WASHINGTON -- The SEC is putting advisors on notice that its examiners will cast a wide net in their reviews of investment advisors over the coming year, identifying a litany of priorities that includes probing for fraudulent activity, conflicts of interest and paying a visit to advisors who have never been examined before.
The exam priorities were selected by senior staff from the 12 offices of the SEC's National Examination Program, which oversees investment advisors and companies, broker-dealers, exchanges and self-regulatory organizations, and clearing and transfer agents.
Some priority areas, such as fraud, corporate governance and conflicts, apply to all segments under the NEP's purview. Others, such as adherence to the SEC's custody rule, are advisor-specific.
Taken together, they amount to an ambitious oversight agenda that encompasses both new and recurring areas of concern for federal regulators. The SEC currently oversees roughly 11,000 RIAs and some 800 advisory companies, together managing nearly $55 trillion in investors' assets. The SEC's jurisdiction expanded with an influx of new registrants in the form of advisors to hedge funds and private equity funds brought under the commission's authority by the Dodd-Frank Act, adding considerable complexity to an examination division already operating under constrained resources.
"The first thing that jumps out is the number of new tasks the SEC has on its plate," says Duane Thompson, senior policy analyst with the advisory consultancy fi360.
In an advisory note circulated Friday, Cipperman Compliance Services cautions advisors to look closely at the guidance the SEC offered, noting that the examiners working out of the commission's Office of Compliance Inspections and Examinations consider that document fair warning for their inspections.
"The OCIE staff has little patience for registrants claiming ignorance about issues specifically raised in the exam priorities letter," Cipperman warns. "Pay special attention to the 'new and emerging' issues."
That means that newly registered advisors might expect a visit from the commission in 2014.
Of the new registrants the SEC is focusing on, the "vast majority" work with hedge funds or private equity funds and were required to file with the SEC under Dodd-Frank. The five criteria that will guide the focus of the so-called "presence exams" targeting those advisors are marketing, portfolio management, conflicts of interest, safety of client assets and valuation.
"The staff will also continue to prioritize examinations of private fund advisers where the staff's analytics indicate higher risks to investors, or where there are indicia of fraud, broker-dealer status concerns or other serious wrongdoing," the SEC says.
Last September, the SEC reported that it had conducted more than 200 presence exams, and that it was on track to review one-quarter of all advisors who had newly registered under Dodd-Frank within two years.
PREVIOUSLY UNEXAMINED ADVISORS
The commission's examiners are also setting their sights on established advisors who have never been examined. That focus, targeting advisors who have been registered with the SEC for at least three years, comes amid concerns that the SEC lacks the resources to fully regulate the RIA sector. In a 2011 study, the commission acknowledged that growth in the RIA population would likely exceed any potential increase in OCIE staff -- which indeed had been declining in the trailing years -- noting that just 9% of advisors had been examined in 2010. At that rate, advisors could expect to be examined at intervals of roughly 11 years.
But despite those warnings, the commission continues to operate with limited resources, which means it will still have to be selective in its examinations. Though the commission suggests that in the coming year it will visit more established firms that haven't been recently examined, Thompson expects that most small firms with clean records will continue to operate under the radar.
"Since the bulk of new registrants are the hedge fund and municipal bond advisors, attention by regulators to the traditional independent retail shop will continue on a reduced level if there are no red flags that pop up, such as custody or a disciplinary history," he says. "The SEC report does not provide any specifics on how it will make long-registered advisers a priority when it is also making newly registered ones a priority, too. Other than stating new advisors will undergo a shortened presence exam, it doesn't really provide any specifics of how it will increase the examination cycle for the veteran advisors."
Other emerging areas of concern for SEC examiners include the wrap fees advisors charge clients, compliance issues and other considerations associated with quantitative trading models, and the oversight and disclosure of payments made to distributors and intermediaries.
In addition to the new issues the SEC is highlighting, the 2014 exam guidance also identifies several longstanding aspects of the advisor sector that it continues to scrutinize.
Some of those issues cross program boundaries at the NEP, such as the continued concerns associated with dually registered advisors and broker-dealers.
"The convergence among broker-dealer and investment advisor representative activity continues to be a significant risk," the SEC cautions. The commission's guidance suggests the potential for a conflict where financial professionals wearing both hats could steer a client into "an inappropriate account type that increases revenue to the firm and may not provide a corresponding benefit to the customer."
In addressing fraud, a cornerstone of the SEC's oversight role, the NEP has been building out a team of technical experts to monitor for risks in the algorithms, software and models employed by the more sophisticated investment companies. A separate risk analysis arm continues to download and analyze the historical transactions processed through clearing firms and large brokerages over a period of several years to monitor for suspicious activity.
The SEC is also signaling that it will take a close look at how advisors and broker-dealers handle the rollover of retirement accounts. Examiners expect to zero in on the sales practices of advisors pursuing retiring workers with the offer to move their employer-sponsored plan into a higher-cost investment vehicle, and whether they are appropriately representing their own credentials and the features of the plans they are pitching.
The commission is also warning advisors about pitfalls associated with its custody rule, which stipulates a number of compliance requirements for financial professionals who hold custody of clients' assets. Past exams turned up such a large number of deficiencies associated with the custody rule that the NEP last March issued a risk alert seeking to help advisors ensure compliance, beginning with the fundamental question of whether or not the advisor, in fact, has custody of the client's holdings.
"Examiners will pay particular attention to those instances where advisers fail to realize they have custody and therefore fail to comply with requirements of the custody rule," the SEC cautions in its 2014 guidance.
Concern about the custody rule, however, is not exactly a new phenomenon, and the extent to which the rule affects garden-variety advisors is limited, according to Thompson.
"The SEC for decades has always made advisors with custody of client assets a priority. Nothing has changed in that regard except the numerous Ponzi schemes that were uncovered and that exposed weaknesses in the SEC's inspection work," he says. "Constructive custody has always been a problem for advisors, meaning inadvertent custody of client assets. But since the vast majority of advisors do not hold custody, I think this issue is a bit overblown."
As much weight as examiners place on the priorities outlined in the exam guidance, the SEC cautions that additional areas of concern will invariably arise throughout the course of its reviews and in response to shifting marketplace conditions.
"This description of NEP priorities is not exhaustive," the SEC notes. "The NEP will conduct additional examinations in 2014 focused on risks, issues and policy matters that are not discussed here. These additional examinations may result from market developments, new information learned from examinations or other sources and coordination with other regulators."
- Advisors Get Ready: More Vigorous SEC Exams Ahead
- State Regulators Zero In on Advisors
- CFP Board Moving to Shorter, Computer-Based Exams