The OCIE’s Top 10 Compliance Issues

March 25, 2008

In a speech delivered last week [1], Lori A. Richards, the Director of the Office of Compliance Inspections and Examinations (“OCIE”) of the U.S. Securities and Exchange Commission (“SEC”) provided valuable insight into the OCIE’s approach to compliance examinations in 2008.

Ms. Richards began by noting the increase in the number of SEC-registered investment advisers since 2001 from 7,400 to almost 11,000 today and the fact that the OCIE’s examiner staffing levels have not increased.  This led to the conclusion that “our limited resources would best be used in examining those firms and issues that have the greatest potential to pose harm to investors;” i.e., a risk-based approach.  The factors the OCIE looks at to determine risk are (i) firm size, (ii) the strength/weakness of compliance controls and supervision, including prior examination and enforcement history, and (iii) the scope of a firm’s involvement in activities that may present increased compliance risk.  In addition, though, the OCIE targets newly registered advisers for limited-scope inspections and conducts examinations of a random sample of all advisers (just to keep everyone honest, not doubt).

Among the problems noted by examiners as existing across the entire OCIE universe of broker-dealers, investment advisers and investment companies, Ms. Richards identified the following:

- misuse of material non-public information and information leakage,
- valuation,
- “best execution,”
- use of brokerage commissions,
- soft dollars,
- revenue-sharing and other hidden payments for business,
- anti-money laundering,
- sales practices,
- internal controls,
- market manipulation schemes, and
- supervision.

These problem areas and the fact that an increasing number of firms operate both as registered broker-dealers and as investment advisers or have entered into affiliations between broker-dealers and investment advisers has led to the development of a pilot to examine dually-registered broker-dealers and investment advisers at the same time, “with a view towards creating a common examination module.”

Ms. Richards then turned to what she herself called the “Top 10” issues focused on by OCIE examinations of investment advisers.  The firm’s internal compliance controls will, to a significant extent, determine which of the Top 10 will receive the greatest to the least degree of attention.  The Top 10 are:

1. Controls Over Valuation relating to structured products, illiquid securities or other difficult-to-price securities, including whether the firm (i) understood the nature of the security prior to acquiring it, (ii) had in place and has complied with a pricing plan with adequate risk management processes and procedures, (iii) has properly disclosed the risks of illiquid securities to its clients, and (iv) has personnel with the experience and sophistication to value such securities, and whether (a) there is independence in the pricing process, (b) “prices are calibrated to observable trade data even if the market for a security is less liquid than in the past,” (c) dealer quotations are use in pricing, and (d) valuations seem to reflect the realities of the market in terms of the prices at which sales could actually take place.

2. Controls Over Non-Public Information/Personal Trading/Code of Ethics, including the prevention of misuse of material non-public information and insider trading in client, proprietary, or employee accounts.  Of interest is whether the firm has (i) identified the source and type of non-public information that it and its employees will encounter, (ii) adopted procedures to prevent its dissemination and observed those procedures, and (iii) developed guidelines for the disclosure of its own confidential information; e.g., regarding its portfolio and trading activity.

3. Dealing with Senior Investors.  Having found problems in the marketing, sales and supervisory processes of many firms with respect to senior citizen clients, the SEC has commenced a new initiative in this area.  Thus, the OCIE is on the lookout for investment advisory and other financial services firms from whom to learn about effective practices employed in dealing with seniors in the following areas: marketing/advertising, account opening; product and account review, both at account opening and on an ongoing basis, identifying and satisfying customer’s changing needs, surveillance and compliance reviews; and employee training.

4. Compliance and Supervision.  Obviously, this is a key area, including whether a compliance program (i) identifies and manages the firm’s particular compliance risks, (ii) incorporates a risk-assessment and conflicts of interest, and (iii) includes procedures to mitigate those risks.  In particular, the OCIE intends to focus on conflicts involving new revenue-sharing payment streams from advisers to broker-dealers for recommendations and other undisclosed compensation.

5. Portfolio Management, including whether (i) recommendations and trading for clients and funds are consistent with previous disclosures and applicable investment objectives and restrictions and (ii) back office functions are adequate in the circumstances, with particular emphasis on structured products and other complex derivative instruments, including CDOs, CLOs, credit default swaps [2], and other types of swaps.  Even money market funds will be under scrutiny for compliance with Investment Company Act Rule 2a-7.

6. Brokerage Arrangements and Best Execution, including whether (i) brokerage arrangements are consistent with fiduciary obligations to clients and disclosures made to clients, (ii) the adviser actively seeks best execution and uses soft dollars in a manner consistent with prior disclosures, and (iii) periodic and systematic evaluations of the costs and benefits of brokerage arrangements are carried out.

7. Allocations of Trades, including (i) whether the adviser has disclosed its trade allocation policy with respect to IPOs, block trades, and investment opportunities among clients and proprietary accounts and (ii) whether historical practice is consistent with such policies and disclosures.  Of particular concern, of course are incidents of cherry-picking and favoritism for proprietary accounts, employees, relatives, high profile clients and clients whose accounts include a performance fee component.

8. Performance Advertising, Marketing, and Fund Distribution Activities. Examiners will be looking to see whether (i) the firm has effective policies and procedures to back up investment performance claims and to confirm the accuracy of advertisements and other marketing materials and (ii) arrangements with third parties to increase assets, other conflicts of interest and the use of solicitors have been effectively disclosed.

9. Safety of Clients’ and Funds’ Assets., including whether the adviser has misrepresented performance results or account holdings to increase advisory fees.  OCIE examiners may review whether (i) the firm has appropriate custodial arrangements in place, (ii) an independent custodian sends account statements directly to clients or whether the adviser submits to “surprise audits” and (iii) client and fund balances are regularly reconciled with custodian statements.

10. Information Processing and Protection (books and records, disclosures, and filings), including whether effective policies and procedures exist for (i) maintaining and for capturing, compiling and reporting information in its books and records (including email and instant messages), and in reports to clients and regulators upon request, (ii) safeguarding information from hackers or other unauthorized persons and (iii) safeguarding information against destruction in a disaster as part of the firm’s business continuity plan.

Although the above Top 10 list will serve to focus Chief Compliance Officers and other investment advisory personnel on the areas currently of greatest interest to OCIE examiners, investment advisers should be cautioned that the scope of any examinations they will experience will likely be substantially broader.  While it behooves all investment advisers to place themselves in a position to respond quickly and completely to examiner’s inquiries with respect to each of the items in the Top 10, it is also important that all areas of compliance be reviewed periodically.  This should be done not only to establish compliance with the requirement that the adequacy of all compliance policies and procedures and their effectiveness be reviewed no less frequently than annually [3], but also to be able to respond quickly and completely to examiners’ inquiries regarding any matter on which their spotlight may shine.

[1] Speech delivered at the IA Compliance Best Practices Summit 2008 presented by IA Week and the Investment Adviser Association, Washington, D.C. (the “Best Practices Summit)” on March 20, 2008.

[2] In a speech also delivered at the Best Practices Summit 2008 on March 21, 2008, Andrew J. Donohue, Director of the SEC’s Division of Investment Management, discussed risk management with respect to derivatives and other new investment products in greater detail.  According to Mr. Donohue, “it is critical that an investment advisory firm is confident that it has the resources in place to appropriately administer those investments. For example, is the adviser comfortable that it has full access to relevant information to understand and assess the risks involved in such instruments?  Is there a sufficient due diligence process in place and is compliance appropriately involved in this process?  As part of its risk management function, is the firm able to adequately monitor and supervise any investment strategy involving such instruments? Also, has the adviser made appropriate disclosures to its clients about investments in derivatives or other complex investment products and the risks involved?

“Finally, the firm’s back office functions should be sufficiently robust to provide effective and timely service regarding these instruments, including when unexpected events occur that cause spikes in activity. Firms must be able to operationally manage the documentation, settlement, valuation and confirmation processes for these products in a timely manner and ensure that any service providers have effective procedures to handle and clear these trades, including in times of high trading volume. You…should be thinking through these issues to be sure that the front office, in their eagerness to generate returns and satisfy clients, does not get ahead of the back office capabilities.”

[3] SEC Rule 206(4)-7(b).

For additional information on this topic, you may contact Howard A. Neuman and Carol Spawn Desmond.