When the SEC Knocks….

What every investment adviser should know.


WITH INCREASING NUMBERS OF CPAs OFFERING investment services, more are registering with the SEC as investment advisers and facing field examinations from the SEC Office of Compliance Inspections and Examinations (OCIE). These investigations determine whether the adviser is complying with the Investment Advisers Act of 1940, protect investors from fraud and provide the SEC with information on industry practices.

WHEN AN EXAMINATION BEGINS, THE OCIE STAFF will provide the adviser with several documents including a “List of Books and Records Requested for Review.” It includes records the staff will review both on- and off-site. This list represents the road map the OCIE follows in a routine examination.

A TYPICAL EXAMINATION INCLUDES AN EVALUATION of the adviser’s supervisory and compliance system, internal controls and the like. After completing its initial on-site review, the OCIE staff may tour the adviser’s facility to observe operations.

THE OCIE STAFF WILL CONDUCT A POSTFIELDWORK analysis of the adviser’s operation, including reviewing documents and information it obtained and discussing legal and accounting issues with other SEC staff. The examination has several possible outcomes: OCIE will notify the adviser that it found no violations, it will send the adviser a deficiency letter outlining violations and requesting corrective action or refer the adviser to the SEC Division of Enforcement for further investigation.

INVESTMENT ADVISERS FACE SEC EXAMINATIONS at least once every five years. Depending on the risk factors the staff observes, the OCIE may make more frequent visits. Advisers with custody of client assets or discretionary investment authority may face increased scrutiny.

BRIAN CARROLL, CPA, JD, is an attorney and special counsel with the SEC in Philadelphia. He is cochair of the securities regulation committee of the American Association of Attorney-CPAs. The SEC disclaims responsibility for any private publication or statement of any employee or commissioner. This article expresses the author’s views and does not necessarily reflect those of the commission, the commissioners or other members of the staff.

n increasing numbers, CPAs are expanding their range of client services to include investment advice. Like many other CPA services, the investment advisory business is heavily regulated, generally requiring firms to register with the appropriate state agency or with the SEC (see “SEC Jurisdiction Over Investment Advice,” JofA, Aug.01, page 32). However, the relationship between the regulator and the investment adviser does not stop when the adviser files registration documents. Indeed, that’s just the beginning.

The SEC Office of Compliance Inspections and Examinations (OCIE), as well as many state regulatory agencies, operates a proactive compliance program covering various securities industry participants—including investment advisers. As part of this program, OCIE conducts field examinations in which staff members travel to the adviser’s office to do an on-site investigation. Every SEC-registered investment adviser is subject to an OCIE examination.

The examinations are designed primarily to determine whether investment advisers are complying with the Investment Advisers Act of 1940 and its rules and regulations to protect investors by rooting out fraudulent schemes and other improper practices, and to provide the SEC with up-to-date information on industry practices and developments. This article provides guidance to CPAs who are SEC-registered on the step-by-step procedures OCIE uses to examine investment advisers. In other words, it tells accountants what to expect when the SEC knocks.

The OCIE’s statutory authority to conduct examinations flows from section 204 of the act. It authorizes the SEC to conduct “at any time or from time to time” a “reasonable periodic, special or other examination” of an investment adviser’s records “as the commission deems necessary or appropriate in the public interest or for the protection of investors.” The courts have consistently upheld this general authority to conduct examinations. In instances where an adviser refuses to permit OCIE access to the books and records that Rule 204-2—“Books and Records to Be Maintained by Investment Advisers”—requires the firm to maintain, the SEC has successfully moved for a temporary restraining order or preliminary injunction in federal court requiring the adviser to comply. When an adviser fails to comply with such a court order, the SEC has initiated contempt proceedings.
Common Mistakes

In recent examinations of investment advisers by the SEC Office of Compliance Inspections and Examinations (OCIE), the most common deficiencies concerned

Form ADV/brochure.
Books and records.
Custody arrangements.
Conflicts of interest.
Internal controls.

Source: SEC, Washington D.C., www.sec.gov .

In addition, the SEC can institute administrative proceedings before an SEC administrative law judge seeking to, among other things, revoke the adviser’s registration. Also, according to SEC Form 1661, Supplemental Information for Regulated Entities Directed to Supply Information Other Than Pursuant to a Commission Subpoena (which the staff typically furnishes to advisers at the start of an examination), a “willful failure to permit inspection by authorized commission personnel of the records and documents” may result in a fine and imprisonment. Finally, as noted on form 1661, CPAs should be aware it is generally a crime punishable by fine and imprisonment to lie to federal officials who are engaged in official duties.

The OCIE staff typically prepares for an examination by reviewing all of the documents an adviser has filed with the SEC, including the basic registration known as form ADV, any past examination reports and OCIE letters along with the adviser’s responses, any client complaints and information in automated databases and the adviser’s Web site. The OCIE staff may or may not contact the adviser prior to its arrival, depending on the circumstances.

After arriving at the adviser’s office, the OCIE staff members will present their official credentials and ask to meet with the compliance officer, the corporate officer who signed form ADV or some other appropriate employee or officer. At this point, the OCIE staff furnishes the adviser with three documents:

Form 1661 (see above).

“Examination Information for Broker-Dealers, Transfer Agents, Investment Advisers and Investment Companies,” which outlines the OCIE program.

A “List of Books and Records Requested for Review.” Divided into a section requesting copies of records the staff will retain and a section of records it will review on-site, this list includes records the adviser is required to maintain under rule 204-2. It is the road map to a routine examination.

During the initial interview, the staff will talk with the officer to help it determine the scope of the SEC examination. The questions cover general areas that provide a snapshot of the adviser’s business operation such as its organizational structure, operations, key personnel and affiliations with other financial service providers. Other questions evaluate the firm’s approach to compliance, covering topics such as the adviser’s supervisory system, compliance system, internal controls, revenue sources, client profiles, existence of major liabilities or pending lawsuits and the like. Throughout the examination, the OCIE staff evaluates the effectiveness of the adviser’s compliance program; OCIE staff is authorized to adjust the scope of the examination to meet this goal.

The staff may then request a tour of the adviser’s facility to observe operations, for example, how the adviser processes a securities trade. The OCIE staff is now ready to review the adviser’s books and records. This review goes beyond determining if the adviser is keeping the right records. The staff also must decide whether the firm is in compliance with the substantive provisions of the act and related rules and regulations.

To do this, the OCIE staff typically reviews certain key areas. (See the exhibit below.) Moreover, since an investment adviser is deemed to be acting as a fiduciary on behalf of his or her clients, the OCIE staff is trained to detect practices that violate this duty.

Generally, the staff performs this part of the examination in the adviser’s office, where it not only has access to records, but also may interview employees. CPAs may want to warn employees in advance that this may happen and suggest they be open and honest in answering the SEC’s questions. While attempting to maintain a cooperative approach and minimize any disruption to the adviser’s business, OCIE staff will nevertheless fulfill its responsibility to conduct the examination.

As with any audit function, OCIE staff will exhibit the requisite degree of “professional skepticism” and, accordingly, follow up on any appropriate leads. CPAs will find a cooperative approach is the most productive. Some advisers have found it helpful to designate an employee to act as liaison to the OCIE staff while it is on the premises to gather required documents and otherwise facilitate the examination.

After the fieldwork is complete, the OCIE staff generally will conduct an exit interview with the adviser. This provides the staff with an opportunity to ask questions or seek clarification of particular issues or practices. If necessary, the staff can arrange for the adviser to forward requested information. Frequently, the adviser will ask a question along the lines of “How did we do?” OCIE staff typically is reluctant to state any definitive finding because, at this point, it has not undertaken any postfieldwork analysis. However, there may be some clear-cut issues the OCIE staff will comment on. If a potential violation arose during the fieldwork and the adviser has already taken steps to correct it, the firm may want to note this correction to the staff.

What Will the OCIE Review?

The OCIE staff may examine any or all of these general areas of an investment adviser’s operation during a routine examination, including

Filings and reports.
Form ADV, brochure disclosure and delivery.
Custody arrangements.
Books and records.
Financial condition.
Internal controls.
Advisory services.
Need for registration under other securities laws.
Portfolio management.
Prohibited transactions.
Limited partnerships.
Conflicts of interest.
Brokerage and execution.
Wrap fee programs.
Marketing and performance calculations.
Compensation and client fees.
Client referrals.

Source: “The SEC Speaks in 2002,” Office of Compliance Inspections and Examinations, vol. 2, pp. 175 to 176.

The OCIE conducts several different types of examinations of investment advisers, each with a discrete purpose. The routine examination is the most common and is the main subject of this article. Other types of examinations include those the SEC conducts for cause and to learn more about industry practices.

The OCIE staff usually initiates a cause examination when it believes an adviser has violated federal securities laws. In one, the staff will investigate the specific allegations of fraudulent conduct that sparked the examination as well as other leads it may uncover. Many times an investment adviser will not know what type of examination the staff is conducting.

The OCIE also conducts examinations to learn more about an industry practice, area of operation or compliance with an SEC initiative. The SEC uses this information in its rule-making responsibilities. Although this type of examination may focus on only one or two areas of the adviser’s operation, the staff is nonetheless still concerned with general statutory compliance and detecting fraud.

The OCIE staff will conduct its postfieldwork analysis of the adviser’s operation by studying documents and information it obtained from the adviser, conferring with other staff members on accounting or legal issues and discussing new issues with senior SEC management.

As part of its effort to bring deficiencies to the adviser’s attention and encourage immediate compliance, the staff usually conducts an exit conference call when the staff has completed most of its follow-up work and is prepared to discuss findings. This call is an opportunity for the adviser to present to the staff any information, including documents, it should know about before the SEC staff drafts the deficiency letter, if one is warranted.

Once the staff completes a full analysis several outcomes are possible:

If OCIE detected no violations during the examination, the adviser generally is notified of this finding.

If the examination revealed the adviser failed to comply with the act or, for example, that its internal controls were deficient, the SEC will send the adviser a deficiency letter outlining the violations and requesting corrective action. Generally, the deficiency letter sets a time limit for the adviser to implement the corrective action and asks the adviser to report back to the OCIE staff on its compliance. Most routine examinations result in a deficiency letter. In some instances the SEC may call or meet with the adviser to discuss significant compliance issues that arose during the examination process.

If the situation warrants it, the staff will refer the adviser to the SEC Division of Enforcement (see “Enforcement Referral,” at right). The adviser is generally not informed that a violation has been referred for enforcement action.

Enforcement Referral
The OCIE works closely with the SEC Division of Enforcement. The division investigates possible violations of federal securities laws and, when appropriate, prosecutes suspected violators in federal court or before an SEC administrative law judge. When an OCIE examination reveals evidence an adviser may have violated federal securities laws, particularly any of the antifraud provisions of section 206 of the act, the staff may refer the matter to the division for further investigation. The adviser is not notified of this referral, even though it may receive a deficiency letter.

The investigation may include subpoenas to witnesses for testimony and documents from the adviser’s clients, affiliates of the adviser, other registered entities and anyone with relevant information. If, after completing the investigation, the commissioners decide to charge an adviser with violating securities laws, the Division of Enforcement will act as prosecutor in civil proceedings. Although the SEC does not have criminal jurisdiction, it often works closely with the Department of Justice when the department files criminal cases against investment advisers.

All investment advisers registered with the SEC can expect a routine OCIE examination at least once every five years. As part of this process, OCIE staff completes a risk factor assessment that will guide it in determining how often to examine an adviser. In this assessment the SEC considers, among other things, the type of products offered, whether there are any customer complaints, if any disciplinary history exists, whether the adviser makes advertising and investment performance claims, and the results of prior examinations. Also, advisers with custody of client assets and discretionary investment authority are of particular interest to OCIE. An adviser suspected of misconduct will be subject to closer scrutiny and more frequent examinations.

What’s New?
The SEC Web site at www.sec.gov provides CPAs with useful information on developments from the OCIE, as well as other SEC divisions and offices, including the Division of Enforcement. The OCIE generally releases a “Dear Registered Investment Adviser” letter annually describing selected examination areas and the violations the OCIE staff found. It is available at www.sec.gov/divisions/ocie/advltr.htm . Recently, the staff has focused on several areas of investment adviser operations, including best execution, performance claims, supervision and compliance with regulation S-P, which covers privacy of financial information.
With this bird’s-eye view of the OCIE examination process in mind, CPAs should be sure to devote the time and effort necessary to operate an effective compliance program that includes strong internal controls and clearly communicated policies and procedures. In the long run, proper compliance serves not only the adviser’s interest, but also clients and the investing public in general.

CPAs can check the SEC Web site for updated information on the OCIE program. (See “What’s New?” at left.) Preventative compliance procedures should be an everyday part of an investment adviser’s operation. Over time, compliance is more cost effective and efficient than having to deal with a deficiency letter. After all, if you’re in the investment advice business, it’s just a matter of time until the SEC knocks on your door.


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