Attorney Says SEC Wants Conflicting Interests Reined In

Attorney Says SEC Wants Conflicting Interests Reined In
Investment Partnership Conference Draws Big Numbers

By Jay Dismukes

Over the last few years, with the emergence of the Sarbanes-Oxley Act and the renewed emphasis on investor protection and confidence, the Securities and Exchange Commission has, perhaps unknowingly, become the ultimate college professor.

Since the collapse of Enron, the division of enforcement for the nation’s premiere regulator has been holding what sometimes seem like class lectures for its overwrought but eager star pupil, the financial services industry. From those lectures, a prominent New York attorney recently pointed out, one clear and consistent theme continues to surface: more prevention, more compliance.

According to Richard D. Marshall, a partner with the Manhattan office of Kirkpatrick and Lockhart LLP who has represented individuals and regulated entities in investigations by the SEC, prevention, compliance and a proactive approach to thwarting violations before they occur have become the “theme of the hour” for the enforcement wing of the Commission. Editor of The Investment Lawyer, Marshall was one of the guest speakers at last month’s Investment Partnership Conference. With approximately 500 attendees, the conference was the largest ever held by the Foundation for Accounting Education.

Drawing from several speeches that Stephen Cutler, director of the SEC’s division of enforcement, has made over the last year, Marshall spoke about a number of issues that comprise this all-encompassing theme. First among those, and what he labeled a top “priority” at the SEC, Marshall encouraged all financial services firms to conduct a “conflicts audit.”

A speech Cutler gave last fall explains the purpose of this type of audit.

“I call upon every financial services firm to undertake a top-to-bottom review of its business operations with the goal of addressing conflicts of interest of every kind,” Cutler said. “…Search for those business practices that have the potential to sacrifice the interests of one set of customers in favor of the interests of another...Identify any situations in which the firm could place its or its employees’ interests ahead of the firm’s customers.”

Business practices that firms may want to address include “side-by-side management” of accounts. Firms should look into whether some of their accounts, such as a hedge fund with a large commission, receive a significantly disproportionate amount of time and attention compared to other accounts, such as a mutual fund with a small commission. Firms should also examine whether their brokers have any financial incentives for promoting and recommending certain accounts to investors.

“Find them, disclose them, monitor or mitigate them, or just get rid of them,” Marshall advised of these potential conflicts of interest.

If the SEC decides to investigate a particular conflict or any other matter, firms and companies will want to carefully consider how they handle the investigation. The best approach, Marshall said, is to exercise scrupulous care, honesty and integrity. While deleted e-mails, altered workpapers and misleading statements are some of the most egregious breaches of the investigative process, the attorney said the SEC also keeps track of more mundane details, like whether or not the investigators received timely responses to their questions or were treated rudely.

Should the SEC find any violations of securities laws or instances of misconduct, the level of cooperation that corporations and firms provide during the investigation could affect the decision and amount of any financial penalty the Commission might impose. Similarly, the SEC will also take into account the intent to defraud, the scope of the injury to investors, and the ability of the companies to pay fines that would teach them a lesson without putting them out of business.

While investigating improper corporate activity, the SEC, as directed by Sarbanes-Oxley, has also placed a greater burden on the capital markets’ gatekeepers to carry out their legal responsibilities. The SEC has imposed fines or taken other action against gatekeepers—auditors, lawyers, analysts, board members—that it found were neglectful of their duties or helped facilitate or hide misconduct. As demonstrated before, the SEC at times has held organizations or firms accountable, as well as their employees.

By applying increased scrutiny and pressure on the gatekeepers, Marshall said the Commission believes these groups “will become little SEC policeman.”

In a speech he made in September, Cutler clarified the idea.

“Ensure good behavior by those who control ‘access’ to our capital markets and you could achieve more than you would by going after every bad actor,” Cutler said.

On the Table

Prior to Marshall’s speech, Leon M. Metzger, executive vice president of hedge fund operation Paloma Partners Management Company, discussed a proposed rule that would require certain hedge fund advisors to register with the SEC under the Investment Advisers Act of 1940. The SEC previously sought public comment on the rule.

As a condition of their registration, advisors would be required to provide the SEC with information about their firms and trading practices. While Metzger believes that the SEC should clarify the type of information that it would collect before any rule is finalized, he shed light on some areas the Commission is interested in exploring. Among those, valuations would probably take precedence, he said.

In comments he submitted to the SEC about the rule, Metzger wrote: “Valuations are the easiest places for managers to commit fraud and the hardest areas for investors to detect problems.”

Metzger urged the attendees to check out a white paper on valuation concepts prepared by the International Association of Financial Engineers (IAFE). Firms, he said, should be prepared to answer the questions posed in that white paper, which can be found at www.iafe.org.

Other information of particular interest to the SEC might include the average size of commissions on trades, the number of independent contractors used, the amount of money held in cash, and whether or not an independent accounting firm audits the fund, Metzger said.

The Society’s Tax Division Oversight Committee, chaired by Maryann M. Winters, sponsored the Investment Partnership Conference, held at the New York Marriott Hotel in Manhattan. Committee member Janice M. Johnson chaired the event.