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Speech by SEC Staff:
The Evolution of the SEC's Inspection Program for Advisers and Funds: Keeping Apace of a Changing Industry


Lori A. Richards

Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

"Compliance and Inspection Issues for Investment Advisers and Investment Companies" Sponsored by Glasser Legal Works
New York, New York
October 30, 2002

The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

Good Morning. I am delighted to be here at this conference specifically geared to the SEC's inspection program for advisers and funds. It's very important to maintain a dialogue between those of you, who work in the investment management industry, and those of us, who regulate that industry. I believe our goals are quite similar — we both want the investing public to feel confident about their decision to put their assets in your hands.

Today's program provides a platform for that dialogue, and to share information. You will hear from us about our inspection process, and the problems that we see the most — about "red flags" that draw the attention of our examiners and bring heightened scrutiny during our inspections. You will also hear about how our inspection program has evolved over time — and must continue to evolve — to respond to changes in this dynamic industry.

I never get bored with my job, and for that, I can thank this dynamic industry and the creative people who work in it. Changes occur so rapidly. Of course, the astounding increase in the number of investors, and the staggering amount of assets under management have caused many of the changes. But make no mistake, much of the change in the industry also arises from innovations — witness the myriad of new products that have been offered under the banner of investment management. In 1940, who foresaw money market funds, or funds of funds, or wrap-fee programs or exchange-traded funds? The ability of the industry to meet the changing needs, and make-up, of its investors has contributed to its success.

SEC regulation has also contributed to the success of the industry. After all, investors have confidence in the industry in no small part because they perceive it as highly regulated and they thus have confidence that their assets will be safe from malfeasance. The 1940 Acts contain proscriptions that provide valuable protections for investors. And, as the industry has grown and changed, the regulation and oversight of the industry has changed as well. Over time, the examination program has evolved in response to changes in the markets. Indeed, as the General Accounting Office concluded in a 1997 review of the SEC's inspection program, "the SEC has responded to the challenges presented by the growth in the [mutual fund] industry through increasing its inspection staffing and adjusting the focus of its oversight activities."

To continue to assure investor confidence, I believe that we, as inspectors, must always be seeking ways to keep pace — and that we have to stay as nimble and creative as you. We must continue to assess the effectiveness with which we use the limited resources available to us for oversight. And that means we have to change and re-tool our inspection program to respond to the realities of the industry as it exists today and to better serve the investing public.

Here are the realities of today's industry:

  • Funds: According to the Investment Company Institute, there are 8,300 mutual funds. As of May 2002, fifty-four million — or 49% — of U.S. households own mutual funds, with over $6 trillion in assets under management. And one-third of American households are invested in employer-sponsored retirement funds, such as 401(k) plans. Thirty-six percent own mutual funds through retirement or savings plans, such as traditional IRAs or Roth IRAs, education savings accounts, and variable annuities.
  • Advisers: As of May, there were 7,581 investment advisers registered with the SEC, an increase of about a thousand advisers from the year before. In fact, there are an average of 67 new advisers registering with the SEC each month. As of May, the assets managed by advisers totaled $19.7 trillion. These assets are highly concentrated; indeed, the twenty largest advisers have about a quarter of all assets under management.

Today I'd like to spend some time reflecting on the tremendous changes in our industry over the past several decades, and correspondingly, how our inspection process has evolved to respond to those changes. Or, how we got from there to here if you will. I'd also like to describe the changes we intend to make to try to keep apace of the changes in the industry.

I. The Creation and Evolution of the SEC's Inspection Program

The SEC's examination program was first established under the Securities Exchange Act of 1934, after the stock market crash of 1929 revealed shocking misconduct and marketplace anarchy. The Exchange Act created a federal regulatory system for securities exchanges and over-the-counter markets, and authorized the SEC to examine those markets. The powers granted to the SEC enabled it to conduct examinations in the public interest and for the protection of investors whenever it deemed appropriate, as often as it deemed appropriate, on a regular cycle, or otherwise. This purpose underlies all of the SEC's examination authority.

Then, in 1940, the SEC's examination authority was broadened to cover investment companies and their affiliates when Congress enacted the Investment Company Act. The Investment Company Act authorized the SEC to mandate that investment companies keep records relating to their financial statements. It also authorized the SEC to conduct examinations and to require investment companies, their affiliates and auditors to provide copies or extracts of these records. Had the SEC used this inspection authority in 1940, it would have been a fairly easy task — at least by today's standards — in 1940 there were only 68 mutual funds with $448 million under management!

It took the SEC another seventeen years to establish an active examination program for investment companies. In 1956, an investigation of an investment company disclosed irregularities in its accounts. In light of these findings, and the rapid expansion of the industry, the SEC determined that a regular program of inspections of investment companies was necessary. The program was started in 1957 with nine inspections. These inspections found a number of deficiencies and, in the SEC's view, revealed the need for continuous field supervision. By 1960, the Commission formalized the program with training for investment company examiners and a process through which headquarters staff reviewed field office inspection reports. This system remains largely intact today.

In 1960, Congress amended the Investment Advisers Act, authorizing the SEC to require investment advisers to keep specific books and records and to conduct examinations of advisers. The SEC immediately put its new powers to work and, by 1963, it was conducting 219 yearly inspections of investment advisers. This was relatively easy too, but by 1965, the SEC was inspecting only about one-sixth of all advisers registered with the SEC each year.

Our earliest inspections focused on investment advisers and investment companies as if they were independent, stand-alone entities. Only one investment company or one adviser was examined at a time, regardless of whether it was part of a larger complex of funds, or served by an in-house transfer agent and adviser. This approach worked well in the late 1950's and 1960's, when the number of registered advisers and funds was relatively small and the assets held by the industry were not astronomical.

Then, from 1960 to 1970, the industry began to change. The number of mutual funds more than doubled in number, to 361, and the number of shareholder accounts reached over 10 million. And legislative changes, starting in 1962, added to the significant growth and change in the industry. To whit, Congress authorized: Keogh Plans in 1962; Employee Retirement Plans and IRAs, municipal bonds, and 401(k) plans in the 1970s; and then, Universal IRAs in 1981. With each new statutory change, the industry responded by creating new and, oftentimes, unique products. And, more and more households placed assets in the industry. By 1979, 200 new funds had been added, and assets grew to $94 billion.

During the 1970's, the SEC recognized that its inspection program needed to adapt to the changing industry. We dropped the one-at-a-time approach and, instead, adopted an inspection program that focused on "systems." In other words, instead of pursuing a one-fund, one-inspection approach, we focused our inspections on fund complexes, which are groups of mutual funds that generally have the same adviser or underwriter, and examined the compliance systems used by all entities in the complex. Let me give you an example: when examining a fund complex, we would review the system used by the adviser to place trades for all of the adviser's mutual fund clients. This "systems" approach did not remain unchanged for long, however, because even more radical changes were about to take place in the industry.

In the last two decades of the century, the investment management industry exploded. Try to grasp these numbers:

  • Assets under management at mutual funds increased over 5000% (from $135 billion to almost $7 trillion), and the number of fund shareholders by 2000% (from 12 million to 244 million).
  • The number of advisers increased by 500%, from 3,500 in 1980 to 22,000 by 1995.

Meanwhile, our inspection program attempted to cope not only with the industry's enormous growth, but also with the increasing complexity of the products and services offered. Although the "systems" examination approach was still used, our limited staff led us to focus on the largest mutual fund complexes and investment advisers. The focus on the largest firms however, reduced the number of exams conducted of small and medium-sized firms. In fact in the early 1990's, the growth in the number of advisers had outstripped our ability to maintain any reasonable exam cycle — with some advisers never being examined by the SEC!

Fortunately, in the early 1990's, the SEC diverted more resources to the inspection program and we refined the systems approach to focus our inspections on those activities that presented the greatest potential risk to investors. In addition, inspections of investment advisers increased. Then, in 1996, Congress passed the National Securities Markets Improvement Act (NSMIA), which divided regulatory responsibility for advisers between the SEC and state regulators. The SEC became responsible for examining only the largest advisers, with more than $25 million in assets under management.

With the creation of OCIE in 1995, our current inspection program began to evolve. In 1998, following the effectiveness of NSMIA, we established an overall goal for our inspection program - our "Five Year Plan." Under this Plan, we proposed to inspect each investment adviser, fund complex, and transfer agent affiliated with a fund group, which was registered at the beginning of the cycle, at least once within a five-year cycle. More frequent inspections of these firms were conducted if circumstances warranted and resources allowed.

Our inspection techniques were further refined to ensure that examiners focus on detecting violations of law that impact mutual fund shareholders and advisory clients. Our experience has shown us that most violations of law that impact clients arise from conflicts of interest, such as, for example, the use of client brokerage commissions to pay for products and services that provide benefits to the adviser, allocations of securities among different types of clients, and calculations of an adviser's performance. As a result, our routine inspections cover areas where these conflicts may manifest into harm to investors. We also conduct special focused examinations on areas of regulatory concern or interest. Some of our recent focus areas have included personal securities trading by fund personnel, privacy, soft-dollar payments, funds investing in bank loan participations, anti-money laundering programs, and payments for fund distribution.

As we are at the end of our Five Year Plan, I am happy to report that OCIE met its objective. We inspected each firm registered with the SEC at least once over the last five years. We conducted over 8,000 inspections of investment advisers and mutual fund complexes, finding everything from clean shops with no deficiencies or violations, to serious violations that we referred for enforcement action, and many deficiencies and compliance lapses along the way. What can never be gauged however, are the improvements in compliance controls and supervision, and the serious violations that were prevented, because of these inspections.

II. Continued Evolution: The SEC's New Inspection Plan

As I think I've shown you today, our industry is not static. Today the investment management industry looks quite different from the industry that existed even in 1998. The growth in the industry has outpaced growth in our resources by multiples. The largest one hundred advisory firms now manage more than half of the industry's assets. Many money managers have implemented internal controls and compliance systems, including through the increased use of automation. With the passage of the Gramm-Leach-Bliley Act in 1999, a large number of investment management firms now operate within the structure of a bank or financial services holding company. We've all witnessed the range of new, complex financial products and strategies being utilized by advisers. Going forward, we will all also be implementing the new Sarbanes-Oxley Act requirements. And after Enron, WorldCom, Adelphia, and other scandals, none of us can assume that large necessarily means well-run. We are all concerned about the potential havoc that a major scandal at a large firm could create for investors. Such an event would have a significant negative impact on investor confidence, with a concomitant blow to investors, the industry and the financial markets.

So once again, we are looking at ways to update and improve our inspection program to reflect the realities of today's investment management industry. We have recognized that a one-inspection-every-five-years, "one size fits all" approach to conducting inspections is no longer appropriate.

To respond to the changes in the industry and regulatory environment, and to improve the ways in which we utilize our limited resources, we are again making changes to our inspection program. First, we are implementing a new, risk-based approach to selecting registrants for inspection that will result in a different inspection frequency for firms with different risk profiles. Second, we are also introducing a substantially enhanced process for conducting inspections that places greater emphasis on advisers' risk management and internal control processes. The result of these changes is that our new inspection program will correlate both examination frequency and examination scope with risk. We would also continue to compliment our routine inspections with cause exams, and with special purpose exam sweeps, from time to time. We hope to implement all aspects of this new inspection plan with additional funding in the SEC's budget.

Let me first describe the changes to exam frequency. Because the largest firms control the vast majority of all assets under management — the top 100 firms control 60% of all assets under management — we intend to give the largest firms enhanced focus. The top twenty of the 100-largest advisory firms and affiliated fund groups will be placed on a two-year inspection cycle. For the remaining 80 firms, we will assess each firm and determine how often it should be examined based on criteria indicating risk. Those firms with a higher risk will be examined every other year while those with lower risk will be examined at least once every four years. Similarly, the remaining 7,600 advisory firms and affiliated fund groups will be inspected on a two or four year cycle, again depending on the firm's risk profile. In addition, we will evaluate the profile of each new firm that becomes registered with the SEC, and those new firms that appear to have the highest risk will be examined within twelve months of the time their registrations become effective. We hope to catch less serious deficiencies before they become serious, and ensure that new advisers understand their compliance obligations.

The net effect of these changes will be more frequent inspections for large firms and firms with higher risk. And no firm will go more than four years without being inspected.

What are the criteria indicating risk? While still evolving, these criteria will include quantitative measures derived from information reported in these firm's filings with the SEC, and qualitative information such as the results of their last examination.

Let me turn now to outline our approach to evaluating the risk management and internal control systems used by funds and advisers. Our approach here is more structured than in the past; and our goal is to focus our exams on areas of real risk to investors. We also believe that we should rely on firms' own internal controls to a greater extent, where those controls are demonstrably robust. Under this new approach, the first steps in an inspection will involve discussions with operating managers and compliance staff to obtain a complete understanding of the firm's control procedures in what we believe are the most critical or strategic areas. These areas reflect the activities of advisers and funds that were the basis for the vast majority of enforcement actions the SEC has brought against advisers over the past ten years. They include things such as:

  • The consistency of portfolio management decisions with clients' mandates;
  • Order placement practices consistent with seeking best execution and disclosures made to clients and funds' boards;
  • Allocation of block and IPO trades;
  • Personal trading of access persons consistent with the firms' code of ethics;
  • Accurate securities pricing and net-asset values;
  • Regular reconciliation of custodian records with fund and adviser records;
  • Controls over information;
  • An independent custodian provides clients with information about activity in their accounts;
  • Calculations and presentations of performance; and
  • Accurate reconciliations of shareholder transactions.

In each of these areas, examiners will ask about your compliance and control policies and procedures, and evaluate their implementation and effectiveness. If we can conclude that your controls are working effectively, we will adjust the depth and amount of test-checking we do to reflect that fact. If we find weaknesses in controls, however, our test-checking will be greater, inasmuch as the likelihood of violations will be greater. Our whole approach here is to rely on sound controls to a more significant extent, and to incentivize firms to create, implement and demonstrate sound controls.

I've outlined a new program for you this morning that more closely calibrates our inspections to firms and areas with the greatest risk. While we will do all we can to ensure that our program adapts and changes, it is simply a fact that government can't be everywhere, all the time. That's why your private sector efforts to ensure compliance and reassure your investors are so critical. You too must think frequently and creatively about ways to retool your compliance systems to ensure that they are as strong as they can be in this new environment.

*   *   *

As you can see, our inspection program has changed over time, as the industry has changed. From the very outset of the 1940 Acts, it was acknowledged that the investment management industry would change and experiment with new structures, products and services. It was logical, therefore, to expect the regulator to have the same ability to change and experiment. As I've described for you today, we have. To be sure, we are not done. We will continue to review what we do, and to make changes to our program to help ensure that we are doing all we can to prevent and detect compliance breakdowns. But the SEC's inspection program is only a single component in the compliance and regulatory system for advisers and funds — we must all be dedicated to ensuring that our nation's investors are protected.

Thank you.



Modified: 10/30/2002