As the SEC zeroes in on "areas that are perceived by the staff to have heightened risk," examiners will be on the lookout for conflicts stemming from undisclosed forms of compensation, such as fees and solicitation arrangements, referrals to affiliated entities and payment from specific funds and fund platforms or other third parties.
The SEC noted that business practices vary considerably across the approximately 11,000 federally registered investment advisors and 800 investment companies -- together responsible for managing some $50 trillion in investor assets -- and that examinations, by necessity, will focus on red-flag issues such as disclosures that expose investors to the greatest risk.
"The scope of an IA-IC (investment advisor-investment company) examination is generally limited to the issues and business practices of the registrant that are perceived by the staff to present the highest risks to investors and the integrity of the market. Thus, the scope of exams will vary from registrant to registrant," the SEC said in its examination guidance. "Nevertheless, across the program, there are certain issues that predominate."
For advisors, the priorities identified by senior exam staff and managers from the 12 offices of the SEC's National Examination Program (NEP) focus heavily on nondisclosures and other misrepresentations, particularly in the areas of marketing and performance advertising.
"Marketing and performance advertising is an inherently high-risk area due to the highly competitive nature of the investment management industry," the SEC said. "Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices."
Adding a wrinkle to the SEC's oversight of the investment-advisor industry is a new set of registration requirements put in place under the Dodd-Frank financial reform law. Now, smaller practices with less than $100 million in assets under management are directed to register with the relevant state securities regulators. Previously, the threshold had been set at $25 million, meaning that a significant number of smaller practices are no longer overseen by federal examiners.
At the same time, the Dodd-Frank law has brought a new class of advisors to hedge funds and other private fund advisors under the SEC's purview for the first time. In response, the SEC is planning to dedicate a significant portion of its oversight resources to the previously unregulated market segment.
"The vast majority of these new registrants are advisors to hedge funds and private equity funds that have never been registered, regulated or examined by the SEC," the agency said. "The IA-IC program therefore intends to launch a coordinated national examination initiative designed to establish a meaningful presence with these newly registered advisors."
Of course, the SEC operates under limited resources, and its enforcement activity could be even further curtailed if looming, across-the-board budget cuts take effect. But even assuming a consistent budget, the agency's examiners could find themselves swamped with oversight of the highly complex practices of advisors catering to private funds, despite the thousands of small and midsized practices that are now regulated by state authorities.
"Some of their resources that I think were allocated to more traditional investment advisors are now going into the more complex area of looking at hedge funds," Duane Thompson, senior policy analyst with the consulting group Fi360, said in a recent interview. "I don't think it's a wash. I think the SEC has increased inspection requirements now."
Further compounding the SEC's examination efforts is the growing trend of dually registered advisors and broker-dealers, a "continued convergence" that the agency intends to address with an expansion of coordinated and joint examinations conducted by examiners in the advisor and broker-dealer offices. Those exams will take a close look at how dual registrants meet their suitability obligations in steering clients toward either their brokerage or advisory accounts, as well as the incentives and disclosures involved each practice.
In addition to its advisor-specific guidance, the SEC's NEP outlined a litany of examination priorities that will guide its reviews of all registered entities, headlined by fraud detection and prevention.
"Our nation's capital markets run, in large part, on trust," the SEC said. "Nothing is more lethal to that trust than loss of investor capital for anything other than knowingly assumed risk, including scams, theft and other fraudulent conduct."
Additionally, the SEC is warning registrants of all types of practice that its examinations will focus on potential conflicts of interest, the use of new technologies and corporate governance and enterprise risk management.
