SMAs Prep for Compliance Exams: Former SEC Attorneys Offer Tip Sheet
April 4, 2005
PHILADELPHIA - Having borne witness to the mutual fund trading scandal, the separately managed account industry, recognizing the perils of potential enforcement actions, is now focused on identifying trouble spots before the SEC comes knocking on its door.
Speaking on a panel at the Money Management Institute's annual convention, three former SEC attorneys identified a laundry list of compliance issues that will attract inquiries from regulators and offered advice on how to deal with them.
"The separately managed account industry probably can expect enhanced scrutiny in the coming years," said Gerald Lins, general counsel at ING Investment Management. "Finite reinsurance contracts are now making the front page of the business section, [so] it's not really a stretch to figure out that managed accounts, wrap-fee programs and program sponsors could actually be on the front page of The Wall Street Journal and The New York Times business section."
He further argued that the size and projected growth of the industry suggests that it will eventually be large enough to warrant more stringent oversight. Assets under management stood at $576 billion at the end of 2004 and are expected to reach $718 billion by the end of 2005 on net sales of more than $80 billion, according to the MMI
"It's a more adversarial environment, perhaps more than it should be," said Larry Stadulis, a partner at Stradley Ronon Stevens & Young. But like it or not, sponsors and managers have to get ahead of regulators on a number of issues before it ends up being addressed by litigators and the press, he said. Stadulis outlined a number of problems that exist across the industry that make it vulnerable to examiners.
One of the biggest concerns, he observed, is a lack of support from senior management. If there isn't a culture of compliance that starts at the top, the SEC is going to start asking questions, he said, adding that compliance needs to "work hand-in-hand with management" and not operate in a vacuum.
Another important challenge is staying abreast of new and often confusing regulations, which takes a lot of time and effort, Stadulis said. Many new rules are amended versions of old rules and are not always updated in a timely fashion on the SEC Web site, he noted. The chief compliance officer designation, while not mandated for SMA platforms, has also become a concern due to the perceived liability of the position and the lack of firm guidance from the Commission.
Recordkeeping requirements present another burden for SMA participants, as firms are now required to retain all e-mails related to their investment advisory business. In addition, there is a lack of specificity from the SEC when it comes to which records must be kept, Stadulis said. Advertising materials are another hot-button issue, as firms must ensure that performance numbers displayed in their ads have been properly calculated and are consistent with AIMR standards. "Saying you're AIMR compliant when you're not is fraud," Stadulis said.
These and many other issues are likely to be the subjects of SEC sweep exams in the years ahead, but the panel of lawyers cautioned that it is not enough to simply know about them; firms must be equipped to address them. By a show of hands in the audience, a handful of attendees conceded the SEC has already examined them since December, illustrating that SMA sponsors and managers are already feeling the heat.
Handling the initial request for information from the SEC is crucial because regulators are now asking for a "written narrative" detailing the internal control processes related to each area of concern. That requires significantly more information than just simply handing examiners your compliance manual, noted Monica Parry, of counsel at Morgan, Lewis & Bockius. The narrative must contain an explanation of the documentation provided and how it is used within the framework of compliance procedures.
For example, it should include how portfolio decisions are made and whether they are consistent with client mandates, she said. Given that SMAs enable investors to restrict certain stocks from their portfolio, there must be a protocol for handling their requests, one that includes determining what is a "reasonable" restriction, how those restrictions are observed and how that process is documented. "You want to know what your process is and you ought to be able to explain it to someone else," Parry said.