investigations of pension fraud, money management abuse, wrongdoing, securities brokerages, pension investment consultants, unethical business practices, benchmark alert, institutional investors, plan sponsors
investigations of pension fraud, money management abuse, wrongdoing, securities brokerages, pension investment consultants, unethical business practices, benchmark alert, institutional investors, plan sponsors
investigations of pension fraud, money management abuse, wrongdoing, securities brokerages, pension investment consultants, unethical business practices, benchmark alert, institutional investors, plan sponsors
(November 1, 2000) No Freedom of Information When It Comes to Money Managers

Money Matters Does the Freedom of Information Act permit the public to view the results of SEC compliance inspections of the money managers they hire? Would public scrutiny of these records have a "devastating effect" on the SEC's ability to regulate managers and cause "embarrassment," as the SEC has testified? Would "public confidence in the investment advisory industry suffer great harm?" Should our primary concern be preservation of confidence in the money management industry, even if accomplished through concealment of wrongdoing? Would investors make better decisions if they had access to this information?

Last month I gave a speech at a convention for institutional investors held in Miami. The subject of my speech was "heightened due diligence" for pension funds. My message was familiar. I have written extensively about the prevalence of illegal and unethical activity in the money management industry. As I have repeatedly stated, the incidence of questionable activity in the industry is far more commonplace than the general public is aware. Every day money managers engage in improper conduct that is harmful to their clients. Yet most clients never learn about the harm that has been done to them. For fiduciaries charged with the responsibility of safeguarding billions in retirement assets, the need for increased scrutiny of the money managers they hire is most compelling.

The intent behind the federal securities laws, including the Investment Company Act and the Investment Advisors Act of 1940, was supposedly to provide investors with material information about money managers to enable them to make informed investment decisions. These federal statutes, however, establish a two-tier disclosure system. Certain information must be disclosed to investors; yet other more sensitive information need only be disclosed or made available to the SEC. We have long been of the opinion that this two-tier system of disclosure is harmful to investors. Investors are lulled into a false sense of security about the integrity of the money management profession when significant information is kept secret. Requiring disclosure to investors of all information about violations by money managers would radically alter the investing public's awareness of the risks related to money management. Investors would think a lot harder before they handed over their hard-earned savings to so-called investment professionals.

Investment advisers regularly, every three to five years, undergo inspection by the SEC for compliance with the federal securities laws. There are few surprises to the industry here; the SEC inspection manual is largely made available to the industry. Upon completion of an inspection by the SEC, the agency issues a letter detailing the firm's deficiencies, if any. Given the complexity of the industry and its corresponding regulatory scheme, few firms are deficiency-free. The letter the firm receives from the SEC upon completion of the inspection is never disclosed to the investing public.

If, in the Commission's opinion, a firm's deficiencies are extremely serious, an "enforcement" action may be recommended against the firm. At this point, there is ample opportunity for the firm, represented by counsel, to negotiate, settle, or lobby its way out of the "enforcement" recommendation. If the matter is not resolved between the firm and the agency and an enforcement action proceeds, eventually, but not necessarily, the matter may be disclosed to the public. The SEC frequently agrees to delay damaging public disclosures. Violations the SEC determines to be less serious, are never disclosed to the public.

Examine the logic: The SEC regularly inspects money managers for compliance with the federal securities laws. The federal securities laws exist for the protection of investors. Yet the results of the SEC's inspections of money managers, including certain violations of the federal securities laws, are not disclosed to investors. It makes no sense. The SEC is keeping information from the very people it is suppose to be protecting. What could be more important to investors than the most recent compliance review by a regulator of the operations of an investment manager they are considering entrusting with their life's savings? Wouldn't pensions seeking to observe the highest standards of due diligence be interested in seeing the results of their managers' inspections? Shouldn't pensions, given their enhanced bargaining positions, demand such additional disclosure from their managers?

Immediately following my speech in Miami, John J. Murphy, Executive Director of the New York City Employees' Retirement System, asked me an intriguing question. "Aren't the results of SEC inspections of money managers available to the public under the Freedom of Information Act?" I honestly hadn't thought about it and John's question got me excited. What if these inspection letters were available under FOIA and investors around the country started writing to the SEC demanding their release? Wouldn't managers behave more ethically if they knew the results of their inspections would be subject to public scrutiny? Shouldn't a manager, in exchange for the right to offer investment advisory services to the public, be required to fully disclose all information about himself? As the owner of a brokerage firm that is regulated and reviewed by the National Association of Securities Dealers, I have no objection to public disclosure of the results of this firm's review.

My calls to senior staff at the SEC got me an immediate answer to my question. In 1997, the U.S. District Court for the District of Colorado in Berliner, et al v. SEC, granted a motion by the SEC to dismiss a complaint filed requesting the production of documents related to an SEC examination of an investment adviser whose registration was revoked by the SEC and was defunct. The plaintiff alleged that the SEC examination related to a large-scale securities fraud perpetrated by the adviser. The SEC examination produced 325 pages of documents. The legal issue the court had before it was whether investment advisors were "financial institutions" within the meaning of exemption 8 of FOIA, thus allowing the SEC to withhold the requested documents. Remarkably, there was no precedent; the issue was one of first impression. No investor had ever before requested disclosure of the results of an SEC examination? More likely, no prior investor had been willing to spend money to litigate the matter.

While the court noted that "FOIA reflects a general philosophy of full agency disclosure unless information is exempted under clearly delineated statutory language" and that "disclosure, not secrecy, was the dominant objective of FOIA," the court nevertheless ruled that the results of inspections of investment advisors were exempt from disclosure under FOIA. The court noted that there was no unambiguous definition of financial institutions in FOIA's text to answer the question of whether investment advisers were included within the exemption . So why did the court rule that such information should be held from public scrutiny?

Well, here's a surprise. The court referred to testimony from the SEC that "revealing the confidential commercial and personal information contained in SEC examination reports relating to investment advisors would have a devastating effect on the SEC's ability to regulate investment advisors and would cause embarrassment to clients whose private financial records would become subject to public scrutiny." So the SEC testified against disclosure to investors. It's more than a little disturbing to me that a government agency whose mandate is "the protection of investors" would have advocated against disclosure of important information regarding illegal activity of money managers. Even the judge wrote that he wasn't convinced revealing the information would be "devastating" to the SEC, but he did share some of the agency's concerns. The record does not indicate any investor advocacy group testified as to the benefits investors would derive from disclosure. Once again, this case illustrates that while the SEC, AIMR and the ICI all advocate on behalf of the money management and mutual fund industry, there is no effective investor advocacy group.

The argument against disclosure that prevailed in this case, is familiar and tired. That is, in order to foster an environment of "full cooperation" between the agency and the entities it regulates, sensitive details collected by the SEC should be held secret. There are major flaws in this argument. First, there is no environment of "full cooperation" between managers and the SEC today. Managers regularly withhold information from the SEC regarding illegalities under the attorney-client privilege and by other means. No manager shows the SEC every questionable practice he has engaged in. What exists today between the SEC and the money management industry is "selective cooperation," not full cooperation. And managers will always cooperate with regulators and law enforcement to a degree because if they don't, they'll face harsher treatment.

Second, the court, while professing to be concerned about the embarrassment of clients of managers and not managers themselves, never considered an alternative that would have required disclosure of all information but the names of clients. What was really being addressed, below the surface, was whether the money management profession would lose credibility if all its wrongdoing were subject to public scrutiny. What would be the effect upon the financial markets if the rules were suddenly changed? Does concealment that fosters confidence benefit or harm investors? The court didn't want to open up a Pandora's box.

Concealment of violations, illegalities and improprieties, is misleading and harmful to investors. Investors are harmed because they trust their money to managers, including mutual fund managers, that appear to be reputable but aren't. The dissemination of all information regarding violations by money managers, not only information the SEC unilaterally determines should be shown to investors, will result in smarter, better investors. The odds that investors will make successful investment decisions are greatly enhanced when the regularity of improprieties is apparent. Nothing is gained by secrecy and the SEC should be the last voice supporting nondisclosure.

Pension funds have tremendous bargaining power with their money managers. Pensions that are willing to become activists on this issue could literally force all institutional managers to disclose the results of their SEC inspections and all investors, including pension participants, would benefit. Pensions that seek to maintain the highest levels of due diligence review should demand such documents and carefully review them. Any manager who refuses to disclose, should be viewed as suspect. If you have nothing to hide, why oppose disclosure? Public pensions subject to state FOIA statutes should be especially sensitive to this issue. After all, if most activity of your fund is subject to public scrutiny via FOIA, why shouldn't the managers to which you delegate your fiduciary responsibility be equally accountable?

By the way, about my earlier offer to disclose the results of this brokerage firm's NASD inspection, apparently the NASD, a self regulatory organization, is not subject to FOIA and SEC information regarding brokerages is also exempt under FOIA. So there's no way the public can find out whether this firm's had internal problems. Thank heavens for sympathetic regulators dedicated to protecting the integrity of us financial institutions.

As always, we welcome your comments and suggestions regarding this article.

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