11 the sec’s examination program jeffrey c. morton aca ... · 10 2008 sec examination statistics...

From PLI’s Course Handbook ABCs of Mutual Funds 2009 #18809

11 THE SEC’s EXAMINATION PROGRAM Jeffrey C. Morton ACA Compliance Group Valerie M. Simpson Prudential Investment, LLC Nothing herein should be construed as legal advice or as a legal opinion for any particular situation. Information is provided for general guidance and should not be substituted for formal legal advice from an experienced securities attorney.

The SEC’s Examination Program

Jeffrey C. MortonACA Compliance Group

Valerie SimpsonPrudential Investments

June 10, 2009

Nothing herein should be construed as legal advice or as a legalopinion for any particular situation. Information is provided for general guidance and should not be substituted for formal legal advice from an experienced securities attorney.

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Purpose of the SEC Exam Program

“The purpose of examinations is to detect fraud and other violations of the securities laws, foster

compliance with those laws, and help ensure that the Commission is continually made aware of

developments and areas of potential risk in the securities industry. The examination program plays a critical role in encouraging compliance

within the securities industry, which in turn also helps to protect investors and the securities

markets generally.”

Source: See Office of Compliance Inspections and Examinations at http://www.sec.gov/about/offices/ocie.shtml.

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Table of Contents

• Recent SEC Exam Observations

• Examination Statistics

• Expectations and Goals of a Routine Audit

• Role of the CCO

• Annual Compliance Review

• Questions

Recent SEC Exam Observations

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Re-Energized SEC Staff

“A strong and reinvigorated SEC will be on the beat like never before to

catch wrongdoers.”

– Mary Shapiro, SEC Chairman

Source: Practicing Law Institute's "SEC Speaks in 2009" Program, Washington, DC, February 6, 2009.

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A Tougher, No-Nonsense SEC?

“We really are now going to take a no-excuses approach to compliance with

the law…firms really need to be ready to be examined by the SEC.”

- Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations

Source: Richards Talks Tough: SEC Examiners Will Take ‘No Excuses’, ACA Insight, February 16, 2009.

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Recent SEC Examination Observations

• Some interesting observations related to SEC inspections that have commenced within the past month:

Surprise examinations are back!

Email requests span up to 2 years with no “keyword” qualifiers

Requests for all versions of particular documents during a review period (e.g., Form ADV, II, Compliance Manual, advertisements)

Questions about compliance budgets and potential cost cutting initiatives

Previous deficiency letters. Re-open those letters and your firm’s response and ensure that all issues have been properly remediated.

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Production of Records: SEC Expectations

• OCIE working with the SEC’s Division of Enforcement to create a policy about when examiners will refer a delay in production or lack of cooperation to SEC enforcement attorneys

• “Examiners will be less tolerant of delays in the production of information and documents…I want examiners to have a clear sense of when they should refer matters to the Division of Enforcement staff when production of documents has not been timely and when we feel that firms have not been fully cooperative with examiners during the examination process.”


Examination Statistics

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2008 SEC Examination StatisticsInvestment Advisers

Investment Companies

Broker-Dealers

Total # of Registrants

11,300 950 5,500 (inc: 174k branch offices and 676k reps)

SEC Staff Dedicated to Oversight

425 315

2008 Exams 1,521 (includes 400 getting to

know you exams)

219 720

Source: Testimony of Lori A. Richards Before the U.S. Senate Committee on Banking, Housing and Urban Affairs Concerning Examinations by the SEC and Issues Raised by the Bernard L. Madoff Investment Securities Matter, January 27, 2009 and Richards Talks Tough: SEC Examiners Will Take ‘No Excuses’, ACA Insight, February 16, 2009.

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2008 SEC Examination Outcomes (Table)

Investment Advisers Investment Companies

Total # of Exams 1,521 219

No-Further Action Letters

31% (impacted by 400 “getting to know you”

exams)

0%

Deficiency Letters 68% 71%

Enforcement Referrals 4% 5%


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2008 SEC Examination Outcomes (Chart)

0%10%20%30%40%50%60%70%80%

InvestmentAdvisers

InvestmentCompanies

No-FurtherActionDeficiencyLettersEnforcementReferral

Expectations and Goals of a Routine Audit

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SEC Exam Preparedness

• SEC examiners expect firms to be prepared for an audit.

• “Many, many times, firms act surprised when examiners arrive onsite or when they receive a document request letter…They act surprised that they are subject to examination by the SEC. And they sometimes act surprised that they have compliance obligations under the law. That’s got to stop and there’s no excuse for that.” –Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations


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Typical Examination Timeline

• Phone call to announce the inspection

• Initial document request list

• Employee interviews

• Subsequent document requests

• Exit interview – Last chance to clarify inaccuracies

• Deficiency letter from SEC within 120 days (almost 90%)

• Response due from adviser within 30 days

Don't be afraid to talk and negotiate with the exam team. Most of them are very reasonable to work with.

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Goal of an SEC Audit – Low Risk Profile

“Because firms that have strong compliance controls will be more likely to prevent problems from occurring, and to detect and correct any

problems that do occur, they will likely be subject to less examination attention, and less thorough examination scrutiny. If controls appear to be non-existent or weak, it's likely that examiners

will drill down in these areas looking for violations.”

Source: Lori Richards, Director, SEC’s Office of Compliance Inspections and Examinations, Frequently Asked Questions About SEC Examinations, January 17, 2008 at http://www.sec.gov/news/speech/2008/spch011708lar.htm.

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Top 10 SEC Exam Blunders

1. Falsify or backdate records.

2. Make employees mysteriously unavailable

3. Use sloppiness and chaos to convince the exam team that your office is out of control

4. Get your facts wrong.

5. Produce records as slowly as possible with no explanation

6. Have employees argue with each other, challenge each other's authority or mutually slough off responsibility in the examiner's presence

7. Respond to problems with indifference

8. Break promises you make to the examining team or you made to past examining teams

9. Withhold records without telling the examining team you were going to do so

10. When the examiners first contact you, do your best to act shocked, stunned, completely unaware of the regulatory proceedings and the commission’s oversight responsibility

Source: Ignites.com, Top 10 SEC Exam Blunders to Avoid, October 4, 2007.

Role of the CCO

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Initial Examination Logistics

• Examiners in a comfortable room with access to telephone and Internet

• Documents initially requested should be ready and waiting for SEC in an organized manner according to the number of their requests.

• Get in first punch – CCO and senior management presentationon the firm’s overall culture of compliance.

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Important Ground Rules

• Assign a single point person to manage and coordinate the entire SEC inspection – all additional requests for documents and interviews should run through this person.

• Ensure photocopies of any original documents are made by the firm and not the SEC. A duplicate set of the exact documents given to the examiners should be maintained by the firm.

• Immediately schedule interviews for the SEC, including:

CEO & CCO

Investment Professionals

Accounting and Finance (CFO)

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Interview Best Practices

• Conduct practice interviews beforehand - - anticipate questions and walk through responses

• Instruct employees to bring certain documents to the interview to explain issues to the examiners (e.g., copy of research and due diligence memos, etc.)

• Don’t try and answer questions that you do not know the answer to - - get the SEC the right person who knows the answer.

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Final Few Reminders…

• Offer beverages – no food

• Lock Files

• Consider FOIA Treatment

• Request Frequent Updates and Exit Interview

• Pick Battles Wisely

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Exit Interview Process

• You should always ask for a closing or exit interview with the SEC’s examination staff.

– Last chance to clarify issues and misunderstandings

– Don’t be afraid to tell examiners they have something wrong

– Ask questions - - get their input as to how to resolve issues

– Fix problems as the examination goes along and provide evidence of the resolution of such matters

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Immediate Remediation of SEC Issues

• Correct legitimate issues raised by the SEC’s examination staff immediately during the examination or shortly thereafter.

• In the Matter of M.A.G. Capital, LLC and David F. Firestone, Advisers Act Release No. 2849, March 2, 2009

• SEC alleged that for about two years, M.A.G. took for itself warrants that were paid for by the funds, but that were apparently bundled into PIPEs offerings. The net value of the warrants retained by M.A.G. was approximately $18.9 million.

• “…between the May 25 exit interview and M.A.G.’s receipt of the September 20 deficiency letter, M.A.G. had continued to take warrants in four PIPEs transactions.”

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The Examination is Over – Now What?

•Three potential outcomes:

1. No-further action letter

2. Deficiency Letter

3. Enforcement Referral

•SEC has up to 90 days (internal rule) to provide a written deficiency letter to an adviser

•Upon receipt of deficiency letter, Registrant has 30 days to provide a written response with regard to the resolution of the matters and issues raised by the SEC

Annual Compliance Review

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Annual Review Requirements

• Investment Advisers –Rule 206(4)-7

• Investment Companies –Rule 38a-1

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Annual Review Focus Areas

• Custody and Safekeeping of Assets

• Compliance with Portfolio Mandates

• Performance Claims & Advertising

• Code of Ethics

• Oversight of Third-Party Service Providers

• Valuation

• Insider Trading

• Trade Allocation

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Top SEC Deficiency

• Deficiency #2: The compliance program rule. Gohlke noted that the "starting point" for SEC adviser examinations is an evaluation of the firm’s overall compliance program. Examiners will review the firm’s process for identifying compliance risks as well the policies and procedures put in place to manage those risks. Here, Gohlke echoed OCIE director Lori Richards’s assertion that examiners will have high expectations in this area: "The situation is better than what it was in the ‘04 to ‘05 time frame," said Gohlke. "Firms are getting the hang of it in terms of identifying compliance risks." However, he cautioned, more needs to be done. "[A]s you can see, issues with the compliance program rules are still second in terms of the areas where we find problems."

Source: CCOs Should Review Areas of Top Exam Deficiencies, ACA Insight, February 23, 2009.

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The “Annual” Review & Compliance Testing

70% of respondents conduct monthly, quarterly or on-going, rolling compliance testing.

8% of firms identified “significant issues” as a result of their testing.

Small firms were more likely to conclude that they had no compliance issues.

Similarly, firms that did not have full-time legal or compliance staff were more likely to conclude that they had no compliance issues .

Not surprisingly, respondents that reported testing on an ongoing, rolling basis were more likely to detect compliance issues than those that reported testing annually

Source: 2007 Investment Management Compliance Testing Survey (the “Survey”), Conducted Jointly in Spring of 2007 by ACA Compliance Group, Investment Adviser Association, IM Insight and Old Mutual Asset Management.

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Other Notable Annual Review Observations

• 30% of respondents indicated that they have outsourced some or all of the testing conducted.

• Most firms appear to be creating a written report or short memorandum and maintaining workpapers created during testing to document the annual review. Only 3% of respondents reported that their firm had not documented the annual review.

• Vast majority of respondents (93%) indicated that senior management at their firm was apprised of the results of the annual review.

• Most respondents do not have policies regarding sharing the annual review with third parties.

Questions