Explosive growth in the number of registered investment advisors and the assets they manage may be manna for the industry. But effectively overseeing the industry presents the Securities and Exchange Commission with one of its leading challenges, according to a report the SEC’s Office of Inspector General sent to SEC Chairman Jay Clayton today.

At a time when the number of registered advisors has risen by more than 15 percent and assets under management by 40 percent, the SEC’s annual appropriation from Congress has remained flat at $1.6 billion since 2016. That has resulted in a 2017 hiring freeze that remains in effect today and has triggered a 5 percent decline in SEC staff in just one year to 4,459 positions in 2018.

But the SEC is not only hampered by a stagnant budget and shrinking staff, found the report, “The Inspector General’s Statement on the SEC’s Management and Performance Challenges.” It is also limited by its own failure to streamline processes, leverage technologies and analytics, meet deadlines for enforcement cases and ensure effective human capital and security management.

Ensuring sufficient examination coverage of RIAs by the SEC’s Office of Compliance Inspections and Examinations (OCIE) remains an “immediate and pressing need for ensuring the sufficient examination coverage of registered investment advisors,” the OIG report found.

Given the current levels of RIA growth, OCIE “estimates there will be approximately 20 investment advisers per staff members. In addition, it is anticipated that the population of investments advisors will be larger and more complex than ever,” the SEC said.

The SEC’s National Examination program is charged with protecting the interests of retail investors by determining whether money managers handling retail customers funds are complying with the SEC rules. While SEC staff examined about 15 percent of RIAs (an increase over prior years), nearly 35 percent of all RIAs have never been examined, the SEC’s own FY 2019 Congressional Budget request stated. 

To cope, the SEC wants Congress to approve the addition of 24 OCIE positions in FY 2019 -- the largest increase for any division or office. The new staff will “partially restore critical staffing losses from the last two years, enhance examination coverage of investment advisors, focus on critical risks impacting market participants, address new responsibilities and implement other program improvements.”

However, given its limited resources, the SEC itself has failed to fully leverage risk-based processes and leverage technology to address regulatory challenges including those of the examination program, the OIG found.

That has also meant that, to date, the SEC has not followed up on an OIG suggestion to create a risk-based rating system for closed exams, OIG said.

“To assess aspects of the SEC’s investment advisor examinations, in FY 2017, we initiated an audit to determine whether OCIE established effective controls over its investment adviser examination completion process,” OIC stated.

To fully create and leverage a true risk-based, data-driven exam selection process, OIC suggested in a 2017 report that the SEC develop and use staff guidance for assigning final risk ratings before closing exams. As of October, 10, 2018, the SEC has failed to follow the recommendation, the OIG said.

In the area of enforcement, the SEC faces greater challenges than ever before because of a June 2017 Supreme Court decision (Kokesh v. SEC) that imposes a five-year statute of limitations on SEC enforcement actions and its ability to recover funds stolen from investors.

The SEC’s do-directors of enforcement told lawmakers in May that the Enforcement Division has already had to forego  more than $800 million of disgorgement in both litigated and settled actions in the year since the Kokesh decision.

“Although the ultimate impact of Kokesh remains to be seen, it is imperative that Enforcement uncover, investigate and bring cases as quickly as possible,” OIG said.

Unfortunately, the SEC did not meet its own targets for shortening the time between opening cases and bringing enforcement actions, the report states.

“We note that, in FY 2017, the percentage of first enforcement actions filed within two years of the opening of the matter under inquiry or investigation was 52 percent. This did not meet the FY 2017 target of 65 percent and was a decrease from FYs 2012 through 2016, when the percentage ranged from 64 percent to 53 percent.  In addition, in FY 2017, the average number of months between opening a matter under inquiry or investigation and commencing an enforcement action was 24 months, which was the same in the 2 previous years.  This also did not meet the FY 2017 target of 20 months and was an increase from FYs 2012 through 2014 when the average number of months was 21,” the OIG said.

To address the need for added timeliness in investigations, Enforcement has reported adopting measures that include emphasizing expediency in quarterly case reviews, promoting best practices regarding efficiencies in various phases of the investigative process, leveraging data analytics capabilities and conducting training on tools that expedite investigations, OIG reported.

Other challenges the SEC is continues to face, according to OIG, include:

• The growing scope and number of clearing agencies the SEC is charged with examining;

• The registration of hundreds of additional municipal advisor registrants with increasingly complex business lines; 

• Rapid growth in distributed ledger (i.e., blockchain) technologies and cryptocurrency markets;

• Cyber threats in securities markets that have continued to increase in both frequency and sophistication. 

“These types of industry developments and financial innovation will continue to present challenges to the staff, requiring additional staff expertise, resources, and a program that is agile, responsive, and continuously improving,” the SEC said in its FY 2019 Congressional Budget Justification and Annual Performance Plan.