Speech by SEC Commissioner:
Remarks Before the IA Compliance Best Practices Summit 2006
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
Washington, D.C.
February 28, 2006
Thank you, Karen, for that kind introduction. I am grateful for the opportunity to be a part of your Compliance Summit. Let me start by saying that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
Now that the Olympics are over, we can all stop dreaming of what it would be like to hurtle down a steep Italian mountain on a luge, effortlessly negotiate a giant slalom course, land a perfectly executed triple lutz, or throw the winning curling stone. We can turn our minds back to the slightly less exhilarating, but critically important work of compliance. Although your efforts are unlikely to be awarded with a gold medal, you should be applauded for your diligent commitment to compliance on behalf of investors — your customers.
Your work is an essential complement of our work at the SEC. Our role in overseeing the securities markets can only work if there is a general commitment to compliance in the industry. Industry groups like the Investment Adviser Association and publications like IA Week help to foster industry-wide cooperation towards achieving better compliance.
A strong private commitment to compliance is particularly important at a time when government resources are stretched thin. In an effort to rationalize our examination resources, the Office of Compliance Inspections and Examinations has moved to a risk-based approach to monitoring investment advisors. This approach, a departure from the five-year exam cycle that was previously in place, is intended to focus our resources on those areas that seem particularly susceptible to investor harm and other trouble.
An effective risk-based examination approach will be particularly important in the new era that was ushered in at the beginning of the month — mandatory registration for hedge fund advisors. I am not among those who welcomed this new era. Indeed, I felt — and continue to feel — a sense of misgiving, as Commissioner Glassman and I spelled out in our dissent. Admittedly, the number of new registrants did not reach the highest levels anticipated by the Division of Investment Management. Some advisors shifted to a two-year lockup period to avoid the application of the rule. This entirely predictable action is not a good result for investors. Others have shut their doors to U.S. investors — another entirely predictable action that also is not a good result for investors. Still others are simply not accepting new investments. Many advisors are just waiting for the resolution of the strong legal challenge to the registration requirement that is currently pending in the D.C. Circuit and then will adjust their business models — or not — depending on the outcome.
Nevertheless, it is not an understatement to say that mandatory hedge fund advisor registration vastly expands the workload of the SEC. Proponents of hedge fund advisor registration cited as the rule’s primary advantage the fact that it would enable the SEC to examine hedge fund advisors on a regular basis. In practice, this necessitates a specially trained staff. Because of the growing number of hedge fund advisors who want ERISA-managed money, many hedge fund advisors have and will continue to register voluntarily. At any rate, we would have had to upgrade our technical abilities to adequately address these registered advisors.
We are discovering that it is no small task to refocus a portion of our examination staff so that they can effectively inspect hedge funds. Some aspects of hedge fund advisors are common to any asset management firm: conflicts of interest, custody, performance advertising, recordkeeping, truthfulness of disclosure. But many other aspects are much more complex: intricate holding structures, more trades, use of leverage, structured products, valuation issues. Because of this complexity, and the resulting diversion of staff resources, the new registration requirement could greatly impair our ability to oversee other investment advisors, whose activities are of much greater consequence to the investing public, based on sheer numbers of investors alone. We have seen time and again over the years just how difficult it is for any examiner or auditor to ferret out fraud at large and small retail-oriented investment advisors using straightforward long strategies. By their nature, fraudsters tend to be crafty and go to great lengths to hide their fraud.
Among hedge fund managers, of course, we will find some amount of fraud. We cannot tolerate fraud, market manipulation, insider trading, misappropriation of client funds, cherry picking, misvaluation, and favoritism in allocation (just to name a few) from registered or unregistered advisors. However, we do not need registration as a hook to pursue fraud — we have broad authority already under the securities laws. Needless to say, we did not find the late trading and market timing problems through our examinations of any of the many registered funds, registered advisors, and registered broker-dealers that were at fault. In these cases, as in so many of our enforcement cases, it took disgruntled investors or former employees of the advisor or a suspicious third party, such as a prime broker, to alert us to problems.
Some advisors might view the registration of hedge fund advisors as a good thing. After all, by swelling the ranks of registered advisors, the rule has lowered the likelihood that any one registered advisor will be examined by the SEC. Because hedge fund advisors are the SEC’s “flavor of the day,” perhaps other advisors are confident that they will avoid SEC scrutiny. But, I do not recommend reliance on the safety-in-numbers approach. While it is true that the SEC has an increased population of advisors to examine, we will not simply focus all of our attention on hedge funds.
One interesting upshot of the hedge fund rule is that some of our staff have belatedly come to the realization that the existing Form ADV will not provide us with the necessary inputs for our risk-based examination model. What, they ask, can we do about this? Well, the response is that we could ask for more information more often. Some have suggested that we seek to get more data from advisors, such as requiring quarterly SEC filings. Because there is no satisfactory way to distinguish among various kinds of registered investment advisors, such an approach probably would have to apply to most registered advisors across the board. Would it not be ironic if the hedge-fund rule increased the regulatory burden on non-hedge fund advisors, as well?
Ultimately, we must use some sort of risk-based approach to our allocation of regulatory capabilities. The SEC’s main line of business is investor protection, after all. We cannot be everywhere for every investor. We cannot put a lifeguard on every beach. In many places, a sign saying "Caution: Riptides (or sharks) — Swim at Your Own Risk" must suffice. Swimmers must decide what their own risk tolerance is and take appropriate precautions — or don’t go there.
In any case, I suspect that those of you who are here enjoying two intense days of discussions about compliance are serious about working hard on behalf of your clients and helping them to maximize their investment goals. Good compliance is good business. Your reputation matters in this business more than almost anything else, including even performance. You are all here because you want to understand better what the rules are and what you need to do to comply with them.
But even advisors who genuinely desire to do what is right struggle in the face of conflicting, complex, and constantly evolving regulatory obligations against a backdrop of intense competition for customers. The SEC should be assisting people like you in your efforts to comply with the rules. Well-intentioned individuals who are trying to comply with the rules on the books should be able to look to the SEC as a resource for facilitating their efforts, not as an ill-tempered policeman with a quota of tickets to hand out. Ideally, it would only be those individuals with bad intentions or a willful disregard for their compliance obligations that should have anything to fear from us.
A compliance exam should be an opportunity for you to learn ways to improve your compliance program, not an opportunity for the SEC to add to its enforcement statistics. I fear that this is not always the case. For example, eleven percent of exams of funds and advisors during the last fiscal year led to enforcement referrals.1 We need to work with those who are genuinely intent on getting things right, so that we can concentrate our enforcement resources on those whose intentions are sinister or who have no interest in getting things right.
The SEC has taken a number of important steps towards providing assistance to firms that are committed to compliance. One primary area of focus has been establishing a working relationship with firms’ compliance personnel. Some attempts have faltered, however, including requests to elicit from CCOs an opinion as to whether their firms are spending “enough” on compliance and requests for written lists of all material compliance breaches. These sorts of efforts can inappropriately shift a business burden onto the compliance officer and clearly ignore human nature and organizational dynamics. In my opinion and in my experience with compliance matters before I came to the SEC, they only serve to isolate the compliance officer from other parts of the firm and actually act as a hindrance to the compliance officer’s effectiveness with fellow employees.
I hope that the more recent efforts are more helpful. For example, last year, the staff held a number of regional seminars for chief compliance officers. Another element of the recently launched outreach program for chief compliance officers will be a newsletter written by the staff for chief compliance officers. As Chairman Cox remarked in connection with last November’s National Seminar for chief compliance officers, “As regulators, our job — and the goal of the National Seminar — is to help CCOs to succeed.”2
Perhaps the most important assistance that the SEC can provide to compliance personnel is clear, but not overly rigid guidelines. In a world in which regulators and class-action lawyers second-guess decisions years after they were made, precise rules behind which a compliance officer can take cover look attractive. Those of you responsible for compliance understandably like clear rules because they give you something to point at when business people in your firm question your decisions.
As in all areas of regulation, however, an overly prescriptive regulatory scheme can lead to a check-the-box mentality and thereby prevent the people who are most familiar with the specific facts of a particular situation from employing their judgment. The SEC, therefore, must walk the fine line of setting forth clear guidelines that allow for flexible application across the diverse advisors to which they apply. This can only work if we restrain ourselves from looking back after-the-fact and imposing additional requirements.
Unfortunately, it is easy to fall into the trap of imposing on advisors standards of behavior that were not embodied in the statutes or regulations in place at the time that the activities occurred. The Investment Adviser Association wrote in a letter to the SEC, “[I]nvestment advisers have a compelling and legitimate need to be notified and to understand what the rules are before the SEC proceeds to engage in new practices that are based on newly articulated expectations. … It is a matter of fundamental fairness that advisers not be penalized on a retroactive basis for failing to take actions that the Commission did not previously require and has yet to formally adopt.”3 I agree wholeheartedly with this proposition. For this reason, attempts to set regulatory standards through our inspection and enforcement programs are unacceptable. Again I quote the IAA’s letter: “Instead of allowing new regulatory policies to be set by inspection activities, the Commission should issue a proposed rule … and give interested parties an opportunity to comment.”4 Is that such a radical concept? It happens to be required by the Administrative Procedure Act.
Incidentally, the subject about which the IAA was writing, namely email retention, production and surveillance guidance, has not yet been resolved. We commissioners must ensure that it will be in the near future. Guidance in this area must be flexible enough to allow advisors to use the latest technology, yet not impose requirements on advisors that are unachievable with today’s technology.
Requirements should be designed to avoid unduly interfering with the ability of investment advisors to communicate with their clients. It is only by asking advisors about the systems that they have in place, the practices that they employ, and the obstacles that they face in applying the recordkeeping rules to electronic documents that we can find out the viability of any particular regulatory approach. We can avoid imposing obsolete or technologically infeasible mandates by utilizing notice and comment rulemaking.
Interpretations of existing regulations that are developed in a vacuum at the SEC can have far-reaching consequences if they fail to take into account the nuances of the business environment in which they operate. For this reason, I also have been an advocate of seeking comment before we take interpretive action. Thus, last fall, the SEC issued proposed interpretive guidance for investment advisors’ use of client assets to pay for brokerage and research services. The comments that we have received should help us to avoid unintended consequences in the area of soft dollars and, along with the steps taken by the United Kingdom’s Financial Services Authority in this area, will inform our consideration of possible enhancements in soft dollar disclosure by investment advisors.
Regardless of whether we are adopting new rules or interpreting existing ones, we need to be mindful of the costs that we are imposing. The determination of costs and benefits of rulemakings is complicated by the diversity among the investment advisors registered. The new influx of hedge fund advisors only magnifies the diversity. It is difficult to write requirements that can be effectively applied across many different contexts without imposing undue burdens on any particular type of investment advisor. Comment from across the full spectrum of advisors and clients is an essential prerequisite.
One area in which input from the full spectrum of advisors will be essential is our upcoming investment advisor/broker-dealer study. As the Commission directed in its rulemaking, the study will compare the levels of protection afforded retail customers of financial service providers under the Securities Exchange Act and the Investment Advisers Act, and recommend ways to address any investor protection concerns arising from material differences between the two regulatory regimes.
Regardless of the requirements that the SEC imposes, rational advisors are cognizant that without a strong compliance program, their core business cannot survive in the marketplace. Nevertheless, resources should not be devoted to compliance unless doing so will yield a commensurate return. A November 2005 survey of members of the Investment Adviser Association found that the costs of compliance are averaging six to ten percent of total operating costs.5 Just last week, the Securities Industry Association issued a report on the costs of compliance in the securities industry.6 The report found, based on a survey of U.S. securities firms, that compliance costs had nearly doubled from 2002 to 2005.7 Much of the increase was attributable to growth in compliance staffs.8 But, as one respondent to the IAA’s survey noted, “Aside from the hard monetary costs, there is also the cost of lost performance due to the attention diverted away from executing the core business. This cost is not quantifiable.”9 Given that respondents to the SIA survey reported an average of 231 — yes, 231 — regulatory inquiries a year, one can imagine that the effects of diverted attention are substantial.10 As we set regulatory policy, we need to be cognizant that there are opportunity costs to resources devoted to compliance.
In order to make the Commission more effective in its oversight role, we have work to do internally at the SEC. Among other things, we need to re-evaluate our incentive structure in the enforcement division, since it has been more than 30 years since the Commission has taken a hard look at that issue. I want to emphasize that I have great respect for our enforcement staff and the fine work that they do on behalf of the agency, markets and investors. At the same time, I am wary that big penalties get collected the way an athlete collects trophies. For example, the biographies of many former enforcement division employees tout the huge settlements that they have amassed during their careers. It parallels the way corporate lawyers tout the size of the securities deals or M&A transactions that they have worked on. But, those of you who are good corporate lawyers know that the number of digits in a transaction’s size does not necessarily indicate complexity or legal skill. Often, especially with new products or venture capital, the small deals are most challenging.
One of the essential principles of Total Quality Management or Six Sigma is that you get what you measure. The SEC’s Annual Report for fiscal year 2005 reports a total of $3 billion in disgorgement and penalties.11 The NASD and New York Stock Exchange enforcement groups have similar approaches and tallies. Should we be surprised, then, if the enforcement lawyers measure themselves that way?
Staff in the enforcement division should be rewarded for acting with deliberation and judgment. Sometimes the reasonable course, as our staff recommended in a recent case, means leaving proffered penalties on the negotiating table when imposing penalties would not serve a regulatory purpose. The Commission’s statement last month that set forth broad principles for the imposition of penalties against corporations is a useful guide for determining the circumstances under which penalties are appropriate. In other cases, the proper resolution of an enforcement inquiry is a determination that proceeding with an enforcement action is altogether inappropriate.
Lack of internal coordination at the SEC can be frustrating for those of you outside the SEC. Concerns about our compliance program garnered Congressional attention last December when Representatives Vito Fossella and Michael Castle introduced a bill that would make a number of changes in the organization and internal functions of the SEC. Among these changes would be moving the compliance function back into the Divisions of Investment Management and Market Regulation, imposing a Commission approval requirement on sweep examinations, and requiring written notification of the closure of inquiries and inspections. The bill has given us some important things to think about and a challenge to act.
As I have said in other contexts, we should look back at our ten years of experience with a stand-alone Office of Compliance Inspections and Examinations to see if this is the most sensible model. Would it be easier for our staff to administer the compliance rule and other regulations consistently if we reintegrated examiners into the Divisions? Would it not build better synergies internally? In the alternative, we could modify reporting lines to strengthen the lines of communication between the Office of Compliance Inspections and Examination and the Divisions of Investment Management and Market Regulation. An integrated structure could allow for improved interaction and exchange between the folks who write and interpret rules and those who are on the frontlines interacting with registrants and assessing their compliance with our rules. On the other hand, potential benefits from a stand-alone OCIE might weigh in favor of implementing more moderate measures to improve coordination between OCIE and the Divisions.
Sweep examinations, a large number of which our Office of Compliance Inspections and Examinations has recently conducted, are one of the items at issue in the bill. These sweeps have yielded valuable insights into industry practice and thus are a useful tool for shaping regulatory policy. One of the complaints that I hear repeatedly, however, is that there is overlap and duplication in the SEC’s sweep exams. With exams being initiated from headquarters and the SEC’s regions, a firm might be the subject of multiple, simultaneous sweeps. To compound the problem, the firm might also be simultaneously in the midst of one or more SRO exams. Far from cooperating, the various regulators might actually be competing with one another for the regulatory glory. This is a completely unacceptable situation. You would cringe if your firm operated in such a fashion.
The concerns expressed by those who are overwhelmed by these exams have not gone unheeded. OCIE is working on improving coordination and has committed to me that the Commission will have the opportunity to weigh in on sweep examinations before they occur. More generally, OCIE has established an Exam Hotline, (202) 551-EXAM, to address any concerns that arise in the context of any kind of exam.
Finally, as always, my door is open. I am interested in hearing the experiences, frustrations, and recommendations of those of you who are doing your best to establish and maintain high compliance standards across the investment advisory industry. Don’t worry — like a physician, I am happy to talk on a non-attribution basis. Only by hearing from you what is going on, can we work to address the issues. Thank you for your attention. I’d be happy to take questions and hear your comments.
1 U.S. Securities and Exchange Commission, 2005 Performance and Accountability Report (available at: http://www.sec.gov/about/secpar2005.shtml) at 9.
2 Statement of Chairman Cox (Nov. 2, 2005) (available at: http://www.sec.gov/news/speech/spch110205cc.htm).
3 Letter of the Investment Adviser Association to Paul F. Roye and Lori A. Richards (Nov. 19, 2004) (available at: http://www.icaa.org/public/letters/comment111904.pdf) at 2.
4 Id.
5 Investment Adviser Association, Cost of Compliance Survey (Nov. 2005) (available at: http://www.icaa.org/public/iaacostofcompliancesurvey-2005.pdf) at 8-9.
6 Stephen L. Carlson and Frank A. Fernandez, The Costs of Compliance in the U.S. Securities Industry, SIA Research Reports (Feb. 22, 2006) (available at: http://www.sia.com/research/pdf/RsrchRprtVol7-2.pdf).
7 Id. at 3.
8 Id. at 4.
9 Investment Adviser Association, Cost of Compliance Survey (Nov. 2005) (available at: http://www.icaa.org/public/iaacostofcompliancesurvey-2005.pdf) at 2.
10 Stephen L. Carlson and Frank A. Fernandez, The Costs of Compliance in the U.S. Securities Industry, SIA Research Reports (Feb. 22, 2006) (available at: http://www.sia.com/research/pdf/RsrchRprtVol7-2.pdf) at 4.
11 U.S. Securities and Exchange Commission, 2005 Performance and Accountability Report (available at: http://www.sec.gov/about/secpar2005.shtml) at 9.
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