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News December 14, 2015 Issue

Watching the SEC: Inspector General Investigates Wrongdoing at the Agency

Someone has to watch the watcher.

The SEC, like many government agencies, is regularly audited and investigated by an internal watchdog, the Office of the Inspector General, which provides regular reports to Congress. In its most recent Semiannual Report, covering April through October of this year, the OIG provides the results of its audits and investigations into a variety of allegations made against the SEC or its employees. These allegations ranged from the significant, such as improper disclosure of material non-public information, to matters of less importance, such as an employee’s misuse of a government-issued travel card.

"The audits, evaluations, investigations and other reviews that we describe illustrate the OIG’s efforts to promote the efficiency and effectiveness of the SEC and demonstrate the impact that our work has had on the agency’s programs and operations," said SEC inspector general Carl Hoecker.

"The OIG report covers a range of areas," said Sidley Austin partner Gerald Russello, "suggesting that the OIG is taking seriously its role as an interested observer of the regulatory agency."

"It would seem that the SEC faces a lot of the same challenges, like information security, that those they regulate do," said Day Pitney counsel Eliza Sporn Fromberg. "It reads a lot like what the SEC has said in its enforcement actions."

Disgorgement distribution

One of the more significant matters the OIG investigated in 2015 was the agency’s use of third-party fund administrators to distribute disgorgements from securities violators to investors. As of July 9, 2015, there were nine administrators administering 77 distribution matters totaling more than $6.5 billion.

The OIG, in a report issued this past September following an audit, found that improvements were needed in how the Division of Enforcement’s Office of Distributions returns these amounts to investors. In words that may ring familiar to advisers and investment companies that have been on the receiving end of an SEC enforcement action, as well as their defense counsel, the OIG said that the Office of Distribution "did not clearly document in its policies and procedures 1) the steps it takes to review and accept payment files submitted by fund administrators, and 2) its responsibilities for fund administrator oversight generally."

"Policies and procedures should address risks identified and, based on those risks, establish controls designed to ensure federal requirements and the agency’s goals and objectives are met," the OIG said.

Office of Distribution officials also identified for the OIG a "limited number of instances" in which "fund administrators submitted and the Office of Distribution accepted inaccurate payments files, and at least one case where a fund administrator made inaccurate payments." Corrective payments were made to the underpaid investors in that case, it noted. "However, the SEC’s oversight of fund administrators could be improved by fully assessing and documenting the risks involved when using fund administrators and updating policies and procedures for fund administrator oversight."

In addition, the OIG found that the SEC, in some instances, did not implement internal controls that the agency itself had designed for fund administrator oversight. "For example," the OIG said, "fund administrators collect on the SEC’s behalf harmed investors’ personally identifiable information (PII). Despite federal and agency requirements to assess fund administrators’ information security controls, the agency did not complete required assessments of fund administrators’ information technology environments before relying on the fund administrators. As a result, the agency lacks assurance that fund administrators adequately protect the investors’ PII collected and maintained on the SEC’s behalf." It noted that the SEC planned to complete the required assessments by December 31 of this year.

The OIG, in its September report, recommended that the SEC do three things: improve oversight of fund administrators, comply with applicable laws and its own policy and requirements, and ensure that goals and objectives are met. The SEC concurred with these recommendations, which according to the Semiannual Report have yet to be completed and verified.

"The SEC has made significant strides in its funds distribution process, but the OIG highlights that there is still more work to be done, especially in the investor privacy area," Russello said.

Other audits, investigations and results

Following is a list of some of the other allegations in regard to the SEC that the OIG addressed in its Semiannual Report:

  • Tips, complaints and referrals system. An ongoing modernization of the TCR system, which the OIG said receives tens of thousands of tips, complaints and referrals from multiple sources each year, has "experienced schedule delays and cost increases," said Hoecker. The modernization project involves an external contractor. "We found that various factors, including unacceptable contractor performance and a lack of adequate contractor and government resources to timely address concerns, have delayed schedules and increased the costs of the project," the OIG report said. While the OIG credited the SEC with having taken action to address contractor performance, it noted that despite these actions, as of September 2013, "the contract value had increased by nearly $4 million, and the project was at least 10 months behind schedule."
  • Unauthorized transmission of non-public information by an SEC senior attorney. The attorney, who had transmitted a spreadsheet containing PII and other non-public information, and about 30 other non-public or SEC-sensitive unencrypted documents to his or her personal email account, reached a settlement with the agency. Under the settlement, the attorney would be suspended for 14 days if found to have engaged in a similar violation in the next two years.
  • Possession of prohibited holdings and possible conflict of interest. The OIG found that an SEC supervisory employee maintained a managed account that contained prohibited holdings, and may have engaged in a possible conflict of interest because "the managed account contained stocks of companies with which the employee may have official SEC dealings." While the employee had disclosed these holdings to the SEC upon joining the agency, he did not divest two of the prohibited holdings, as the SEC had instructed him to do, and still had them more than four years later. "The investigation also found that the employee failed to pre-clear 37 individual securities in the managed account," the OIG said. Response from the SEC after receiving the results of the investigation in September 2015 was still pending at the end of October, according to the report.
  • Disclosure of non-public information. An OIG investigation found that an SEC supervisor forwarded an email containing non-public SEC information to the supervisor’s spouse on one occasion several years earlier. The OIG was unable to substantiate an additional allegation that the supervisor retaliated against the employee who made the allegation about the supervisor’s disclosure of non-public information.

Another investigation, this one to determine the validity of allegations of bias on the part of SEC administrative law judges, began in June 2015 and resulted in an interim report issued in August.

The SEC’s use of ALJs has been the focus of much contention, with a number of defense attorneys, as well as two SEC commissioners, making the argument that the Commission’s increased use of them over trying cases in federal court has provided the SEC with an advantage in prosecuting the cases, since the ALJs are SEC employees and because the defense has fewer rights in an administrative hearing than it does in federal court.

The interim report described the results of the OIG investigation as of August 5, 2015, which included interviews with two SEC ALJs and two other SEC staff members, as well as a review of documents. "The OIG reported that as of the issuance of the interim report, the OIG had not developed any evidence to support the allegations of bias in ALJ’s decisions in the Commission’s administrative proceedings," the Semiannual Report said.