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News October 11, 2004 Issue

Is the SEC Over-regulating? Will it Lead to an Industry Backlash?

October 5 has come and gone. But the mini-sweep letters are still pouring in. And donít forget that new personal trading code of ethics, which needs to be up and running by early January.

Ready for a vacation? Longing for the good old days? Youíre not alone.

"For a lot of people, itís just taken a lot of the fun out of it," said one in-house lawyer at an East Coast adviser. That, he said, is particularly true for individuals who view investment management as their "profession or craft." Now, he said, the concern is that "there are people lying in the weeds everywhere" waiting to pounce. Itís not just the SEC that has people worried. "It could be the media, plaintiffsí lawyers, academics writing articles, or state regulators," he said. "You donít necessary need to have done anything wrong. Someone just needs to take offense."

In addition to facing heightened risks, advisers are facing greater costs and burdens. For example, not only did the new compliance program rule impose hard dollar costs on many firms (such as the cost of paying outside consultants), it imposed perhaps more significant "soft costs" ó namely, the time and internal resources that were spent developing the compliance program, as well those that will be required on a going-forward basis to comply with the new policies and procedures. The sentiment of many in the industry is that those resources may have been better spent serving clients.

Of course, most industry participants would readily acknowledge the benefits of the compliance program rule. Despite the costs, "I think people overall view this as a good thing," said Investment Company Institute general counsel Elizabeth Krentzman. Her perception is that people "have really rolled up their sleeves," although "probably we all have underestimated how much work the formalization of a compliance program entails."

The bigger issue, she said, is the continuous sweeps being brought by the SECís regional offices. The regions are requesting "repetitive, redundant information," at the same time that the industry "is trying to work extremely hard" on the compliance program rule. "Thatís where the pressure is," she said. "From what I hear day-to-day, one of our membersí biggest complaints is the significant drain of resources necessary to answer very broad ó and sometimes contradictory ó sweep exams requests."

Others agree. "I think there is almost an exhaustion factor going on in the industry with the new compliance program rules, the nearly constant sweep exams, and the pressure on enforcement," said one senior law firm partner. "Itís been an onslaught. People really have been put through the wringer." And, he added, "there is a certain level of resentment there" towards the SEC.

That resentment was clearly articulated last month by Robert Olstein, chairman of the Olstein Financial Alert Fund. In a letter to shareholders, Olstein expressed his personal views on the fund governance rule, compliance program rule, and other SEC reforms.

He didnít mince words.

Regulators, he said, have lost sight of the fact that efforts to "legislate honesty" actually are anti-shareholder. "Although on the surface, the regulations appear to be politically correct, I believe that they could ultimately harm mutual fund shareholders by increasing costs and creating prohibitive barriers to entrepreneurs looking to enter the fund industry." Instead of imposing burdensome regulations, Olstein urged the SEC to deal severely with isolated wrongdoers. "You cannot assure 100 percent integrity via stifling controls and directives without incurring prohibitive costs," he said. "A few rats in the basement of a sound building does not warrant blowing up the entire structure to eliminate them."

If there isnít already a backlash against the SEC, Olstein would like to see one get started. "It is time for the mutual fund industry to rebel, protect its shareholders, punish unethical participants, and not allow successful well-respected icons, regulators, and government officials who are either uninformed, shoot from the hip or take politically expedient views to destroy a successful investment vehicle," he said.

Opportunity Partners LP president Phillip Goldstein (author of the now-infamous "Bumpty Dumpty" comment letter) echoed Olsteinís sentiment: "They need a new reality show on T.V., where the reality is that funds spend money on regulations that the SEC imposes on them and which produce no perceptible benefit for shareholders."

In particular, Goldstein criticized the SECís statement in rulemakings that the agency is "sensitive" to the costs imposed by their regulations. Goldstein noted that he sits on the board of a registered fund. As a result of the compliance program rule, "weíve got to pay a guy $24,000 year plus expenses" to review the fundís compliance program. When it comes to approving the compliance program of nationally-recognized service providers, such as Bank of New York, he asked, "what is one dinky little fund going to do?" In his view, he said, the benefits donít exceed the costs.

And consider this, from a recently-released report†titled "Shooting From the Hip: The SEC Has Stopped Doing Its Homework," by the American Enterprise Institute: The SECís recent initiatives "have seemed ad hoc and superficial ó indeed, almost ideologically driven ó and as a result have drawn far more opposition from inside and outside the securities industry and within the Commission itself than has historically been true of SEC rulemaking."

Adding fuel to the fire: the SECís aggressive enforcement posture. The perception of some in the industry is that advisers are being sued for things that just a few years ago would warrant deficiency letter comments. IM Insight recently heard of a relatively small adviser that "is getting reamed" in an SEC enforcement case for things such as failing to comply with the four corners of the cash solicitation rule. One lawyer pointed to last monthís case against Bridgeway Funds founder John Montgomery (for incorrect calculation of performance fees) as something that historically would have been dealt with in a deficiency letter, with an agreement that the adviser would make restitution to affected clients.

Moreover, because advisers are facing incredible pressure to settle, some of the resulting cases are making "bad law," according to industry lawyers. As one Washington D.C. lawyer put it, firms facing an enforcement action are "over a barrel." The longer the case is played out in the press, he explained, the worse it is for the firm. "Thereís a feeling that thereís no leverage." At the same time, he added, "the SEC and state attorney generals are running hog wild." Case in point: PIMCOís distributorís settlement last month with attorney general Bill Lockyer, in which Lockyer went farther than the SEC in deeming undisclosed hard dollar revenue sharing payments to be fraudulent. "Thatís the deal that was struck," said the lawyer. "PIMCO needed to make a business decision." The upshot, however, is that Lockyer seems to have taken the position that funds face a new disclosure requirement in California, NSMIA notwithstanding.

Another example: in announcing an agreement in principle with Bank of America to settle market timing allegations, the SEC said that BOA had agreed to implement "certain election and retirement procedures" for the Nations Funds trustees. Those changes were intended to result in the replacement of the trustees within one year. Looking at the 1940 Act, however, lawyers questioned how a fundís manager could unilaterally change the composition of the fundís board. "Itís shenanigans," said the D.C. lawyer. (IM Insight checked around about the notion in the BOA settlement that an adviser could reconstitute a fundís board and was told by a person familiar with the matter that "the Commission is aware of the issue." The person also noted that the Commission has not yet approved any final settlement in the BOA matter, much less issued a final order.)

Could the recent rash of lawsuits against the SEC be a symptom of a larger industry backlash? Perhaps. But despite the suits, said the senior industry lawyer, the feeling is that "most of these regulatory initiatives are going to stick in one way or another."†