High Risk Advisers to Be Targeted For Cause Examinations
A group of senior SEC staff is developing a list of factors that will be used to identify high risk advisers for cause examinations by the SECís Office of Compliance Inspections and Examinations (OCIE). The news was announced by Division of Investment Management director Paul Roye at the SECís July 14 meeting on hedge fund manager registration.
As part of the SECís "enhanced risk based approach" to oversight and examination of advisers, said Roye, "Chairman [William] Donaldson has specifically directed that members of the Commissionís senior staff . . . work together to develop risk assessment protocols [that] could be used to identify investment advisers whose activities are raising Ďred flagsí that suggest a more focused, cause inspection may be in order." He said that the approach would permit the SEC to "leverage its resources, increase its surveillance capacity and target the use of examination resources to high risk advisers."
The SEC traditionally has scheduled "cause exams" when it has reason to believe that there is a problem at a firm. Unlike routine exams, which are often announced, cause exams are typically conducted on a surprise basis.
In addition to Roye, the working group includes OCIE director Lori Richards, Division of Market Regulation director Annette Nazareth, and the SECís chief economist and general counsel. Roye described the group as a "component" of Chairman Donaldsonís risk assessment initiative, and said that a similar effort is underway for mutual funds. Earlier this month, the SEC announced it had hired former Fidelity v.p. Charles Fishkin to head the agencyís newly-formed Office of Risk Assessment.
Based on comments made during the SECís July 14 open meeting, the project seems designed to address criticism that the SEC does not have adequate resources to inspect the additional advisers that would be swept in under a hedge fund manager rule. But Donaldson described the initiative as proceeding on a "parallel track" to the hedge fund proposal, and an SEC spokesperson similarly downplayed the connection. "The risk assessment initiative is agency-wide and separate and apart from the rule proposal," said the spokesperson. However, he added, if the proposal is adopted, risk management "will play an important role."
What types of activities might flag an adviser as high risk? Barry Barbash of Shearman and Sterling noted that "risk" is generally equated to "potential for conflicts of interest." He offered the following examples of conduct that, in the current climate, might be considered high risk:
advisers that have portfolio managers "who engage in a fair amount of personal investing";
"a high degree of IPO involvement," which raises questions of how IPOs are allocated;
managing hedge funds and mutual funds;
advisers that engage in significant trading activities involving soft dollars; and
advisers that engage in a significant amount of trading in mutual funds. Barbash noted that to the SEC, the profile of active mutual fund asset allocators might "look like Canary Capital Management or a market timer."
The following Form ADV responses might flag an adviser as high risk: indicating that the adviser has custody; has an affiliated broker-dealer; manages hedge funds (even without side-by-side mutual funds); and/or is newly-formed (and therefore has not yet been examined). Advisers with significant disciplinary histories, or that employ individuals with significant disciplinary histories, also might be targeted.
Bell, Boyd & Lloyd member Alan Goldberg suggested that the SEC might consider advisers that provide their own securities valuations for client accounts, without using an outside provider, to present higher risks. He added, however, that advisers typically use an outside pricing service for all but "very esoteric products." He also pointed out that it would be difficult for the SEC to determine which advisers perform their own valuations. "I donít know how they would identify that," he noted.
Traditionally, as part of its pre-examination preparation, OCIE reviews a firmís Form ADV and past deficiency letters, as well as media accounts referencing the firm. Since 2000, however, advisers have not been required to file their Schedule Fs with the SEC, and therefore the SEC does not have ready access to narrative information about subjects such as an adviserís soft dollar practices or IPO allocation procedures.
Barbash, however, speculated that OCIE might "change its mechanisms" for identifying high risk advisers. "One of the themes is for the SEC to be in front of the issue, instead of reacting to issues," he said.