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News February 23, 2009 Issue

CCOs Should Review Areas of Top Exam Deficiencies

The top five areas of deficiencies most commonly found during adviser exams "are very, very consistent from year to year," according to OCIE associate director Gene Gohlke. And since those areas are so well-known, CCOs should do something about them.

Speaking at the recent "SEC Speaks" conference in Washington, D.C., Gohlke said that if he were an advisory firm CCO, he would take the "top five" list back to his firm and say "Well, if these are areas that are top of the list in regards to what the SEC finds, maybe I ought to take a closer look at our regime."

Deficiency #1: Disclosure, reporting, and filings. This is quite a broad category, encompassing virtually every public statement made by an advisory firm. Still, as evidenced by the recent Merrill Lynch enforcement case (see ACA Insight, February 16, 2009), firms should pay close attention to their disclosures and make sure they are not only talking the talk, but walking the walk.

When reviewing disclosures, Gohlke suggested that CCOs look at how their firm has disclosed material issues and material information to clients. Is the firm "doing that in a way that is likely to capture all of the material issues that advisory clients ought to know about?" he said. In particular, disclosures should be reviewed when there have been changes at the firm, such as "changes in significant high-level people, changes in the business, changes in fees, changes in risks, [and] changes in conflicts of interest." According to Gohlke, examiners "often" find situations where a firm "appears not to have identified those matters as significant or needing disclosure." When examiners identify the change, rather than the firm, a deficiency letter comment may result.

To that end, Gohlke urged CCOs to go back and focus on their firmís processes for ensuring that their disclosures are adequate, whether in Form ADV, fund prospectuses, SAIs, or in other statements. Gohlke suggested that this review evaluate whether the disclosures "reflect the current environment [and] the current activities of the firm."

Deficiency #2: The compliance program rule. Gohlke noted that the "starting point" for SEC adviser examinations is an evaluation of the firmís overall compliance program. Examiners will review the firmís process for identifying compliance risks as well the policies and procedures put in place to manage those risks. Here, Gohlke echoed OCIE director Lori Richardsís assertion that examiners will have high expectations in this area: "The situation is better than what it was in the Ď04 to Ď05 time frame," said Gohlke. "Firms are getting the hang of it in terms of identifying compliance risks." However, he cautioned, more needs to be done. "[A]s you can see, issues with the compliance program rules are still second in terms of the areas where we find problems."

Deficiency #3: Personal trading. Here, examiners often find that firms are not following the provisions in their personal trading code of ethics, or that they are failing to review the submitted personal securities reports as required by the Advisers Act personal trading rule.

"I would say that the biggest issue that we find is that so many firms comply with the letter of the personal trading rule, in regards of getting reports of personal trading [and] trying to get those reports in on a timely basis, but where they fall down is they donít do anything with the reports," said Gohlke. The reports "come in to a clerk" and are "put in a file cabinet." When examiners come in and ask about personal trading, they find out "great, everybodyís filing on a timely basis."

But itís not enough that a firm can "account for them all," he emphasized. The question is, "what do you do with them?" Examiners will look to see whether the firm really reviews its access personsí personal trading reports against the trading that the firm is doing for its clients. "A lot of firms donít do that," Gohlke said. "We feel thatís just a huge gap in the firmís compliance program."

Such an approach, he added, defeats a key purpose of the personal trading rule. "You know, the Commission didnít adopt that rule just to place additional burdens on firms to collect this information," he said. "There was a purpose," namely, to try to make sure those at the firm who know what clients are going to be investing in arenít front- running client trades or arenít doing other bad things that could potentially harm clients.

(Not to be forgotten: Gohlkeís urging aside, the personal trading rule explicitly requires firms to review collected personal trading reports.)

Deficiency #4: Performance advertising and marketing. This is a "perennial issue," said Gohlke. "There are just so many ways firms can mess up in computing for performance or in not adequately disclosing all the issues around performance."

Deficiency #5: Portfolio management. Gohlke did not spend much time on this topic, other than to note that firms should review their internal controls.

Bonus Deficiency #6: Fund governance issues. Gohlke said that on investment company exams, examiners often find issues related to corporate governance. "Often," he said, "that may have to do with attendance of the board," or "the boardís review of important activities by the fund [or] by service providers to the fund."

Gohlke also provided additional detail about the 1,521 investment adviser exams conducted last year by OCIE. Those exams covered about 15 percent of the total number of SEC-registered advisers. By assets under management, the exams covered about a third of the total assets under management. He noted that in the beginning of 2008, advisers managed a total of $42 trillion; SEC examiners examined advisers that managed about $13 trillion.