Alert April 08, 2008

OCIE Director Identifies Top 10 Compliance Issues

At the 2008 IA Compliance Best Practices Summit, Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), reviewed OCIE’s “Top 10” compliance issues.  (See  the February 5, 2008 Alert for coverage of a related speech by Ms. Richards on frequently asked questions about SEC examinations.)  Ms. Richards reiterated OCIE’s risk-based approach to selecting firms for examination, which seeks to identify those firms that have the greatest potential to pose harm to investors, based on firm size, type of investment activities, and any prior indications of weak compliance controls or supervision.  Ms. Richards emphasized that OCIE also examines a random sample of advisers that are not otherwise targeted for examination, and targets newly-registered advisers for limited-scope inspections.  Mr. Richards indicated that, in view of the increasing number of firms that are operating as both registered broker-dealers and investment advisers, the OCIE is working on a pilot aimed at creating a common examination module for such dual registrants.

Mr. Richards then reviewed the following top ten areas of exam focus for OCIE:

  • Controls Over Valuation.  OCIE examiners are focusing on what controls firms have in place to value structured products, illiquid securities or other difficult-to-price securities.  She noted that examiners will generally look at whether a firm understood the nature of the security before buying it, whether the firm had a plan on how to price the security, whether the firm has adequate processes and procedures for risk management, valuation, and accounting, and whether the firm has disclosed the risks of investments in illiquid securities to its clients.
  • Controls over Non-Public Information.  OCIE regards insider trading as a high priority for all types of entities – broker-dealers, advisers and funds.  Examiners will focus on whether a firm has identified the source and type of non-public information that it and its employees may be privy to, whether the firm has created and implemented adequate procedures to maintain the confidentiality of that information, and whether the firm is periodically testing those procedures.
  • Senior Investors.  The SEC has prioritized the protection of seniors.  Consequently, OCIE is interested in understanding the practices that firms are developing in specific areas related to senior investors, including marketing and advertising to seniors, account opening, product and account suitability, ongoing review of the relationship and suitability of products, discerning the changing needs of seniors, surveillance and compliance reviews, and training for firm employees.
  • Compliance and Supervision.  OCIE examiners will seek to understand an adviser’s compliance program and whether it is the product of a risk-assessment process conducted to identify the firm’s compliance risks and conflicts of interest.  OCIE is also very interested in seeing how compliance procedures are actually implemented and that an effective annual review was performed.
  • Portfolio Management.  OCIE examiners are interested in whether the securities recommendations and investments made for clients are consistent with an adviser’s disclosures and client investment objectives and restrictions.  OCIE is currently giving particular scrutiny to investments in structured products and other complex derivative instruments, as well as money market funds and compliance with Rule 2a-7 under the Investment Company Act of 1940, as amended.
  • Brokerage Arrangements and Best Execution.  OCIE examiners will look at whether an adviser seeks best execution, whether it uses soft dollars consistent with its disclosures, and whether the adviser periodically and systematically evaluates the costs and benefits of its brokerage arrangements.  Examiners are particularly looking for any inappropriate and/or undisclosed use of soft dollars for the benefit of the adviser, and the use of any affiliated or preferred broker-dealers for excessive commission payments, kickbacks to the adviser, or other undisclosed arrangements.
  • Allocations of Trades.  Examiners will be looking for any instances of cherry-picking and client favoritism in allocations.  Examiners will also review a firm’s testing of allocations.
  • Performance Advertising, Marketing and Fund Distribution Activities.  OCIE is interested in whether funds and advisers have effective policies and procedures to make sure that their marketing materials contain accurate information, and in whether conflicts of interest have been effectively disclosed.  Ms. Richards emphasized that this area is one where the OCIE continues to find deficiencies.
  • Safety of Clients’ and Funds’ Assets.  OCIE examiners will look for funds and advisers to have effective policies and procedures for safeguarding their clients’ assets and for instances where an adviser has made false representations regarding performance results or account holdings.  OCIE will review the firm’s custodian arrangements, including whether the adviser has “surprise audits,” and whether it has a process for regularly reconciling the securities balances shown on its books with those shown on custodians’ books.
  • Information Processing and Protection.  OCIE is interested in whether an adviser has effective policies and procedures for capturing, compiling, maintaining and reporting relevant and timely information in its books and records (including e‑mail and instant messages), and in reports to clients and regulators.  Examiners will be looking for controls that protect this information from hackers or other unauthorized persons, and for measures in a firm’s business continuity plan that will prevent an adviser’s books and records from being destroyed in a disaster.