Required Third-Party Reviews?! At What Cost?

5x_Simons-Tim-154On October 23, 2015, David Grim, the Director of the SEC’s Division of Investment Management, appeared before a subcommittee of the House Financial Services Committee.  A comment he made, which prompted the writing of this article was,

“Division staff, working in conjunction with the staff from the SEC’s Office of Compliance Inspections and Examinations (OCIE), is developing a recommendation for the Commission’s consideration that, if proposed and adopted, would establish a program of third-party compliance reviews for registered investment advisers.  The reviews would not replace examinations conducted by OCIE, but would supplement them in order to improve compliance by registered investment advisers.”

It should be noted that many institutional clients require their advisers to have an independent third-party compliance examination on some regular basis, typically every other year or every third year.



Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) required the SEC to review and analyze the need for enhanced examination and enforcement resources for investment advisers.  The purpose of investment adviser examinations is to: improve compliance; prevent fraud; monitor risk; and inform regulatory policy.  A major concern is that the number of registrants has continued to increase, while the number of examiners has decreased.  The intent of raising the assets under management requirement to register was an attempt to give the SEC a chance to get ahead of that curve.  The SEC estimated that the number of registered investment advisers would drop by a little over 3,000 registrants, but it actually only dropped by about 2,000, while the addition of private fund advisers now required by Dodd-Frank to be registered added almost 1,500 new advisers.  At that time, the SEC estimated that by FYE 2015 the investment adviser population would be 10,378 with over $46 trillion assets under management. Unfortunately for the SEC, the actual number for FYE 2015 is almost 12,000 registered investment advisers and over $66 trillion in AUM.  The sense at the time of the study was that Congress would not be willing or able to increase the SEC’s budget to provide the necessary additional staff.  In fact, for the last few years, the staff has only been able to examine roughly 10% of the registered investment advisers on an annual basis.

At the conclusion of the SEC’s study, the Staff recommended that Congress consider the following three approaches to strengthen the SEC’s investment adviser examination program:

  • Authorize the Commission to impose user fees on SEC-registered investment advisers to fund their examinations by OCIE;
  • Authorize one or more Self-Regulatory Organizations to examine, subject to SEC oversight, all SEC-registered investment advisers; or
  • Authorize FINRA to examine dual registrants for compliance with the Advisers Act.

For those of you who have not read the report on the study, it is available on the SEC’s website.  Read the Study on Enhancing Investment Adviser Examinations.


The Investment Adviser Association

According to the Investment Adviser Association (“IAA”) website, “The IAA has consistently supported appropriate and effective regulation and oversight of the investment advisory profession by a single governmental regulator – the SEC.”  The IAA supports efforts to provide the SEC with the resources it needs to examine advisers more frequently.

One of the concerns of the IAA is the current high cost of regulatory compliance, especially on small investment advisers, which are the vast majority of federally registered advisers.  While most of us would agree that a higher percentage of registered advisers should be examined on an annual basis, the IAA maintains that SEC regulation is comprehensive, and that we need more exams to be conducted, not more regulations.

The IAA website explains that existing laws and regulations govern how an adviser attracts new clients, describes itself and its services, contracts with clients, custodies client assets, trades client accounts, and manages and discloses potential conflicts of interest. Federally registered investment advisers are subject to extensive recordkeeping requirements and must also maintain comprehensive compliance programs, including codes of ethics. All investment advisers’ activities are further subject to an overarching fiduciary duty that requires them to act in the best interests of their clients.

Since the Section 914 Study report was issued, the IAA has identified itself agreeing with authorizing the imposition of user fees as the most economical solution, especially for the registered advisers.  The costs of establishing another SRO, or just an additional layer of bureaucracy between the regulator and the regulated must be higher than charging user fees to finance the additional staff for the SEC.  They also believe that Commissioner Gallagher’s suggestion that third parties could augment the SEC’s advisory examination program would be a worthwhile discussion.


Back to the Present

It seems that the blending of user fees and examinations by independent third parties is a viable solution that recently has been gaining traction, even though the SEC has indicated that those exams will not be a substitute for SEC exams.  I heard someone at a recent compliance roundtable indicate they had heard that the SEC would require firms to have the third-party exam starting in 2016, but I have to say that if the SEC Commissioners decide to take that route, the road starts with a rule proposal, followed by a comment period, then a period for the SEC to consider the comments received (which I would expect to be a very large number), and then issue the rule with a compliance date sometime in the future. I would be surprised to see a compliance date prior to fiscal year end of 2016.

Commissioner Gallagher has been a proponent of third-party reviews (including SROs in the definition of third parties) for several years as a way to increase the review of investment advisers, at least having someone independent of the firm reviewing practices and compliance with federal securities laws and the adviser’s fiduciary obligation to the client.  Some of the issues that will need to be addressed are:  the standards, scope and frequency of reviews, the qualification process and oversight for third-party reviewers, and the cost to advisers (hopefully based on the complexity of the adviser and not just on AUM).


Investment Advisers Don’t Need Mystery Monitors

On November 22, 2015, Norm Champ, a former Director of the SEC’s Division of Investment Management addressed the idea of third-party reviews in the Wall Street Journal.  Champ suggested that although the idea of third-party exams is appealing, “the unintended consequences need to be examined.”  These may include:

  • that the examination costs would be passed on to clients;
  • the firms conducting the exams would have a guaranteed revenue source with little incentive to perform quality exams or to keep costs down;
  • the third parties could develop their own agendas for examinations;
  • it would not be economically feasible for the third parties to look at compliance for every rule; and
  • the SEC does not have the authority to regulate those third parties.

Champ also suggested that perhaps the examination problem could be cured by the SEC using its resources more efficiently, since the investment adviser examiners only complete about two exams per person per year.  He also notes that the SEC has over 200 broker dealer examiners, even though the SRO for broker-dealers examine 40% of its firms each year, and perhaps some of these examiners could be reassigned to the investment adviser program.


My Perspective

Since I am one of those third-party compliance reviewers, my perspective is slightly different from those expressed above.  My biggest concern is satisfying my client, that’s what I get paid to do, and that’s how I generate additional business.  The clients who hire me now do so because they have a client requiring them to, or because they want to be ready when the SEC comes calling.  They share things with me that they would not share with the SEC, so that I can help them address those concerns.

  • If the adviser knows that the SEC will expect to see a copy of my findings, will they still be willing to share their problems with me, or will they see me as the SEC’s stooge?
  • What education or experience will the SEC expect a third-party examiner to have?
  • Will the SEC generate some kind of approved list, identifying those third-parties who find the most problems or the biggest problems as “approved by the SEC?”
  • What happens when the third-party examiner finds a deficiency that the SEC missed?
  • Will advisers think that third parties who charge higher fees are better than those who charge lower fees?

I think third-party compliance consultants will need to look at the framework the SEC sets up and how they plan to administer the program for the third-party examiners before we make that decision.  I know I will have comments when the proposal comes out for comment, although there is always the possibility that the SEC will ask for input from third-party examiners before establishing the framework.

It’s easy to say that whatever the SEC decides, it will be better than the current situation, but whatever the SEC decides, there is the potential for unintended consequences.

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