The Examination and What Is Requested

An examination is an inspection. The statutory authority is broad: records made and kept by a registered adviser are subject at any time, or from time to time, to such reasonable periodic, special or other examinations by representatives of the Commission as the Commission deems necessary or appropriate in the public interest or for the protection of investors. No predicate finding of wrongdoing is required, and none should be inferred from the fact that an examination has begun.

How a firm is selected

Selection is driven by a mixture of risk analytics, published priorities and events. Analytic screens read the data reported on registration forms and in regulatory filings, looking for outliers: unusual growth, custody arrangements, concentration in illiquid or complex products, previously identified deficiencies, or a disciplinary history. Published examination priorities announce areas of focus for the year in general terms, and firms with business in those areas can expect attention.

Events also trigger examinations. A customer complaint routed to the examination staff, a filing that appears inconsistent with a prior one, a referral from another regulator, or the departure of a compliance officer under unusual circumstances can each prompt one. Newly registered firms are commonly examined within a period after registration, which is closer to an orientation than an inquiry but produces the same paperwork.

The document request

The examination opens with a written request list, typically delivered with a production deadline measured in days. The list follows a recognizable pattern. It asks for organizational information, the compliance manual and code of ethics, the annual compliance review, minutes of committee meetings, the client list with account values and fee arrangements, advisory agreements, trade blotters and allocation records, custody and cash movement records, marketing and performance materials, personal trading reports, complaint files, and financial statements.

The most consequential parts of the list are the ones a firm cannot produce quickly. A trade blotter in the required form, an accurate client list, and evidence that the annual compliance review actually occurred are the three items whose absence changes the character of the examination immediately. A firm that produces its manual but not the evidence that the manual was followed has answered the wrong question.

Requests increasingly reach data rather than documents. Staff commonly ask for transaction and holdings data in a specified electronic format so that it can be analyzed independently, and inconsistencies between the data produced and the narrative in the compliance manual are among the first things noticed. A firm whose systems cannot generate the requested extract has a practical problem that is difficult to characterize as anything other than a records issue.

Fieldwork and interviews

Fieldwork may be conducted on-site, remotely, or in combination. The staff works through the production, samples client files against the disclosure documents, traces selected transactions from decision through allocation to settlement, tests fee calculations against the advisory agreements, and compares marketing claims against the underlying records. Sampling is targeted rather than random; a screen that identified a concern will usually determine which files are pulled.

Interviews accompany the record review. The chief compliance officer is interviewed at length about the design of the program, the annual review, how deficiencies are identified and escalated, and what resources the function has. Portfolio and trading personnel are asked how decisions are made and allocated. Operations personnel are asked about reconciliation, custody and cash movement controls. Senior management is asked about supervision and about the compliance function's standing within the firm.

The recurring difficulty in interviews is not dishonesty but drift: personnel describe what the firm does, and the description differs from what the manual says. Where the practice is sound and the manual is stale, the finding is a documentation deficiency. Where the manual is sound and the practice has drifted, the finding is a failure to implement, which is the more serious of the two.

An exit discussion usually closes the fieldwork. The staff summarizes what it observed, often with the caveat that the observations are preliminary and subject to internal review. That conversation is worth attending carefully, because it is the firm's first and sometimes only opportunity to correct a factual misunderstanding before it is committed to writing. Firms that take contemporaneous notes of the exit discussion find them useful when the written communication arrives weeks later.

Sampling method matters to the outcome. Where a screen identified a concern, the files pulled will be the ones the screen flagged, so a firm that regards the sample as unrepresentative should say so and offer the broader population rather than argue the point in the abstract. Staff generally accept a documented offer of additional files, since a wider sample either confirms the concern or dissolves it.

Scope, expansion and what follows

Scope is set by the staff and can be expanded. A review focused on marketing that uncovers an unreported custody arrangement will grow to include custody, and the firm has no standing to object. Conversely, an examination sometimes narrows when early production resolves the concern that prompted it. Firms that ask what the scope is at the outset generally receive a useful answer; firms that treat the request list as a negotiation generally do not.

An examination is administratively separate from an enforcement investigation. Examination staff inspect for compliance and communicate findings; enforcement staff investigate potential violations with subpoena power and can institute proceedings. The two are connected by referral, and conduct that appears deliberate, that involves client harm, or that involves misstatements to the staff is the conduct most likely to move across the line. The path an enforcement matter then takes is described in settling an enforcement action.

Most examinations end in writing rather than in referral, and the written communication is where the firm's obligations begin again. What that letter contains and what response it expects is set out in the deficiency letter and the response expected. The records the examination draws on are governed by books and records and how long they are kept, and the disclosure documents against which client files are compared are described in the disclosure brochure and its annual update.