative." This was a project that I started in early 2007 to examine the duties imposed on independent directors of mutual funds. Since launching this initiative, I have attended more than 25 mutual fund board meetings and have obtained insight directly from directors and other industry participants. Based on this feedback, my staff is assembling a variety of recommendations for the Commission's consideration for ways to increase the effectiveness of independent directors. The relevance for this audience is that as part of the staff's recommendations, we plan to recommend that the Commission issue interpretive guidance recognizing situations where independent directors, while maintaining ultimate responsibility for fund oversight, may delegate certain responsibilities consistent with the valid exercise of their business judgment. Although we do not contemplate specifying either the specific responsibilities or to whom they may be delegated, compliance personnel are clearly within the universe of persons directors mentioned that they rely upon. Accordingly, stay tuned for further developments.
You have a full program today and I have used up my allotted time. Thank you for allowing me the opportunity to participate this morning.
Endnotes
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1The 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 of the author's colleagues upon the staff of the Commission.
2See Division of Investment Management September 25, 2008 Letter to the Investment Company Institute available at www.sec.gov/divisions/investment/noaction/2008/ici092508.htm.
3See Division of Investment Management October 8, 2008 Letter to the Investment Company Institute available at www.sec.gov/divisions/investment/noaction/2008/ici100808.pdf.
4See Division of Investment Management October 10, 2008 Letter to the Investment Company Institute available at www.sec.gov/divisions/investment/noaction/2008/ici101008.htm.
5http://www.sec.gov/litigation/admin/2008/33-8913.pdf
6http://www.sec.gov/litigation/admin/2008/ia-2784a.pdf
717 USC 275.206(4)-7(b).
8Investment Advisers Act of 1940, ch. 686, 54 Stat. 789 (codified as amended at 15 U.S.C. §§ 80b-1 - 80b-18a).
9Pub. L. No. 86-750, 74 Stat. 885, 886 (1960).
10Investment Adviser Release No. 114 (May 25, 1961).
www.sec.gov/news/speech/2008/spch102908ajd.htm
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