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SEC Official Explains Risk-Based Targeting

Because the SEC cannot conduct in-depth examinations of every mutual fund and investment adviser, said Lori Richards, director of the SEC's Compliance, Inspections, and Examinations Division, the agency is focusing on the highest-risk firms and the highest-risk compliance issues. In recent remarks at a fund director's workshop, she reported that risk-based targeting has identified problems and ensured prompt corrective action. For example, recent SEC examinations have detected significant and emerging problems, resulting in remedial and corrective actions.

Faced with the challenge of managing a risk-based examination program for a diverse and geographically-dispersed registrant population, the SEC has provided consistency in examination. This is a matter of fundamental fairness, noted Ms. Richards, since firms have a right to expect that the SEC will interpret and apply the law in a transparent and equal manner. The risk-based examination methodology facilitates this, she said, because examinations review the same issue across different types of firms and the results are summarized in reports provided to other SEC staff, including the Division of Investment Management. In this way, the SEC ensures that interpretations of law are consistent firm-to-firm, and fully in accord with the division's views.

Full coordination is also ensured by the fact that all risk-based examinations are coordinated in advance by the SEC staff. This practice prevents the duplication of issues examined and balances the number of examinations to which any one firm may be subject. But she also observed that, with respect to the largest and most diverse firms, those with multiple affiliated fund groups and advisers, the SEC staff may be reviewing discrete issues simultaneously.

More broadly, Ms. Richards emphasized that the key for the SEC is to obtain a level of confidence in the firm and in its compliance controls that fraud and violations are unlikely to occur. This is one reason why examiners will often ask to review a sample of e-mail communications. According to Ms. Richards, the Commission has found that e-mails often reveal what she described as the "unvarnished truth." Indeed, she said that one lesson of the recent industry scandals has been that e-mail records can be critical in detecting fraud.

Sensitive to the costs of producing e-mails, and understanding of the fact that firms ask outside counsel to review e-mails for attorney-client privilege, the Commission has begun to apply a more risk-based approach to its review of e-mail communications.

Ms. Richards also urged firms to establish a reasonable system to ensure that they are maintaining all required records. If the firm's system is to rely on individual employees not to push the delete button, she cautioned, SEC examiners will ask why the firm has confidence that this procedure is reasonably designed to work in practice. She reminded that SEC rules require advisers and funds maintaining records in electronic format to establish procedures to safeguard those records. The rules also require an annual review of the adequacy of the procedures and the effectiveness of their implementation.

The director's remarks come against the backdrop of a recent Government Accountability Office finding that, as the SEC refocuses its inspection resources to target higher risk mutual funds, the resulting trade-off in resources may limit the Commission's capacity to examine lower-risk funds and its capacity to accurately identify and target for routine examination the funds that do pose a higher risk. After reviewing a draft of the report, Ms. Richards said that risk-targeted examinations are a reasonable and effective means of quickly addressing industry risks.

In a risk-targeted review, she explained, the SEC staff conducts roughly contemporaneous examinations of the same risk at a number of firms. She described these as horizontal exams in the sense that they look at the same risk across the industry, which allows the staff to promptly investigate emerging compliance risks and compare a firm to its industry peers. Addressing GAO concerns that this approach may give insufficient attention to low-risk advisers, the director noted that the SEC is developing a program that will employ statistical techniques to select lower-risk advisers for full scope examinations.