9/4/18 - Recent SEC Actions Likely Signal Increased Focus on Model Risk Management Among Investment Advisers
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9/4/18 - Recent SEC Actions Likely Signal Increased Focus on Model Risk Management Among Investment Advisers

The Securities and Exchange Commission recently charged four entities of a large asset-management company with misconduct related to faulty investment models and, in separate orders, found that two individuals caused certain of the entities’ violations. These announcements will likely lead to a greater focus on model risk management among asset-management firms.

In a press release announcing the order against the entities, the SEC claimed that billions of dollars were invested based on the outputs of quantitative models that contained numerous errors. When the entities learned about the models’ errors, they stopped using them but failed to disclose the errors to investors. To resolve the charges detailed in the SEC’s enforcement actions, the four entities agreed to pay nearly $98 million, comprised of disgorgement, interest, and a $36.3 million penalty.1

The SEC also found that a former global chief investment officer of one of the entities did not take reasonable steps to ensure the models worked as intended, and that the former GCIO and a former director of new initiatives contributed to compliance failures related to the entities’ development and use of models. The two individuals agreed to settle the SEC’s charges by paying a total of $90,000 in penalties.2


These actions can be understood in the context of the SEC’s February 2017 IM Guidance 2017-02 on robo-advisers.3 While 2017-02 is not directly applicable to the case against the four entities, which did not involve “robo-advisers that provide services directly to clients over the internet,”4 the investment strategy used by the entities was explicitly model-driven. The issues highlighted in the SEC’s press release could have been avoided, for the most part, had the entities followed 2017-02, which states that the guidance “may be helpful for other types of robo-advisers as well as other registered investment advisers.”5 In addition, some of the text of the SEC’s order against the entities closely mirrors that of 2017-02.

Investment advisers use models in various aspects of their business and operations, including quantitative investing and portfolio management, risk management, and reporting. As the use of proprietary and third-party models becomes increasingly common, asset managers should focus on developing on a robust approach to model risk management.

From an investment-management perspective, model risk is a risk multiplier that can undermine risk and compliance programs that rely on model output. The aforementioned SEC order demonstrated that insufficient control over model risk creates vulnerabilities that may result in legal and regulatory exposure, reputational harm, and monetary loss. Moreover, the enforcement cases involving the four entities and their senior officers — in addition to 2017-02 — raise the profile of model risk management among investment advisers and highlight the potential of financial and regulatory exposure resulting from uncontrolled model risk at firms that use models for portfolio management, risk management, and reporting.

Indeed, asset managers are increasingly viewing model risk as a traditional risk category, such as investment or operational risk. Firms should use a risk management framework to ensure the integrity of the models they use, whether they develop those models internally or procure them from third-party providers.

How Promontory Can Help

Promontory can help ensure that your firm’s model risk management framework and processes effectively control model risk and meet the heightened expectations of investors, senior management, regulators, and other stakeholders. Specifically, with respect to model development, implementation, validation, and use, we can assess the following:

  • The roles and responsibilities of relevant stakeholders
  • The effectiveness of controls, including policies, procedures, and training
  • The quality of testing, documentation, and oversight
  • The integrity of errors and incident-escalation and governance processes

Our quantitative analysts and regulatory professionals regularly work with clients on the following:

  • Creating or evaluating model-risk management frameworks, policies, procedures, practices, and governance toolkits, including model-risk ranking and model-use definitions, as well as other controls
  • Performing independent reviews of internal model-development and validation functions
  • Remediating model development, documentation, and validation through the implementation of enhanced standards
  • Developing models in a manner that facilitates model risk management and validation

Promontory’s experts can also help your firm understand the impact of model use and model risk management on its regulatory, compliance, and legal exposure. Relevant federal-securities laws may include rules related to fiduciary duties, disclosure obligations, and even anti-fraud provisions; we can help your firm understand how model risk — if not properly managed — can trigger such provisions. Furthermore, we can assist in drafting necessary and appropriate disclosures to mitigate risks posed by model use and help investors understand the risks models pose.

In addition to helping your firm develop an appropriate framework and related processes for model risk management, Promontory can help implement the framework, through services ranging from comprehensive change management to employee training and other forms of knowledge transfer. We have the resources and experience to build a model risk management group from scratch and to perform (and to train a firm’s employees to perform) model validation. We can also assess the strengths and weaknesses of your firm’s validation practices and recommend enhancements to address any identified issues.

Contact Us

Conway Dodge, Managing Director
cdodge@promontory.com | +1 202 370 0461

Michael Sullivan, Managing Director
msullivan@promontory.com | +1 202 370 0507

Nick Kiritz, Director
nkiritz@promontory.com | + 1 202 370-0401


2. Ibid.

3. SEC, “IM Guidance Update 2017-02,” (February, 2017)

4. Ibid.

5. Ibid.