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March 1, 2004

SEC Keeping a Closer Watch: New Rules, Best Execution, a Ban on Commissions

By Nina Mehta

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  • SEC Keeping a Closer Watch: New Rules, Best Execution, a Ban on Commissions
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It's not the best of times for compliance officers at trading firms.

The SEC's Office of Compliance Inspections and Examinations (OCIE) has been instituting a new risk-based compliance assessment program in its audits of investment advisers.

This is a top-down, bottom-up system that evaluates investment advisers based on the riskiness of their activities and the sufficiency and pro-activeness of compliance programs. The measure of a firm's compliance success is that it is detecting problems and fixing them quickly, as well as deterring problems from happening.

And if that is not enough to keep compliance officers up at night, there is also a new focus on best execution on the trading desk. This is part of the broader-gauge assessment of firms' internal controls across many areas. Best execution is notoriously hard to define and is also a compliance concern.

Confused by all of this? Well you may be soon. That's because the Securities and Exchange Commission is instituting or reviewing several new rules to stem the tide of business and brokerage practices that harm investors. On February 11, the SEC proposed a ban on the use of brokerage commissions to pay for the distribution of mutual funds. On January 14, the Commission proposed new code-of-ethics requirements for investment advisers. Back on December 17, the SEC proposed additional mutual fund disclosure rules regarding discounts on front-end sales loads.

While the more formal risk-based system was instituted about a year ago, best execution has been a "key focus of examinations" for the past several years, said Lori Richards, the OCIE director, in an interview with Traders Magazine. This emphasis was a direct response to the "increasing recognition that there are alternative execution venues available, that there are conflicts of interest associated with the use of brokerage, and that, fundamentally, advisers have a duty to seek best execution," she said.

The Warpath

Why does the SEC appear to be on the warpath? Critics of the fund and trading industries say these businesses brought it on themselves.

In the past year, the $7.2 trillion mutual fund industry has been repeatedly bruised by scandals involving conflicts of interest and abusive brokerage practices. Most recently, in January, an SEC probe of 15 brokers revealed that 13 had been compensated by mutual fund companies for selling fund shares to clients. Half of the brokers did not disclose these arrangements to their customers.

Some customers were hit twice: they were steered to mutual funds because of incentives they knew nothing about, and they paid excessive brokerage commissions.

OCIE's evaluations will be used to determine the frequency of audits. While some large investment companies may be audited annually, the majority of mutual funds and their advisers will be on a two-to-four-year cycle. Those considered riskier will be inspected every two years, while those considered less risky will be inspected every four years. Richards notes that this is already happening. To implement this inspection regime, OCIE increased its staff from 370 to 495 in the past year, and is continuing to hire examiners.

OCIE approaches the issue of best execution during an audit by asking which brokers an investment adviser uses, how and why.