Tuesday, November 24, 2009


The SEC's Office of Inspector General (OIG) issued a report making recommendations to improve the Office of Compliance Inspections and Examinations’ (OCIE) process for selecting investment advisers and investment companies for examination. The report focused on the reasons OCIE did not perform an examination of Bernard Madoff Investment Securities, LLC’s (BMIS) investment advisory business soon after the firm registered as an investment adviser in 2006.

The OIG noted that OCIE’s practice is to assign each registered investment adviser a “low,” “medium,” or “high” risk rating, which is initially based on each adviser’s response to certain questions in Part 1 of the Uniform Application for Investment Adviser Registration (Form ADV). When BMIS registered as an investment adviser in 2006, BMIS was classified as “medium risk,” based on its answers to the questions provided on its Form ADV Part 1. BMIS filed two subsequent Form ADVs in 2007 and 2008. Each of the three Form ADVs received by the Commission resulted in BMIS being assigned a “medium risk” designation in 2006, 2007, and 2008. The OIG found that only firms categorized as “high risk” trigger routine OCIE examinations within three years of receiving the “high risk” rating.

The OIG found that a contributing factor to OCIE’s failure to conduct an examination of BMIS’s advisory business was Enforcement’s and OCIE’s broker-dealer examination unit’s failure to communicate with OCIE’s investment adviser unit. An OCIE Branch Chief testified that BMIS might have been subject to a “cause exam” immediately after it registered had the investment adviser examination staff been informed that Madoff had made misrepresentations to Enforcement and OCIE broker-dealer examination staff.

The OIG also found that OCIE’s risk rating process did not adequately weigh an investment adviser’s level of assets under management and the number of clients that receive investment advisory services. The OIG’s belief is that advisers with more assets under management and more clients who receive advisory services should receive progressively higher risk scores.

The report presents 11 specific recommendations designed to improve OCIE’s process for selecting investment advisers and investment companies for examination:

1. OCIE should implement a procedure requiring, as part its process for creating a risk rating for an investment adviser, that OCIE staff perform a search of Commission databases containing information about past examinations, investigations, and filings related to the investment adviser.

2. OCIE should change the risk rating of an investment adviser based on pertinent information garnered from all Divisions and Offices of the Commission, including information from OCIE examinations and Enforcement investigations, regardless of whether the information was learned during an examination conducted to look specifically at a firm’s investment advisory business.

3. The Division of Enforcement and OCIE should establish and adhere to a joint protocol providing for the sharing of all pertinent information (e.g., securities laws violations, disciplinary history, tips, complaints and referrals) identified during the course of an investigation or examination or otherwise.

4. OCIE should establish a procedure to thoroughly evaluate negative information that it receives about an investment adviser and use this information to determine when it is appropriate to conduct a cause examination of an investment adviser. OCIE should ensure its procedure provides for timely opening of a cause examination.

5. When the OCIE becomes aware of negative information pertaining to an investment adviser, OCIE should examine the investment adviser’s Form ADV filings and document and investigate discrepancies existing between the adviser’s Form ADV and information that OCIE previously learned about the registrant.

6. OCIE should establish a procedure to thoroughly evaluate an investment adviser’s Form ADVs when OCIE becomes aware of issues or problems with an investment adviser. OCIE should document areas where it believes a Form ADV contains false information and initiate appropriate action, such as commencing a cause examination.

7. OCIE should re-evaluate the point scores that it assigns to advisers based on their reported assets under management. OCIE should assign progressively higher risk weightings to firms that have greater assets under management.

8. OCIE should re-evaluate the point scores that it assigns to firms based on their reported number of clients to which they provide investment advisory services. OCIE should assign progressively higher risk weightings to investment advisers that serve a larger number of clients.

9. OCIE should recommend to the Chairman’s office that it institute a Commission rulemaking that would require the following additional information to be reported as part of Form ADV: Performance information; A fund’s service providers, custodians, auditors and administrators, and applicable information about these entities; A hedge fund’s current auditor and any changes in the auditor; and the auditor’s opinion of the firm.

10. The Commission should finalize the proposed rule titled Amendments to Form ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the Commission should consider what, if any, additional information investment advisers should include in Part II of Form ADV by consulting with OCIE and the Division of Investment Management (IM). Further, the Commission, in consultation with OCIE and IM, should consider provisions that would assist OCIE to efficiently and effectively review and analyze the information in Part II of Form ADV.

11. OCIE should develop and adhere to policies and procedures for conducting third party verifications, such that OCIE verifies the existence of assets, custodian statements, and other relevant criteria.

A complete copy of the OIG's report can be found here.

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