Reforming the SEC: Wither OCIE?

The Division of Enforcement is going through some wrenching change, some likely to have long term benefits, others less likely.  But it is not the only Division that was tarred by the Madoff scandal.  Likewise, the Office of Compliance Inspections and Examinations fared poorly.  Substantial reform can be expected in that Division as well.

It is an office that has an almost impossible task given the resources allocated to it.  As Lori Richards, the former head of the office described:   

• There are approximately 11,300 registered investment advisers and 950 fund complexes with over 8,000 mutual fund portfolios (this is a highly transient population: approximately 1,200 advisers became registered and 750 de-registered in FY 2008).
• There are approximately 5,600 broker-dealers, 174,000 branch offices, and 676,000 registered representatives (as more firms have consolidated, the broker-dealer registrant pool has declined slightly in recent years, while the number of branch offices has increased dramatically). And, there are approximately 410 SEC-registered transfer agents.

And the resources available to inspect the thousands of advisers, mutual funds, brokers, and transfer agents?  Again, according to Lori Richards:

• "There are 425 exam staff for oversight of over 11,000 advisers, including hedge fund managers, and the entire mutual fund industry. Similarly, the SEC has just over 300 exam staff for examinations of broker-dealers, markets, transfer agents, SROs, clearing agencies, credit rating agencies, and other types of firms."

In short, very few examiners to inspect very many regulated entities.  No wonder that the Office had a reputation for a check the box mentality to inspections.  No wonder in the Madoff report there was a sense of examiners needing to get to the next examination.

So what are the proposed reforms?  Full blown change will probably have to await the appointment of the head of the Office (expect ala Enforcement the appointment of someone with no internal Commission experience, either from the bank inspection side or from the criminal side).  In the meantime, the Commission announced in a release back in August that examiners would:  

• conduct a “sweep” of firms that present certain risk characteristics to ensure, among other things, that the clients’ assets in fact exist. Such risks include advisers whose clients’ assets are held with an affiliate, as opposed to an independent entity; hedge funds that seem to have “smooth” or outlier returns; firms that use an unknown auditor or no auditor at all; firms with a disciplinary history; and broker-dealers that sell an affiliate’s hedge fund or limited partnership.

In addition, techniques would be developed that would facilitate the ability of examiners to detect fraud.

• The measures include more rigorous reviews of firms before the examiners enter the premises, and a more complete exam guide that focuses not only on obvious signs of fraud but also more subtle signals that deserve closer inspection, such as a firm using an unknown accountant. The measures also include increased checks on outside entities to verify that assets actually exist there and expanded use of exams of an entire entity when firms have joint or dual registrants such as affiliated broker-dealers and investment advisers.

Finally, there would be an emphasis on recruitment of staff with greater experience and industry knowledge.  This would include:

•   Senior Specialized Examiners: The agency is hiring new staffers to the examination unit who have specialized experience in areas such as trading, operations, portfolio management, options, compliance, valuation, new instruments and portfolio strategies, and forensic accounting.
• Industry and Market Fellows Program: The agency is hiring new staffers who are highly-seasoned financial experts to keep pace with the practices of Wall Street and protect investors. These experts would provide other staffers with new information and perspectives to help them identify emerging issues and understand the ways the industry is changing.

Finally, there would be expanded training and more resources devoted to the examination process. 

All of these proposals are short term.  With a small number of examiners relative to the size of the industry, the inspection program will need to make even greater use of "around the corner" techniques, inspecting those brokers, advisers and transfer agents who have present a higher risk profile (one that cannot be easily circumvented as was the case with Madoff).  That will mean some regulated entities will never be inspected while others will be visited regularly.

But the big unanswered question with OCIE is whether it will survive at all.  There is at least some possibility that the inspection function will go back to the respective operating divisions, with Trading and Markets and IM becoming responsible for the examinations.

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