The Office of Compliance Inspections and Examinations (OCIE)

During the early 2000s Lori Richards took a course at Harvard’s Kennedy School on regulatory and enforcement programs that convinced her an exam-by-exam approach could not have sufficient impact on the industry. OCIE therefore began working to identify discrete compliance problems for each type of registrant, and to identify ways to solve them, thus creating a more assertive exam program. At the same time, scandal in the IA/IC sector prompted the office to create a more risk-based program. Meanwhile, OCIE succeeded in overcoming exchange resistance to make its exchange examination effort comparable to its other programs.

Late Trading and Recalibration

In the early 2000s, IA/IC examiners continued to work mostly on a cyclic basis. In 2002 OCIE put the top twenty advisory firms and fund groups, representing about 90 percent of IA/IC examinations, on a two-year cycle. But that frequency could not continue as the adviser sector continued to grow and a scandal forced the issue.

In September 2003, the New York attorney general revealed that several mutual fund complexes had allowed hedge fund Canary Capital to trade shares after market closing. OCIE sent document requests to some 100 firms and discovered that “late trading” and “market timing” (which involved trading more frequently than fund provisions allowed) were widespread.

The scandal finally prompted Congress to heed the Commission’s warnings about funding shortfalls—OCIE staffing increased more than 18 percent during the next year and continued upward for another two years. In a trade-off necessitated by still-scarce resources, however, OCIE discontinued its policy of looking at every new investment adviser or company during its first year in order to reinvest in risk-based examinations.⁽³⁶⁾

The Risk-Based Program

SEC examiners had always taken risk into account. Since 1995 OCIE had been steadily refining its risk assessment mechanisms to include size and number of customers, type of business, length of time registered, prior history, products offered, complaints, claims, and information from other regulators. IA/IC “smart exams” were essentially risk based, and the broker-dealer program employed “risk management examinations” to evaluate a firm’s ability to identify, monitor, and control financial hazards.

William Donaldson, who took office just as the late trading and market timing revelations surfaced, made risk assessment a cornerstone of his chairmanship and tasked OCIE with “looking around the corner and over the hill.”⁽³⁷⁾ OCIE examiners conducted a new series of risk-targeted sweeps and further refined risk assessment, identifying about 25 categories of risk and assigning a risk score to each one. Eventually OCIE created a unit to identify and rate risks across all registrants and regions, which was shared widely within the Commission. OCIE also conducted a pilot program to monitor large asset management firms on an ongoing supervisory basis but learned that the industry was skeptical of working closely with examiners, who they considered too close to enforcement.

Through the mid-2000s and beyond, the risk-based reinvention continued to be a challenge. For one thing, lacking data from its registrant base that only new rulemaking could provide, OCIE’s risk targeting methodology was not as effective as it could have been. For another, old incentives ran counter to the new emphasis on risk. Regional personnel who opened an examination, for example, were reluctant to narrow their focus, justly concerned that they would be held accountable should problems later appear in an unexamined area. Those concerns ran right to the top. Relying so much on risk assessment and limiting the review of other areas, said Lori Richards, “was deeply scary to me, really, because what were we not able to see?”⁽³⁸⁾

Exchange and Market Oversight

As OCIE sought to balance risk and routine in IA/IC and broker-dealer exams it also worked to achieve more effective exchange supervision. The exchange SROs had historically been reluctant overseers, more intent on protecting their members from SEC oversight than extending the regulatory regime down to the trading floor. American Stock Exchange veteran Arthur Levitt knew this and was determined to change it. One of OCIE’s first initiatives was to conduct individual examinations of specialist firms along with a review of the exchange’s own surveillance program to detect trading ahead of customers. An important new component of these new inspections was working with the SEC Office of Economic Analysis to analyze exchange data and identify and quantify the impact of surveillance weaknesses and specialist violations.

As the nature of oversight changed, the exchanges themselves were changing due to the SEC’s Order Handling Rules imposed after the odd-eighths scandal. One of the new rules required customer limit orders to be displayed immediately—but no later than 30 seconds after receipt of the order. On a tour of the NYSE floor, OCIE Associate Director John McCarthy asked a specialist how limit order compliance was going. The specialist forthrightly admitted that he usually waited the full 30 seconds to post, making it clear to McCarthy that exchange self-regulation was perfunctory at best.⁽³⁹⁾

During the 2000s, a few notable OCIE examinations helped counter exchange floor power. In 2003, examiners discovered that AMEX options specialists avoided filling orders from direct access brokers, who offered smaller spreads than traditional brokerages. The SEC compelled the American Stock Exchange to clean up the practice.⁽⁴⁰⁾ Arthur Levitt, a veteran of exchange boardrooms, was particularly gratified when SRO inspections pushed exchanges to recruit public governors to defend the interests of investors.

More immediately consequential was an examination following a tip about front running by a NYSE specialist. OCIE found that the practice was widespread, and the NYSE came under public scrutiny when the confidential inspection report was leaked, exposing other deficiencies in the NYSE surveillance and enforcement program. In response, the NYSE undertook a series of fundamental trading floor and oversight reforms.

In the end, OCIE’s tougher exchange inspection regime led the Commission to bring enforcement cases against most of the exchanges, a process that resulted not only in better exchange self-regulation but also in more knowledge about exchange activities and trading rules, which inspection staff made available to enforcement lawyers.