More On Legal & Compliancefrom The Advisor's Professional Library
- Do’s and Don’ts of Advisory Contracts In preparation for a compliance exam, securities regulators typically will ask to see copies of an RIAs advisory agreements. An RIA must be able to produce requested contracts and the contracts must comply with applicable SEC or state rules.
- Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIAs failure to stay within the scope of the Section 28(e) safe harbor may violate the advisors fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients transactions.
After repeated complaints from broker/dealers, mutual funds, and investment advisors about the SEC's new sweeps examination process, Congress is threatening to abolish the SEC's Office of Inspections and Examinations (OCIE). That's the division started in 1995 by former SEC Chairman Arthur Levitt, and is now headed by Lori Richards.
One of the key provisions of legislation introduced by Representatives Michael Castle (R-Delaware), and Vito Fossella (R-New York) in December--the Compliance, Examinations, and Inspections Restructur-ing Act of 2005 (H.R. 4618)--stipulates that SEC examiners should no longer operate under a separate division, but should instead be housed in one of the SEC's policymaking divisions--which is the way the SEC operated before OCIE's creation in 1995. Shannon Finney, executive VP at The Financial Services Roundtable in Washington, which is backing the bill, says the original concept of OCIE was simple enough: to create a separate inspections division at the SEC. But it's become increasingly unclear how OCIE interacts with the policymaking divisions at the SEC, she argues. "There has been a divorce between the policymaking divisions--investment management, market regulation--and the inspectors," Finney says. "You have OCIE going off and doing sweeps, inspections, and trying to understand the current [industry] climate, [as well as] business practices on a particular issue, except that it's the divisions that have the policymaking authority." SEC staff members working in the division of market regulation, for instance, "no longer have the ability to go out and have a dialogue with the industry" on a particular issue, she says. That's up to the examiners. "The operation of the SEC would be much more effective, and investor protection would be enhanced," Finney maintains, "if the policy-making people and the people who are doing the sweeps were back in the same division."
Is Legislation the Answer?
While Tom Giachetti, an attorney with the law firm Stark & Stark in Princeton, New Jersey, agrees that "the scope and duration" of SEC exams have gotten out of hand (see June 2005 Playing Field, "Mini-Sweeps Season")--particularly the SEC's use of its new two-year exam schedule called risk-targeted sweeps, which also include mini-sweeps, in which the SEC randomly selects firms to examine in between the two-year exam cycle--he doesn't think OCIE should be "legislated out of existence." The answer, he believes, is for the SEC to create "one cohesive policy" that can be carried out by policymakers and the examiners, so "the examination staff is not going in its own direction." Giachetti adds that it wouldn't hurt OCIE staff and even SEC commissioners to hold some face-to-face meetings with industry officials and let them air their complaints. Giachetti is not alone in pointing out that SEC exams have been "greatly enlarged." Advisors really never know when an exam is finished, he says, and this bill gives SEC officials "some appreciation of the fact that advisors need some finality."
Indeed, David Bellaire, general counsel and director of government affairs at the Financial Services Institute (FSI), which represents broker/dealers, says FSI supports the bill because "it will help bring some sanity back to the [exam] process." Of late, B/Ds have "been through sweep exams and requests for information at an ever-increasing rate," Bellaire says, and the disruptions are "making it difficult to run a good, clean business." The bill would help curtail the amount of sweeps by requiring examiners to first get approval from SEC commissioners before conducting a sweep, which is how the SEC's enforcement division currently functions. "Because the commission is the policy-setter, [the commissioners] ought to know what is happening in terms of the sweep process," adds Finney of The Financial Services Roundtable. "The effort is to tie together the policymaking apparatus at the SEC with the examinations and inspections function."
A Risk-Based Schedule
Remember that it was former SEC Chairman William Donaldson who modified the exam process for investment advisors. He went from requiring examiners to inspect advisors every five years to a risk-based inspections schedule--which included sweeps--that he said was designed to catch problems before they grew into full-blown scandals. In theory, the sweeps, which are designed to zero in on areas of particular concern, aren't a "bad idea," notes David Tittsworth, executive director of the Investment Adviser Association (IAA) in Washington, which represents SEC-registered advisors. IAA has been vocal in airing its complaints to the SEC about the amount and types of information that SEC examiners require during inspections, particularly e-mails. SEC has yet to come up with specific guidelines on what's required as far as e-mails are concerned, but the legislation would limit the request for documents under a sweep exam or regular exam to only those "existing books and records that the registered broker or dealer, registered investment company, or registered investment adviser is required to keep and maintain under applicable rules and regulations." Examiners, the bill says, "may not require the creation of a new document or the calculation or presentation of data that is not required to be kept or maintained under applicable rules and regulations." While Giachetti says he believes the SEC's request for additional information during exams merely provides information in a way that's easier for examiners to digest, "there has to be some middle ground whereby the advisor can conduct his business and know when the exam is over."
Establishing an Ombudsman
Another important provision of the bill would require the SEC to notify the public when an investigation of a particular firm has been completed. While that may not seem like a "big deal," says Finney, "if you're a company and an investor, and you're trying to understand as an investor what's going on with a particular company, not knowing that the SEC has finished an investigation is a piece of info that you need to know." This provision would help increase transparency at the SEC, she says, so that "investors and business are better served." In talks that Finney has had with SEC officials, she believes the commission as a whole understands that more transparency is needed. One recent example of this is the press conference SEC Chairman Christopher Cox and Linda Thomsen, director of enforcement, held in early January announcing the SEC's future practice on levying fines against corporate wrongdoers.
Industry officials also applaud the provision of the bill which would create an ombudsman to act as liaison between the SEC and the firms its oversees. For instance, B/Ds could contact the ombudsman and ask "'What-if' questions, and get a view on what the SEC's position is on certain issues," says FSI's Bellaire, "without fear of immediate enforcement activity as a result." Adds Finney: "When companies are trying to figure out how to comply with SEC rules and regulations, you want to be able to call the SEC and say, 'We're thinking about doing it this way. Does this make sense? What advice do you have for us?'" Rep. Fossella is the brainchild behind the ombudsman, and Finney says Fossella believes that if "businesses are going to be as effective as possible, they ought to have a cooperative relationship with the SEC so they can find out what the regulator's thinking is."
Giachetti agrees that an ombudsman is a good idea, and that it's imperative that there be a mechanism that allows for ongoing communication with the SEC on ways it can improve exams. But the ombudsman idea becomes troubling because if there were ever an enforcement proceeding against an advisor, the bill requires "the ombudsman to turn over any confidential communications that he or she had with the investment advisor." Giachetti adds that in his mind, the SEC, like the IRS, "suffers from an identity crisis." Does the regulator want firms "to self-report?" he asks. "Are they there to help and answer questions? Or are they there to enforce?"
All of the sources interviewed have been engaged in ongoing talks with the SEC and members of Congress about the regulator's examination routines, operations, and its transparency. They agree that the quickest way to resolve the industry's concerns is for the SEC to take action itself, not be forced to take action through legislation. However, as Finney says, "it helps [the SEC] to focus on [how to improve its operations] when members of Congress express their views." The financial services community has been "in a pretty difficult regulatory environment for a long period of time, and I think the companies [that must] comply with the SEC rules want to know what the operating rules of the road are," Finney says. "We've been talking to members of the [House] Financial Services Committee and Senate Banking Committee on ways to improve the SEC's operations to achieve that goal."
The IAA's Tittsworth says there are definitely "parts of the bill that we would support," and that IAA has been talking to "OCIE and SEC commissioners about e-mail and other abuses in the inspection area, or areas where there could be improved processes." FSI's Bellaire says the group plans to visit Rep. Fossella and offer its support. "There needs to be a little more sanity brought to the [SEC exam] process and balance between an understanding of the SEC's need to ensure that the markets are running in an appropriate fashion without harm to investors, and at the same time in an efficient manner allows good, honest businesspeople to run a business without unnecessary costs," Bellaire says. "There definitely is a feeling within the industry that some change is necessary."
An SEC spokesman said that Lori Richards as well as other top SEC officials declined to comment on the legislation. If Congress decides to hold hearings on the matter, that's when the SEC would voice its opinion. That may be Congress's next move.
Washington Bureau Chief Melanie Waddell can be reached at email@example.com.