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SEC Won't Let Up On Compliance: SEI: Non-Public Information, Soft Dollars on Radar

Like death and taxes for the rest of us, Securities and Exchange Commission oversight will always be a concern for the mutual fund industry.

A report by consultantcy SEI of Oaks, Pa., warns that there are ominous indicators of increased regulatory surveillance and a tougher enforcement regime on the horizon.

"It's important for managers to know and understand the SEC's hot-button issues," said Jim Volk, chief compliance officer for investment manager services at SEI and a co-author of the report, "What's Next from the SEC? How to Make Sure Your Compliance Program is Ready."

CCOs and other executives should pay close attention to the SEC's informal signals, prepare for more intensive exams, work to improve risk assessments and fill in compliance gaps when they are identified, according to SEI.

SEI identified six areas of concern for regulators and CCOs: use of non-public information, hidden fee arrangements, soft dollars, brokerage relationships, alternative investment management activities and securities lending.

Volk said that while funds have shorn up on their compliance programs in the past four years since the scandal broke, one challenge for them is to do more with the information they collect and to be able to show a rock-solid compliance pathway.

SEC officials have indicated that 40% of the compliance programs they reviewed last year were deficient. Taken together with SEI's assertion that "in the last six to nine months, the SEC has been going out of its way to make sure the industry knows what's on its mind," it might seem that mutual fund managers may face sleepless nights. SEI argues that with the Commission's increased outreach will come increased expectations when they ask firms for data.

But before industry executives reach for tranquilizers, it should be noted that experts reacted to the report by adding some caveats to its conclusions.

Brian Regan, a partner at the Washington-based law firm Sutherland Asbill & Brennan, said that because the SEC is doing more target exams, it isn't surprising that it is finding more deficiencies.

Niels Holch, head of the Coalition of Mutual Fund Investors in Washington, said that it is important to distinguish between material and technical violations when assessing the 40% result.

Another issue in judging the impact of the assertion that a high percentage of SEC exams were deficient in 2006 is the fact that SEC fines went down from $1.5 billion in 2005 to $975 million last year.

However, Volk said the level of fines has nothing to do with changes in the Commission's reporting requirements. He said that attendees at an April 2007 SEI conference agreed that in the face of the SEC's move toward a risk-based strategy, it has become harder to manage compliance.

Risk-based regulation takes a principles-based regulatory approach, as exemplified by the U.K.'s Financial Services Authority. The SEC has indicated it will move away from its traditional rules-based approach, which emphasizes specific guidelines, to a principles-based approach. Clearly, this is an offshoot of the formation of the SEC Office of Risk Assessment in 2004 to uncover emerging forms of fraud and illegal activity.

Another take on the Commission's posture comes from Jeff Keil, principal of Keil Fiduciary Services in Littleton, Colo., an industry consultant who works with mutual fund board members.

From Keil's perspective, an important question is, what should the summary of a complicated compliance program for board members look like? But, in all, he said, most large mutual funds have taken effective steps to beef up compliance regimes since the scandals of recent years.

Avoiding Burns From Hot Buttons'

The Commission's concern about the use of non-public information typically arises when information leaks in advance of large customer orders. This variation on illegal insider trading must be staunched by funds.

The soft-dollar issue was ticked off by Volk as a good example of how potential conflicts can be managed. He said funds are reluctant to abolish the practice because it is a good mechanism for keeping execution costs low. He recommends disclosure and monitoring by CCOs as one approach to making sure they are managing the soft-dollar issue effectively.

With securities lending, a problem may arise for mutual funds if they can't get the security back before they are faced with a proxy vote in which they have a vested interest. If the security can't be retrieved, the fund may be unable to vote its proxy.

Yet on the whole, Volk said, securities lending is a beneficial revenue generator for funds. He said the risks associated with it are minor.

In relation to brokerage relationships, the report suggested that the elimination of Rule 12-b-1, which allows funds to pay for distribution from their asset pools, is less endangered than it once seemed to be. Compromise is more likely than outright elimination of the rule, SEI said.

Still, Tim Levin, a partner at Morgan, Lewis & Bockius in Philadelphia, advises fund executives to continue to monitor the SEC's posture on this issue.

On the question of investments in alternative assets, such as derivatives, Volk said it is important for fund managers to understand the securities they are investing in. This is critical as more mutual funds adopt hedge-fund like strategies and invest in additional asset classes.

Volk urged compliance executives to stay abreast of the SEC's hot-button issues, as what is on the Commission's radar now is different from what its top concerns were six months ago. And even if most of the issues don't apply to a given fund, managers can be sure that a few of them will apply to their fund.

But as far as whether there is a trend toward less rule making by the Commission, Regan said that's something the industry has to wait and see.

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