Review of SEC’s Process for Selecting Adviser Examination Targets

Review of the Commission’s Processes for Selecting Investment Advisers and Investment Companies for Examination

To continue the Madoff dogpile on the SEC, the SEC’s Office of Inspector General released a report criticizing the SEC’s process for selecting investment advisers and investment companies for examination.

Review of the Commission’s Processes for Selecting Investment Advisers and Investment Companies for Examination pdf-icon

As a result of OCIE never having examined Madoff’s investment firm, the Inspector General conducted this review to determine OCIE’s rationale for not performing an examination of Madoff’s investment advisory business. They came up with 11 recommendations:

Recommendation 1:

The Office of Compliance Inspections and Examinations (OCIE) should implement a procedure requiring, as part its process for creating a risk rating for an investment adviser, that OCIE staff perform a search of Commission databases containing information about past examinations, investigations, and filings related to the investment adviser.

Recommendation 2:

The Office of Compliance Inspections and Examinations (OCIE) should change the risk rating of an investment adviser based on pertinent information garnered from all Divisions and Offices of the Commission, including information from OCIE examinations and Enforcement investigations, regardless of whether the information was learned during an examination conducted to look specifically at a firm’s investment advisory business.

Recommendation 3:

The Division of Enforcement and the Office of Compliance Inspections and Examinations should establish and adhere to a joint protocol providing for the sharing of all pertinent information (e.g., securities laws violations, disciplinary history, tips, complaints and referrals) identified during the course of an investigation or examination or otherwise.

Recommendation 4:

The Office of Compliance Inspections and Examinations (OCIE) should establish a procedure to thoroughly evaluate negative information that it receives about an investment adviser and use this information to determine when it is appropriate to conduct a cause examination of an investment adviser. OCIE should ensure its procedure provides for timely opening of a cause examination.

Recommendation 5:

When the Office of Compliance Inspections and Examinations (OCIE) becomes aware of negative information pertaining to an investment adviser, OCIE should examine the investment adviser’s Form ADV filings and document and investigate discrepancies existing between the adviser’s Form ADV and information that OCIE previously learned about the registrant.

Recommendation 6:

The Office of Compliance Inspections and Examinations (OCIE) should establish a procedure to thoroughly evaluate an investment adviser’s Form ADVs when OCIE becomes aware of issues or problems with an investment adviser. OCIE should document areas where it believes a Form ADV contains false information and initiate appropriate action, such as commencing a cause examination.

Recommendation 7:

The Office of Compliance Inspections and Examinations (OCIE) should re-evaluate the point scores that it assigns to advisers based on their reported assets under management. OCIE should assign progressively higher risk weightings to firms that have greater assets under management.

Recommendation 8:

The Office of Compliance Inspections and Examinations (OCIE) should re-evaluate the point scores that it assigns to firms based on their reported number of clients to which they provide investment advisory services. OCIE should assign progressively higher risk weightings to investment advisers that serve a larger number of clients.

Recommendation 9:

The Office of Compliance Inspections and Examinations (OCIE) should recommend to the Chairman’s office that it institute a Commission rulemaking that would require the following additional information to be reported as part of Form ADV:
• Performance information;
• A fund’s service providers, custodians, auditors and administrators, and applicable information about these entities;
• A hedge fund’s current auditor and any changes in the auditor; and
• The auditor’s opinion of the firm.

Recommendation 10:

The Commission should finalize the proposed rule titled Amendments to Form ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the Commission should consider what, if any, additional information investment advisers should include in Part II of Form ADV by consulting with the Office of Compliance Inspections and Examinations (OCIE) and the Division of Investment Management (IM). Further, the Commission, in consultation with OCIE and IM, should consider provisions that would assist OCIE to efficiently and effectively review and analyze the information in Part II of Form ADV.

Recommendation 11:

The Office of Compliance Inspections and Examinations (OCIE) should develop and adhere to policies and procedures for conducting third party verifications, such that OCIE verifies the existence of assets, custodian statements, and other relevant criteria.

This is now the fourth report the SEC’s OIG has issued as a result of Madoff, following up on:

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