July 22, 1996
TO: COMPLIANCE COMMITTEE No. 19-96
INVESTMENT ADVISER ASSOCIATE MEMBERS No. 23-96
INVESTMENT ADVISER MEMBERS No. 25-96
RE: SEC OFFICIAL’S SPEECH REGARDING INVESTMENT ADVISER
EXAMINATIONS
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Lori Richards, Director of the SECs Office of Compliance Inspections and Examinations
(OCIE), recently delivered a speech regarding investment adviser examinations, focusing on
the changes that have been made to OCIEs examination program over the past year.
Significant aspects of her speech are summarized below and a copy is attached.
Scope of Exams
In an effort to maximize its resources, the OCIE has shifted away from conducting
cyclical, comprehensive exams of every part of an advisers operations towards a more focused
review of "critical" issues. What are deemed to be the critical issues will vary, depending on the
type of adviser being examined. Richards stated that generally examiners will spend more time
on the areas of the advisers operations where deficiencies or violations have been noted in the
past, areas of importance to the adviser, areas where internal controls appear to be weak and
areas where clients appear to be most exposed to potential conflicts of interest.
Richards explained that the shift from a one-size-fits-all approach to a variable scope
approach is part of the shift towards what she called "smart exams." These exams are intended
to work as follows: once an adviser is selected for examination, the examiner will begin
preparing for the exam by reviewing the advisers filings with the Commission, past inspection
history, customer complaints received by the Commission and other relevant materials; the
scope of the examination is then determined by two variables -- what the staff knows about an
entity before they begin and what they learn while the exam is in progress -- and largely
depends on the examiners professional judgment of an advisers own internal controls. The
more confidence examiners have in an advisers own compliance and internal control systems,
the more they will waive routine examination procedures. The customized or "smart exam"
approach is intended to be fully implemented within the coming year.
Selection of Advisers To Be Examined
Richards reported that rather than continuing to use a purely cyclical approach, the
OCIE has overlaid other considerations into its cycle to focus on those firms that present the
most risk to investors. She stated that, "The single most important criteria in determining risk
and therefore priority of examination for advisers is access to client money." In this regard, she
stated that advisers with discretionary authority over investments, custody of assets or large
amounts of money under management (e.g., non-discretionary management of $100 million or
more), pose the greatest risk. To better ensure examination of these advisers, they are now the
responsibility of the regional offices. Dividing the inspection program in this manner should
reduce the inspection cycle for these advisers from twenty years to eight to ten years. She
hopes to reduce the cycle even further to once every five years after the new staff that the OCIE
was recently allocated becomes available. Advisers not in the higher risk category are now
being inspected in joint sweep examinations conducted with state securities regulators.
Factors Triggering More Frequent Exams
Richards stressed that the risk-based selection will not replace cyclical exams; rather,
application of certain risk factors will assist examiners in determining whether an adviser
should be examined more frequently than allowed by the cycle. These risk factors include: the
size of the adviser; the number of clients; the advisers business; the length of time the adviser
has been registered; the advisers prior exam history and results; its disciplinary history; its
customer complaints; its affiliated persons; its advertising and performance claims; and
information obtained from other regulators, including, among others, self-regulatory
organizations and state securities regulators.
With respect to advertising and performance claims, Richards stated that this summer
the OCIE will be targeting for examination the "more successful money managers" and, as part
of these exams, will pay particular attention to their performance claims. In this regard, it
appears that the OCIE will focus on those advisers who "claim to have generated large short-
term profits for clients that are substantially in excess of their peer group" and, consequently,
"are the advisers that are winning frequently in selection contests, and are rapidly growing
their money under management."
Examination of "Trading Practices"
Richards identified several items that fall under the broad topic "trading practices" that
the staff is paying particular attention to this year. These practices include: allocation of trades,
including allocation of bunched orders; the level of individualized treatment being provided to
clients, to evaluate whether accounts are being managed like an investment company; soft-
dollar arrangements; principal transactions, to ensure that the adviser is obtaining client
consent before completing the transaction; and, personal trading conflicts.
Amy B.R. Lancellotta
Associate Counsel
Attachment
Note: Not all recipients of this memo will receive an attachment. If you wish to obtain a copy
of the attachment referred to in this memo, please call the Institute’s Information Resource
Center at (202)326-8304, and ask for this memo’s attachment number: 8078.