The Securities and Exchange Commission
In December 2008, Bernard L. Madoff admitted to perpetrating a massive Ponzi scheme. Shortly thereafter, the SEC began taking decisive and comprehensive steps to reduce the chances that such frauds would occur or be undetected in the future. Today, the agency is continuing to reform and improve the way it operates. Among other things, the SEC has been:
Revitalizing the Enforcement Division: Under new leadership, the Enforcement Division was restructured to better ensure that it focuses on significant cases that will have a meaningful impact. The newly structured division includes national specialized units, which were staffed and fully launched in May 2010. These units focus on the key areas of Structured and New Products, Market Abuse, Municipal Securities and Public Pensions, Asset Management, and violations of the Foreign Corrupt Practices Act. To stay on the cutting edge of industry trends, the units are hiring industry experts to work directly with teams of experienced attorneys and accountants. In addition to the work of the specialized units, the division has streamlined its management structure and made its investigative procedures more efficient.
Revamping the Handling of Complaints and Tips: Each year, the SEC receives a massive number of tips and complaints. In order to improve the way it handles this information, the agency has updated its policies and procedures and implemented a centralized information technology system for tracking, analyzing, and reporting on the handling of the tips and complaints. In addition, the agency is working on a future system to apply data analytics to this information so the agency can be more proactive in detecting fraud.
Last year, the Enforcement Division created the Office of Market Intelligence (OMI) to gather all tips and complaints in one place; combine them with other public and confidential information on the persons or entities identified; and match investigative resources with those tips presenting the greatest threat of investor harm. OMI also serves a strategic function, harvesting data to identify newly-emerging schemes and trends in securities fraud. The Division hopes to increase the technological capacity of OMI to enhance these capabilities. OMI’s strategic function is critical to the Enforcement Division's top priority of being more nimble and proactive, permitting it to identify misconduct as quickly as possible.
Encouraging Greater Cooperation by 'Insiders': The SEC has developed formal agreements, similar to those used by criminal law enforcement authorities, to secure the cooperation of persons who are on the "inside" or otherwise aware of organizations engaged in fraudulent activity. These agreements provide that insiders who offer truthful evidence and agree to cooperate and testify will be eligible for a possible reduction in sanctions. These cooperation agreements have the capacity to secure the availability of witnesses and information earlier in investigations, enabling the agency to build stronger cases more quickly. Since its launch in January 2010, the cooperation initiative has been used to support and strengthen investigations nationwide in areas including financial statement and accounting fraud, insider trading, investment adviser fraud, market manipulation, offering fraud, and FCPA violations.
Enhancing Safeguards for Investors' Assets: In December 2009, the SEC adopted rules to better protect clients of investment advisers from theft and abuse. The rules provide greater assurance to investors that their accounts contain the funds that their investment adviser and account statements say they contain. Among other things, the new rules encourage registered investment advisers to place their clients' assets in the custody of an independent firm, unlike Bernard Madoff did. In situations where an independent custodian is not used or an adviser has control of client assets, surprise exams and third party reviews are required to protect investors’ assets.
Surprise Exams: The new custody rules require registered investment advisers who control or have custody of their clients' assets to hire an independent public accountant to conduct an annual "surprise exam" to verify those assets actually exist. This surprise examination provides another set of eyes on the clients' assets, thereby offering additional protection against the theft or misuse of funds. The Commission expects to take up a complementary proposal with respect to the custody of customer assets by broker-dealers in the near future.
Third Party Reviews: Under the new custody rules, registered investment advisers whose client assets are not maintained with independent firms must obtain a third-party written report assessing the safeguards that protect the clients' assets. The report — prepared by an accountant registered and inspected by the Public Company Accounting Oversight Board — among other things, must describe the controls that are in place to protect the assets, the tests performed on the controls, and the results of those tests. The old rules made no distinction between an investment adviser whose affiliate holds its clients' funds and an investment adviser that uses a truly independent custodian. In addition, the SEC adopted changes in July 2010 to the principal disclosure document that SEC-registered investment advisers provide to clients and prospective clients. The changes substantially improve the quality of disclosure clients receive and allow them to better evaluate the risks associated with a particular investment adviser.
. . . In June 2011, the SEC proposed rules to better protect customer assets maintained at broker-dealers. The proposals would strengthen SEC and SRO oversight of broker-dealers’ custody practices. Under the proposals:
Audit Enhancements: A broker-dealer that maintains custody of customer securities and cash would be required to undergo a compliance examination — by a Public Company Accounting Oversight Board-registered public accounting firm — that would include an audit of the controls the broker-dealer has in place to protect customer assets. Broker-dealer audit requirements also would be updated to facilitate the ability of the PCAOB to inspect broker-dealers’ registered public accounting firms.
Auditor Access: A broker-dealer that maintains custody of customer securities and cash — or clears transactions — would have to allow SEC and SRO examiners to access the work papers of the registered public accounting firm that audits the broker-dealer and discuss any findings with the personnel of the registered public accounting firm.
Custody Reports: A broker-dealer would file a report on a quarterly basis with the SEC and its designated examining authority that contains information about whether and, if so how, the broker-dealer maintains custody of its customers’ securities and cash. The report would establish a custody profile for broker-dealers that examiners could use as a starting point to focus their custody examinations.
Improving Risk Assessment Capabilities: The SEC continues to improve its risk assessment procedures and techniques, agency-wide, to better identify areas of risk to markets and investors. For instance, the agency is enhancing the information that financial firms submit and is improving techniques to better identify those particular firms that may warrant an examination. New information now being submitted by money market funds on Form N-MFP is further enhancing the agency's risk assessment capabilities. Proposed revisions to Form ADV and the creation of Form PF will increase the amount of information available for use by the agency in conducting risk assessment. The agency is also increasing collaboration with third parties and other government agencies. Finally, the agency created a new Division of Risk, Strategy, and Financial Innovation that is providing expertise to examiners and the policy divisions in risk assessment, financial products, and financial engineering.
Conducting Risk-Based Examinations of Financial Firms: The SEC is using its enhanced risk assessment to select firms for examination based on certain risk characteristics so that it deploys its limited examiner resources to have the greatest impact in protecting investors. Such risks include, among other factors, advisers whose clients' assets are held with an affiliate, as opposed to an independent entity; funds that seem to have "smooth" or outlier returns; firms with a disciplinary history; and broker-dealers that sell an affiliate's hedge fund or limited partnership. Several firms with these risk characteristics identified in exams have been the subject of enforcement investigations.
Improving Fraud Detection Procedures for Examiners: The SEC has instituted measures to improve the ability of examiners to detect fraud and other types of violations. Examiners across the country now routinely reach out to third parties such as custodians, counter-parties, and customers during exams to verify the existence and integrity of all or part of client assets managed by the firm. In addition, the measures include more rigorous reviews of firms before the examiners enter the premises, and an exam approach 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 or no accountant at all. The measures also include expanded use of joint broker-dealer and investment adviser examination teams for entities that have joint or dual registration as broker-dealers and investment advisers.
Recruiting Staff with Specialized Experience: The SEC has been bringing in new staff with diverse skill sets to expand its knowledge base and improve its ability to assess risk, conduct examinations, detect and investigate wrongdoing, and focus our priorities. Some initial examples included:
Senior Specialized Examiners: The agency has hired new staffers to the examination unit — and will bring on board more — who have specialized experience in areas such as derivatives markets, derivatives trading, private funds, clearing, risk management, trading, operations, portfolio management, options, compliance, valuation, new instruments and portfolio strategies, and forensic accounting.
Additional Staff with Capital Markets Expertise: The agency has been hiring additional staff with expertise in modern financial products and techniques — such as structured debt, derivatives, and private fund activities. Now, other staffers can tap into that expertise to help them identify emerging issues and understand the ways the industry is changing. Such expertise can also be helpful in efforts to improve the techniques used in examinations and the collection and analysis of data.
Expanding and Targeting Training: The SEC has provided — and will continue to provide — staff training related to hedge funds and specialized products; derivatives and options; the verification of trades and custody arrangement; and the use of databases maintained by exchanges and clearinghouses, among other things. Additionally, hundreds of staffers have been training to become Certified Fraud Examiners, and the SEC is expanding the availability of programs for staffers to become Certified Financial Analysts and Chartered Alternative Investment Analysts.
Improving Internal Controls: The examination program and Enforcement Division each have implemented a quarterly review program to help ensure that important issues are resolved in a thorough and timely manner and that no examination or investigation falls through the cracks. As part of the quarterly review programs, examination and enforcement managers meet with their respective staffs to review and discuss all open examinations and investigations and address whether additional expertise is needed to resolve issues, finalize exams, and bring investigations to conclusion. In addition, the examination program has enhanced its management controls and decision-making through a new governance structure that includes a National Leadership Team composed of both headquarters and regional office managers.
Advocating for a Whistleblower Program: In 2009, the agency requested expanded authority from Congress to protect whistleblowers from retaliation and to reward those who bring forward substantial evidence about significant federal securities violations. The Dodd-Frank Act established such a whistleblower program and now prohibits retaliation by employers against individuals who provide the Commission with information about potential securities violations. In May 2011, the agency adopted rules to implement the statute. In addition, our new Office of the Whistleblower is fully staffed, and the fund that will be used to pay awards to qualifying whistleblowers is fully funded.
Seeking More Resources: As part of the Dodd-Frank Act, Congress has authorized additional funding for the SEC to hire more examiners who can go into more financial firms to see whether those firms are in compliance with the law, as well as more enforcement staff who can bring more enforcement cases when fraud and other violations of the law are found. Congress still will need to appropriate the funds to hire and sustain these personnel over the long term. In addition, the Dodd-Frank Act includes a new budget process for the SEC designed to provide more stable funding for the agency, including access to a contingency fund for funding shortfalls.
Integrating Broker-Dealer and Investment Adviser Examinations: The SEC has instituted several measures to integrate broker-dealer and investment adviser examinations. The New York Regional Office, for example, has adopted a protocol that integrates examination teams for firms that are registered as broker-dealers and investment advisers to make sure staff with the right skill sets are assigned to examinations. Under the new protocol, a single team of examiners, drawn from the broker-dealer and investment management units, will jointly examine selected firms with such operations. In addition, the examination program has expanded opportunities for examiners to cross-train and increase coordination between broker-dealer and investment management staff on their examination plans. Finally, selected regional offices have fully integrated their broker-dealer and investment adviser examination units to provide seamless oversight of firms offering both brokerage and investment advisory services.
Enhancing the Licensing, Education and Oversight Regime for ’Back-Office’ Personnel: Working with senior SEC staff, FINRA has committed to establish a new system to enhance the oversight and professional requirements of personnel performing back-office functions at broker-dealer firms. "Back-office" personnel typically perform critical custody, accounting, account transfer, settlement, and account maintenance functions. They have an important role that must be performed with skill and integrity. The Commission published FINRA’s formal proposal to establish its new system for public comment in March 2011. Under FINRA’s proposed regime, certain back-office personnel would be subject to licensing and education requirements. This proposed regime is intended to promote the qualifications and professionalism of those performing back-office functions so that client accounts are better protected. The public comment period for the proposal closed in April, and the Commission is now carefully considering the input received in determining whether to approve the proposal.