Financial Services: The SEC’s ‘Top 10′ compliance issues

By James J. Eccleston
Shaheen, Novoselsky, Staat, Filipowski & Eccleston

Recently, the Securities and Exchange Commission revealed its current examination priorities for investment advisers. Speaking before the 10th Annual IA Compliance Best Practices Summit, Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations, detailed the ”Top 10” issues. Let’s explore each of these.

Preliminarily, a shortage of SEC staff examiners to oversee nearly 11,000 investment advisers has forced the commission to adopt a risk-based approach to examining investment advisory firms. Nonetheless, the SEC is quick to point out that it continues to conduct random examinations. The SEC recently has emphasized that it ”targets” newly registered investment advisers, and is interested in determining the adviser’s ”risk-assessment process.”

1. Controls over valuation. Valuing securities is a Top 10 issue because clients need to know the value of their investments. Advisers should not overstate the value in order to overcharge their investment advisory fees. The SEC particularly wants to ensure that an advisory firm has ”controls and is implementing those controls when pricing structured products, illiquid securities or other difficult-to-price securities.”

2. Controls over non-public information/personal trading/code of ethics. Richards revealed that the instances of suspicious trading have increased. She states that, generally, examiners will focus on ”whether a firm has identified the source and type of non-public information that they and employees may be privy to, whether the firm has crafted and implemented adequate procedures to maintain the confidentiality of that information, and is implementing those procedures.” The SEC also will inquire as to ”whether the firm has guidelines with respect to when and to whom it will provide information, for example, information about its portfolio or its trading.”

3. Dealing with senior investors. Protecting seniors is a high priority at the SEC. According to Richards, the SEC is focusing on: ”marketing and advertising to seniors; account opening; product and account review; ongoing review of the relationship and appropriateness of products; discerning and meeting the changing needs of customers as they age; surveillance and compliance reviews; and training for firm employees.”

4. Compliance and supervision. Advisers must tailor their programs to identify and effectively mitigate their particular compliance risks and conflicts of interests. According to Richards, the conflicts that the SEC is seeing ”include new revenue-sharing payment streams from advisers to broker-dealers for obtaining space on the broker-dealers’ ‘recommended adviser’ lists, and other undisclosed compensation and gifts for business (e.g., to solicitors, fund consultants, and municipal consultants).” The SEC also is examining for adequate supervision of ”dispersed offices and independent advisory contractors.”

5. Portfolio management. The SEC continues to review whether investment recommendations are consistent with the adviser’s disclosures and the client’s investment objectives and restrictions. More recently, the SEC has focused on ”client investments in structured products and other complex derivative instruments.”

6. Brokerage arrangements and best execution. Investment advisers owe fiduciary obligations to their clients. Fiduciary obligations include seeking the best execution for trades and ”periodically and systematically” evaluating the costs and benefits of their brokerage arrangements. Along those lines, the SEC is examining for ”any inappropriate and/or undisclosed use of soft dollars for the benefit of the adviser, and use of any affiliated or preferenced broker-dealers for excessive commission payments, kickbacks to the adviser, or other undisclosed arrangements.”

7. Allocation of trades. Advisers must disclose their policies and procedures, and test them for fairness in allocating IPOs, block trades, and investment opportunities among clients and proprietary accounts.

8. Performance advertising, marketing, and fund distribution activities. Advisers must ensure that their claims about past performance, their advertisements, and marketing materials contain accurate information.

9. Safety of clients’ and funds’ assets. The SEC is interested in whether funds and investIllegal ‘X-value’ for character STYLs voided here ment advisers have ”effective policies and procedures for safeguarding their clients’ assets from theft, loss and misuse.” Notably, Richards said that examiners ”assess whether there is a process for regularly reconciling client and fund balances of securities owned with those shown by custodians and ensuring that the books reconcile.”

10. Information processing and protection. This large examination area covers required books and records, disclosures, and filings. It includes effective policies and procedures for capturing, compiling, and maintaining e-mail and instant messages. The SEC ”will be looking for controls that protect this information from hackers or other unauthorized persons, and from being destroyed in a disaster as part of the firm’s business continuity plan.”

As one can see, investment advisers face a great deal of scrutiny in complying with SEC requirements.