The Securities and Exchange Commission (SEC) has issued a risk alert that provides detailed insights into how it selects investment firms for examination, the areas it focuses on during these probes, and its criteria for requesting specific documents. This move by the SEC, which aims to help advisors prepare for examinations, is seen as unusually transparent by experts.
How does the SEC determine who to examine?
For starters, the agency will consider a firm’s risk characteristics; a tip, complaint, or referral; or the staff’s interest in a particular compliance risk area. When selecting advisers to examine, the Division said it considers factors such as which advisers provide services, recommend products or otherwise meet criteria relevant to the focus areas described in the Division’s priorities for the year. There are also firm-specific risk factors that the staff may consider when selecting advisers for examination, such as those related to a particular adviser’s business activities, conflicts of interest, and regulatory history.
For example, the staff may consider:
- prior examination observations and conduct, such as repetitive deficient practices;
- supervisory concerns, such as a disciplinary history of associated individuals or affiliates;
- tips, complaints, or referrals involving the firm;
- business activities of the firm or its personnel that may create conflicts of interest;
- the length of time since the firm’s registration or last examination;
- material changes in a firm’s leadership or other personnel;
- indications that the adviser might be vulnerable to financial or market stresses;
- reporting by news and media that may involve or impact the firm;
- data provided by certain third-party data services;
- the disclosure history of the firm; and
- whether the firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks.
How does the SEC determine what to focus on?
The typical exam will focus on reviewing advisers’ operations, disclosures, conflicts of interest, and compliance practices with respect to certain core areas, including but not limited to, custody and safekeeping of client assets, valuation, portfolio management, fees and expenses, and brokerage and best execution.
What documents will the SEC request?
The risk alert also includes an attachment outlining the types of information and documents typically requested during an examination, including:
- general information, which provides the staff with an understanding of the adviser’s business and investment activities;
- information about the compliance risks that the adviser has identified and the written policies and procedures the firm has adopted and implemented to address each of those risks;
- information to facilitate testing with respect to advisory trading activities; and
- information for the staff to perform its own testing for compliance in various areas
While the SEC examines only about 15% of the 15,000 registered investment advisors annually, it aims to increase this number, possibly by preparing the industry for smoother examinations through this transparency initiative.
To read the full risk alert, click here.