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News September 26, 2005 Issue

New GAO Report Criticizes OCIE’s Emphasis on Sweep Exams

A new GAO report has questioned whether the SEC is relying on sweep exams to the detriment of traditional full-scope exams.

The report, titled "Mutual Funds: SECís Revised Examination Approach Offers Potential Benefits, but Significant Oversight Challenges Remain," focused on how the SECís fund and adviser examination program changed after the Canary scandal broke and whether the current allocation of exam resources is appropriate. (Of note: despite the reportís name, and GAOís repeated reference to "funds" throughout the report, GAOís study focused on all types of advisers).

As you may recall, OCIE rolled out a new exam program in late 2003 that placed a higher priority on sweep and cause examinations and a lower priority on routine examinations. While high-risk firms are still on a two- to three-year exam cycle, low-risk firms are examined only infrequently, as OCIE now pulls small random samples of low-risk firms for routine exams. Other new features: OCIE is developing teams to provide continuous and in-depth oversight of the largest mutual funds. It also is working on a data surveillance system to collect and analyze mutual fund information, although this project appears to be in the very earliest stages of development.

In any event, GAO wasnít keen on the idea of OCIE sacrificing routine exams for sweeps. Based on the current number of SEC-registered advisers, it said, "it is possible that up to a third of the total number of firms would not be selected for examination within a 10-year period," said GAO. "We believe that this is a lengthy time period for firms to conduct business without being examined."

And, of course, thatís even before hedge fund managers register. Given the tradeoffs made by the SEC in overseeing the mutual fund industry, said GAO, the SECís capacity to effectively monitor the hedge fund industry "is open to question."

GAO also hinted that the SEC should not have so quickly abandoned its reliance on regular routine exams, given that OCIE was only a third of the way through scoring all SEC-registered funds and advisers (remember how OCIE announced in 2002 that every adviser would get a score?). Between late 2002 and October 2004, said GAO, SEC routinely examined 30 percent of the existing fund complexes and assigned each complex a risk rating of low, medium, or high. "Had SEC not decided in late 2003 and 2004 to shift examination resources to sweep and cause examinations, it might have been able to assign risk ratings to all [the remaining two-thirds of] fund complexes within the following three years in accordance with its routine examination cycle," said the report. "Completing risk ratings for all fund complexes would have provided SEC with an additional basis for allocating resources to the highest risk firms."

In a letter responding to GAO, OCIE director Lori Richards defended the use of sweep exams, which she described as a "reasonable and effective means of quickly addressing risks." Risk-targeted reviews, she said, allow the SEC to address compliance problems "before they become major crises." Richards said that GAOís concern that OCIE is giving insufficient attention to low-risk advisers is addressed by its review of a random sample of low-risk firms. Not only will low-risk firms not know when they will be up for an exam, she said, the use of statistically valid sampling techniques will allow OCIE to make inferences about the overall state of compliance in the advisory industry.

GAO provided a number of suggestions for improving the SECís internal operations, such as requiring examiners to prepare a formal, written examination plan identifying potential risks and areas to be covered during an exam (currently, some SEC examiners do this, others do not). GAO also recommended that OCIE supervisors formally review examination workpapers and sign off on completed score cards.

A large section of the report was devoted to the topic of the SECís oversight exams of SRO exams of broker-dealers. GAO seemed miffed that the SEC had not followed its 1991 recommendations that the SEC essentially recreate NASD or NYSE exams six to twelve months after the fact. Instead, the SEC conducts an independent exam of the same broker-dealer firm, sampling different time periods. In her letter, Richards emphasized that the SECís oversight exams serve multiple additional purposes, such as detecting violations that might not otherwise be detected by the SROs and allowing the SEC to review new products and services that have not yet been identified as posing a significant compliance risk.