Examination Process Overview

The purpose of this overview is to acquaint you with the actual procedures and objectives of an examination of your business by members of the Alabama Securities Commission staff.
Why an Examination?
  • In 2010, President Obama signed into law the Wall Street Reform and Consumer Protection Act. One requirement of the ACT is that states must regulate investment advisers with up to $100 million in assets under management that are not registered in at least 15 states. With the enactment of this law, the states recognized that they alone must monitor the activities of most of these advisers. Alabama now has an examination program wherein we examine every investment adviser under our jurisdiction at least once every three years.
  • Your firm may be examined for a variety of reasons. The examiner may or may not tell you why you were chosen. If it is a routine exam and your records are in order you probably have little reason to worry; but, if you learn that the exam is for cause you may want to contact your attorney. In the extreme, a “For Cause” exam could be part of an investigation that leads to criminal prosecution. Eventually, you and every other adviser may be examined on a regular schedule but for now your selection may have been totally random. You may be told in advance that an exam is coming; probably never more than two days in advance, but more likely it will be a surprise visit. Finally, the exam may last from a few hours to a few weeks depending on what the examiner finds and why you were chosen in the first place. If there have been complaints filed against you or your firm, it could be a long process.
  • When an examiner shows up at your firm, don’t assume the worst. The examiner is there to do a job. Unfortunately, this is a job that will likely disrupt your business to some degree. However, by fully cooperating you can expedite the process, resulting in a quicker return to your normal routine. First, you should understand that the examiner has a legal right to look at every book or record in your office that is in any way related to your activities as an investment adviser. Delayed cooperation in the area of providing copies of or access to requested books and records will extend the examiner’s time onsite and the overall length of your examination. Second, designate one individual to act as the contact person for the exam. Obviously, this designee must be familiar with the operation of the adviser, the location of files and records, etc. The best choice is your compliance officer. Third, provide the examiner(s) with an office that has a telephone, a table or other work surface, and easy access to a copying machine. Lastly, it is suggested you call a brief staff meeting to tell everyone what is happening and enjoin them to cooperate with the examiners. Having done all that, try to carry on business in as normal a fashion as possible and the examiner will try to be the least disruptive to your business as possible, given the task at hand .

What happens during an examination of an investment adviser?
  • The examiners arrive.
  • The initial interview.
  • Examiners request documents and files.
  • Examiners review documents and files provided.
  • The exit interview.
  • The exam report.
  • The follow up.
  1. Here we are! The examiners will introduce themselves and explain that they are here to look at your books and records. Usually, they will not tell you why you were selected. There are a variety of reasons. You just happened to win the lottery of who is to be routinely examined that day, you were examined a year ago and they are here to see whether you have addressed all the deficiencies found on the last visit, someone has complained about the way you do business and they are looking for information that will support or refute the allegation, or perhaps they had intended to examine another adviser in the neighborhood whose office is closed because he is on a business trip and they don’t want to go back to their office empty handed.
  2. What are we looking for? This is a natural question, especially if you have not been examined before. If the exam is “for cause,” we may be looking for information that will support or rebut an allegation. At a follow up visit, we may be checking to see that previously noted deficiencies have been corrected. In a routine visit, we want to learn how the adviser operates. Does the ADV accurately reflect the way the business runs? Are your books and records complete and maintained in the manner required? We will physically examine your files to see, for example, if client files contain the necessary information, records of investments, disclosure document receipts, signed advisory agreement. What is the financial condition of your firm? Is it solvent? Does it maintain the required level of net capital or net worth? We want to know if your adviser representatives are being supervised as required. Are the recommendations your firm makes to customers appropriate? Does your firm provide required disclosure to customers? Does it put the customers’ interests first? Is one person designated as the compliance officer for the firm? Are there any discrepancies or breaks in the continuity of registrations? Do you keep files of advertisements as required? Does any ad contain a testimonial, reference to past performance, or an indication that any information has been used that is or could be misleading?
  3. Beginning The Exam. At this point the examiners will conduct a brief interview to gather a general understanding of your operations. They will ask for details about your operations and your personnel. If you don’t make the offer, they will probably ask for a tour of your offices. They will request that you assign them a place where they can work. A conference room is a good choice. They are going to require a work surface such as a table in a relatively quiet place, a telephone, access to a copying machine and to your files and records. You should designate one person to act as the contact for the adviser; your compliance officer may be the best choice but the individual must be able to answer questions and know where to find things in your files. The examiners will probably ask if you have any questions before they begin.
    You or your designated contact person will be given a list of things, the Document Request List, that the examiners want to see. Bring them in as soon as possible. Once the exam begins it is in your interest to cooperate with the examiners. The law requires that you make information available, and, the sooner they can finish what they came to do, the sooner they will get out of your office.
  4. Books and Records. The examiners may look into virtually every area of your business or they may examine only selected parts. They may examine all the books and records that you are required to maintain or just a selected sample. They will want to see whether all the necessary records are present and what they contain. If you file the records from your investment advisory business with those of other businesses, the examiners may have to look through all the records to complete their examination. If you are a sole proprietor, it may be necessary for the examiners to look at your personal financial records in the course of their examination.
  5. Advertising. You must have on file a copy of every advertisement that you use. This is true of radio, television, print media including newspaper or magazine ads, pamphlets and brochures, letters or cards, and audio or video tapes, disks, etc. E-mail and the Internet are also included. Anything that you have given to ten or more clients or prospects must be on file. The examiners will look at content and format. The basic test of an advertisement is truthfulness. You must tell your clients and prospects the truth, the whole truth and nothing but the truth. You must also present the truth in such a way that it cannot be misleading. If you advertise on the Internet you must make it clear that your services are only available in those jurisdictions where you are lawfully registered to do business. Reminder: anything you put on the Internet immediately exceeds the de minimis exemption. If you use performance figures to show that you have been successful in the past, you must be able to produce the data and the calculations that resulted in those performance figures. The performance figures you use must be accurate and not misleading. They must accurately reflect your track record. You may not pick and choose the recommendations to include in your performance figures. The performance figures must be presented with whatever explanation is necessary to make them not misleading. You must add to the text the caution that past performance does not guarantee future success. In addition to looking at use of performance figures in advertising, the examiners may look at performance figures provided to clients in account statements or correspondence to determine whether the figures are calculated correctly.
  6. The adviser as a Fiduciary. The restrictions on advertising occur in part because an investment adviser is a fiduciary. This means that the adviser must hold the interests of the client uppermost at all times. If you are about to do something that is not good for the client, don’t do it! This status as a fiduciary also colors other things that you do in relation to your clients. If you are selecting an investment for a client, you are bound to consider whether it is the best one for that client. This is essential when you make a determination about the suitability of an investment.
    The examiners may look at records showing the trades your firm or your employees made in their own accounts in order to check for potential conflicts of interest. If the examiners find potential conflicts of interest, they will check to make sure that the conflicts were fully disclosed to investors. In all conflict situations the key issue is the effect of the conflict on the customer. Has the customer been told of the conflict? Has the customer consented to the transaction despite the disclosed conflict? If the customer consented, was the customer in a position to evaluate the effect of the conflict on the customer’s interest? The more vulnerable the customer the greater the burden on the investment adviser to show that the customer has knowingly consented to the conflict. Disclosure and customer consent may not always be sufficient remedies for conflicts of interest.
    The examiner will review any written policy of the investment adviser on conflicts of interest and will consider conflicts issues throughout the review of books and records during the audit. An examiner might spot a conflict through review of correspondence with customers, customer complaints, or through the statements of account of customers and of the investment adviser itself and of its employees. Once an examiner has spotted a conflict, the examiner will generally ask the principals of the investment adviser for an explanation. The examiner will then seek further evidence to confirm the representations of the investment adviser. Conflicts of interest may involve serious securities law violations, such as sale of unregistered securities, fraud in connection with the purchase or sale of securities, and unlawful acts of a person advising another. Some of the most serious conflicts problems arise when the investment adviser is also an issuer or is an affiliate of an issuer. If there is an apparent conflict of interest, the investment adviser has a greater burden of showing that the investment recommendation was suitable for the customer.
  7. Custody and Discretion. The examiners will look at the way your firm operates to determine whether it has discretion or custody of client funds. If the adviser has direct or indirect access to client funds or securities, it has custody of client funds. An adviser who is also an issuer of securities is deemed to have custody unless an independent custodian is utilized and the custodial agreement(s) include provisions that define the method by which the advisor receives payment and withdraws funds (via an independent representative). If your firm uses an independent custodian, the examiners may look at whether the adviser has any affiliation with the custodian. The examiner may obtain information regarding how instructions are conveyed to a custodian, who determines where the client funds or securities are maintained, and, if the custodian is a person other than a broker-dealer (such as a bank), how the transactions are settled.
    The examiner may look at your firm’s billing practices to determine whether it has custody. An investment adviser may also be deemed to have custody of client funds if it sends the bills for its services directly to the custodian who then automatically pays the adviser unless:
    • The client authorizes the arrangement in writing
    • The adviser sends the invoice to both the client and the custodian at the same time
    • The invoice shows the amount of the fee, how it was calculated and the value of the assets on which the invoice is based
    • The custodian notifies the client at least quarterly of how much has been paid to the adviser
    If you have or are deemed to have custody of client assets, we will want to see how you handle those assets. In particular we will look for any evidence of failure to comply with the rules relating to safeguarding client assets in the adviser’s custody. Does Form ADV reflect that the adviser has custody? Are these assets maintained in segregated accounts? Does the adviser maintain the required records of client assets in its custody? Does the client get an itemized statement at least every three months showing the assets in the adviser’s custody and the activity in the account? Has the surprise audit of client assets been conducted at least annually by an independent accountant? If the adviser has discretionary authority over the client’s account is there any evidence of excessive trading, self-dealing, preferential treatment, unsuitable recommendations, unauthorized transactions or incomplete disclosure?
  8. Compensation. How is the adviser compensated? (Fixed fee, hourly fee, asset-based fee, performance fee, wrap fee arrangements, start up fees, termination fees, soft dollar arrangements, etc.) Is there any evidence of variation in the fees being charged to different clients for the same service? Do the fees charged appear to be reasonable? Are the fees charged consistent with what the clients were told the fees would be?
  9. Marketing. Does the adviser employ paid solicitors? Performance advertising? Testimonials? Misleading DBAs? Does the adviser in any way misrepresent its qualifications? Guarantee results? Any evidence of incomplete disclosure or non-disclosure? False advertising? Use of non-registered persons?
  10. Disclosure. How is the required disclosure made? If a document other than Part 2 of Form ADV is used does it contain all the necessary information? Does the adviser maintain records of delivery of the brochure? Does it appear that disclosure is consistently made in a timely manner? The examiner will look at what investment advisory services are being provided, who is providing those services, what is the client being charged for the services, and what conflicts of interest might be involved for the investment adviser. The examiner will then compare the way the firm operates to the disclosure the firm provides to customers to see if the disclosure accurately reflects the firm’s practices.
  11. Contracts. Does the adviser maintain a copy of each contract with every client? Is the contract in writing? Does the contract describe the services to be provided? The term of the contract? The advisory fee and a formula for computing the fee? Is there a provision for the return of any prepaid, unearned fee in the event of termination or nonperformance? Does it state whether discretionary power is granted to the adviser? Does it provide that the contract may not be assigned by the adviser without the consent of the other party? What services are being provided and who is providing are questions that often arise where the investment adviser only introduces the clients to one or more other advisers who will actually provide the investment advice to the client. These questions also arise in connection with wrap fee programs, where some services may be provided by someone other than the investment adviser. The investment advisory agreement should answer these questions, as should the investment adviser’s brochure (Part 2 of Form ADV). Alabama Securities Commission auditors review the investment advisory contract and compare the contract with the activity the auditor observes at the audit site and with the contents of Form ADV.
    Does the contract contain a hedge clause, mandate arbitration of disputes, restrict the venue for settlement or otherwise impinge upon the client’s rights? Examiners review investment advisory agreements to make sure they do not contain “hedge clauses” in which the investment adviser disclaims liability for losses occasioned by the investment adviser’s negligence. Hedge clauses are usually inconsistent with state laws and are therefore ineffective. Inclusion of hedge clauses in an agreement is therefore misleading to clients.
  12. Practice Management. Has the adviser established and maintained written supervisory procedures? Do they include provisions for effective supervision of representatives? Are personnel familiar with the procedures? Is there any evidence of instances of failure to supervise? Does the adviser maintain records of all transactions by the firm and all associates? Are all books and records complete and current? Has the adviser amended its filings with the jurisdiction promptly following changes in the information? Are the adviser’s records in an easily understood format? Does the adviser engage in other business activities that present a current or potential conflict of interest?
    How are such conflicts handled? Are financial records and reports prepared and maintained in accordance with accepted accounting principles? Are copies of all filings with the jurisdiction available? Are copies of all advertising or other sales pieces available for examination? Does the adviser maintain a complaint file? Is there anything therein, or elsewhere, that indicates that clients may have misunderstood or been confused by or about the services, contract, compensation, or some other issues?

What is going to happen as a result of the exam?

Once the examiners determine that their job in your office is finished, they still have more to do. Normally, and if time permits, the examiner will conduct an “exit interview” during which the adviser will be apprised of the major points discovered during the on-site portion of the exam. Having discussed their findings and possible action, they will collect their notes and leave.
If the findings are minor, the adviser will be sent a letter outlining the deficiencies and requesting that the adviser respond with a plan to resolve them. If serious violations are discovered, the examiner may refer the matter to the enforcement staff for further investigation and enforcement action. The enforcement action might include having the adviser execute a Consent Order wherein it agrees to specific corrective steps such as hiring an outside consultant to supervise certain aspects of the business or paying a fine or instituting new supervisory procedures. The aim of any such action is to get the adviser into compliance with the law. Occasionally, the examiner discovers violations that cannot be corrected or that suggest that the continuing presence of the firm or one or more of its principals or employees in the investment advisory business would put the investing public at undue risk. In such cases, enforcement staff may take action to suspend or revoke the registration of the offending persons. In the even more rare situations where a crime has been committed, enforcement staff may investigate and make a referral to Alabama Securities Commission’s legal division for criminal prosecution.
What about a written report?

As mentioned above, in time, usually sixty to ninety days, you will get a letter from the Alabama Securities Commission. It will set forth any deficiencies noted and ask you to reply stating what corrective action you plan to resolve the stated deficiencies. Fourteen days are usually given to respond to the letter. If you have questions you should call or write to the person who signed the letter. If you need more time to reply send an interim report and note what you have done and how you plan to complete the necessary action. Normally an extension can be granted upon reasonable request.
How do we know it is over?

Most of the time, when you satisfactorily reply to the deficiency letter and receive an exam closure letter this will mark the end of the experience until the next exam cycle. However, if you had significant problems, a follow up exam may be scheduled to see how you are progressing and whether the Alabama Securities Commission has a further interest in your case. As was mentioned earlier, the Alabama Securities Commission maintains a regular schedule of exams. We will be back in your office on regular intervals.


We have covered what you can expect during the course of an examination by the staff of the Alabama Securities Commission. Although it may be hard to accept these exams as a matter of doing business, remember that an exam is not necessarily a reflection on you or your firm. It is simply one more way for the Alabama Securities Commission to find out what is going on in the industry and to bring everyone into compliance with the Alabama Securities Act.