(Article from Registered Funds Alert, November 2015)
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As the number of registered investment advisers has grown over the years, the SEC has struggled to keep up when it comes to examining advisers. SEC Chair Mary Jo White has consistently acknowledged that the SEC currently does not have sufficient examination resources, with a current ratio of approximately 450 examination staff to 11,500 registered investment advisers and 9,000 investment companies. Currently, the SEC only examines about 10% (or about 30% of total assets under management) of advisers in a given year, and on average an adviser can expect to be examined once every 11 years.
Over the years, a number of solutions have been proposed to solve this perceived examining shortfall, including: (i) increasing SEC resources; (ii) reallocating current SEC resources; (iii) delegating examination authority to a self-regulatory organization (“SRO”), such as the Financial Industry Regulatory Authority or a newly created body (either of which would presumably be funded by dues from investment advisers); or (iv) requiring advisers to be audited by a third-party each year.
An act of Congress would be required to increase SEC resources as well as to turn over regulatory oversight to a SRO. And, while Chair White has consistently requested significant budget increases over the years, appropriations have fallen short, and it is difficult to imagine the bipartisan effort that would be required for either such option to materialize in the current political environment. However, no such Congressional act would be required for the SEC to implement a third-party inspection program. Given this, it is not surprising that the third-party inspection/audit program recently has gained significant traction. Chair White has directed SEC staff to develop a proposal that would require investment advisers to undergo third-party compliance inspections, which would supplement, not replace, SEC examinations and then make such inspection results available to the SEC.
Proponents of the third-party inspection program, such as former SEC Commissioner Dan Gallagher, have pointed to certain unique benefits of this approach, such as the ability to “leverage the resources and expertise of the private sector.” Advisers would have the flexibility to “shop around” for an examiner and select the firm that provides the best fit for it. From an investor-protection perspective, a third-party inspection program would, proponents argue, give the SEC the ability to oversee effectively a much larger percentage of the growing number of investment advisers, which theoretically could increase the deterrent effect of inspections as well as detect a higher percent of wrong-doing within the industry.
However, some interested parties argue against imposing a third-party inspection requirement on advisers. Some have concerns and questions regarding the quality, scope, cost, oversight and confidentiality of such an inspection program. For example, what standards would apply? Unlike for financial statement audits, there are no clear standards and principles that deal with grey areas. If the inspections only focus on black-and-white issues, it raises the question of whether there is really a problem that needs to be addressed (i.e., is clear-cut non-compliance a significant enough concern that this huge imposition of costs, ultimately borne at least in part by investors, is justified?). Separately, would inspection results be subject to FOIA requests and civil discovery?
Others have raised questions regarding the qualifications of potential third-party examiners, noting that Chair White has acknowledged that current SEC examiners are the most qualified experts in this field. Finally, given that the proposed third-party inspection program would only supplement SEC inspections, some also contend that the proposed system would only add another burden on advisers, as even after an adviser made available the results of its third-party inspection, it would not exclude the SEC from also performing its own inspection of the adviser. As in the current debate over the fiduciary rule, initiatives that may serve to make investment advice more costly for retail investors need to be considered carefully to avoid unintended consequences.