Most investment advisors face SEC audits and examinations with dread. After all, the SEC has beefed up its registered investment advisor (RIA) exams in the past year or so, increased its inspection budget and is working towards increasing the number of examiners on staff. These days, RIAs have a lot more rules to follow too: They must maintain a written compliance manual, complete an annual compliance review and keep a code of ethics (among many other things). What’s more, most exams—a full 80 percent in 2006—result in deficiency letters or requests for correction.
Certainly, there is no shortage of potential problem areas for regulators to look into. In a speech to advisors in March 2007, Lori Richards, director of the Office of Compliance Inspections and Examinations, told her audience that this year, SEC examiners would be looking closely at possible insider trading activities, brokerage arrangements, best execution and soft dollars, allocations of trades (a.k.a. "cherry-picking"), personal and proprietary trading by advisors, pricing and valuation, controls to prevent the theft of client funds and information, and supervision.
Still, some wealth managers say they have been surprised to find that if you are, in fact, well prepared, and take compliance seriously, there is very little to worry about.
“When it was all done, it was the total opposite of what I was anticipating,” says Gary Rathbun, president of Private Wealth Consultants, whose offices were recently graced by a pair of SEC examiners. “I was expecting people to come in with real attitudes, question every little thing we did, because we have discretion over almost all client accounts. I was just prepared for battle.” The exam itself lasted 20 hours, and he asked all of his employees to stay overtime at the office. But the examiners were very professional and polite, quickly realized he ran an honest shop and when they were all done, told him he wouldn’t see them for another three to five years.
“If you’re well prepared, there’s nothing to worry about,” he says. “The key is documenting and disclosing everything.”
Of course, Rathbun says his firm, which manages several hundred million dollars, does run a tight ship where compliance is concerned. They document every contact they make with a client, and they have a full-time compliance officer on staff. While he says it’s hard to calculate the total compliance cost to his firm because of all of the time put in by various employees, he estimates that it adds up to around $50,000—not including his compliance officer’s salary. For a boutique firm like his, that’s quite a lot.
Examiners did find a few snags for Rathbun’s firm to fix. Though it has a business continuity plan, it had never done a dry run—something he’s scheduling now. Also, because the firm does block trades for clients through Schwab, and offers the same price to everyone regardless of the number of shares the client wants to trade, some clients are getting a slightly better price per-share than others. So his firm had to add disclosure of this practice to its Form ADV. Still, Rathbun says the examiners told him they write up every advisor that custodies with Schwab on this point because so many of them do similar block trades on Schwab’s platform.
There are a few other things RIAs should make sure they’ve got in order before an exam. Rick Cortese, vice president of consulting and executive director of National Regulatory Services, says that the most common deficiencies that the SEC is finding in its examinations are problems with risk assessment and annual compliance reviews, performance advertising and disaster recovery or business continuity plans. “I think they found significant deficiencies in how firms conducted annual compliance reviews,” says Cortese. “Whether the firm’s policies and procedures addressed the firm’s risks, and whether they had undertaken a sound risk assessment process. They also certainly looked at whether firms were including or omitting relevant disclosures to ensure ads were not misleading, as well as inadequate disclosure of soft dollars and compensation arrangements, among other things.”
Ultimately, though, a deficiency letter is not the end of the world. It often requires nothing more than a bit of tweaking to your compliance policies. It is enforcement referrals you should worry about. But very few SEC examinations find violations that are serious enough to warrant enforcement referrals: just 6 percent in 2006. According to the annual report from the Office of Compliance Inspections and Examinations (OCIE), the most common problems referred to enforcement were related to: conflicts of interest, misleading performance calculations; Form ADV/Brochure disclosure and delivery; internal controls; brokerage/execution practices; personal securities transactions; material compliance program concerns; and books and records.