Overview of SEC Inspections and Examinations

Overview of SEC Inspections and Examinations

Reported by Joan Hinchman, Executive Director, NSCP

Two of the 41 workshops offered at the NSCP 1995 National Membership meeting dealt with the subject of regulatory inspections of broker-dealers and investment advisers. Two of the panelists were Associate Directors of the SEC’s new Office of Compliance, Inspections and Examinations (“OCIE”). Mary Ann Gadziala, joined by Stephen C. Strombelline of Salomon Brothers Inc, spoke on “Regulatory Audits of Broker-Dealers.” Gene A. Gohlke, joined by Gerald T. Lins of The Chase Manhattan Bank, N.A., spoke on “Regulatory Audits of Investment Advisers.” What follows is a report on the information provided by the two SEC staff members. Additional Commentary on Mr. Gohlke’s presentation was authored by Barbara Brooke Manning of Rosenman & Colin LLP, and commentary on Ms. Gadziala’s presentation, by Saul S. Cohen, also of Rosenman & Colin LLP.

The SEC’s Formation of OCIE

Both Ms. Gadziala and Mr. Gohlke opened their talks with background on the formation of OCIE in May 1995. The two explained that OCIE consolidates virtually all the examination and inspection programs at the SEC that had previously been within the purview of the Divisions of Market Regulation and Investment Management. The inspection and examination of all 8,000 broker-dealers with their 60,000 branches, the SROs, all 1,000 investments company complexes, approximately 22,000 investment advisers and all registered transfer agents are now the responsibility of OCIE. This consolidation followed SEC Chairman Arthur Levitt’s major re-organization of the SEC’s nine field offices and their branches by consolidating them into five regional offices, New York, Chicago, Los Angeles, Miami and Denver. Within these regions are district offices consisting primarily of the former regional offices, some branch offices, and their staffs.

Creating a separate office dedicated solely to conducting examinations was Chairman Levitt’s way of increasing the SEC’s focus on regulated entities. OCIE’s program is also designed to address a number of global issues. In addition to increasing and facilitating staff inspections of dual registrants, such as broker-dealers that are also registered as investment advisers, OCIE’s program is expected to further the coordination of examinations, so as to avoid overlap, among all regulatory authorities, including the bank regulatory authorities, the four SROs, and the states. The goal in the situation where a firm is subject to the oversight of a number of agencies is to have all these agencies schedule inspections so that they start and conclude at the same time, if possible.

By creating an examination office, the SEC staff may now establish priorities and coordinate the processes for every aspect of the SEC examination program, and since OCIE’s establishment, the staff has introduced a number of changes to its approach in conducting examinations.

“Smart Exams”

In addition to changing how the staff identifies or targets advisers and broker-dealers to be inspected, OCIE is directing field office staff to change the way in which they conduct inspections. In the past, field staff usually would attempt to examine every activity in which the firm engaged. For example, with respect to investment advisers they would review marketing activities, portfolio management activities, custody arrangements, relationships with broker-dealers, and take a careful look at partnerships under the adviser’s management. Now, the regional offices have been instructed to conduct what OCIE Director Lori Richards calls “Smart Exams.”

The idea behind Smart Exams is to allow the staff to focus on those activities that the staff feels present relatively higher risks to investors, either because the firm is engaged in a very aggressive investment approach or perhaps because the firm’s internal control environment or operating procedures are perceived as weak. So what investment advisers and broker-dealers may expect during an SEC examination is the staff’s overall assessment of its business, then a focused examination of those activities that are of greatest concern to the staf.

Compliance Assessments

The overall assessment is apt to involve review of the firm’s Form ADV or FOCUS Reports, as the case may be, and other SEC filings, as well as customer complaint records. In addition, the staff will refer back to the results of any previous inspections. The staff also intends to discuss activities with management at various levels throughout the firm on a much more rigorous basis than they have in the past. For example, representatives of a firm’s senior management may be interviewed early in the examination process so that the staff may get a better sense of the firm’s organization and general approach to compliance. Senior managers can expect to be asked questions such as: “What do you see as the potential problem areas of the firm?”, “What are the firm’s weaknesses, the firm’s strengths?”, “What is the internal control environment at the firm?”, and “How do you participate in the internal control process?” Mr. Gohlke and Ms. Gadziala both emphasized the importance of senior management’s support of internal controls and the compliance system. Examiners will attempt to find out from the very top levels of a firm what the attitude is towards compliance and whether the firm’s culture reflects a commitment to such procedures.

Separation of Functions

The staff will also be looking at how the firm has organized its activities. Of particular concern is the separation between doing things and recording things — e.g., between trading and recording trades. Attendees were reminded of several instances that were widely reported in the press over the last year where a failure to separate functions caused fairly large losses to major firms.

“Paper Trails”

The staff will continue to request access to extensive sets of books and records, as it has in the past. The purpose of looking at these records is, in part, to confirm what examiners have been told.

Upon Completion of an SEC Examination

Once examiners’ field work is done, their report on the inspection is reviewed by SEC supervisory personnel, a determination is made as to whether action should be taken. It is now standard practice for the staff to conclude an examination by notifying the registrant within 90 days of the end of its field work either by sending a letter indicating that no further action is necessary at this time, a deficiency letter, or a letter saying that it is still working on the exam but will be back to the registrant within X number of additional days or weeks. Perhaps one of the biggest changes effected in the SEC’s examination program is that when no problems are found, the staff will send a letter to the registrant saying, in effect, no further action will be taken at this time. However, when the examination is referred to enforcement, the registrant will not be getting a letter from the staff and, more than likely, will not hear from the enforcement staff within 90 days. While the absence of a deficiency or a “no further action” letter from the staff after an examination should be cause for concern, registrants should bear in mind that not every situation that is referred to enforcement becomes an enforcement case. It was suggested that, perhaps, less than 50 percent of these referrals result in an investigation.


Money Managers Prior to OCIE

Gene A. Gohlke focused his presentation on the examination of investment advisers by OCIE and the field staff. He first described how the staff had been conducting adviser inspections over the last five years. From roughly 1991 through 1993, the field inspection staff focused primarily on discretionary money managers with one billion dollars or more under management. During this three-year period, the staff conducted an inspection of virtually every one of the 500 to 600 advisers that fit this category. Examinations of the offices of financial planners and smaller advisers were conducted as time permitted. In 1994 and 1995, the field staff was directed to focus primarily on smaller investment advisers engaged in money management. Consequently, insofar as routine examinations are concerned, the financial planning side of the adviser population, while not totally ignored, has received little of the staff’s attention over the last five years.

Results of Investment Adviser Examinations Prior to OCIE

During 1995, the staff completed 1,075 examinations of investment managers. As a result of those examinations, deficiency letters were sent to about 87 percent of the advisers examined; another 5 percent of the examinations were referred to enforcement for further review. Approximately 92 percent of the staff’s 1995 investment adviser examinations resulted in some findings of problems that needed correction — some minor, others a bit more egregious. In roughly 5 percent of all examinations, no further action was needed. Mr. Gohlke stressed that this statistic does not necessarily mean that nothing was wrong, “it was just that we didn’t come across it in the exam.” In roughly 2% of the examinations that resulted in no action being taken by the staff, where perhaps only very technical deficiencies were found, problems were resolved on site at the completion of the examination.

Investment Adviser Examination Cycle Prior to OCIE

With the formation of OCIE, the staff reviewed the prior focus of examinations. It was estimated that at the time there were about 22,000 registered advisers with total assets under management of almost $11 trillion. When the number of staff prior to OCIE (about 60-65 full-time) was compared to the number of registrants, it was calculated that, on average, the staff examined an adviser once every 22 years; effectively no examination at all. In fact, Mr. Gohlke pointed out that on a 22-year schedule, some advisers might never be examined because many people are in and out of the business in less than 22 years.

The Selection Process

Given the size of the adviser population, the vast amount of money under management and the relatively small SEC staff, OCIE decided to take a different approach. First, the staff divided the adviser population into two sections, based primarily on its perception of the risk an adviser presents to its clients. An adviser that has discretionary authority over client assets (that is, it can select securities based upon a plan or based upon a contractual relationship, select broker-dealers, and use client commission dollars in a variety of ways) presents the greatest relative risk to clients. On the other side, there are advisers that manage money on a non-discretionary basis (e.g., they call the client first with a recommendation and obtain authorization for the transaction). That type of money manager might, in the staff’s view, pose less of a risk to clients. Grouped together with the “non-discretionary” advisers are the many financial planners registered as advisers who do not manage money at all; they prepare plans and perhaps direct clients to invest in mutual funds. Looking at the relative risks across the adviser population, the staff divided it into two parts — advisers who have discretionary authority (numbering roughly 9,000), and those who do not (about 13,000.)

Investment Adviser Examination Cycle Under OCIE’s Plan

As a result of its review and perception of relative risks to clients, OCIE directed the field office staff to concentrate their resources on examining the discretionary money managers. Mr. Gohlke said that assuming that the field staff continues to perform about 1,000 exams a year, with about 9,000 discretionary money managers, the frequency with which the SEC examines these advisers will increase to somewhere between 81/2 to 9 years.

Geographical Sweep Plan of Lower Risk Advisers

What about the other 13,000 advisers? Mr. Gohlke stated that the staff intends to conduct inspections of these advisers through what they call a “geographical sweep,” whereby inspections of all non-discretionary investment advisers located in and around a metropolitan area will be conducted. The staff anticipates that these exams will be coordinated with state examiners; a team of examiners from both the SEC and the applicable state securities commission will conduct surprise exams of these advisers. Mr. Gohlke informed the group that the SEC had completed three of these sweeps — one on the East Coast, one in the Midwest, and one on the West Coast, and that another would begin shortly.

Questions Advisers Might Expect

Examiners may also be expected to speak with research analysts, portfolio managers, traders, and back office people to get a sense of what they do. An analyst may be asked to describe what he/she does during an average day. Similarly, a portfolio manager may be asked to walk through a trade so that the examiner can follow the flow of paperwork to see who is required to sign off on it, where it ultimately comes to rest and what sort of reconciliations are done. Where analysts or portfolio managers visit companies or attend company presentations, examiners will want to know who pays the expenses associated with this activity and details of any arrangement whereby someone other than the adviser picks up the tab. The staff will also be looking to see what controls are in place to determine whether analysts/managers attending any such functions come into possession of inside information and what procedures are in place to prevent the misuse of such information.

Advisers’ “Paper Trails”

Given the recent no-action position taken with respect to bunching proprietary account trades with client trades, the documentation of such trading activity is likely to receive careful scrutiny. Examiners will be looking to see if order tickets identify all of the clients participating in the trade; if allocation among the parties to the trade is indicated on the ticket; and whether clients actually receive their predetermined allocation at the end of the day.


The SEC’s examination program has shifted emphasis from an historical review of books and records to a focus on current internal systems of control within the entity. Advisers should review their existing policies and procedures and up-date and create policies and procedures where necessary. For example, allocation of bunched trades is a “hot issue.” Even if you do not bunch proprietary trades with client trades, every adviser should have written procedures governing the allocation of bunched client trades. Review current procedures to determine whether they are workable. Do not adopt procedures that look good on paper but are not feasible or appropriate for your organization.

Make sure existing procedures are being followed. There is nothing worse than having procedures that are ignored. Analyze why they are not being followed. It might be that they are unworkable, given your organization’s structure.

You should take an active role in the examination process. A few tips: (i) make sure all previous deficiencies have been corrected; (ii) assign one knowledgeable person to interact with the examiners and control the flow of paper (make sure to control the examiners’ access to the copying machine and make your own copy of all documents of which copies are requested); (iii) make sure the liaison sits in on all interviews; and (iv) be cooperative and patient. The staff is comprised of examiners with varying levels of experience.

As can been seen from this report, the creation of OCIE has resulted in greater emphasis being placed on broker-dealers’ and investment advisers’ internal systems of control. The old method of preparing for an examination (i.e., reviewing books and records to insure they are complete and up-to-date) is no longer sufficient. Registrants should be focusing their efforts on their compliance policies and procedures.

Barbara Brooke Manning, a member of NSCP who currently serves on the NSCP Securities Compliance Advisory Committee, is a partner in the New York law firm of Rosenman & Colin.


The SEC’s Authority Over SRO’s and Broker-Dealers

The oversight of broker-dealers, unlike that of investment advisers’ includes an additional layer of authority by the self-regulatory organizations. As Mary Ann Gadziala explained in her panel, the SEC derives its examination authority as to broker-dealers and the inspection programs of self-regulatory organizations (“SROs”) from Sections 17 and 19 of the Securities Exchange Act of 1934. The SROs, which are the first line broker-dealer examiners, conduct cyclical examinations of those firms which they have regulatory responsibility. Since broker-dealers are often members of more than one SRO and may engage in a variety of activities, they may be examined by more than one SRO. The Commission, through its 200 examiners operating out of its Washington and regional offices, exercises oversight of the SROs’ work, and conducts “cause” examinations related to possible enforcement proceedings.

SRO Oversight Exams

An oversight exam is essentially a quality control measure conducted to oversee the effectiveness of SRO programs. It aims to help the SRO improve its review and supervision efforts, especially in the sales practice and financial and operations areas, so as to insure that its members are in regulatory compliance. Only five or six percent of the firms examined by SROs receive such an oversight examination and then usually within six to nine months after the SRO exam.

SEC examiners typically do not inform registrants when they commence an inspection whether they are conducting a generalized, oversight exam or one based on a particular cause, and thus related to enforcement action. Cause exams may be conducted whenever a problem or concern exists; for example, when the SEC staff suspects that a major problem such as insider trading or fraud exists. OCIE will also be conducting surveillance examinations focused on a variety of risk factors. Ms. Gadziala added that OCIE’s plan includes an increase in cause and surveillance exams, with fewer oversight examinations.

Broker-Dealer Branch Office Inspections

As mentioned above, OCIE’s program is designed to address a number of global issues. Among these is the development of a comprehensive branch examination program. This focus on broker-dealer branches has grown out of both the increase in branch offices over the past few years and the Commission’s large firm examination sweep. Thus the SEC is committing greater resources to overseeing securities activities conducted away from firms’ home offices.

The Selection Process

Ms. Gadziala commented, “As markets continue to expand, technological advances are implemented, the number of brokerage firms continues to grow, and the products which they sell and trade in are ever more complex, it becomes increasingly important to use examination resources effectively and efficiently.” Since the SEC’s resources remain limited in relation to this growth, the staff must focus its examinations carefully. Broker-dealers are chosen for oversight examinations based on risk factors such as: customer exposure to loss, a large number of customer complaints, firm mismanagement and particular financial products which have created problems at other broker-dealers (e.g., the sale of interests in limited partnerships and penny stocks). Also, as with investment advisers, selection may reflect matters found in previous staff examinations.

Specific Areas of Staff Concern Relating To Broker-Dealers

MSRB Rule G-37 compliance is one area of great interest to the Commission at this time. This rule restricts broker-dealers from engaging in certain public finance underwritings when municipal finance professionals and certain others they employ have made contributions to political figures who may be in a position to direct the municipalities underwriting business to the firm. Reflecting Chairman Levitt’s views, the staff has developed a new inspection module aimed at discovering Rule G-37 violations.

Cold calling practices are also receiving more attention from the staff, particularly with regard to the maintenance of “do not call” lists by broker-dealers. As our readers well know, consumers who do not wish to receive telephone solicitations may request that their names be placed on a list for this purpose. Firms engaged in cold-calling sales activities are required to keep such lists, as well as comply with other regulations regarding cold-calling. The staff is currently reviewing firms’ systems and procedures with respect to this kind of sales activity to insure compliance with the rules.

The employment and supervision of so-called “rogue brokers” continues to be an area on which all regulatory authorities focus. Rogue brokers may generally be described as sales representatives with histories of disciplinary actions, large numbers of customer complaints, or adverse arbitration awards. As a follow-up to the sweep the regulators conducted several years ago of nine large brokerage firms that employed brokers generally fitting this profile, the SEC recently examined other firms, mostly medium-sized and smaller broker-dealers, specifically with respect to hiring and retention practices of such individuals. Problem brokers who move from firm to firm are a subject of grave concern, and if the SEC sees numbers of them at a firm or in particular branch offices, these entities may expect greater regulatory scrutiny of their compliance procedures, supervisory systems and supervisory personnel.

The final area of SEC focus, described by Ms. Gadziala as possibly the most important area, is that of internal controls. The current environment — characterized as one of high volume and increased volatility, involving increasingly diverse and complex products traded in many markets, both domestically and internationally — makes it impossible for the SEC to review every transaction at every firm. Ms. Gadziala explained that the SEC is therefore dependent on firms’ internal controls. In that regard, OCIE examiners will be reviewing these controls for adequacy. The problems experienced by Daiwa, Barings and Kidder Peabody, among others, all had one element in common: laxity of internal controls. The SEC is therefore assessing the degree to which firms have developed and adhere to policies and procedures to manage their risks in critical areas.

Broker-Dealer Internal Controls

While controls function differently at each firm, OCIE examiners will be looking specifically at credit and market risk, internal audit, proprietary trading, new products, sales practices, senior management responsibilities, and even physical premises to understand the functioning of a firm’s control structure. Examiners perform specific tests on these control procedures, seeking to gauge the firm’s risk management overall. For example, they ask such key questions as: Does the broker-dealer have procedures to identify, measure, monitor and control financial risk? Is senior management at the highest levels involved and pro-active? Is there risk management oversight independent of the trading function? Does the firm have a fully integrated system of controls that covers all its interconnected areas of business?

Ms. Gadziala concluded her presentation by commenting, “While we haven’t designed a blueprint for internal controls, there have been some recent efforts along these lines, particularly for derivatives, by the Federal Reserve, the Group of 30 and the Treadway Commission. Thus if you are designing an internal controls program, although it must be firm specific, there are important insights in these groups’ studies that may assist you in designing your internal controls and risk management system.”


Ms. Gadziala’s discussion of the work of OCIE provides valuable insight into her office and its efforts. Please consider the following as important to your firm:

1. The SEC’s focus has shifted in its inspection program to searching for specific items of wrongdoing at broker-dealers, rather than the SRO quality control measure it was previously. Thus firms which are being inspected by the SEC should assume that they are at some risk in the process.

2. Firms should make sure that they have remedied all deficiencies noted in previous inspections, whether by SROs, the SEC or others. You can expect that OCIE will look at items previously found by others.

3. Ms. Gadziala noted that firms could call OCIE (or regional offices) for information about the examination process at any time. Calls certainly should be made if you are subject to an overlap or if you believe the examiners to be acting improperly.

4. It is important that you assign a knowledgeable person to explain the firm’s business to the examiners and to act as liaison. Examiners should not be permitted to roam around the office, but rather their needs should be attended to in a business-like fashion. The liaison person should take notes of the subjects being discussed and should be present whenever employees are interviewed.

5. Deficiencies which are identified during the course of the examination should be immediately remedied. In the event they appear in a deficiency letter sent by OCIE, it will show the firm’s good faith that the deficiencies have been addressed prior to the letter’s receipt.

6. The examiners may send letters to customers who have previously complained about the firm and its activities. Registered representatives and other individuals who service such accounts should be alerted to that possibility so that they are not surprised if such individuals call them regarding the letter. If customers do so and ask for advice, they should be informed that the determination to respond to any letter is theirs alone although the firm considers it in the public interest that everyone cooperate with the SEC.

7. Ms. Gadziala’s remarks indicate that the SEC is continuing to put pressure on firms which hire “problem brokers.” If you hire such individuals, you should be prepared to demonstrate the reasons for doing so and any necessary heightened supervision.

8. The Commission’s inspection program has become more sophisticated and demonstrates a real concern with systemic risk. Firms should be sure that they have adequate internal controls for all areas of their business, but most especially those areas in which capital is at risk, or that involve new businesses or new products.

Saul S. Cohen is a partner in the New York law firm of Rosenman & Colin.

This article originally appeared in the July/August 1996 issue of the NSCP Currents, a publication of the National Society of Compliance Professionals, 24 Millerton Road, Lakeville, CT 06039. Reprinted with permission of the National Society of Compliance Professionals and the author. The foregoing was a report on the information provided by two SEC staff members at the National Society of Compliance Professionals’ 1995 National Membership Meeting. The NSCP 1996 National Membership Meeting offers 43 workshops and will be held at the ANA Hotel in Washington, D.C. on October 23, 24, and 25. For more information, call the office at (860) 435-0843.

Return to the Arbitration Information Center

Return to the Securities Law Home Page


Securities Attorney at Sallah Astarita & Cox | 212-509-6544 | mja@sallahlaw.com | Website | + posts

Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page - SECLaw.com, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.