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News March 14, 2011 Issue

di Florio Offers Exam Takeaways For Advisers

Last month OCIE director Carlo di Florio spoke to broker-dealers about OCIE’s overhaul and the new national exam program.

Last week, advisers got their turn.

At the Investment Adviser Association’s annual Compliance Conference, di Florio offered key takeaways for advisers regarding OCIE exam priorities, new methods and points of view, and his office’s view on current hot topics such as expert networks and insider trading.

His remarks highlighted four topics:

  • Important developments across the SEC that will have an impact on advisers;
  • Dodd-Frank provisions that will impact the examination program;
  • Key exam focus areas that impact the way advisers manage compliance programs; and
  • Insider trading enforcement actions and implications for the examination program.

SEC developments.

Chairman Mary Schapiro has had an enormous impact on the SEC, said di Florio. There’s been a change in culture at the SEC regarding teamwork, collaboration, recruiting new expertise and tapping existing talent, and ensuring it all works together in protecting investors, ensuring market integrity, and facilitating capital formation.

The SEC has undergone a period of prolific rule-writing over the past year and a half. Significant initiatives have resulted, such as:

  • the custody rule amendments, which are critical for the safeguarding of customer assets;
  • Form ADV Part 2, which will provide more and better information for both investors and regulators;
  • money market fund reforms, which significantly changed liquidity risk management; and
  • the pay-to-play rules, "which will ensure an adviser’s selection is on the merits and not politics."

National exam program.

OCIE leadership has undertaken a comprehensive review of the existing exam program, he said. The biggest change is a move from a loose configuration exam model to a coordinated national exam program. "I think it will have a big impact for you all as to how you interact with examiners," di Florio observed, "and hopefully it will enhance the quality of exams."

OCIE is also risk-focusing the exam process. Like the industry itself, OCIE must strive to use it limited resources as efficiently as possible. As a result, "we spend a lot of time ‘picking our spots,’" said di Florio.

More specifically, OCIE has a new Risk Analysis Surveillance unit that will be working closely with the Division of Risk, Strategy and Financial Innovation. OCIE will be conducting more front-end analysis using those resources.

OCIE is also spending a lot of time thinking about expertise and expertise strategies. With last year’s funding, OCIE brought in experts in structured products, portfolio management, trading strategies, derivatives, and risk management. "We hope to continue our expert recruiting; it will have a huge impact on our program."

OCIE also has designed a number of other specialty units, developed training modules, increased risk assessment activity, and is bringing expertise from across the staff into the exam process both remotely (by phone) and through in-person participation in exams.

OCIE has made significant improvements to the training program, said di Florio. It is developing certification standards and protocols that will be a consistent baseline of competence for examiners across the country. As the budget process moves forward and OCIE considers the use of limited resources, the office is looking for ways to streamline and risk-focus the exam program without sacrificing quality. Also, holding ourselves to the same standard as the industry, we recently appointed our own CCO, said di Florio.

As a result of all these initiatives, "I hope you will see exams that are more effective, efficient and more valuable," he said.

OCIE is also working on the transfer to the states of the 4,000 or so advisers with under $100 million in assets under management. As part of that process, OCIE participates in bi-weekly conference calls with NASAA. To prepare for the incoming new registrants from the private fund arena, OCIE is focusing on training modules and recruiting additional expertise.

As those initiatives move forward, several others flowing from the Dodd-Frank Act are still in progress. Enhanced regulation around derivatives and swaps, and the regulation of municipal advisers represent some of that work.

The SEC’s Section 914 study (regarding adviser examinations) highlighted a really important theme, said di Florio. It is insufficient to examine only nine percent of all registered advisers. With the crises and failures the SEC has had, there’s a real disconnect between 9% and risk profiling, he observed.

The study suggested several ways to enhance the examination of advisers. It can happen by investing further in the SEC exam program already in place. To enhance the resources available for that option, the staff has suggested the introduction of user fees that would provide a scalable solution. In the alternative, said di Florio, "if Congress doesn’t want to further the work of the SEC," an SRO option could offer a solution. OCIE stands ready to respond whatever path Congress takes.

Whistleblower provisions.

di Florio wrapped up his review of significant and current Dodd-Frank initiatives with the whistleblower provisions recently proposed by the SEC. di Florio assured his audience that the staff is aware of the concerns being raised that the new rules will undermine the work registrants and their compliance professionals are doing to ensure effective programs for identifying, escalating, and resolving issues. Since the initial proposal came out, significant comments have been filed. In responding to those comments, "we’re trying to strike the right balance while respecting the processes that institutions have put in place," he said.

Exam focus areas for investment advisers.

While noting that OCIE will not focus only on these topics, di Florio offered advisers the following areas of heightened interest by the exam staff.

Valuation – continues to raise issues, especially derivative investment products that are harder to value. We are looking to understand a firm’s governance, risk, and control environment around the valuation process and are looking at specific valuation issues, said di Florio.

Conflicts of interest – OCIE will review whether the firm manages and mitigates risks in the following areas:

  • trade allocation
  • insider trading
  • side letters
  • best execution
  • directed brokerage
  • soft dollars

Here, OCIE expects that the new Form ADV Part 2 will be very helpful in describing the conflicts and conflict management processes that firms have in place.

Portfolio management – Examiners will review whether a particular strategy presented is in line with disclosures. "It is an area where, if we see drift from the strategies presented to investors, we typically see a whole host of other control and deficiency issues that arise," said di Florio.

Performance – "Performance is also a great risk analytic tool for us," di Florio said. Performance calculations as presented in offering materials are a focus for examiners. OCIE will review those calculations, assessments, models, and of course, any aberrational performance.

Asset verification – OCIE will verify client assets and ensure that controls are in place for the safeguarding of assets.

‘See the forest for the trees’ – The SEC has learned the lessons of the Madoff case, said di Florio. Madoff’s auditor was not a well-known auditor, controls were lacking in the trading environment at the firm, and there was a lack of segregation of duties, for example.

As a result, OCIE intends to take a really strategic look at the organization and understand these five critical areas of inquiry:

  • How does the business itself identify and manage risk?
  • Is the compliance function designed to operate effectively as an adequate and independent authority within the firm?
  • What is the tone at the top? How do senior management and board committees view the role of compliance at the firm?
  • How does the firm oversee risk?
  • Is there a valid independent audit function, which plays a critical role in compliance oversight.

Expert networks.

And finally, di Florio discussed key compliance takeaways from the recent enforcement cases involving expert networks. The mosaic theory is not endangered, he observed, the reality is that OCIE understands that it is part of a fiduciary trading process. What OCIE is really focusing on is whether effective systems and controls are in place around the information network and research process.

On the front end – OCIE wants to ensure that the compliance function is involved in vetting agreements between the firm and the expert network. OCIE also wants to see that compliance is involved and participating in the engagements and the interactions so compliance can monitor the extent to which there is compliance with the firm’s policies and procedures under the enhanced risks that this process represents.

On the back end – Does the firm get certifications from employees regarding adherence to insider trading policies and procedures? Is there forensic testing around the firm’s use of expert networks and the firm’s trading relative to the dialogues they’re having with expert consultants?

"This is not to say the use of expert networks can’t happen, rather, it is how it is happening and the controls a firm puts around it," said di Florio.