The Securities and Exchange Commission is taking a closer look at registered investment advisers. Last year the SEC began considering a proposal from former commissioner Daniel Gallagher to allow third-party firms to provide regulatory examinations of RIAs. Then in January, through the release of its examination priorities for 2016, the SEC signaled that it would be using what resources it had to put the industry under more scrutiny. No matter who’s doing the exams, industry observers have concerns about enforcement as well as the consistency of the process.
“The recent tension we’ve seen, where OCIE [the SEC’s Office of Compliance Inspections and Examinations] is more willing to go to the enforcement division if they find something during the examination process, is a real thing,” says Derek Steingarten, a New York–based partner with the investment management practice at law firm K&L Gates. “That said, they’ve also been much more transparent about going into detail on the examination process. So in some sense parties should be aware of what they need to have in place from a compliance perspective prior to an examination.”
The commission has been trying to improve examination of investment advisers since the 2008–’09 financial crisis. By its own admission, it examines about 9 percent of advisers in the industry each year. This means that an RIA can expect to be reviewed once over a five- to ten-year period, but in some cases a review never happens.
The SEC has asked Congress for more money, and the idea of filling the gap by charging a user fee for exams has been floated, but neither option is likely to yield enough cash to boost examinations in a meaningful way. Congresswoman Maxine Waters, the California Democrat who last year introduced a user fee bill that stalled in committee, stands by the concept, however. “I continue to support a modest fee on investment advisers to increase SEC examinations in a way that is both protective of investors and cost-effective for taxpayers,” Waters says. For its part, the RIA industry has pushed back hard against the idea of a Financial Industry Regulatory Authority–style body that could manage exams.
Now the SEC, which declined to comment on policy considerations for this story, is looking at letting third-party examiners take over. Later this year it’s expected to release a draft proposal for opening up examinations to such providers. The highly anticipated proposal will be the first step in creating a process for third-party examiners, and the investment adviser industry has questions.
“The idea of having third-party companies do an exam is a politically elegant solution,” says Todd Cipperman, a securities lawyer and founding principal of Wayne, Pennsylvania–based Cipperman Compliance Services, which provides compliance consulting and outsourced chief compliance officer solutions. “By going with a third party, taxpayers aren’t on the hook for more funding, and investment advisers would be on the hook for their own examination costs.”
Requiring a third-party examiner would be similar to the rule mandating that public companies have their financial statements independently audited, and an exam could fit easily within the compliance review that RIAs must already undertake each year, Cipperman contends.
Daniel Bernstein, chief compliance attorney at MarketCounsel, an Englewood, New Jersey–based adviser to RIAs, isn’t so sure. The timeline before the industry sees a proposal is likely to be extended beyond the end of this year, and the comment period will be rife with tension, Bernstein predicts. “I think there are a lot of questions to be answered here,” he says. “How do you vet the examiners and ensure quality? What will the questions be? This is going to be a long process.”
Supporters of the proposal, like Skip Schweiss, TD Ameritrade Institutional’s Denver-based managing director of adviser advocacy and industry affairs, say that if the rules keep the examinations narrowly tailored and objective, the SEC could mitigate the risk that the process becomes murky or lacks rigor.
“We think the examinations should focus on clearly objective topics, like asset verification, that are also narrow in scope,” Schweiss explains. “I call them smoke detector exams: If I smell smoke while I’m going through the building, then I’m going to call the fire department.”
Compliance consultants have suggested that a whistle-blower mechanism could be put in place if an area of material weakness is found and raised by a third-party examiner and if senior management doesn’t fix the issue. But the role that third parties could play in enforcement is unclear. During a financial statement audit, for example, accountants may bring up areas of weakness they find in a statement, or even refuse to sign off on an audit, but that doesn’t limit an entity from going out and finding an auditor who will sign.
There’s also potential for embedded conflicts of interest if third-party examiners that also happen to be accountants or consultants are allowed to pitch other services. “One of the questions I have about this is how the relationships would be managed,” says Mitch Kraskin, founder and CEO of New York–based Compliance Science, which provides compliance technology consulting and solutions. “If you have firms coming in and pitching exam services that are also doing the audit, that could create perverse incentives.” Compliance consultant Cipperman also notes the possibility that larger professional services firms would get into the examination business as part of a broader compliance offering they can pitch to advisers.
New technologies available to the financial services community could make enforcement easier for providers and the SEC, Kraskin suggests. “You could do something where there is a flag embedded in the examination file if it is delivered electronically, for example,” he says. “I think there are more scalable ways to improve coverage beyond just adding more examiners if we bring more of the process online.”
Despite questions about process and enforcement, third-party examiners will probably become the norm for investment advisers, absent a big cash infusion from the federal government to the SEC. Once the commission releases its proposal, the industry can provide feedback.
Cipperman and others expect those comments to focus on standards that will make the examination process consistent. “I can tell you empirically that I don’t see massive fraud in the RIA community,” he says. “I think you have seen some weakness in procedure, and if this process tightens that up, it will ultimately be better for the industry.”
