Managers hit by high cost of SEC probes

WASHINGTON — Bombarded by requests for documents, e-mails and other records from SEC staff, big investment advisers and mutual fund companies might be facing millions of dollars in expenses this year in dozens of "minisweep" examinations.

"When a sweep occurs, you're talking about days or weeks, not minutes," said John Benvenuto, director of mutual fund distribution research at Boston-based Financial Research Corp. "It's a major drain on the resources of the firm."

Several regional offices of the Securities and Exchange Commission as well as the Washington headquarters are zeroing in such issues as soft-dollar arrangements at index funds, personal trading, market timing, performance-based fees, advertising and marketing of performance data, and exchange-traded funds.

"In the last year, (office of compliance examinations and inspections) staff has discovered how wonderful e-mail is, and they haven't always been reasonable in requesting e-mails" for their investigations, said a securities lawyer who is a former SEC official. "If the SEC activity continues at its current levels," these companies will be forced to move resources from other areas to cover the additional costs of collecting and providing data to SEC examiners, said the lawyer, who now advises several large money managers and mutual fund companies on regulatory issues.

No one interviewed for the story could give a dollar estimate of how much the sweeps are likely to cost.

An investigation in August by the SEC's Boston office into personal trading and market-timing practices asked investment advisers to mutual funds to produce all e-mails by current and former employees from Jan. 1, 2001, to June 30, 2004, that mentioned any of 25 phrases, including "exchange privilege," "round-trip," "transfer fee," "redemption after 4" p.m., and "purchase after 4" p.m.

Just sifting through those e-mails, as well as producing reams of documents and records, could take weeks or months, some sources said. "In a large firm, you can have an exam over a three-year period, and that can cover millions and millions of e-mails that have to be searched," the securities lawyer said.

Some money managers and mutual fund companies also could face thousands of dollars in expenses if they have to overhaul their existing technology systems or hire outside vendors to help them search for the information requested by the SEC, sources said. "Some firms kept a backup tape, but not in a searchable format, and they could have spent tens of thousands of dollars to convert them," said Karen L. Barr, general counsel of the Investment Counsel Association of America, a Washington-based industry trade group.

What's more, the costs of reviews of e-mails and documents by outside lawyers, accountants or compliance consultants also adds up.

"You turn around, and your lawyer racks up $100,000," said a securities lawyer who preferred to remain anonymous.

Some say those being regulated need to get used to the new regulatory regimen.

"It's more pro-active regulation," said Theodore Eichenlaub, partner in the Morristown, N.J., office of Adviser Compliance Associates, a consulting firm. "The idea is to look at one area and understand everything about that area."

David G. Tittsworth, executive director of the Investment Counsel Association of America, Washington, concurred.

"A year or two years ago, the cornerstone or basic thrust was routine examinations at least once every five years. Now what you are seeing is less emphasis on a scheduled, routine examination and more emphasis on risk-based exams, and minisweeps are one facet of that," said Mr. Tittsworth.

For example, in early August, the SEC's Philadelphia office sent out requests to the largest some investment advisers to mutual fund companies nationwide, asking them to produce a list of documents and data by Aug. 27. The list included a request for all marketing materials with performance data provided to clients in the prior three years, as well as the performance composite against which the firm's performance was measured.

According to the questionnaire sent out by the Philadelphia office, investigators were looking for information on internal controls, written policies and procedures guiding the firm on performance calculations, and the names of the officials who were responsible for calculating performance, as well as a detailed description of the computer software and methodology used to calculate the performance.

Finally, the SEC wanted to know the criteria for including a client in the performance composite, and whether the firm had retroactively changed the composition of the composite.

Frank A. Thomas, branch chief of the SEC's Philadelphia office, declined to comment.

The Boston office led a sweep on market timing and personal trading; the Fort Worth office investigated performance fees; and the Chicago office conducted a sweep of investment advisers affiliated with high-yield municipal bond funds after the regulator filed enforcement action against Heartland Advisors Inc., Milwaukee, last December.

In a random check of firms, officials at Vanguard Group Inc., Valley Forge, Pa.; Turner Investment Partners, Berwyn, Pa.; and Babson Capital Management LLC, Cambridge, Mass., declined to comment on whether they'd been contacted by the SEC Representatives at Cooke & Bieler LP, Philadelphia, and 1838 Investment Advisors LLC, King of Prussia, Pa.; did not return several calls seeking comment.

Lori Richards, director of the SEC's office of compliance inspections and examinations in Washington, said in a written statement to Pensions & Investments about the advertising and performance marketing investigation: "The SEC has brought many enforcement cases against investment advisers who overstated their performance results. This is a high-risk area, and one that SEC examiners are focusing on."

Advisers that advertise their performance records "should be prepared to substantiate it," she added.

"Historically, there have been organizations who have been creative in their calculations, and the SEC staff probably felt that this is an area that is ripe" for inspection, said Gary Gardner, a partner in the Philadelphia law firm of Pepper Hamilton LLP.

In fact, Ms. Richards told the Senate Banking, Housing and Urban Affairs Committee in March that "performance claims" by investment advisers was one of the hot-button issues the SEC intended to focus on as part of an effort to detect potential problems before they explode.