How to survive an SEC exam
Advisers might not relish the prospect of an SEC exam, but think of it as a trip to the dentist: there are certain steps to take that can help prevent a routine checkup from turning into a triple root canal.
SEC officials offered guidance on how to prepare for an exam at a forum this week in Chicago, suggesting that advisers can help their cause by rolling out the welcome wagon when examiners come knocking.
Steven Levine, an associate regional director at the SEC's Chicago office, appealed to advisers to greet examiners with an introductory presentation to orient them to the practice, explaining the firm's business model, risk controls and vision for growth.
"Our examiners come in, many of them don't know your firm. What they know they've read on your form ADV, your brochure, some other background information," Levine said. Spending 30 minutes to introduce the firm to the examiner has no downside, he said.
Also, advisers should be aware that the SEC has been tweaking its process. In a bid to break down siloes at the commission, it's common for exam staffers to be accompanied by members of the policy and enforcement division when they visit firms, according to Thoreau Bartmann, senior special counsel with the SEC's Division of Investment Management.
Often, enforcement staffers will sit in on a visit to a firm in an effort to burnish their own understanding of the industry, or, in some cases, because they have a particular expertise that could inform the examination, according to Paul Montoya, an assistant regional director at the Chicago office's enforcement division.
"There's really no cause for alarm if occasionally an enforcement attorney participates on an exam," Montoya said. "We're not trying to send any particular message by having an enforcement attorney participate, and it's not necessarily any indication that the exam is going to lead to something further like an enforcement investigation."
Spending 30 minutes to introduce the firm to the examiner has no downside.
However, Montoya conceded, examination referrals are one of the primary avenues for cases against firms to escalate into enforcement actions. But with limited resources, the enforcement team has to weigh a variety of factors before determining when to take legal action. So what are the red flags?
"The obvious top of the list is evidence of fraudulent activity," Montoya said, referring to "ongoing" conduct creating "actual or potential investor harm."
But if clear-cut fraud is an obvious one, there are a number of other considerations that enforcement officials look for, including whether the adviser was a repeat offender. That could either mean that the registrant was sued by the SEC in the past, or simply that they were cited for a deficiency in a prior exam, and then, years later, are found to be engaging in the same conduct.
Many of the exam flaws that SEC staffers find arise from basic, unforced errors stemming from advisers' fiduciary duty and the disclosure requirements, Levine said.
"So many of our findings in so many areas revolve around the fiduciary duty and the failure to disclose conflicts, expenses, favoritism among clients, the negotiability of advisory fees where some are benefiting and others are not," he said.
"As CCOs, you should be looking very [closely] at your disclosures." -- Steven Levine, associate regional director at the SEC's Chicago office
"Every time an adviser appears not to be fulfilling these duties, we look to the disclosures," he said. "And so as CCOs, you should be looking very [closely] at your disclosures -- are they adequate to the issue?"
Examiners are also considering the attitude that CCOs and other firm leaders project when they are on-site, and they can be counted on to relay their impression to their colleagues in enforcement.
"Another big consideration for me is the tone of the registrant during the exam -- is the registrant conciliatory or are they defiant?" Montoya said. He referenced the close collaboration between the SEC's examination and enforcement divisions, stressing that the adviser's demeanor during the exam can be a determining factor in whether a firm gets referred for legal action. "I guarantee you we'll know what the tone of the exam is when we're considering an enforcement referral, and it really does play into what we think about the risk profile of that firm."
Other factors enforcement staffers weigh include the relative strength of the firm's compliance program, and whether the firm has taken steps to correct the conduct in question -- whether it is "ongoing or historical," Montoya said.
"That's helpful to us, but that's not necessarily going to result in a pass," he said, observing that the SEC is "not in the business of ‘catch and release.'"