Alert December 01, 2009

SEC Inspector General Issues Report Recommending Changes to Processes for Selecting Investment Advisers and Investment Companies for Examination

The SEC’s Office of Inspector General (the “OIG”) issued a report detailing the results of its review of the SEC’s processes for selecting investment advisers and investment companies for examination.  The review’s objectives were to determine why the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) had not inspected Bernard Madoff Investment Securities (“BMIS”) shortly after its registration as an investment adviser given the information gathered in prior examinations of BMIS by OCIE’s broker‑dealer inspection staff and investigations by the SEC’s Division of Enforcement, and to make recommendations designed to strengthen the SEC’s selection process for regulatory examinations.  Most of the report’s recommendations are aimed at improving OCIE’s processes for determining whether and how frequently to conduct an examination through (i) more thorough review of an adviser’s Form ADV, particularly when it learns of negative information about an adviser, and (ii) consideration of other information collected or made available to the SEC about an adviser.  The report also recommends that OCIE and other divisions develop better information compilation and sharing mechanisms so that, for example, an adviser might receive a higher risk rating, and be subject to more frequent inspection, based on negative information resulting from an examination or inspection of its non-advisory activities (e.g., as a broker-dealer).  In terms of the risk ratings used to determine the frequency with which an adviser is inspected, the report recommends that OCIE assign progressively higher risk ratings to an adviser as its assets under management and number of clients increase.  Other specific recommendations in the report include the following:

Revisions to Form ADV.  The report recommends that investment advisers be required to report additional information in Form ADV, such as (a) performance information (so OCIE can assign higher risk factors to performance outliers), (b) information about hedge fund service providers such as custodians, administrators and auditors (so if OCIE detected a problem with a service provider at one adviser it could easily determine which other advisers were using the same service provider and administrator), (c) a hedge fund’s current auditor and any subsequent changes of auditor, and (d) auditors’ opinions (so OCIE would have independent information regarding the safety of client assets).

Mandatory Filing of Form ADV Part II.  In 2008, the Commission proposed a number of amendments to Part II of Form ADV (as discussed in the April 22, 2008 Alert), which, to date, have not been finalized.  Unlike Part 1 of Form ADV, which is electronically filed with the SEC and used by OCIE to assign risk ratings to advisers, Part II is maintained in an adviser’s files and must be provided to the SEC only upon request.  The report recommends that the SEC finalize the proposed amendments, which would, among other things, required mandatory electronic filing of the Part II with the SEC.  Before adopting final amendments, the report suggests that OCIE and the Division of Investment Management consider what, if any, additional requirements relating to Part II, such as electronic data tagging like that used in other filings made with the SEC, might assist OCIE in efficiently and effectively reviewing and analyzing information provided in Part II.

Third Party Verification.  The report’s final recommendation calls for OCIE to develop policies and procedures for verifying that client assets are properly accounted for, including obtaining third party verifications of client assets.

OCIE concurred with all of the report’s recommendations, noting that gathering and coordinating information regarding registrants in a Virtual Data Warehouse is one of the SEC’s information technology priorities.  The Divisions of Enforcement and Investment Management concurred with the report’s recommendations pertaining to their processes, but did not provide any formal response.  A corrective plan of action to address the recommendations is due to OIG within 45 days.