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.
Trading is another sensitive issue. "For those SMA managers that have contracts that permit them to trade away, this is an area where the SEC is going to swing the gun turret around pretty soon," Parry said. Managers that send everything to the sponsor because they claim they know they get best execution even though they have the freedom to trade away, and yet have no basis, no process for demonstrating that, are leaving themselves open for some pretty hard questions from the SEC, she said.
Managers must justify their assumption that it is okay to always trade with the sponsor when they have the option to trade away, she continued, suggesting that they provide evidence by either looking at other client accounts that they're trading with other sponsors or looking at non-wrap accounts.
A third area the SEC has questions about relates to the allocation of initial public offerings, blocked trades and cross-trades. Managers need to make sure they disclose to their clients whether they'll have access to IPOs and if the client agreements permit cross-trades, Parry said.
With respect to recordkeeping obligations, an important area for the sponsor is assuring the accuracy of information provided to investors regarding their transactions and account balances. While the back-office duties typically are not the manager's responsibility, some firms employ a mirror or shadow version of those records in order to protect themselves from liability. The panel suggested that managers and sponsors work together to streamline the documentation to avoid duplication but at the same time be able to provide the necessary documents promptly in the event of an SEC exam.
The security of confidential account information and profiles is another important topic that will draw the ire of regulators if it is not protected properly, Parry said. She urged attendees to start having conversations with the IT staff at their respective firms to ensure there are firewalls in place. Data, such as account numbers, account balances and Social Security numbers must be accurately captured and safeguarded from inadvertent release, she said (see "At Deadline," page 1).
These issues along with suitability and manager availability to the client are the most likely to turn up on the SEC's radar screen, the panel agreed. While none of the attorneys anticipate a major scandal in the SMA industry, Lins cautioned, "You root around enough, you'll find some stuff."
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