Speech by SEC Staff:
Keynote Address Before IA Week's 6th Annual Fall Compliance Conference
by
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, N.Y.
September 25, 2006
I. Introduction
Good morning. It is truly a pleasure to be with you here today. And I am pleased to see so many participants attending a conference devoted to investment adviser compliance. Your attendance reflects a strong commitment to your compliance functions and the central role that compliance must play in any well-run asset management organization.
I would like to discuss the importance of compliance as well as some of the initiatives we are pursuing at the SEC that will impact your work as CCOs and compliance professionals. First, however, I need to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the staff.
II. The Role of CCOs and Compliance Professionals
Let me begin my remarks by stating that I have much in common with you. I have spent 30-plus years in the financial services industry, much of that time as General Counsel of asset management firms with the firms' compliance departments reporting to me. I understand many of the challenges of running an effective compliance program. I know how essential it is to have the respect and support of top management in order to build a meaningful and workable system of compliance controls. I have had the good fortune of working for firms where compliance activities were respected and a focus on compliance was a core attribute of the firm culture.
I believe that the chief compliance officer position is one of the most critical positions in an asset management firm. It should be filled by someone who is knowledgeable, experienced, responsible, thorough, energetic and committed.
While effective compliance programs are a firm-wide undertaking, the CCO is responsible for ensuring that all compliance tasks are being performed-and hopefully performed in a conscientious manner by appropriate personnel within the firm. In my experience, one of the core functions of a CCO is to "drill down" to test whether a firm's personnel are actually performing assigned compliance duties, following specified compliance procedures and whether those procedures are effective.
By drilling down, a CCO can identify areas where compliance standards are being met on consistent basis as well as areas possibly requiring additional focus and attention. Another important tool is forensic testing, which can enable CCOs to identify patterns or problems that spot checking may not find. I encourage you to implement these types of systems to help fulfill your compliance oversight responsibilities.
As a CCO, attorney or compliance professional in the investment advisory business, one of your most significant responsibilities involves the identification and oversight of conflicts of interest. As investment advisers, you owe a fiduciary duty to your clients. Because of this fiduciary duty, conflicts must be managed in a fair and appropriate manner. And an investment adviser cannot stick its head in the sand and pretend the conflicts do not exist or that they are fully accounted for and addressed.
As soon as an investment adviser accepts a second client, an adviser's conflicts become more complex. The adviser then has to institute appropriate trade allocation practices, disclosure strategies, and other procedures. Conflicts are not static. Conflicts evolve as an advisory business evolves, and a firm's executives and those responsible for overseeing compliance matters must continuously work to identify conflicts and implement an effective mechanism to eliminate, or at least establish controls to address, those conflicts. Similarly, an adviser's disclosures to clients must be appropriately updated to reflect the evolving nature of the adviser's conflicts.
Conflicts identification, elimination, oversight and disclosure merits significant focus in any investment advisory organization. I encourage you to give these matters the attention they require, and to impress upon your colleagues that conflicts management is the responsibility of all employees in the firm, not just those with a "compliance" title next to their names.
III. Diversity of the Investment Advisory Industry
I firmly believe that we should provide flexibility, where possible, to let firms design compliance programs that are tailored to their particular business models, based on their own products and services and client relationships. There is great diversity among the estimated 10,000 investment advisory firms registered with the SEC. Very often, a mandated one-size-fits-all approach to regulatory requirements may not be the best approach and may not work.
A recent report prepared by the Investment Advisers Association and National Regulatory Services stated that the "typical" SEC-registered investment adviser had $96 million in discretionary assets under management, 6-10 employees and 26-100 clients. While these are interesting statistics, I would guess that few, if any, of the firms represented here today fit this "typical" profile.
I am very mindful of the fact that SEC-registered advisory firms include well-known mutual fund and institutional advisers that are affiliated with large international financial services firms, as well as smaller regional or even local firms that provide advisory services for friends, neighbors and families. Our challenge as regulators is to develop an effective regulatory regime that is workable at both ends of the spectrum — and all of the firms in between.
The CCO rule was designed to strike the right balance between mandated requirements that benefit investors and flexibility to tailor compliance regimes in a way that is most rationale and meaningful for a particular advisory firm. As Director of IM, I hope that we can continue this approach with respect to our future initiatives.
IV. Priorities for the Division of Investment Management
Speaking of future initiatives, I want to discuss some of the priorities I have for the Division of Investment Management that likely will impact the important work you perform on a daily basis. One of the largest and potentially most consequential initiatives we are undertaking right now at the Securities and Exchange Commission is the Investment Adviser/Broker-Dealer Study.
The study, in part, will hopefully afford the Commission the ability to gather data and information through an objective, third-party contractor. This data and information gathering should provide the Commission and the staff additional materials to make fully informed evaluations regarding the broker-dealer and investment advisory regulatory schemes and how those schemes impact both firms and investors. This is an exciting process and a worthwhile endeavor. I look forward to examining the data, along with my colleagues in other Divisions. I am also hopeful that the Investment Adviser/Broker-Dealer Study will further the dialogue on these important issues, especially as the broker-dealer and investment advisory industries continue to evolve.
The second major initiative the Division of Investment Management hopes to tackle involves a less exciting, but no less critical issue — books and records modernization. The investment adviser books and records rule was adopted in the early 1960s, long before most of us were even involved with the investment advisory industry. From my perspective, and that of many of my colleagues at SEC and my former colleagues in the industry, the rule has not kept up with changes in the industry and thus is in great need of reform to make its requirements meaningful in the 21st century.
What I envision for this project is a comprehensive review of our books and records requirements, including consideration of the purpose behind each requirement and whether we can obtain the same information in a more meaningful manner. As part of this review, we should consider technologies available today that may assist firms in maintaining and producing records in a cost-effective manner. Many of these technologies were certainly not available four decades ago when the books and records rule was adopted.
This type of wholesale re-thinking of our books and records requirements cannot take place overnight. It will require close scrutiny and analysis — as well as a healthy notice and comment process once any revised rule is proposed.
Another significant initiative, and one we will be working on with the state securities regulators, is Form ADV, part 2. As the principal disclosure document investment advisers provide their advisory clients, Form ADV, part 2 serves a critically important purpose. The document is designed to inform investors about material conflicts, and the resolution of those conflicts, by an investment adviser. It also provides investors with basic, "users manual"-type information about the services and operations of their investment adviser.
As you may recall, the Commission proposed to amend Form ADV in 2000. The Commission adopted revisions to Part 1 of the form and deferred adoption of Part 2 to focus on the establishment of the IARD electronic filing system and the Investment Adviser Public Disclosure website that provides public disclosure of Form ADV information. Given the passage of time, and the evolving nature of the advisory industry and our regulatory system, I believe it is appropriate for us to re-propose Form ADV, part 2 so that we can receive a fresh set of comments on its form and content. My staff is working on a re-proposal recommendation for the Commission, and I certainly encourage your input, in the form of comment letters, when the proposal is issued.
Another investment adviser related initiative I have asked our staff to focus on relates to soft dollars, portfolio trading practices and best execution. As you are aware, the Commission issued an interpretive release on soft dollar practices this summer. Now there is a second step. There is an outstanding request, both from fund boards and from our own SEC Commissioners, for additional guidance to assist fund boards and others with their responsibilities in this area. The Division staff is working to do our part on this initiative. We would like to provide guidance that would enable fund boards and others to have a meaningful dialogue with fund managers on soft dollar practices, as well as the adviser's philosophy with respect to brokerage and trade allocation. This is an important dialogue for advisers and their clients to have — and the dialogue should be ongoing.
In my view, advisers and their clients should not consider soft dollars in isolation, but should instead focus on how soft dollar arrangements influence the overall practice of how an adviser places trades and whether that adviser is meeting its best execution obligations. Because brokerage commissions (and spreads and markups) are an asset of the client — and not an asset of the adviser — you as compliance professionals should be focused on the conflicts involved, monitoring the way this asset is used and the way that brokerage and other trade practices are described to clients. Your inquiry should not be limited to commissions on equity trades. There are best execution challenges in other asset classes as well, including fixed income. In addition, best execution inquiries should be made across all accounts and products, each of which, including separately managed accounts, may have its own best execution issues and challenges.
Moving from soft dollars and best execution, the final major initiative I would like to discuss today concerns hedge funds. As Chairman Cox has stated when testifying on hedge funds before the Senate Banking Committee, he will recommend that the SEC promulgate a new anti-fraud rule under the Investment Advisers Act that would have the effect of "looking through" a hedge fund to its investors. This would reverse the side-effect of the Goldstein decision that the anti-fraud provisions of Sections 206(1) and 206(2) of the Act apply only to "clients" as the court interpreted that term, and not to investors in the hedge fund.
Chairman Cox stated, he believes that such a rule is possible because the court itself noted that another anti-fraud provision, Section 206(4), is not limited to fraud against "clients." The result would be a rule that could withstand judicial scrutiny, and which would clearly state that hedge fund advisers owe serious obligations to investors in the hedge funds. The staff is currently analyzing what the contours of such a rule might be, given the Commission's authority to adopt such a rule under Section 206(4).
V. Conclusion
In conclusion, having spent just over four months in my new role as Director of the Division of Investment Management, I am not sure which is more challenging: being the regulator or the regulated. I can now honestly say I have been on both sides.
It is my hope that my three decades of experience in the investment advisory industry will make me a more effective regulator. I hope my experience will enable me to evaluate regulatory reforms from the perspective of determining which regulations add value and meaningful protections for investors, and which could be enhanced. As always, we welcome your input on these issues as well. As all of you know, those of us who serve in the government are unlikely to have all of the answers. We certainly need and value your real-world insights.
One of my goals for my tenure as Director of the Division of Investment Management is that it be marked by a healthy and productive dialogue among the SEC staff, the investment advisory industry and, of course, your clients. Together, I believe we can institute some positive, meaningful regulatory reforms.
Thank you again for inviting me here today. I would be pleased to answer a few questions as time allows.
Endnotes
http://www.sec.gov/news/speech/2006/spch092506ajd.htm
