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The SEC's new examination program

by contributor John H. Walsh, Sutherland Asbill | Published April 19, 2012 at 1:19 PM

The Dodd-Frank Wall Street Reform and Consumer Protection Act gave the Securities and Exchange Commission several new enforcement powers. Some of these new powers -- such as paying bounties to whistleblowers -- have attracted widespread commentary and discussion. Less attention has been given to the new relationship between enforcement and examinations. More attention is due. The end of routine examination oversight will have a significant impact on the securities business.

Enforcement investigations are the better known of the SEC's oversight tools. In an investigation, the SEC obtains records, takes testimony and, at the end, may bring a public case that describes the alleged violations and often imposes penalties. The SEC publishes its enforcement cases, and it may issue press releases and hold press conferences. In congressional testimony on March 6, SEC Chairwoman Mary Schapiro indicated that the agency brought 735 enforcement actions last year.

Examinations are less well known. The interviews conducted during an examination are less formal, and rather than a public case, an examination often results in a nonpublic deficiency letter, which asks the firm to rectify problems discovered during the examination. Although examinations are not public, they are a significant regulatory tool. In her testimony, Schapiro indicated that the agency completed more than 1,600 examinations last year.

The SEC's powers to enforce and to examine are based on different statutory provisions and are subject to different controls. Anyone subject to the SEC's enforcement authority enjoys multiple layers of due process protection. Participating in an investigation -- producing documents and giving oral information -- is voluntary, unless the SEC issues a formal order of investigation authorizing the issuance of subpoenas. After a formal order has been issued, a subject under investigation may require the staff to go to a federal judge, who will decide whether the subpoena should be enforced. As a final level of protection within the SEC, the commissioners must vote on the case, and the subject has an opportunity to present its side of the story in a document known as a Wells submission. Finally, even after the SEC brings an action, a subject may require the SEC to prove its case before the SEC's chosen forum, either a federal judge or an administrative law judge. Of course, throughout the investigative process, a firm must give careful consideration to the most prudent course of action.

Seeking maximum review at each step of an investigation is rarely an effective response. Nonetheless, the availability of these protections ensures a certain level of governmental regularity. A firm can always respond: "We don't think the commissioners or a judge -- federal or administrative -- will agree."

By contrast, no such process is available in an examination. When the SEC examines broker-dealers and investment advisers, examiners have authority to review "all" of the firm's records "at any time" or "from time to time." The SEC has described this power as "unconditional." The federal courts have not disagreed. While an examination must be "reasonable," this means only its time, place and manner, not its scope.

The juxtaposition of two different powers -- one bound by multiple layers of due process and the other unconditional -- could create tension in any organization. Why subject oneself to limits and rights of appeal when the same action can be taken directly through the unconditional power? Instead of gathering information through enforcement, with its checks and balances, why not simply use examiners? This is not a new issue.

Traditionally, the SEC has viewed enforcement and examinations as two separate programs. This balanced the unconditional nature of the examination power through at least two practical restraints. First, many examinations were routine and intended primarily to assess a firm's overall risk and compliance health. Second, when examiners believed they had found a serious problem, they would conclude their examination and refer the matter to enforcement staff who, upon accepting the referral, would conduct an investigation subject to the normal due process protections. Today, these distinctions are breaking down.

Routine examinations are a thing of the past. For several years, the examination program has emphasized its focus on "firms or activities where examiners believe the investing public or market integrity are most at risk." On Jan. 31 at an SEC conference for investment advisers, Roz Tyson, the SEC regional director for the Los Angeles regional office, discussed what this means in practice. She indicated that examiners are targeting firms that have a higher risk profile and give examiners "the potential for finding significant violations."

Further, in recent months, managers in both the enforcement and examination programs have stated publicly that they are working together and collaborating at a new level. In congressional testimony on Nov. 16, Carlo di Florio, director of the SEC's Office of Compliance Inspections and Examinations, said the collaboration between the two programs is "particularly close." Similarly, at the Jan. 31 conference, Tyson noted that examiners are encouraged to consult with enforcement and the "swiftness" of referrals has been heightened. Finally, Bruce Karpati, co-chief of the Division of Enforcement's asset management unit, participating in the same conference confirmed that with the current level of coordination, there are additional "outlets" for examinations, beyond the historical approach of making an enforcement referral.

What do these changes mean to a securities firm? When a firm is examined, it should recognize that it was probably targeted because the examiners believe it may be placing the investing public or market integrity at risk. The firm should also recognize that the examiners may be coordinating behind the scenes with enforcement investigators. Stories are beginning to circulate of enforcement investigators suddenly appearing in the middle of an examination, or after the firm was given a deficiency letter but before it had time to respond.

To their credit, SEC managers have been very frank about this new reality. At the Jan. 31 conference for investment advisers, Tyson recognized that examiners can go into a firm, and the "next thing you know," it receives a subpoena. Alternatively, she suggested a firm may respond to a deficiency letter and then it gets a subpoena. In any event, the regional director emphasized that the new approach has led to an increase in enforcement actions.

On a practical level, what can a firm do? In the current environment, prudence dictates treating an examination like an enforcement investigation. A firm should protect its privileges, be careful about volunteering unrequested information and exercise discipline in the informal contacts it allows between employees and examiners. Unfortunately, this enhanced prudence is likely to slow down examinations. Nonetheless, when every examination is tantamount to an investigation, firms must exercise care.

On a policy level, can anything be done to mitigate the new reality's negative side effects? A new initiative already announced by the SEC could help. At a conference on Nov. 21, Norm Champ, the deputy director of the Office of Compliance Inspections and Examinations of the SEC, stated that the SEC is conducting a "myth buster" program for its examination managers. As an example, he noted it was a myth that examiners cannot tell firms anything about an examination. In the future, he stated, examiners will share more information.

The time has come to bust the myth that examinations and enforcement are separate programs. The SEC should acknowledge the end of routine examination oversight and reform the notice it gives to examined firms. Specifically, examiners should disclose the perceived risk that brought them to the firm and whether the examination is being coordinated with enforcement. If so, the examiners should provide the name and contact information of the responsible enforcement manager. At a minimum, this information will provide the firm with accurate notice of the type of government action being taken against it. Beyond that, it will help firms move quickly to address and correct any risks they might pose. In short, by acknowledging the end of routine oversight and providing an appropriate notice, the SEC's practices can begin to catch up with the new reality.

John H. Walsh is a partner in Sutherland Asbill & Brennan LLP's financial services practice group and a member of its securities defense team.

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