With a huge growth in the number of investment advisers over the last several years, the SEC’s inspection program has not been able to keep up: the current exam cycle is about seven years if examiners were to review every investment adviser, potentially leaving investors vulnerable. And a proposed solution to fix this problem could translate into more revenues for accounting firms.
Worried that outright fraud or abusive practices might not be detected or prevented, the SEC’s Investor Advisory Committee (IAC) on June 22, 2023, voted to provide a set of recommendations for the commission to consider, among other measures, establishing a third-party exam program, to supplement the staff’s compliance reviews.
In particular, an outside firm—such as accounting, law or consulting firm—could perform the exam, and a copy of the results would be submitted to the SEC.
“This approach could be structured to leverage the expertise of the private sector but maintain critical SEC oversight of advisers,” according to a draft of the IAC recommendation. “There are many organizations, including accounting, law and consulting firms that provide compliance reviews or mock audits for investment advisers and they have experience in assessing the effectiveness of compliance programs. The SEC has clear statutory authority to impose such a requirement and has used this authority to require registered advisers that have custody of customer assets to have surprise annual audits to verify assets.”
Because there are several issues that need to be addressed for it to work, the IAC recommended that the SEC first start with a request for comment. And if feasible, the commission could propose and adopt a third-party exam program.
Since 2016, the number of SEC-registered investment advisers has increased 25 percent to over 15,000, advising 65 million clients. The growth far outpaced the increase in the number of SEC staff. In 2022, the SEC’s Division of Examinations reviewed about 15 percent of registered investment advisers. The commission does not have enough resources to cover all of them, and the division examines advisers based on a risk assessment. Moreover, if Republican lawmakers get their way, the commission will get its budget slashed. (See House Appropriations Panel Advances Bill ‘Drastically Underfunding’ SEC in the June 23, 2023, edition of Accounting & Compliance Alert.)
Along with the third-party exam option, the panel asked the SEC to request legislation from Congress that would authorize the Division of Examinations to impose user fees on investment advisers. The SEC would use the revenues to enhance its investment adviser exam program.
The IAC also recommended support for efforts by the North American Securities Administrators Association (NASAA) to enhance adviser compliance programs.
One IAC member voted against the recommendation. Leslie Van Buskirk, administrator, Division of Securities of the State of Wisconsin Department of Financial Institutions, emphasized that she supports other parts of the recommendations except for the third-party exam.
“I think it’s indisputable that the SEC is in dire need of more money to do more exams so that they can have a higher percentage of IAs examined every year. And I fully support this recommendation in regard to the user fees and in regard to the support and enhanced advisor compliance program,” Van Buskirk said. “However, with great respect, I strongly object to the idea of delegating an essential governmental regulatory function to a non-governmental third party.”
She cited significant cost in setting up the program and then supervising third-party examiners. In her view, the money would be better spent on hiring and training additional examiners and investing technology within the SEC.
“The inherent conflicts of interest and the risks of a check the box mentality are likely to result in less trustworthy exams if delegated to third parties,” she explained. “I strongly object to the use of third-party examiners in any area that would require the exercise of discretion or judgment, or the interpretation of policy or law. I have been a securities regulator for over 20 years now. I personally witnessed how even when designed by regulators with the best of intentions, in reality, the implementation of these programs, which outsource regulatory functions, often ultimately generate results vastly different than the anticipated outcomes.”
Paul Roye, former senior vice president and senior counsel of Capital Research and Management Company who presented the recommendations during the IAC meeting, said that it would be best for the SEC to have sufficient funding.
“It has just not happened, which is why [it] led us to the third-party exam request for comment,” Roye said. “We didn’t move directly to a proposal because we recognize there are a number of issues that need to be sorted through.”
Some of the issues are:
- qualifications necessary for firm to conduct compliance reviews
- periodic recertification of qualified examiners
- scope of exams
- frequency of exams
- type of advisers to be subject to reviews
- exemption for certain types of advisers
- independence requirements for firms
- potential conflicts-of-interest
- resources for SEC to oversee the initiative
- liability exposure of third-party firms
In response to Van Burskirk’s concern over subjective interpretation by third-party examiners, Roye said that the recommendation tries to address it.
“We specifically said in the examination that we didn’t want them in the subjective judgment business,” he said. “The scope of this could be such that they are there to examine objectively, determine factual information that can be reported back to the SEC. So it wasn’t to introduce people making subjective judgments and interpretations of SEC rules. So, you know, I think we were cognizant of that. But again, I respect your views on this.”
This article originally appeared in the June 27, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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