SEC Exams to Focus on Executive Outlook
October 27, 2003
NEW ORLEANS - Regulators at the Investment Company Institute's Operations Conference here, in the crescent city, said they will be focusing more on electronic communications and management's attitude towards internal controls as they go forward, in an attempt to be more proactive in examining firms' internal controls.
For months, Securities and Exchange Commission Chairman William H. Donaldson has been preaching to fund companies and others in the financial services community to change the "tone at the top," or management's attitude towards internal controls and compliance. Investor confidence had been depleted through the combination of a three-year bear market and numerous shenanigans at many of the nation's largest companies, but the commission's push to regulate attitudes left some skeptical as to the practicality of such subjective criteria.
However, John Walsh, chief counsel of the office of compliance inspections and examinations at the SEC, along with the rest of the panel on "How to Prepare For an SEC Examination," made it clear that Donaldson's warning was not just rhetoric or done for appearance sake. "Our chairman has challenged us to be more proactive and not to wait until after people firm's get hurt," Walsh said. He added that the SEC will look at a firm's "risk profile" and how effective management is at maintaining control over its own company.
He said the move towards increasingly more transparent methodology and a risk-based approach is not a revolution in the SEC's thinking, but more of an evolution in philosophy.
With mutual funds present in nearly half the homes in America, and the industry in the midst of a potentially confidence-crippling scandal, it is a critical time to convey to the fund executives that tone at the top will, in fact, be a real focal point for examiners. Walsh said that in order to assess the tone at the top, examiners will focus on four areas: reports, attention to compliance, management statements and leading by example.
The staff will look at what kinds of reports are personally reviewed by the executive suite of a firm. "The worst kind of reporting a firm can have is the kind that stops halfway up," Walsh said. Attention has to do with time and resources dedicated to the compliance department. Inspectors will take particular note of whether or not top-level executives have regular meetings with their compliance department and devote adequate time to this issue.
Executives' statements and their ability to lead by example will also be taken into consideration. "That's a good yardstick for us to look at," he said. The best way to avoid being thought of as a company that needs extra attention from the SEC's staff, he continued, is simply not to fight the new initiative, but to thoroughly clean up areas that need to be tidied, as well as tightening up loose ends in other cogs of the business.
The staff's new approach will also give firms an incentive to keep business and compliance departments in good working order. Those that have major deficiencies and failing grades will be much more likely to undergo additional and more frequent examinations by the SEC in the coming months and years.
However, firms will not be given any real room for relaxation, as they will not be told how they were graded on the examination. They will be given a letter outlining areas of deficiency, but will not be told their exact score, as to keep them on their toes and to never be satisfied with the status quo since they could be given the SEC equivalent of a pop-quiz on short notice. This approach, in theory, will lead firms to constantly work to improve controls. However, Walsh said that no firm should be misled by the absence of a grade, because weaknesses are clearly spelled out in the information contained in a deficiency letter.
"You get a lot of keys from what they say," said Kenneth Gorvetzian, vice president and senior counsel for the fund business management group at Capital Research Management Co., advisor to the American Funds family.
Gorvetzian said his firm recently underwent an SEC examination and that it prepared by reviewing its own records, identifying problems and then rectifying them. The firm also reviewed deficiency letters from the past. He said that it is wise to alert the SEC to problems that were found during internal reviews and that it is important to do this up front in order to establish trust and good faith.
"The worst thing you can do if you have a problem, is to try to hide it," Walsh said. "The trust factor is gone at that point. We will then start to worry about things we shouldn't be worrying about."
Another area that will draw increased scrutiny in the examinations is electronic correspondence, specifically e-mail, Walsh said. The SEC is already modifying its procedures in this area, he said. "E-mails became notorious last year during the Wall Street analyst action," he said, referring to the record-setting $1.4 billion settlement from the Street's Big 10 analyst firms. In fact, in New York State Attorney General Eliot Spitzer's investigation into mutual fund trading practices, e-mails from no other than Richard Garland, Janus International's chief executive officer, caught him red-handed giving the go-ahead to arbitrageurs.
From the tone and words that Walsh used, fund firms can come into compliance the easy way, which would be by sharing information and cooperating with the SEC, or the hard way, which would involve frequent visits and involvement by regulators. Either way, the SEC's compliance initiative is obviously not just rhetoric.
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