Exam Referrals to Enforcement: How Much Should Advisers Worry?
It’s every advisory firm’s nightmare. SEC examiners visit, find some deficiencies and suggest some corrective actions, which the adviser makes. Some months later, the advisory firm learns that it is the subject of a Division of Enforcement investigation, based on a referral from the exam team.
Likely or unlikely? The answer comes down to that attorney maxim: It depends.
"While examinations are not stalking horses for Enforcement – historically only approximately 10 percent of exams conducted by the agency’s Office of Compliance Inspections and Examinations are referred to Enforcement – the two groups are in constant communication in the SEC’s offices across the country and therefore are highly coordinated in setting priorities and sharing information and field observations," said Debevoise partner and former Division of Enforcement Asset Management Unit co-chief Julie Riewe.
Kirkland & Ellis partner and former SEC Division of Investment Management director Norm Champ noted that since the 2008 financial crisis, "the effort has been to involve Enforcement earlier if OCIE thinks there are possible violations of law. The idea is to get a read from Enforcement sooner and have them consult more so they know the facts. While this is good practice, it doesn’t seem to be increasing the rate of referrals, which is currently about 6 percent."
It should be noted that it is not entirely clear what constitutes a "referral" as that metric is reported by the SEC’s exam program. For example, it could be that the metric tracks only formal documented referrals from the exam staff to enforcement, as opposed to enforcement actions that result from more preliminary or less formal interactions between exam and enforcement staff.
"It’s important to keep in mind how OCIE chooses what to investigate," said Stern Tannenbaum partner Aegis Frumento. "Yes, there are exam priorities coming from Washington, but OCIE really operates in the regions, and reacts more to what is happening in the regions. Also, its resources are constrained by the budgets and workload of the regions it operates in."
"It is too simplistic to say that OCIE is an early scout for the enforcers," he said. "It’s probably more accurately the reverse, because OCIE will react in its exams to what the Division of Enforcement staff has found to be problem areas as a result of enforcement actions. So, sure some OCIE exams will uncover a problem so serious that enforcement action will follow. But it is better to say that you are being examined for a particular matter because someone like you was charged with wrongdoing in connection with that matter."
"Once the SEC has been educated about a certain conduct through an enforcement action, OCIE will know what to look for," Frumento said. "The SEC will then use OCIE exams to see how prevalent the problem is. Sometimes that will result in enforcement actions, sometimes in a new rule, sometimes only in annoyance. But to say that OCIE is looking for cases to refer to the enforcement staff is going too far. That isn’t really its job."
The issue of just how separate OCIE and the Division of Enforcement are was discussed during a panel at last month’s Investment Adviser Association’s 2018 Compliance Conference in Washington, DC. Asked about Enforcement staff accompanying exam staff during examinations, SEC Division of Enforcement co-director Stephanie Avakian said that when this occurs, "it’s almost entirely circumstances when Enforcement is trying to learn."
Debevoise partner and former SEC Division of Enforcement Asset Management Unit co-chief Robert Kaplan, who was also on the panel, said that the issue was more complex than simply enabling regulatory staff members to learn – although he agreed that "from a resource, integration and staff education perspective, I understand why the Commission would want Enforcement there."
Nonetheless, he said, having Enforcement staff present during examinations "dramatically changes the complexion of an exam."
"To the extent you were ever told by your counsel five or six years ago, ‘We’re going to approach an exam by voluntarily surfacing issues and problems as transparently as possible, and if we have an issue, we’ll fix it and that will be the end of it,’ I think the stakes have changed dramatically," Kaplan said. Now he tells clients that when they talk to the examination staff to be honest and accurate, but talk "as if they are talking to the Division of Enforcement, because there is much more of a fluid relationship between the two."
As an anecdotal example, he shared a story from what he said was about four years ago, at the end of what was a lengthy exam that resulted in deficiencies and a request for substantial remediation. During a discussion with the head of an SEC regional office’s exam staff, Kaplan said, he asked whether, if the advisory firm took certain actions, that would satisfy the agency and there would not be a referral to the Division of Enforcement.
"The person said to me, ‘What are you talking about? We’ve been talking to Enforcement about this exam since its second week,’" Kaplan said. "So there is not the same bifurcation of processes anymore. I think that probably doesn’t encourage the same sort of open-vest approach that may have been the case years ago."
What does this all mean? Probably that the safest course for an adviser to take when visited by examiners is to treat such visits as though they will be referred to the Enforcement Division, said Paul Hastings partner John Nowak. "It would also be wise to check with outside counsel and to be proactive in evaluating whether the examiners might look at additional areas – beyond those areas in which the examiners initially expressed an interest."
An advisory firm would be wise to take the approach that "when you are talking to examiners, you are talking to the SEC writ large," Kaplan said. "You should assume that the information will be conveyed to the Division of Enforcement."