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Regulation and Compliance > Federal Regulation > SEC

A Tougher Stance

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The Securities and Exchange Commission plans to create a stiffer examination program for the top 100 advisory firms–placing the top 20 advisors, and their affiliated fund groups, on a two-year exam cycle. The other 80 advisory firms will be on a risk-based schedule, with higher-risk firms getting examined every other year and lower-risk ones getting checked every four years.

Lori Richards, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), told a group of lawyers in New York in late October that the OCIE will be creating more stringent exam rules for the top 100 advisory firms because they “manage more than half of the industry’s assets,” about 60% of all assets under management. The remaining 7,600 SEC registered advisory firms and their affiliated fund groups, she said, will be inspected on a two- or four-year cycle, again depending on their risk profile. And new firms registering with the SEC that are considered “higher risk” will be examined within twelve months of their registration’s effective date, Richards says.

While the definition of “risk” is still evolving, Richards said, the SEC’s new exam approach will “involve discussions with operating managers and compliance staff to obtain a complete understanding of the firm’s control procedures in what the (OCIE) believes are the most critical or strategic areas.” They include:

* The consistency of portfolio management decisions with clients’ mandates;

  • Order placement practices consistent with seeking best execution and disclosures made to clients and funds’ boards;
  • Allocation of block and IPO trades;
  • Personal trading of access persons consistent with firms’ code of ethics;
  • Accurate securities pricing and net-asset values;
  • Regular reconciliation of custodian records with fund and advisor records;
  • Controls over information;
  • An independent custodian provides clients with information about activity in their accounts;
  • Calculations and presentations of performance; and
  • Accurate reconciliations of shareholder transactions.

The SEC crackdown is largely a reaction to the Enron, Worldcom, and Adelphia scandals. “None of us can assume that large necessarily means well-run,” Richards said. The SEC is also modifying its exam to cope with the sheer growth of the advisory and mutual fund industries, as well as the complexities of new products and strategies being used by advisors. In the last two decades, she said, assets under management at mutual funds increased over 5,000% (from $135 billion to almost $7 trillion), and the number of fund shareholders by 2,000% (from 12 million to 244 million.) The number of advisors increased 500%, (from 3,500 in 1980 to 22,000 by 1995.)

While it’s unclear when the new exam schedule will take effect, the OCIE hopes to use funds in the SEC’s new budget to implement the plan.

Thomas Giachetti, a partner with the law firm Stark & Stark in Lawrenceville, New Jersey, warned advisors attending the northeast regional meeting of the National Association of Personal Financial Advisors in Baltimore on November 15 that “the scope of the SEC exam has changed tremendously.” He said advisors should be proactive in preparing for SEC exams. “This is a new SEC,” he said, and the regulator will continue to clamp down on inspections even without former SEC Chairman Harvey Pitt at the helm.

Giachetti told advisors to be vigilant in preparing for exams because advisors are being sued “heavily” by clients these days. He said he’s defending an unprecedented number of advisors against suitability and market corrections lawsuits, as well as lawsuits in which clients claim they didn’t understand advisor documents and questionnaires. “Don’t use boilerplate documents,” he warned advisors, cautioning them to ensure documents contain language that applies to their business only, and to put in bold type any language that clients may just gloss over.

Giachetti also offered a ten-step plan for preparing for, and surviving, an SEC exam.

  • Get a copy of a regulatory checklist;
  • Take care of past deficiencies;
  • Have a qualified official, not the summer intern, handle recordkeeping, which is of paramount concern;
  • Pay particular attention to the entrance interview, the most important part of the exam. Tell the SEC what your practice does and what it doesn’t do, so that you can narrow the scope of the exam;
  • Designate a qualified point-person to work with the SEC examiner;
  • Consult with a compliance attorney before and after the exam;
  • Make a copy of all documents viewed by the SEC, and don’t let the SEC rummage through your files; let the point person retrieve all documents.
  • During the exit interview, find out if the SEC has found any deficiencies.
  • If you have deficiencies, take care of them ASAP, but make sure the SEC is correct. “Of the ten things the SEC cites you for, five are probably wrong,” Giachetti says. “Two are probably correct.”
  • And be careful how you set up your firm. Don’t elevate people to officer status unless they’re qualified.


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