In a strongly worded public statement in response to an SEC study on enhanced investment advisor oversight, Commissioner Elisse Walter registered her concern about what she says is woefully inadequate funding for the agency’s exam resources.
In her statement, Walter acknowledges that she voted in favor of releasing the study, but that she is disappointed in its conclusions. She wrote that for the first time since serving as commissioner, “I feel that it is necessary for me to write separately in order to clarify and emphasize certain facts, and ensure that Congress knows that the current resource problem is severe, that the problem will only be worse in the future, and that a solution is needed now.”
Walter declined to offer further comment beyond her statement.
Although the study looks at creating a uniform fiduciary standard for brokers and advisors, Walter’s statement delves into the challenges SEC examiners will encounter under new oversight duties proscribed by Dodd-Frank and how that will result in less oversight of the fund industry.
Her statement comes as the Republican-controlled House threatens necessary funding to carry out the provisions contained in Dodd-Frank. The two Republican commissioners — Kathleen Casey and Troy Paredes — issued a joint statement criticizing the study. They question the need for overhauling investment advice rules and the potential negative consequences of that action.
In a footnote in Walter’s statement, she states that although mutual funds are not directly covered by Dodd-Frank for purposes of the study, “resources to examine funds are at risk as well.” The footnote goes on to state that examinations of investment companies are expected to drop in fiscal year 2011 and “the need to cover the fund industry will place additional strains on the examination resources [investment companies] share with advisers.”
Walter’s concern that the SEC’s struggle for funding will translate into weaker oversight of the industry makes sense, some industry sources say. The SEC’s Office of Compliance Inspections and Examinations (OCIE) is responsible for examining funds and their advisors, which are nearly always examined jointly.
The Securities and Exchange Commission study, released last week, provided three options, including allowing the SEC to maintain oversight and impose a user fee to cover examination costs; allowing Congress to choose a self-regulatory organization to regulate advisors; and having the SEC delegate to the Financial Industry Regulatory Authority (Finra) the authority to examine large brokers registered as advisors.
Walter takes to task the SEC staff’s study for being biased in favor of the user fee option because the study claims it would cost less than the SRO option.
She points to the study’s statement that the SEC’s and Commodity Futures Trading Commission’s experience with SROs shows that SROs could aid the agency’s oversight with more frequent examinations. The study notes, for instance, that Finra examined 57% of its members in 2008 and 54% in 2009, while the National Futures Association, another SRO, examined 33% of its members in 2008 and 30% in 2009.
"Thus, OCIE’s current examination rate for investment advisers (9%) — which it estimates could drop as low as 7% in 2011 if additional examiners are not added — would have to increase by nearly five times to reach the average SRO examination rate for those years (43.5%), and more than six times to reach the average rate at Finra,” Walter wrote in her statement.
Walter cites additional burdens and the diversion of resources from the advisory area due to other new tasks OCIE will have to take on because of Dodd-Frank, including:
-The number of large, private fund advisors needing to register with the SEC, which will jump from 38% to 58%, and the increased time spent due to higher risk associated with large hedge funds
-The requirement that municipal advisors register with the SEC, which could translate into thousands of new entities and more than 20,000 individuals
-Annual examinations of credit rating agencies
-The requirement that security-based swap dealers, major security-based swap participants and security-based swap data repositories register with the SEC and be subject to examination
-An expected increase in examinations due to tips, complaints or referrals from the whistle-blower program
“Significantly, OCIE is not able to add any new staff to conduct examinations of investment advisers or any other entities under the Commission’s jurisdiction, and in fact will continue to divert resources from the advisory area in order to address other examination priorities,” Walter wrote.
David Hearth, partner at Paul Hastings, says that in the normal examination process two letters would be issued, one requesting the investment company’s books and records and a similar letter requesting the investment advisor’s books and records. He says it is rare for an examination to be solely focused on the mutual fund or the advisor to that mutual fund.
“So when the SEC staff shows up on the premises of the advisor, the examination would cover both because these exams are typically done jointly,” he says.
Shannon Behara, managing director at ACA Compliance Group, agrees that it would be detrimental to the exam process to separate the advisor’s exam from the mutual fund exam.
“Looking at the investment company without looking at the fundamental service provider in the investment advisor does not make a huge amount of sense,” Behara says. “I think whatever resources they decide to go with, whether it’s user fees or the SRO option, that it will affect registered investment companies.”
Hearth does not agree that OCIE needs to reach the examination frequency of Finra and suggests that it be allowed to keep more of what it collects. The agency also may better serve its mission by enhancing its efforts to use risk-based examinations that are shorter and more frequent and “may give the SEC better coverage of the industry than longer, traditional exams,” because they can do fewer of these, Hearth says.
Diane Ambler, partner at K&L Gates, in June joined other attorneys on the Federal Bar Association Securities Law Committee Executive Council in calling on Congress to allow the SEC to self-fund instead of sending what it collects to the Treasury and having Congress appropriate its budget every year. The group is made up of securities attorneys, many of whom were former SEC senior officers and now represent the industry on agency issues.
As it stands now, the SEC is “subject to the whims of Congress,” Ambler says. The congressional budgetary hold-ups with the Republican-controlled House have already resulted in the SEC's putting off deadlines it set for proposed rules and studies mandated by Dodd-Frank.
“The fact is the SEC has to look for other ways to make ends meet,” Ambler says. “It is given responsibilities that far outweigh its financial resources.”
Roger Joseph, head of Bingham McCutchen's investment management practice group, says, however, that even if OCIE is beset with new challenges, funds have a chief compliance officer and structure that should provide some comfort to examiners. A CCO is required to do annual reviews and report to the board.
“There are a variety of safeguards and checks and balances that are already in place,” Joseph says. “It is not a structure or system that is relying exclusively on SEC inspections in order to ensure compliance.”
