The SEC recently released a Risk Alert (“the Alert”) from the Division of Examinations on how it goes about selecting firms for examination. This is a first of its kind Alert since traditionally the Staff has not released its examination strategy and registrant selection process. The Alert even includes a chart that shows the items on its initial document request letter to registered advisers.
The goals of the Division of Examinations are to:
- Promote compliance
- Prevent fraud
- Monitor risk
- Inform policy
Firms get examined for many reasons, such as information gathered from tips or complaints, ongoing investigations, referrals from other regulators, and fact-finding on high-profile topics. The annual Examination Priorities report, typically released early in the first quarter, offers a glimpse into the subject areas the Staff will be looking at during the year. Registrants should take note if they find those topics match their business model. Further, notice to a firm about an examination may be provided by the SEC in advance, or an exam can occur unannounced.
The most interesting part of the Alert is the section on firm-specific factors that the Staff considers when making its decisions on the advisers to select for examinations. These include:
- Findings from previous examinations of the firm
- Tips, complaints, referrals (as stated above)
- Disciplinary actions of the firm or its related persons
- Business models that create conflicts of interest, such as outside business activities with affiliates or dual registrant firms
- Length of time since a firm has been examined
- Material changes in key personnel
- Perceived vulnerabilities of firm (i.e., financial or market stress)
- News/media coverage of a firm or activity that a firm participates in
- Third-party data received on registrants from databases it utilizes
- Custody of client assets
The examination process itself is risk-based once a firm is selected. The various items listed above will be reviewed in relation to the registrant selected as well as the specific business model of the firm. A sample initial document request is shown as an appendix to the Alert and lists the typical documents requested at the start of an examination. It is a long laundry list of items, by topic only, and does not give the level of detail found in an actual examination letter. Actual letters are also more tailored to the firm, so not all items in this list will be relevant to all registrants. However, it could be a useful tool to check against current firm books and records.
Understanding the many examination factors considered by the SEC, as outlined in the Alert, should provide valuable insights for firms in determining their likelihood for an upcoming exam.