SEC exams of advisers get tougher and meaner

The SEC may be examining fewer investment advisers than ever, but when it does pay a visit, even routine exams are more demanding, according to lawyers, consultants, advisers and the agency itself.

The Securities and Exchange Commission has been forced to cut back on exams of advisers because of budget constraints, a rapid increase in new advisers and shifting priorities. However, industry officials say the examiners who are on the job have been more demanding, more focused on inconsistencies and more likely to write up lengthy deficiency reports.

Under attack by legislators and its own inspector general for failing to catch Bernard Madoff’s Ponzi scheme, the SEC in recent weeks has taken to the road to warn that it is a less kind and gentle organization than it was during the deregulatory atmosphere of the Bush administration.

“To put it bluntly, the world of compliance of 2008 is dead,” John Walsh, acting director of the SEC’s Office of Compliance, Inspection and Examinations, said at the National Society of Compliance Professionals’ national meeting this month in Philadelphia.

“I can assure you, the examination program is changing, and it will continue to change,” he said.

The SEC is hiring more people with experience in trading and other investment areas to coordinate specialized sweeps and exams, breaking down internal barriers.

This allows experts from previously siloed SEC divisions such as asset management, trading and markets, and enforcement, to get a cross-disciplinary view of a firm’s practices and reach out to clients and third-party custodians to verify that assets reported by advisers to clients are accurate, Mr. Walsh said.

Although some of the talk may be regulatory bluster, lawyers say it is translating to very real time and money for all advisers.

“The SEC is trying to recover from several black eyes so they aren’t giving anybody a free pass anymore,” Jeffrey Blumberg, a partner at Drinker Biddle & Reath LLP in Chicago, said in a telephone interview.

“There is no room to say, “I didn’t know about it, but I’ll fix it.’ Deficiency letters that used to conclude something was in the process of being repaired may now be referred to the SEC’s enforcement division,” Mr. Blumberg said.

Advisers must be prepared to show examiners that they have detailed compliance manuals that are updated regularly, and be able to produce e-mails and other documents quickly, said lawyers whose clients have recently been examined. Firms also face higher compliance costs, whether they remain under the sway of the SEC, which generally oversees those with $25 million of assets or higher, state regulators or — under potential plans being considered by Congress — a self-regulatory organization such as the Financial Industry Regulatory Authority Inc.

“The 13,000 investment advisers will be paying for the dramatic rise in SEC staffing” if it continues to be the primary regulator, David Blass, a former SEC lawyer now with Willkie Farr & Gallagher, said at a TD Ameritrade conference for registered investment advisers in New York last week. “And if it goes SRO, you’ll pay, too,” he said. “There will be a disproportionate effect on small players.”

The SEC has revived talk of raising the assets-under-management threshold for advisers it regulates to $100,000, while a bill that would allow the SEC to charge advisers for exams is before a House Financial Services subcommittee.

Meanwhile, Finra, which already imposes fees on its broker-dealer members, is reorganizing its examination procedures to focus on risk. Finra, at times, will look over the fence at brokerage firms it regulates to inspect their RIA affiliates when brokerage clients are involved, chief executive Richard Ketchum has said.

In preparing for exams, lawyers are advocating several new strategies to combat tougher and trickier questions from investigators.

PRE-EMPTIVE STRIKE

At an Investment Advisers Association compliance seminar in New York this month, Mr. Blumberg suggested that firms step forward and disclose problems to examiners, preferably those that can be easily fixed, since examiners find deficiencies anyway in well over 90% of their reviews. He also suggested that the top officer of a firm at the beginning of an exam pre-empt initial questions by first presenting an overview of the firm’s business and strategy.

That can fend off questions about irrelevant areas that the SEC may have on its agenda or at least show that executives are sensitive to hot-button issues such as proprietary trading by the firm.

Gary Watkins, a partner at ACA Compliance Group, told advisers at The Charles Schwab Corp.’s annual Impact conference for RIAs in San Diego last month that examiners are now asking “broad and open-ended questions” in a search for inconsistencies. “And they evaluate body language,” he said, reminding advisers that lying to the SEC is criminal.

Kathleen Furey, a senior counsel at the SEC, was more conciliatory at the IAA meeting.

“It’s just you and us,” she told attendees, noting that at least for now there is no self-regulatory group overseeing independent advisers. “You’re the first line of defense, and we want to make sure you’re supported.”

PRIORITY AREAS

Ms. Furey outlined five priority areas that examiners will focus on this year, some of which are reactions to the Madoff scandal:

• Ensuring that client assets are safely under custody and valuations are reported accurately.

• Scrutinizing the sufficiency of customer disclosures, with a particular emphasis on potential conflicts involving trading.

• Reviewing marketing material, especially performance claims that may be outdated.

• Determining whether resources to support compliance efforts are adequate.

The fifth priority area is more idiosyncratic. Examiners are looking closely at esoteric or new areas of investing particular to a firm, and are also asking questions about changes evident in a firm’s client base, Ms. Furey said.

She declined to discuss the criteria that the SEC used to decide which firms to examine, but the probability of a routine exam has been decreasing. An RIA between 1998 and 2002 was subject to a periodic exam at least once every five years, but the rapid growth in the number of registered advisers has “outstripped our ability” to keep up that pace, former OCIE director Lori Richards said in a speech last year.

Today, about 10% of large advisers are examined about once every three years, she said, while others may “only be examined for cause, in sweeps or randomly,” she said.

The selection process remains of keen interest.

“The single biggest cost of being an RIA is the disruption of your business during a review,” Mr. Blumberg said at the IAA conference.

Richard Salmen, an adviser at GTrust Financial Partners and president of the Financial Planning Association, half-joked last week at the TD Ameritrade conference that several of his predecessors have been subject to recent exams, implying that the SEC is targeting big firms, or at least prominent advisers.

“That’s been joked about during meetings, but it’s not a litmus test for those willing to run for president,” said Paul Auslander, president of American Financial Advisors and a member of the FPA’s national board. “If it continues, it could be.”

E-mail Jed Horowitz at [email protected].