Thursday, October 23, 2008

OCIE's Director Shares Focus for SEC Compliance Exams

On Tuesday, October 21, in an address before the National Society of Compliance Professionals, Lori Richards, Director of the SEC's Office of Compliance Inspections and Examinations, shared some insights into areas of focus for the Division's examination program, particularly in light of today's market environment.  Ms. Richards noted that, though the areas are not new, they are timely now, and the Division's examiners will be paying special attention to these areas:
  • Portfolio management: recent losses may provide an impetus for portfolio managers to trade more aggressively than they should or to deviate from investment objectives in order to make up losses, and perhaps also to catch-up on performance-based fees. This is an area where compliance personnel should be active.

  • Financial controls, including compliance with net capital and customer control requirements by broker-dealers, as well as these firms’ risk management and internal control procedures. While the Division of Trading and Markets will no longer be supervising the holding companies of large broker-dealer firms — OCIE examiners will continue to focus attention on controls within the registered broker-dealer, which are intended to protect investors’ accounts with a broker-dealer. And, if you’re an adviser in precarious financial condition — you must disclose this fact to clients. This is an area where your focus is warranted.

  • Valuation, at all types of registrants, including controls and procedures for valuation of illiquid and difficult-to-price securities at all registrants. Reluctance to fair value or mark down prices cannot take precedence over the firm’s pricing procedures — investors and fund shareholders have a right to know the current value of their holdings. If you work for a broker-dealer that provides quotes or for an investment adviser or other user of broker quotes — be particularly alert to and look for the possibility of “accommodation quotes” — which don’t reflect prices at which the security could actually be sold. At its worst, this could be fraudulent conduct. A reminder too — under accounting rules (FAS 157), issuers must classify their assets within a hierarchy. For those assets valued by using a broker’s quote or a price from a pricing service — you should be sure that you understand whether the quote or price is based on actual transactions, reflects the willingness of the broker to trade at that price, or is based on a model or another methodology.  Among strong practices in this area are to require multiple sources of pricing information, and also to regularly go back and compare the actual prices realized on any sale to the fair values used: then, determine the reasons for any wide gaps and implement improvements in pricing processes. This is an area where your focus is needed now — be sure that your firm is implementing its controls and its oversight over pricing.

  • Sales of structured products by broker-dealers and advisers. Of special note — given that investors may be particularly looking for lower-risk investment products, examiners will focus on products marketed as being relatively “safe,” such as principal protected notes and other products, and will review the adequacy of disclosures concerning credit risk, liquidity, and investment risk. Conversely, investors may be looking to recoup losses, and may be more vulnerable to sales of high-risk, high-return products. You will want to focus on both types of products and make sure that representations are accurate and that your firm is treating investors fairly.
  • Controls and processes at recently merged or acquired firms, both advisers and broker-dealers. This is an area where compliance staff must be active — to help make sure that controls and processes do not fall through the cracks in a merged organization.

  • Money market funds, including, at a minimum, compliance with Rule 2a-7 regarding the creditworthiness of portfolio securities, shadow pricing, and compliance oversight — and more broadly, whether funds’ are stretching for yield and subjecting the fund to excessive undisclosed risk. We have examinations underway. The problems experienced by money market funds should be seen as cautionary for all managers and CCOs of money market funds.
  • Short selling and compliance with Regulation SHO and filings of Form SH. Examiners are also focusing on firms’ policies and procedures to prevent employees from knowingly creating, spreading, or using of false or misleading information with the intent to manipulate securities prices, and will be concluding a sweep of broker-dealers and hedge fund advisers in this area.
In addition to these areas of focus, Richards noted that OCIE would be on the lookout for indications of fraud and "acts of despiration" by individuals and firms under financial duress, as well as the following set of compliance risks she urged compliance professionals to give special attention:

  • Suitability and appropriateness of investments for clients: Examiners will focus on whether securities recommended and investments made for clients and funds are consistent with disclosures, the client’s investment objectives and any investment restrictions, and with the broker or adviser’s obligations to clients to only recommend securities that are suitable or appropriate. We’ll focus in particular, on how firms are interacting with their senior customers and clients. We’ll also focus on structured products and other complex derivative instruments, variable annuities, niche ETFs, managed pay-out funds, and 130/30 funds.
  • Disclosure: Examiners will focus on ADVs, performance advertising, marketing, fund prospectuses and any other information provided to clients. This is a good time for you to review your firm’s disclosures to investors and shareholders. Make sure that any steps the firm has taken in recent days or weeks to deal with the credit crisis are consistent with the firm’s disclosures. Examiners will be specifically looking at how the firm represents its participation in Treasury’s money market guarantee program, the existence of SIPC coverage, and at advertised performance figures. Consider your disclosures as your “Constitution” — even in a crisis, it’s your governing document, and it must match your practices.

  • Controls to prevent insider trading: We’re focusing on the adequacy of policies and procedures, information barriers, and controls to prevent insider trading and leakage of information including the identification of sources of material non-public information, surveillance, physical separation, and written procedures. Controls to prevent insider trading should be strong in any environment.

  • Trading, brokerage arrangements and best execution: We’ll be looking at whether brokerage arrangements are consistent with disclosures, whether the firm seeks best execution, and whether soft dollars are used appropriately (consistent with disclosures), Reg NMS and direct market access arrangements. We will particularly scrutinize the use of an affiliated broker-dealer or any undisclosed relationships with a broker-dealer for excessive commissions, kick-backs and other conflicted relationships. Your best execution committees will want to particularly review execution quality in current markets.

  • Proprietary and employees’ personal trading: This is a basic part of any compliance program — when we find weaknesses in this area, it makes us wonder about the firm’s commitment to addressing other conflicts of interest. This is not an area to be overlooked.

  • Undisclosed payments: Examiners are looking for compensation or payment arrangements that may be part of revenue-sharing, or other undisclosed arrangements with third parties. These payments may be made to increase fund sales or assets under management (such as fund networking fees and payments by advisers to broker-dealers for obtaining space on the firms’ recommended adviser list). Undisclosed payments may also involve misappropriation of adviser/fund/broker-dealer assets by, for example, creating fictitious bills and expense items, or receiving kick-backs from a service provider.

  • Safety of customer assets: Examiners will look at whether brokers, funds and advisers have effective policies and procedures for safeguarding their clients’ assets from theft, loss, and misuse. This is a good time for you too to assess controls in this area. Make sure that advisory clients’ money is with a qualified custodian and review prime brokerage relationships. You may want to ensure that the process for sending account statements to clients has controls to ensure that the account statements cannot be intercepted or falsified. Examiners will also continue to focus on controls for compliance with Regulation S-P with respect to customer information.

  • Anti-money laundering: Examiners will look at whether funds and broker-dealers are complying with obligations under the securities laws, the Patriot Act and Bank Secrecy Act to have effective policies and procedures to detect and deter money-laundering activities, whether these policies and procedures are regularly tested for continued effectiveness, and whether actual practices are consistent with the policies and procedures.

  • Compliance, supervision, and corporate governance: While this is the last item I’ll list, it’s the most important — because it underpins all the other compliance responsibilities that firms have. In the coming year, examiners will focus in particular on supervisory procedures and practices at large branch offices of broker-dealers and at advisory branch offices, on supervision and controls over traders, whether funds have appropriately-constituted boards and have considered required matters (e.g., fair value procedures), and whether firms have implemented effective internal disciplinary processes. Also, we’ll examine: firms that advertise themselves as allowing maximum independence to registered representatives; for abuses in transferring customer accounts as registered representatives move to new firms; supervision of producing branch managers; bank broker-dealer branches; and the adequacy of firms’ testing to detect unsuitable or aberrant trades.
Toward the end of her remarks, Ms. Richards made special note that, for advisers and mutual funds, this is the fifth year of both the Compliance Rule and the SEC's CCO outreach efforts for adviser and fund CCOs, and she hoped "to see improvements in firms' compliance programs, and in particular, that significant deficiencies were identifies properly and corrected appropriately by firms." 

The full text of Ms. Richard's October 21, 2008 speech is available here: