Inside the mind of the SEC

By Amy Lynch, CRCP, Founder & President, FrontLine Compliance

As featured in interviews on CNBC, Bloomberg TV, and in The Wall Street Journal

As a former SEC examiner myself, I seem to have an innate ability to know what the SEC is going to do before they do it. As you can imagine, this comes in handy when advising our clients on their regulatory compliance and SEC exams. Lately, with the buildup of so much rulemaking, many CCOs and others in the industry seem to be pondering the question of how the SEC will act in 2023. So, let’s dive into it.

The National Exam Program, now under the Division of Examinations (“EXAMS” and formerly “OCIE”) has changed its approach to exams, while some things remain as they have for many years. The goal now is to expand the volume of exams. Previously, the department was under fire for years for the lack of depth of its examination program, only hitting an average of 9 percent of all investment advisers annually.

In the last few years, there has been an increase in the number of exams achieved annually, but still not enough to make a big difference for the industry. There are more than 17,000 SEC registered investment advisers and perhaps only 700 examiners. With each exam taking about 8-12 months to complete, it’s impossible to have all firms examined in a given year at the current staffing levels. Plus, annual examinations are not the SEC’s goal. So, what’s the magic number? In short, the SEC just doesn’t know yet. Especially since investment advisers are not the only firms requiring examination. Mutual funds, private funds, transfer agents, administrators, and insurance company separate accounts also fall under the ’40 Act exam program. The “number of exams” math becomes truly problematic once you take these additional firm types into consideration. In short, EXAMS cannot keep up with the industry’s growth at its current staffing levels.

When I was at the SEC back in the 1990s, the goal was to have all firms visited once every 5 years. It worked on paper back then, but not in reality since the growth of the industry could not be accounted for in real time each year. The SEC’s structure has not changed much since then.  A few more internal offices were created when the SEC took its punches during the financial crisis. A consulting group was hired post-crisis and showed them how they could be more efficient. The SEC responded by putting more resources into technology and hiring more outsiders from the private sector as opposed to promoting from within like most regulatory agencies that operate on a seniority-based system.

The SEC has been making strides in improving its fintech. It wants its regulatory approach to be up to speed with the modern era of technology. However, the industry is still many years ahead of the SEC in how it utilizes technology. The SEC is still trying to figure it out, as it already collects a huge amount of data (mostly via legacy systems). Its biggest problem isn’t the lack of data, but rather information overload and how to analyze the data and organize new systems that produce meaningful information to its EXAMS program.

The examination program now takes a risk-focused approach to exams. Registrants are selected for review based on an algorithm that contains a risk scoring metric. Each time a firm is examined a new risk score is created, which will determine when it gets visited again.  No one (outside of the SEC) knows the “secret sauce” of the algorithm, but it makes sense to assume that firms with more examination deficiencies get higher risk scores. But, of course, each deficiency type must be weighed by severity and the overall score is an average risk weighted score.

Last year the SEC managed to examine about 15 percent of all advisers. With an objective of even more exams in 2023, the industry should be prepared for a SEC goal of 20 percent or more. But, for this to happen the SEC must conduct risk-focused exams and continue to conduct more of its work off-site so that examiners can be working on more than one exam at a time.

The 2023 examination year began on October 1, 2022, so we are already over three months into the year and the 2023 Examination Priorities letter has yet to be released. Last year, it was not released until March when the examination year was already half over. Thus, it would be much more timely and beneficial to have the priorities letter out in January this year, as they have in years past. However, we do know what they are focusing on already. Thanks to all of the rule proposals released over the past year, as well as finalization of the new Marketing Rule, the picture of what the SEC will be focused on is pretty clear. Expect the SEC to conduct sweep exams that may target multiple compliance areas during one of these exams. Private funds and advisers are in the cross hairs as are brokerages and exchanges regarding transaction transparency.

With greater rulemaking and the goal of increased regulatory oversight on tap for the industry during the next few years, the SEC will need to justify this through an increased volume of exams. SEC Chairman Gary Gensler appears to want to leave his stamp on an industry that will have become more accountable to regulations than it ever has in its history. Plus, SEC priorities often change with the political winds, and there have been a lot of headwinds this past year. With such massive goals, the SEC will need to be smarter, faster, and more efficient with its resources. Will the SEC’s 2023 plans come to fruition? Time will only tell, and the clock is ticking.

AMY LYNCH is the Founder and President of FrontLine Compliance, LLC. Amy has earned her industry expert status through her regulatory experience with the SEC and FINRA, and through senior management private-sector roles as CCO, DOC, and Vice President. An expert on regulatory issues involving investment adviser and broker-dealer compliance, insurance products, mutual funds, and private funds, Amy was one of the first graduates of the FINRA Institute/Wharton School Certification Program and holds the Certified Regulatory Compliance Professional (CRCP) designation in addition to her B.S. in Business and Economics. Amy has been quoted in numerous industry publications and featured on national TV and in the media, with appearances on CNBC and Bloomberg TV and interviews in The Wall Street Journal and BARRON’s.