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SEC Revises Examination Hotline: Commission Responds to GAO study


The Securities and Exchange Commission has revised its examination hotline system, at 202-551-EXAM, following a 38-page Government Accountability Office study analyzing its examination procedures.

The hotline, previously lodged in the chief counsel office of the SEC's office of compliance inspections and examinations, now gives callers the option of speaking with that office or with the office of the inspector general.

This move stems from the GAO's recommendation that the SEC relocate the hotline to an independent office. However, the SEC issued only a preliminary response to another important recommendation of the GAO report.

The GAO recommended that the SEC, which now focuses more on frequent routine examinations of investment advisers at "higher risk" for compliance issues, incorporate information on the strength of a firm's compliance controls in its risk assessment. Since 2004, registrants have been required to prepare compliance reports and maintain them onsite, but those reports needn't be filed with the SEC.

Obtaining those reports, the GAO notes, would require SEC rule making.

"We continue to believe, however, that using these reports outside of the examination process could potentially allow OCIE to improve its ability to identify higher risk firms," the GAO stressed.

The SEC "is continuing to identify and consider other sources of information and data that could assist us in further refining our risk-based program, including compliance reports of investment advisory firms," responded Lori Richards, the SEC's OCIE director.

The GAO report, "Securities and Exchange Commission: Steps Being Taken to Make Examination Program More Risk-Based and Transparent," was unveiled on Sept. 12 by Rep. Vito Fossella (R-N.Y.), and Rep. Spencer Bachus (R-Ala.), the ranking member of the House Financial Services Committee.

The analysis, conducted between October 2006 and July 2007, covered fiscal years 2003 to 2006. It is designed to analyze SEC examinations in the wake of the mutual fund trading scandals. During the period examined, the SEC radically changed from examining all registered investment companies and advisors at least once every five years to only "higher-risk" firms onsite every three years. In addition, a small random sample from the remaining 90% of the "lower risk" firms is examined annually. The new examination system gives higher priority to "sweep" examinations, targeting specific activities across firms, and "cause" examinations, targeting known problems at an individual firm.

The report cites the growth of investment advisors for the change in procedures, as well as the old system's inefficiency in detecting compliance problems.

But the effectiveness of this newer system depends largely on the accuracy of the SEC's risk assessment procedure. So far, the report indicated, that may need more work.

Based on fiscal year 2006 data, OCIE's assessment shows a 91% accuracy rate for predicting lower-risk ratings, but a lower accuracy rate when considering newly registered investment advisors. The accuracy rate for higher-risk firms was 25%, "in part because the risk-rating did not incorporate information on the firms' ability to mitigate the compliance risks identified," the report said.

"Continued assessing and refining the risk algorithm is warranted," it declared.

The OCIE began assigning risk ratings to investment advisors after evaluating compliance controls through routine examinations. But 70% of registered investment advisors have not yet received this evaluation. Nor have more than 4,500 registered investment advisors since fiscal year 2004 been examined. As a result, the OCIE has been using "proxies" for risk in a database. Examples of public information it considers might include participation or interest in client transactions, managing portfolios for individuals and receiving performance fees, the report said.

OCIE determines the risk profile of all registered investment advisors every year using a risk algorithm. Those designated high-risk get examined. Some 10% of registered investment advisors have a higher-risk designation.

"Because only a small number of low-risk firms are selected for routine examinations in a year, improperly categorizing investment advisors as lower-risk could lead to harmful practices not being detected on a timely basis," the report warned.

The report carefully examined widespread concerns by representatives of investment companies, investment advisors and broker/dealers, that they went unnotified when certain types of examinations were completed.

Registrants complained that the inability to determine early on the outcome of an exam hindered their ability to address deficiencies immediately. It also prevented them from being able to clarify any potential misinterpretations by examiners of a firm's policies, procedures and practices before a deficiency letter is sent, the GAO study said.

Exit Interview

Under current rules, registrants are entitled to an "exit interview" in which they learn of any deficiencies and a "closure letter" detailing the outcome. There are certain exceptions. One, for example, included the sweep examinations for market-timing and other new high-risk compliance issues.

The data showed that examiners were largely following the rules. The report estimated exceptions to the rules at just 9% of investment company and investment advisor exams and 7% of broker/dealer exams.

It noted that the SEC, since January 2006, implemented the exam hotline and added a new procedure that requires registrants to be notified of the status of an exam when it extends 120 days beyond the onsite visit.

Many, though, hesitate to use the hotline, citing the lack of independence of the hotline's staff. Some also said that the hotline system failed to satisfy concerns about rule interpretations during an examination. Consultation, it reported, was necessary with the market regulation department before the exam was officially over or a deficiency letter was sent. Another group complained that the OCIE was unresponsive to past concerns.

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