When an examiner calls, expect a lot more questions

The webcast “What are the SEC auditors looking for now?” was held April 5 and was moderated by deputy editor Evan Cooper and reporter Liz Skinner. An edited transcript follows.

InvestmentNews: What’s new in the world of SEC exams?

Mr. Schwartz: We’re seeing greater scrutiny during examinations, and examiners’ giving less of a benefit of the doubt to registrants. We’re also seeing longer and more thorough examinations.

For those of you who have been registered with the Securities and Exchange Commission for years, you may be familiar with the idea that the SEC tried to get to registrants once every five years. That essentially has gone by the wayside, replaced by a risk-based examination approach. Because of that, these examinations tend to be geared toward firms where the SEC is working off a tip, a complaint, a referral or something they learned during another examination.

Because of this, they seem to be putting their resources toward the higher-risk registrants, at least in their minds, and therefore, they’re coming in with a greater amount of scrutiny. We’re also seeing that the SEC examination staff has become more tenured.

Certainly moving through the crisis of 2008-09, they lost fewer examiners, so they have a more seasoned examination team. They’ve also hired some terrific experts from the industry who bring a real-world approach to the examination program.

Mr. Hamburger: Like Barry, we are seeing more-thorough examinations. However, examiners are asking a lot more irrelevant questions. They’re asking more questions that are outside the scope of most typical advisers’ operations. Advisers that have been in the business for a long time don’t really understand why the examiners are taking such an aggressive approach with them.

We are also seeing a more experienced roster of examiners. But along with that level of experience, we’re also seeing examiners who are a bit more jaded and cynical as to some of the responses that advisers are giving.

InvestmentNews: Mena, you’re the compliance officer for a firm that just had an audit. What was it like?

Ms. Bielow-McAfee: Well, it was a very painful and stressful experience. Some of the things that I was asked for were a surprise to me. The last audit was in 1999, so half the list is what has been asked before.

They want to see your trades, financials, bank statements and check register. Then, you have a mix of new things that have to do with the compliance program that came on after 2004, and they ask for things like proxy policies. I was asked for things I had never been asked for before, like charities and political contributions.

They told us that although there is no rule, we maybe should disclose to our clients in the Form ADV that we give charitable contributions. I know that I will have to keep track of the political contributions for future reports. We have a golf event in November, and we were asked if we had the list of everyone that attended the golf event.

Then they asked who attended other marketing events. They wanted to know who paid for the event. Those are things that had not come up before. There are certainly no written rules saying that I have to keep a list of the golf attendees. So, yes, there were some surprises in there.

UNCOMFORTABLE TONE

InvestmentNews: You mentioned earlier that the tone of the examiners when they came in was a little off-putting to you.

Ms. Bielow-McAfee: Yes. The first three days were quite uncomfortable. They were being — not aggressive but a little bit obnoxious. So I spoke to our attorney and my boss.

And I was told that it was OK to say, “Please, can we talk in a different way, or can you change your approach?” And after that, things changed and I didn’t have a problem anymore. So I would say, “If you feel uncomfortable, speak up,” because they do not have the right to come in and be aggressive.

InvestmentNews: Is this typical of what’s going on?

Mr. Hamburger: I don’t know if it’s typical. I will tell you that we are noticing a different tone when the examiners come in — just a lot more direct and focused on the tasks at hand. One of the things that concerns us about exams is that they tend to say, “Best practices would have you disclose this, and you really should be doing that,” without furnishing any regulatory guidance or pointing to any particular rule. And what that often does is to change the behavior of an adviser. The adviser is forced to take on additional costs beyond those required or mandated by law, rule or regulation. So when we see an examination team be very broad with their demands without furnishing any rooted guidance, I think an adviser really has an obligation to push back.

Advisers have to start to be a lot more sensitive as to the additional costs and the burdens that they’re voluntarily accepting without really any clear benefit.

Mr. Schwartz: There is an examination hotline that you can call that rings in the [SEC] chief counsel’s office in Washington. Some of our clients have called that number, and it actually has changed the tone of the examination.

That said, we’ve been part of plenty of examinations where the examiners were forthright, professional and comprehensive but were never unduly burdensome or unfair. I think that examiners are trained as examiners, and not trained as investigators. Some examiners seem to cross the line from time to time. Where we have seen the most success is in the preparation of the investment adviser. If it starts out amicably — usually the examination ends amicably. But you can certainly run into an examiner who’s having a bad day, a bad week or is just that kind of examiner. So certainly, the more preparation an adviser can do, the better off they are for the examination.

InvestmentNews: Do you ever sit in on the examination?

Mr. Hamburger: We really discourage that almost universally. It seems really, really shady, quite frankly, when the first introduction an adviser makes to the examiners is the securities attorney or the compliance consultant. It seems that the firm is ill-prepared or that they have inadequate resources to respond to an examination. We think we perform best when we have an ability to make the adviser look like a superstar in the eyes of the SEC. We’re running around backstage, e-mailing documents, helping them respond to information requests. But the SEC never has to be any wiser that we are part of the engine that is responding to these requests.

Mr. Schwartz: We’ve taken the opposite approach. Oftentimes, not only are we involved in the preparation for the examination, but we’ll even attend the opening interview and sit right at the table next to the chief compliance officer. We’re not there to answer questions necessarily. When we do have to speak up, it’s usually because the examiners are asking about issue A and, because of semantics more than anything else, the investment adviser answers question B.

AUDIT REQUIREMENTS

InvestmentNews: Where can an adviser get a comprehensive list of the actual requirements for an audit?

Mr. Hamburger: The SEC has been wavering for the last couple of years now on furnishing either a universal examination request list that is shared by the regions around the country or, more recently, on releasing their national examination manual. They had promised it. Over the past few weeks, the SEC has actually changed course and said, “Well, on second thought, it may not be a good idea for us to release the cookbook.” There are a number of places on the Internet that have published sample examination request lists from different regions, but there is no universal list. They’ve yet to come to a consensus, and they have not published that national exam manual as they had initially promised.

InvestmentNews: Is a registered investment adviser examination easier than a Finra examination?

Mr. Hamburger: Yes. It’s easier, it’s less frequent, it’s not nearly as invasive. The reason is that there are far fewer conflicts of interest in the typical investment adviser’s business than a typical broker-dealer’s business.

Mr. Schwartz: [The Financial Industry Regulatory Authority Inc.’s] regulations have tended to be more rules-based, where the SEC tends to take a more principles-based approach. On the Finra side, they tend to make sure that each rule is specifically followed, while the SEC examiners are given wide latitude to search out conflicts of interest. The fewer conflicts of interest that those investment advisers have, the shorter and less invasive the examinations tend to be. So the better the firm is prepared in exploring, documenting and mitigating its conflicts of interest, the better the examination.

InvestmentNews: In the post-Madoff world, what issues have been heightened?

Mr. Hamburger: In the New York regional office, we have almost exclusively focused on limited-scope remote examinations. Advisers have been getting a 12-question letter asking about their business practices. There’s a follow-up request for documents. There’s typically a follow-up telephone call. And from there, there’s either a deficiency letter or a letter stating that the examination’s over and no further action is necessary. So we’re seeing certain regions rely upon the touch-and-go approach to examinations. Hot topics continue to be in the areas of valuation. We’ll never get away from the issue of conflicts of interest. Specifically, allocations favoring certain clients, side letters, best execution, some soft-dollar issues, certainly in the portfolio management area, not delivering upon promised strategies and making unannounced strategy shifts without alerting clients, and then, of course, advertising and marketing, including improper performance calculations. But the fastest-moving trend has been in the area of asset verification, à la Bernie Madoff. With that, there are verification letters going out either to the account custodians and/or directly to clients, verifying that the assets that are being reported to them are in line with the assets being reported by the independent third-party custodians.

Mr. Schwartz: I’d add expert networks, which is reaching out, formally or informally, to experts on a particular industry topic to aid your research process. Unfortunately, some of the experts are not just sharing information on trends but also are sharing material nonpublic information about particular companies. This is what the SEC has focused on in some of its most recent enforcement cases.

InvestmentNews: Mena, did the auditors look at how you use social networking?

Ms. Bielow-McAfee: We were asked for archives of our website but we were not asked for e-mail and we were not asked about social media.

Mr. Hamburger: This is perhaps the issue that has received more media attention than any other. While I’m not surprised when I see it come up in an examination, it’s certainly not the focus of any examination. E-mail archiving and messaging tools have caught up, and most of the leading tools out there capture social-media activity alongside e-mail and instant messaging and chat. So it really is not viewed any differently in terms of the surveillance obligations.

Mr. Schwartz: We have seen a handful of clients receive a request list from the SEC looking into how investment advisers use social media. They’ve asked the advisers about their involvement in social media. They’ve asked to take a look at posts on Facebook, Twitter, LinkedIn and so on. They’ve looked to see the policies and procedures that advisers have adopted before engaging in social media. They’ve looked to see where those advisers are using third parties to help them in their marketing efforts on Facebook or Twitter.

Ms. Bielow-McAfee: The most important thing an adviser can do is to keep up with their website because the SEC is going to look at it before they come in and pay you a visit. When they look at the website, they’re going to research every adviser that is listed there.

Mr. Hamburger: When it comes to information that is external to the firm — and that includes the new Form ADV Part 2 materials that you’re posting to the web, or an RFP that’s going to be public — expect that examiners are doing their homework before they come on-site, and that homework is largely going to center around what they find about the firm in an Internet search. That also includes — which I think many advisers are not aware of — their discussions with various media outlets, and specifically claims of assets under management made to the press that may not exactly match disclosure documents.

InvestmentNews: We’ve done stories about how advisers are having problems getting the ADV 2 in on time. What’s the issue with that?

Mr. Hamburger: This industry, unlike broker-dealers, is really not used to absolute deadlines where something must be filed. Most of the regulatory initiatives that have been launched over the last couple of years have dealt with change internally. This is the first major regulatory obligation that actually has to be filed by a certain date. So I think a lot of this is just getting used to the fact that there are deadlines, and whether the regulators take those deadlines seriously or not remains to be seen.

InvestmentNews: One adviser said that due to a technical glitch, they ended up submitting their ADV two days late. Any sense of what the commission will or won’t do?

Mr. Schwartz: I would anticipate that not too much would come from a two-day delay. We know of a number of advisers who didn’t get to submitting their Part 2 and still have not done so. Usually what happens is, you get a letter or a telephone call first that says, “We haven’t seen your filing. Is there something we should know?” And through that process, the SEC learns that some advisers fell out of the business and never withdrew, some advisers never heard about the requirement — and so on. But most advisers file their Part 1 by March 31 each year, and we know advisers who have slipped into the first week of April to do the Part 1, and we haven’t seen the SEC bring fines or penalties, as long as the adviser submits the form in a reasonable amount of time.

InvestmentNews: Give us some examples of conflicts of interest.

Mr. Hamburger: Conflicts of interest are very difficult to identify. Having a conflict of interest is simply that you have a dilemma. There’s something hanging out there that may cause you to behave in a way that is inconsistent with your obligations to your clients. Preferably, the first thing we try to do with a conflict of interest is to get rid of it. How can we work around it so that the conflict of interest simply doesn’t exist? When that fails, then disclosure is the typical remedy, and it’s often coupled, if we can, with some type of mitigation. So how can we reduce the effect of the conflict of interest and disclose it so that clients are making informed decisions?

InvestmentNews: What are three or four conflicts of interest that come up a lot?

Mr. Hamburger: The most prevalent conflict of interest that we deal with has to do with trading and whether an adviser has a conflict of interest of favoring one account — whether it’s their account, that of a related person or perhaps an account where they earn a performance-based fee. Are they favoring one account or the interests of one client above another? Most advisers deal with it by stating their methodology for allocating trades. That discloses how those trades are going to be allocated and puts clients at ease while mitigating the problem.

Mr. Schwartz: Things that distract you from managing client assets on a day-to-day basis. Gifts you give or receive from brokers, dealers, custodians, service providers; referring a service provider and receiving compensation for doing so.

If you’re voting proxies for a client and you are conflicted in some way, either through a family relation or a large client who works at that issuer, or if you’re referring affiliates. These conflicts of interest can sneak into almost every decision that the adviser makes, even just how you dedicate your time in the day among your various clients, based on the fees that they pay.

Mr. Hamburger: What makes it most difficult to identify conflicts of interest is perspective, because an adviser starts with the perspective that they’re out to do the right thing. In their minds, they would never act in an improper way. That doesn’t change the fact that some things are a conflict of interest. It’s very difficult for professionals to look at their own business with that type of critical eye.

PRICING ETFS

InvestmentNews: We spoke to one adviser who uses ETFs a lot. ETFs are priced like stocks, so when a position is sold, all the customers don’t get the same price. A three-second difference could mean a different price. And the SEC examiner was saying, “You have to get the same price for all your clients.” How would they deal with that?

Mr. Hamburger: There are various methods for dealing with that particular problem. Many broker-dealers and custodians allow advisers to buy their overall allocation in the aggregate, batch the orders, buy it once, and then within a certain period of time, typically by the end of the business day, allocate those shares to the various client subaccounts so that all clients do indeed get the average price that’s being paid. But if an adviser lacks that capability, then their policies and procedures have to state their methodology for allocating those trades. Perhaps it’s done on a rotating basis in terms of who buys first. But the SEC demands that it’s done in a fair and equitable manner.

Mr. Schwartz: The Part 2 instructions now require an adviser to disclose its allocation and aggregation processes within the ADV. So clients will be aware of whether that process is average price, rotation or random, and examiners can, over time, see that no one client was advantaged or disadvantaged.

SWITCHING TO STATES

InvestmentNews: Many advisers now will come under state regulation. How is that going to change things?

Mr. Hamburger: Advisers will find that there are myriad regulatory standards in place among the various states. Some states have regulatory examination programs that rival, if not surpass, the standards that are set by the SEC, while many others have virtually nonexistent programs. So it remains to be seen what the effect is. Some states certainly are more prepared than others.

Mr. Schwartz: The states are really not in a much better situation financially than the federal government is. So the states have a couple of options. One is to simply do cursory examinations or to impose some type of user fee, perhaps, on their state registrants that’s much more material than what it is now in order to fund an examination program. We know that when Dodd-Frank goes into effect in July, the states have to certify to the SEC whether or not they have an examination program.

For the states that can’t certify that they have a reasonable examination program, either the SEC won’t give those registrants to the states or the states may simply say, “Hey, we’re going to let the feds handle this.”

Mr. Hamburger: States want to be able to show that they do have an examination program in place. However, a few of those states think that an adequate examination program is simply a one-page questionnaire sent out to advisers at the time of their state renewals simply saying, “Please respond to this.” That’s their examination. So I think you’ll continue to see widely varying standards among all the various states as to what they deem to be an effective examination program.

InvestmentNews: Could you define what the SEC might deem a higher-risk RIA firm?

Mr. Hamburger: We remain very skeptical that the SEC has scientifically calibrated or come up with a quote, unquote, “risk-based” examination program. We think they are collecting more data. We think they may vary their examination schedule somewhat, based on that, and have different items of focus. However, we’re not seeing them utilize a risk-based approach nearly as much as the current rhetoric would have you believe.

Mr. Schwartz: To answer the question specifically — how do you find a higher-risk adviser — it might be identifying advisers using an accounting firm that the SEC knows has a particular problem. They now instantly can find each adviser that uses that same accounting firm, even down to the offices of where those accounting firms are.

They can find out whether your surprise verification is, in fact, not a surprise because it’s the same month entered into your ADV time after time.

Those are a couple of examples where the SEC is gauging risk in the industry better. But what creates a high-risk adviser? It’s either because they engage in higher-risk practices, such as using soft dollars outside of the safe harbor of 28(e) or they have an affiliated broker-dealer and commissions tend to be higher than they could get at an unaffiliated broker-dealer — things that really create a conflict of interest.

Or it’s because the SEC looks at a firm that’s typical, yet its compliance program is so weak that the SEC can’t trust it and has to dedicate more oversight resources to what otherwise would be a plain-vanilla investment adviser.

InvestmentNews: How do you handle the conflict of using just one custodian? Is there a best-execution issue?

Mr. Hamburger: Best execution does not necessarily mean best price or fastest execution. Most advisers who have thought this through define best execution to include a lot of qualitative features that help them justify why they would be using a single broker-dealer or custodian. When you start to define best execution in its broader sense, it’s an easy justification to make.