2013 SEC Examination Priorities

SEC National Exam Program

The Securities Exchange Commission published its examination priorities for 2013. They cover a wide range of issues at financial institutions, including broker-dealers, clearing agencies, exchanges and self-regulatory organizations, investment companies, hedge funds and private equity funds, and transfer agents.

The scope of an IA examination is “generally limited to the issues and business practices of the registrant that are perceived by the staff to present the highest risks to investors and the integrity of the market. Thus, the scope of exams will vary from registrant to registrant.”

But of course there are issues that will be at the top of the list. In addition to the specific risk areas unique to each registrant, the staff will consider the following focus areas when scoping and conducting examinations in 2013 that I saw as relevant to private funds..

1. Safety of Assets.

The staff will review the measures taken by registrants to protect client assets from loss or theft, the adequacy of audits of private funds, and the effectiveness of policies and procedures in this area. Exams will focus on issues such as whether advisers are:

  • appropriately recognizing situations in which they have custody as defined in the Custody Rule;
  • complying with the Custody Rule’s “surprise exam” requirement;
  • satisfying the Custody Rule’s “qualified custodian” provision; and
  • following the terms of the exception to the independent verification requirements for pooled investment vehicles.

2. Conflicts of Interest Related to Compensation Arrangements.

The exam will look for undisclosed compensation arrangements and the conflicts of interest that they present. These activities may include undisclosed fees or solicitation arrangements, and referral arrangements. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.

3. Marketing/Performance.

Marketing and performance advertising is an inherently high-risk area due to the highly competitive nature of the investment management industry. Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation practices. The exam will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures. Of course, the exam will test compliance with record keeping requirements by asking for the backup data.

In a surprise reference to the JOBS Act, the exam will review changes in advertising practices related to the JOBS Act, where feasible.

4. Conflicts of Interest Related to Allocation of Investment Opportunities.

Advisers managing accounts that do not pay performance fees side-by-side with accounts that pay performance-based fees face unique conflicts of interest. While reviewing portfolio management practices, the staff will confirm that the registrant has controls in place to monitor the side-by-side management of its different accounts. The exam will not want to see more profitable trades being allocated to the accounts that pay the most in fees.

5. Fund Governance.

Fund governance and assessing the “tone at the top” is a key component in assessing risk during any investment company examination.

6. New Registrants and Presence Exams.

Approximately 2,000 investment advisers have registered with the SEC for the first time as a result of Dodd-Frank. The vast majority of these new registrants are advisers to hedge funds and private equity funds that have never been registered, regulated, or examined by the SEC. The presence exam initiative is expected to run for approximately two years and consists of four phases: (i) engage with the new registrants; (ii) examine a substantial percentage of the new registrants; (iii) analyze our examination findings; and (iv) report to the industry on our observations.

7. Compliance with the Pay to Play Rule.

To prevent advisers from obtaining business from government entities in return for political “contributions”, the SEC implemented the Pay to Play rule. The staff will review for compliance in this area, as well as assess the practical application of the rule. Given that state and local elections are on tap for the next two years, the pay-to-play rule will be even more difficult for fund companies.


One Comment