Setting rules for outside exams

SEC chairwoman Mary Jo White has endorsed the idea of using third-party examiners to increase the frequency of compliance exams for registered investment advisers. It is a good solution for a widely acknowledged problem, but any plan to allow outside testing firms to conduct RIA exams must be implemented wisely if it is to succeed.
The lack of adequate oversight of RIAs is well-known and has been a long-standing problem. Only about 10% of the nation’s 11,500 RIAs are tested each year, despite the fact the SEC has a staff of 450 devoted to RIA exams.
For years, the SEC has pleaded with Congress for more funding to hire additional examiners. This year, legislators added $150 million to the agency’s budget, and some of that money will be used to hire more examiners. But the SEC said it was not nearly enough.
(More: SEC investor advocate opposes third-party adviser exams)

FUNDING LEVEL

By coming out in favor of allowing RIAs to hire outside examiners, Ms. White is finally acknowledging that — whether for ideological or fiscal reasons — Congress is not likely to fund the SEC at the level it has requested the past several years, the level it claims it needs to significantly increase RIA exams.
Ms. White made it clear that outside examiners would augment the SEC staff conducting exams, not replace them. One would think that the SEC would want to focus on bigger, more complex firms, but Ms. White did not give any details on how the SEC and outside examiners would divide the work.
There are a couple of other things that should be kept in mind as the SEC begins shaping a formal proposal.
The first is cost.
Each SEC examiner now conducts about three or four exams a year. That translates to the agency’s spending in the neighborhood of $25,000 in salary alone on an exam, according to back-of-the-envelope estimates. That may not be a lot for an RIA with $1 billion or more in assets under management, but it is for one with $100 million in AUM. Of course, those expenses probably would be passed along to clients — not a positive outcome for investors.
As the SEC moves toward outsourcing, it is time for the agency to take a hard look at its exam process and consider ways to streamline it. When you have a pool of 11,500 firms that need to be tested every two to three years, each exam can’t take three to four months. Coming up with a newer version that takes no more than three to four weeks makes more sense and will be less expensive. That’s especially important if RIAs are going to pay for the exams themselves.

POSSIBLE CONFLICTS

Another concern has to do with the outside testers who will be conducting the exams. If they are paid by the firms they’re examining, there could be conflicts of interest. Will an RIA put pressure on an examiner to go easy on the firm, exploiting the fact that it is paying for the exam? Will a testing firm itself make the decision to go easy on a firm because it wants to be hired again?

The SEC will have to monitor examiners closely to make sure they are conducting the exams impartially, without fear or favor. In fact, the agency should consider creating a pool of examiners and assigning them to the exams itself, taking the choice out of the hands of RIAs.

It is clear that the SEC still has a lot of work to do to flesh out an actual plan for outsourcing.

“This is not an easy road, not a quick road,” Ms. White said when she announced her support for the idea. But it is a road worth going down, given the goal of increased protection for the American investing public.