Speech by SEC Staff:
Remarks at SIFMA Compliance and Legal Society December Monthly Luncheon, December 2010
Carlo V. di Florio1
Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
December 21, 2010
On December 21, 2010, Carlo V. di Florio, Director of the Securities and Exchange Commission’s (“SEC” or “Commission”) Office of Compliance Inspections and Examinations (“OCIE”), spoke at the SIFMA Compliance and Legal Society December Monthly Luncheon (“SIFMA Luncheon”). Mr. di Florio discussed certain key recent SEC developments, focusing on two main areas: 1) overall changes and developments occurring at the SEC, and 2) changes and developments in connection with the SEC’s national examination program. The following provides an overview of Mr. di Florio’s remarks at the SIFMA Luncheon.
Overall Developments at the SEC
Mr. di Florio first discussed certain of the “big picture” changes that were occurring at the SEC. In 2010, the SEC focused on reforming its procedures, revamping its systems, bringing complex enforcement actions, better targeting its examinations efforts and adopting a series of rules intended to protect investors and ensure fairness in the markets. Additionally, it began working to fulfill its obligations under the recently-enacted Dodd-Frank legislation.
Mr. di Florio discussed new leadership teams that had joined the SEC to enhance and improve regulation and oversight. Mr. di Florio noted that this provided the SEC with new energy, ideas, and an overall new culture of teamwork, including breaking down silos that that had previously existed. Mr. di Florio highlighted the SEC’s creation of a new Division of Risk, Strategy, and Financial Innovation, and the hiring of new employees for this Division who were bringing new skills to the SEC, and were helping the Commission to examine new and emerging risks.
With respect to the SEC’s Division of Enforcement, Mr. di Florio indicated that, under the leadership of Robert Khuzami, the Division has not shied away from tough and complex cases, bringing notable actions against major financial firms such as Goldman Sachs, State Street, Citigroup, Morgan Keegan, ICP Asset Management, and a TARP-related fraud action. He also noted proceedings against Banc of America Securities for fraud in connection with the investment of proceeds of municipal securities, and actions against Quadrangle Group and its former principal arising from a kickback scheme to obtain investments from New York’s largest pension fund, and additional charges (and defendants) in continuing investigations concerning insider trading rings involving personnel at hedge funds, law firms, public corporations, and financial institutions.
Mr. Di Florio noted that Enforcement has established specialized units for the following five high priority areas: (i) asset management; (ii) market abuse; (iii) structured and new products; (iv) foreign corrupt practices; and (v) municipal securities. Mr. di Florio also discussed the SEC’s process for handling tips, complaints and referrals. Mr. di Florio noted that the SEC’s process for managing tips, complaints and referrals is being upgraded significantly. In light of the Bernie Madoff ponzi scheme and other lessons learned over the past few years Enforcement has built up a new Office of Market Intelligence, which reviews and analyzes the enormous number of tips, complaints and referrals the SEC receives. The implementation of this centralized system is a top priority for the SEC.
Mr. di Florio next discussed the Commission’s significant rulemaking initiatives emanating out of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), as well as the ambitious rulemaking agenda of the Division of Trading and Markets, under the leadership of Robert Cook. Mr. di Florio indicated that, in his view, the new rule proposals could generally be separated into the following three categories:
(i) Rules designed to strengthen market structure, such as the proposals on the consolidated audit trail and the large trader reporting system. Many of these proposals are responsive to the May 6th 2010 “Flash crash”;
(ii) Rules designed to improve disclosures to investors and increase investor protection. These include proposed rules concerning disclosures related to municipal securities, and asset backed securities (“ABS”), which would among others things enhance disclosure of information on the underlying assets of the ABS; and
(iii) Rules designed to enhance corporate governance. In this regard, Mr. di Florio stated that the SEC was focusing on obtaining better information on how regulated organizations were managed, on incentive and compensation structures and processes within regulated organizations, and how incentive and compensation are linked to overall risk. Mr. di Florio also noted that the SEC was focused on providing shareholders with an opportunity to participate in corporate governance matters by obtaining a greater role in the proxy process.
These categories are complemented by rulemaking under Dodd-Frank, which overlays a statutory requirement for rulemaking to strengthen disclosure and investor protection in many of these same areas, such as asset- backed securities, say-on-pay, municipal adviser registration, strengthening oversight of investment advisers, and a new regulatory regime around security-based swaps. Dodd-Frank also requires an SEC rulemaking regarding creation of a whistleblower program that would reward individuals who provide the Commission with high-quality tips that lead to successful enforcement actions.
Changes to the SEC’s Examination Program
Mr. di Florio highlighted certain key changes in connection with the SEC’s examination program. The Dodd-Frank Act will have a substantial impact on the SEC’s examination program. It will switch jurisdiction over investment advisers with assets under $100 million from the SEC to state regulators if the state in which the investment adviser has its principal place of business requires registration and subjects registered advisers to examination. At the same time it will expand SEC jurisdiction by requiring most advisers of private funds to register and be subject to examination. Mr. di Florio also discussed some entities that would be newly subject to SEC examination, noting specifically the SEC’s new authority with regard to major securities-based swaps participants and securities-based swaps dealers, execution facilities, clearing agencies and data repositories, as well as recent rule proposals under the Dodd-Frank provisions on securities-based swaps.
Mr. di Florio stated that the Dodd-Frank Act created new requirements for the Federal Reserve and the SEC, particularly in connection with the regulation of clearing agencies designated as systemically significant. Mr. di Florio explained that the SEC will have significant new oversight of such agencies, which will involve a statutorily-required annual examination of these agencies. Mr. di Florio also described the SEC’s recent proposal to implement the whistleblower provisions of the Dodd-Frank Act (“Whistleblower Program”), stating that the Commission release noted that the new program was not intended to encourage employees to bypass internal compliance and reporting processes. In this regard, Mr. di Florio stated that the SEC is interested in receiving comments on how the SEC can best ensure that companies continue to maintain strong internal processes designed to identify and address potential issues.
Mr. di Florio indicated that, as part of its process to revise its examination program, the SEC engaged in an internal review, focusing on the strategies, structures, people, skills, processes and technology related to the examination program. As a result of this internal review, the SEC examination program has identified 25 self-improvement initiatives that were going to be rolled out in the next 12 to 18 months. A key focus of these self-improvement initiatives involves improving the national examination program. In order to have a more efficient and consistent examination program, Mr. di Florio indicated that the SEC has established a national examination committee and steering committees to help implement the national examination program. Additionally, for the first time, the SEC has developed a standard manual detailing the proper process for conducting an examination. Mr. di Florio further noted that the SEC was using one technology tool to conduct examinations, which would enable the examination process to be more efficient and, therefore, registrants would experience more consistent examinations.
Mr. di Florio indicated that a major area of focus for OCIE is the use of risk-based examinations. To that end, the SEC is moving towards limiting and stopping routine cycle examinations, and instead focusing examinations on particular risk issues. In order to enhance and improve the focus on risk, Mr. di Florio noted that the SEC had recruited new specialists in certain key areas, such as risk assessment and technology. Mr. di Florio further stated that the SEC was focused on: (i) understanding risk and how such risk is managed; (ii) the way in which organizations structure control functions to identify and address issues; and (iii) how the internal audit system is structured to provide for independence and assurance with regard to risk management and incentives linked to risk. In addition, Mr. di Florio stated that the SEC was focusing on understanding the role corporate boards play, in terms of the boards’ role in the oversight of risk and compliance and the boards’ interaction with risk and compliance departments.
With regard to examinations of broker-dealers, Mr. di Florio stated that OCIE is focusing on, among other things, new products, variable and municipal securities, the valuation of those products, including what controls are in place in terms of the valuation of those products, the sales practices around those products, including whether customers fully understand the products, and the steps management is taking to ensure compliance in connection with those products. With regard to investment advisers, Mr. di Florio stated that OCIE is focused on, among other things, portfolio management, asset verification, and variations on performance, which is something the SEC uses to target examinations.
Mr. di Florio concluded by answering several questions. Mr. di Florio was asked to comment on how the SEC plans to address the incentives that may be created by the Whistleblower Program for employees to bypass the internal compliance process. Mr. di Florio indicated that the SEC has invited comments on its proposal and will carefully consider comments on this issue. Mr. di Florio further stated that the SEC is seeking to understand the programs firms have in place, and how these programs can be factored into the whistleblower process. Mr. di Florio was also asked for his thoughts on whether a self-regulatory organization (“SRO”) should be used to regulate investment advisers. Mr. di Florio noted that a study on this issue was required and is currently being undertaken, and that the SEC would be looking at this issue very closely. Mr. di Florio was asked to comment on the SEC working together with the Federal Reserve in connection with examinations. Mr. di Florio indicated that there would be more detail on the implementation of the examination process in the future, but that both the SEC and the Federal Reserve were beginning to get together and discuss the coordination process. In this regard, Mr. di Florio stated that the coordination process would be significantly improved and less duplication would exist in terms of examinations, which would make the overall examination process more efficient. Mr. di Florio was asked about the interaction between the SEC and state regulators in terms of the examination process. Mr. di Florio noted that he had attended several inter-regulatory meetings with SEC district offices, and that he believed that, moving forward, the SEC and state regulators have a good relationship and foundation to build on. Lastly, Mr. di Florio was asked to describe how OCIE plans to examine non-U.S. fund managers that are required to register with the SEC under the Dodd-Frank Act. Mr. di Florio noted that OCIE is currently focusing on this issue and that most of the examinations would likely come from the SEC’s home office. He further noted that, in connection with these examinations, OCIE would need to balance knowledge, budget and jurisdictional issues.