SEC allows companies to bend the rules, with no follow-through

Introduction

The Securities and Exchange Commission has a mechanism to allow financial companies “exemptions” from financial laws. But it allows those companies to essentially police themselves and a report by the SEC inspector general suggests those companies might not be doing a very good job.

From January 2008 through March 2010, the SEC’s Office of Compliance Inspections and Examinations, or OCIE, launched 477 investigations into companies that had been granted exemptions. In some cases, a company had been issued a so-called exemptive order, allowing them to undertake an activity otherwise forbidden by SEC regulations. In others, it was a no-action letter, in which an SEC staffer indicated that a particular course-of-action that otherwise might run afoul of regulations wouldn’t yield any enforcement activity.

In one example cited in the report, a financial company asked for permission to distribute capital gains to its shareholders more frequently than permitted under law. A no-action letter cited in the report suggested that investment companies could lend their portfolio securities.

In these special cases, the exemption is contingent on the company adhering to strict conditions. But the report found that the SEC agencies setting those conditions don’t follow up to make sure that companies comply with those rules. Rather, investigations are carried out exclusively by the OCIE, with no formal sharing of information between other divisions and that office to indicate when exemptive orders or no-action letters have been issued.

The report looked at 72 of the 477 examinations flagged for the presence of an exemptive order or no-action letter, and found that companies had violated the conditions of the order or letter more than 60 percent of the time.

The report recommends that the three divisions of the SEC—Investment Management, Trading and Markets, and Corporation Finance—coordinate with the OCIE to track compliance with exemptive orders and no-action letters. The divisions track their issuance of the exemptions differently, and the report calls for them to develop a standardized tracking method.

Investment Management and Trading and Markets will be required to develop internal examination units under the Dodd-Frank act and the report calls on them to coordinate those efforts with the OCIE and use that staff to look at compliance with the orders and letters.

Finally, the report recommends that the divisions and OCIE consider the issuance of orders and letters as a risk factor in determining which companies to investigate.

While the SEC generally agreed with most of the findings, the Commission’s official response indicated that it believes companies that apply for orders or letters are less of a risk for breaking the law, because those companies are more “attuned to compliance issues.”

FAST FACT: One in 10 investigations undertaken by the SEC’s Office of Compliance Inspections and Examinations between January 2008 and April 2010 involved a financial entity that had been granted an exemptive order or no-action letter.