SEC Examination Interview: What Portfolio Managers and Research Analysts Need to Know

The Office of Compliance Inspections and Examinations (OCIE), which we blogged about a few months ago, conducts the National Examination Program for the SEC. The portfolio management process and the related investment performance are playing an increasingly important role in not only determining which firms are examined but also in the examination itself. SEC examiners now routinely interview portfolio managers and research analysts. Sometimes enforcement attorneys and specialists from other offices join in on these interviews. Because portfolio managers and research analysts represent the top two occupations held by CFA^® charterholders, we organized a presentation for CFA Institute members so they could hear first-hand about the examination process and how they can prepare for an examination.

CFA Society Boston sponsored the event and Mike Garrity, Chief Regulatory Counsel of the Examination Program at the SEC’s Boston Regional Office, and Scott Pomfret, Chief Compliance Officer at Highfields Capital Management, were the featured speakers.

Examination and Interview Process

Garrity spoke about the review that is performed on aberrational performance before OCIE even lets a firm know that it has been selected. The SEC has access to a huge amount of data, including data from all the major exchanges, and it will use that data to help determine why a particular portfolio may have greatly outperformed a benchmark. If they have trouble figuring out the reason or they want to corroborate it, the SEC can ask for the firm’s performance reports and attribution analysis in addition to the firm’s trading records as part of its document request list. Of course, if the registrant uses model performance, such as back tested performance, the examiners will most certainly ask for the supporting documentation and copies of all performance-related materials that have been distributed.

Before the Madoff scandal, the examiners may have only spoken to the chief investment officer about the investment process, but now they will typically also interview portfolio managers and often research analysts as well. Those involved in the investment decision-making process are expected to easily articulate the investment strategy and how the investment strategy is being implemented. The interview is an average of 90 minutes to 120 minutes, and although there could be 8­­–10 people from the SEC at the firm’s office working on the examination, usually only 2–3 of them will be at the interview. The firm’s chief compliance officer usually sits in on the interview and sometimes will bring an external compliance consultant or outside council. Garrity indicated that these individuals could help to move the interview along but should not be coaching the portfolio manager or analyst during the interview.

Conduct during the Interview

The person being interviewed should be courteous and not patronize the SEC staff. If the portfolio manager is unable to explain his or her own strategy, it could result in a referral to the SEC’s Division of Enforcement. If the interviewee doesn’t know the answer to a question, the best response is to simply state that and indicate that the question will be researched as soon as possible. Pomfret noted that these interviews are not intended to be depositions, but it may feel like that if you haven’t been through one before. Many firms will now prep their portfolio managers and analysts for such an interview and even videotape them so they can more easily see how they perform. Pomfret stressed that an interviewee should answer only the questions asked and provide only the documents specifically requested because the scope of the examination could quickly expand if more information is provided.

Other Need to Know

The question was asked whether attorney-client privilege was ever cited in response to a specific question or request, and if so, how is that viewed by the examiners. Garrity said that examiners sometimes encounter that response, and although some might view it with suspicion because the maneuver could be used to hide something, he recognizes that examiners are government employees and as such they should never be too overreaching. He tries to always keep that in mind to ensure that the examiners aren’t asking for things that should be off limits. Of course, when attorney-client privilege is invoked, the lawyers from both sides typically get involved. But the key is to understand the reason the claim has been invoked and to determine whether there is a way to work around it, which in some cases might be done by reviewing related documents or conducting further interviews that might provide the information that is needed to understand the specific facts and circumstances.

Another question was raised about the supporting documentation that might be requested regarding security recommendations prepared by research analysts. Garrity replied that in the past, analysts would typically have a physical file for each security they reviewed, which would include supporting technical analysis, annual reports, SEC filings, and notes of meeting materials with company executives. But because most work is now done electronically, Garrity said the key is for firms to have policies and procedures regarding what analysts must maintain to support all security analysis.

This is a timely issue as the SEC announced in October 2016 that Deutsche Bank Securities agreed to pay a $9.5 million penalty for failing to properly safeguard material nonpublic information generated by its research analysts. In addition, the SEC stated that Deutsche Bank also published an improper research report and failed to properly preserve and provide certain electronic records sought by the SEC during its investigation. Deutsche Bank agreed to the SEC’s order without admitting or denying the findings. Back in February 2016, a former Deutsche Bank research analyst was charged with certifying a rating on a stock that was inconsistent with his personal view.

Based on the Deutsche Bank case, Pomfret stressed that it is important that registrants also have adequate policies and procedures that cover the supervision of research analysts. The chief compliance officer must understand not only what materials analysts generate, but who they interact with and when.

High Ethical Standards Should Guide Research Analysts

It is important to note that high ethical standards are critical to maintaining the public’s trust in financial markets and in the investment profession. CFA Institute members and candidates must abide by the high standards of the CFA Institute Code of Ethics and Standards of Professional Conduct, which promotes integrity in the investment profession and serves as a model for measuring the ethics of investment professionals globally, regardless of job function, cultural differences, or local laws and regulations.

There are numerous places in the Standards of Professional Conduct that cover the work performed by research analysts. For example, Section I covers professionalism and states that members and candidates must understand and comply with all applicable laws, rules, and regulations, and must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

Section II covers the integrity of capital markets and states that members and candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.

Section III covers duties to clients and asserts that members and candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

Section V covers investment analysis, recommendations, and actions and states that members and candidates must (1) exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions; and (2) have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action. In addition, members and candidates must develop and maintain appropriate records to support their investment analyses, recommendations, actions, and other investment-related communications with clients and prospective clients.

Are you a portfolio manager or research analyst that has been interviewed by a regulator? If so, feel free to share your experience in the comments section below.

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