SEC’s Division of Examinations Sheds Light Regarding Exam Selection and Scoping

On September 6, 2023, the staff of the US Securities and Exchange Commission’s (the “SEC”) Division of Examinations (the “Division”) issued a risk alert describing how it selects investment advisers for examination and the scope of risk areas on which to focus. The risk alert notes that the Division selects advisers for a variety of reasons—e.g., to evaluate the risks present at a particular adviser, to respond to events that present risks to investors or the markets more broadly, and/or to assess how registrants are adapting to new regulatory requirements. The Division uses technology to collect and analyze large sets of industry- and firm-level data to help identify risks and understand the adviser’s business and reviews disclosure documents filed with regulators (e.g., Form ADV, including the brochure, and Form PF). The risk alert does not provide any new information or suggest that the Division is changing its historical practices. However, it provides a useful explanation of the factors that go into the decision to examine a particular adviser and also the general categories of information requested in standard examinations.

I. Selecting Examination Candidates

There are currently more than 15,000 advisers registered with the SEC. The Division can examine approximately 15% of that number each year. Due to resource constraints, the Division utilizes a “risk-based approach” for selecting examination candidates and deciding the initial scope of risk areas to review.

The risk alert notes the following factors Division staff use to assess risk and select advisers for examination:

• Adviser’s risk characteristics based on the Division’s published annual priorities;¹
• A tip, complaint, or referral;
• Recidivist conduct (i.e., prior deficiencies and/or violations);
• Significant fee- and expense-related issues;
• Significant compliance program concerns;
• Supervisory concerns, such as disciplinary history of certain associated individuals;
• Business activities that may create conflicts of interest (e.g., outside business activities and advisers dually registered or affiliated with broker-dealers);
• The length of time since the adviser’s registration (e.g., newly registered advisers²) or last examination;
• Material changes in the adviser’s leadership, other personnel, or business practices;
• Signs that the adviser might be vulnerable to financial or market stress;
• Media reports that may involve or impact the adviser;
• Data provided by third-party data services;
• Disclosure history of the adviser; and
• Whether the adviser has access to client / investor assets and / or presents certain gatekeeper or service provider compliance risks.

II. Selecting Examination Focus Areas

Once a candidate is chosen, the Division conducts additional research to determine the initial scope of the examination,³ which varies from exam to exam depending on the adviser’s business model, associated risks, and the reason for conducting the examination. However, examinations typically include reviewing advisers’ operations, disclosures, conflicts of interest, and compliance practices. The risk alert provides an overview of a typical “initial request list,” which contains requests for documents and / or information regarding the following areas:

• Organizational information;
• Business and operation;
• Disclosure and filings;
• Legal and disciplinary;
• Compliance program and oversight / review process;
• Valuation;
• Information processing, reporting, and protection;
• Advisory clients / accounts information;
• Portfolio management;
• Brokerage and trading;
• Conflicts of interest and insider trading;
• Marketing and advertising;
• Financial records; and
• Custody and safety of client assets.

III. Takeaways

The Division staff’s practices regarding selecting examination candidates and scoping areas for selected candidates as described by the risk alert is consistent with historical practices, and the risk alert does not convey any changes or new methods. It is helpful, however, that the Division staff provided transparency through this risk alert, which allows advisers to answer certain common questions regarding SEC examinations, e.g.:

• How likely am I to be selected as an examination candidate? A quick answer is about a 15% chance in a given fiscal year. However, the chance of an examination can increase or decrease depending on what the Division staff views as risk areas at the time. The bottom line is that, if an adviser is registered with the SEC, it needs to be prepared for an examination by the Division staff at all times.
• I just received an initial request list from the Division staff. What can I glean by looking at the initial request list? The risk alert provided the contents of a standard initial request list. Accordingly, if an adviser received a request list like the one described in the risk alert, it is likely that the adviser was selected for a “standard” exam. If the initial request list contains requests that are heavily (or solely) skewed towards certain scoping areas (e.g., fees and expenses, custody, the Marketing Rule) or certain entities (e.g., FTX), then the adviser may have been selected as part of a local or national Division initiative or a market event.

Lastly, the typical initial information request from the Division staff serves as helpful guidance regarding the types of documentation advisers should maintain as part of their compliance programs and in anticipation of possible examinations by the Division staff.

 

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^[1] SEC Division of Examinations, Risk Alert: Investment Advisers: Assessing Risks, Scoping Examinations, and Requesting Documents (Sep. 6, 2023).
^[2] SEC Division of Examinations, Risk Alert: Observations from Examination of Newly-Registered Advisers (Mar. 27, 2023).
^[3] Although not described in the risk alert, scoping is not static, but rather, a dynamic exercise. Throughout the course of an examination, the Division revises the scoping areas (typically by adding more areas) based on advisers’ responses during interviews and / or documents and information provided in response to requests from the Division staff.