Examinations and Audits – Page 3

Preparation for SEC Examinations

ascendant

Ascendent Compliance put together a presentation on Preparation for SEC Examinations.

Last year the SEC examined 9% of advisers which represent 25% of the RAUM. Of those exams, 87% had deficiencies, 25% had significant findings, and 14% were referred to enforcement.

The SEC has implemented a new telephone assessment for offsite remote exams. The examiners do not end up in your office. Unless they find something that catches their attention.

The Never Before Examined Initiative is continuing for advisers registered before 2012.

The Presence Exam Initiative may be winding down. The SEC is still continuing its lengthy routine exams.

“Enhancing Risk Monitoring and Regulatory Safeguards for the Asset Management Industry” speech by SEC Chair Mary Jo White on December 11, 2014 talks about new rule makings and possible wide reaching changes.

In the SEC Report on Objectives 2015 from the Office of Investor Advocate recommends investment advisers being examined every three years and longer than five years without a comprehensive exam.

OCIE is continuing to develop technology to help them with exams to identify fraud, manipulation, and compliance failures. If they have new tools, it’s likely that they will be using them in the exam process.

Based on the 2015 initiatives, the SEC will focus on issues affecting investors’ retirement accounts, including marketing practices and recommendations. There will likely be a focus on placing assets in a firm’s sponsored investment vehicle.

What’s New with the OCIE Document Request Lists?

Longer exam period for information – 2 years
New questions
Slide deck presentation on the firm, affiliated entities and services
List of all committees, including description, meeting frequency, membership, and keeping of written minutes
Summary of valuation process
All emails form particular individuals over a period of time

2015 Examination Initiatives

Retail Investors – Retail investors are being offered products and services that were formerly characterized as alternative or institutional, including private funds, illiquid investments, and structured products. Additionally, financial services firms are offering a broad array of information, advice, products, and services to help retail investors plan for and live in retirement. OCIE will assess risks to retail investors that can arise from these trends.

Market-Wide Risks – OCIE will examine for structural risks and trends that involve multiple firms or entire industries, including: monitoring large broker-dealers and asset managers in coordination with the SEC’s policy divisions, conducting annual examinations of clearing agencies as required by the Dodd-Frank Act, assessing cybersecurity controls across a range of industry participants, and examining broker-dealers’ compliance with best execution duties in routing equity order flow.

Data Analytics – Over the last several years, OCIE has made significant enhancements that enable exam staff to analyze large amounts of data efficiently and effectively. OCIE will use these capabilities to focus on registrants and registered representatives that appear to be potentially engaged in illegal activity.

First Impressions

Set a tone of cooperativeness
Set a tone of compliance
Let them know that you thought about the issues ahead of time

Exam Plan

What do you do after you get the call from the examiner
Organization of materials
FOIA Protection
Role of consultant
Role of counsel
Prepare key personnel for interviews

Improving Your Next Exam

Fix deficiencies from prior exam
Respond to deficiencies from current exam
Set up a training plan to fix problems
Implement testing and documentation

SEC Exam Priorities for 2015

In 2013 the Office of Compliance Inspections and Examinations at the Securities Exchange Commission laid out their examination priorities for 2013 and did so again last year with its 2014 Examination Priorities. OCIE just released its Examination Priorities for 2015.

One item jumps out for a focus for private funds:

Fees and Expenses in Private Equity. Given the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses, we will continue to conduct examinations in this area.

Given the resources focused on this last year, it’s no surprise that this remains an initiative for the national exam program.

What is surprising is how different the priorities look from last year’s release. It is much more sparse and focused than in the past.

OCIE announced three broad areas of priority:

Sources:

Private Equity Funds and Broker-Dealer Registration

Broker concept.

There was a lots of hand-wringing after a speech by David Blass indicated that the SEC was focusing on transaction based fees that private equity funds were earning on securities transactions. Since then, there has been rumblings during presence exams, but no official enforcement action or ruling from the SEC.

One group of fees at issue was compensation paid to the fundraising team. If your sales team was paid a commission on fund commitments, it raised an issue of broker/dealer registration for the employee. The second group was the fund or fund manager receiving fees for arranging debt or equity for a portfolio company. This raised broker/dealer issues for the fund manager.

Gretchen Morgenson wrote a story in the New York Times that was focused on the hiring of an independent adviser to monitor a private equity fund’s practices. That oversight was triggered by an SEC exam in April 2013, according to the story.

Although the monitoring aspect is interesting, I also found the trigger events to be more interesting. The firm was “reaping fees from investment-banking-type transactions without fulfilling the regulatory requirement of being registered as a broker-dealer.” This seems to be evidence that the SEC is (or was) looking at this issue during private fund exams.

But, the story also notes that the firm was failing to share those fees with the funds as apparently required by the fund documents. So that leaves it unclear if the SEC was continuing to focus on broker/dealer registration or was merely noting a violation of fee calculations. (Not that violating fee calculations is okay.)

Sources:

Entering the Secret Garden of Private Equity by Gretchen Morgensen in the New York Times
Private Equity Miscreant Freeman Spogli Illustrates Investor and SEC Cowardice by Yves Smith in naked capitalism
Are Your Private Fund Employees Licensed?

Getting Ready for Your SEC Exam – Introductory Presentation

presentation

The phone rings and the caller ID pops up with US Securities and Exch… You swallow hard. They are coming. What now?

One thing a private fund manager can do to smoothly take the SEC through an exam is to have an introductory presentation when they walk in the door.

The SEC examiners will have read your firm’s Form ADV and looked at your firm’s website. They may also have run a quick web search for any stories. That three things are unlikely to give them much insight into the operations of your firm. The better they understand your firm, the less likely they are to be concerned. (Assuming you are not actually lying, cheating or stealing.)

The goal of the presentation should be to provide an understanding of the firm, that your firm is treating its investors well, that your firm understands the regulatory requirements, and that your firm is serious about compliance.

These are some things I have in my opening presentation:

History of the firm
Ownership of the firm
Overview of each fund: closing date, investment period, size
Investment strategy for each fund
Types of investors (look at Form PF filing)
Case study for an investment: why we bought it, what we plan to do with it, how to make money from it
Key personnel
Overview of compliance program
Fees and revenue paid to the firm and how calculated
Custody and how you comply with the custody rule
Valuation policy and procedures
Marketing
Conflicts in the firm and how they are managed
Address key regulatory compliance requirements
- Code of ethics
- Political contributions
- Disaster recovery/business continuity
- Placement agents
- Anti-money laundering

The presentation is not a pitch to investors, so it’s not time to sell the firm or use a pitchbook. (You likely could take some elements from the pitchbook for this opening presentation.) You want to sell compliance.

I recommend putting together the opening presentation now and updating it every quarter. Once that call comes from the SEC you are going to be crunched for time. It’s much easier to update the presentation than create a new one.

More Findings on SEC Exams of Private Funds

Andrew Bowden unloaded a truckload of information at the recent CFA Institute in Boston. Andrew Bowden is the Director of the U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations. His comments were based on audience questions, instead of a prepared speech. You can’t find it on the SEC website, but you can watch it at the CFA Institute’s website.

Of the 1,500 private fund advisers that registered because of Dodd-Frank, the SEC set out to examine roughly 25 percent of these firms by the end of 2014. According to Bowden, 370 firms have been examined, and OCIE is on track to reach 400 by the end of the year. Half of those are hedge fund managers and half are private equity fund managers.

Bowden noted his May speech on fees and expenses at private equity funds.

He said the deficiencies for hedge funds largely fell into three main categories: Custody, valuation, and marketing/advertising. On the positive side, he found hedge funds to be doing a generally good job on compliance. The marketplace of institutional investors demanded it.

(The contrarian in me will argue that SEC examiners merely better understand hedge funds than private equity funds.)

The custody-related deficiencies were mostly technical in nature. For example, the hedge fund may have an account that was not subject to an audit.

Regarding valuation, the SEC found that some firms were switching their valuation methodology from period to period to achieve the highest possible investment valuation.

For the marketing-related deficiencies, the SEC examinations discovered that most of failures were mostly technical failures under the SEC rules. Some of that can be chalked up to moving from pre-registration materials to post-registration requirements. In some cases, hypothetical and/or back-tested performance was being represented as actual performance, portability situations were being improperly documented and disclosed, and inappropriate benchmarks were being used. He focused that false claims of compliance with GIPS is a material misrepresentation. He also used the Bitran case as an example of false performance advertising.

Bowden also highlighted the SEC’s new national exam analytics tool, which allows its examiners to rapidly analyze trade data.

“Three years ago, an SEC examiner would go into a firm and ask to see its trade blotter for the past two weeks or month, put it into Excel, sort it into columns, and try to spot signs of cherry picking, front running and insider trading,” he said. “The quants developed a tool that allows examiners to see the trade blotter for three years as a standard practice and subject that to more than 50 tests.”

He also highlighted the never-before examined initiative. That has reached about a significant chunk of the 20% of the firms registered for 3 years that had never before been examined. He also noted that several regional offices are calling new firms as they register for an hour long call.

Sources:

How Does the SEC Use Form PF in Adviser Exams?

Form PF

You slave over Form PF trying to get the information demanded by the Securities and Exchange Commission. What happens to that data?

The Dodd-Frank Wall Street Reform and Consumer Protection Act Section 404 directed the SEC to establish reporting requirements for investment advisers to private funds as necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk by the Financial Stability Oversight Council. Form PF was the result of Section 404. That section of Dodd-Frank also requires the SEC to submit an annual report to Congress on how the SEC is using the data.

According to the latest annual report, the SEC uses Form PF data in its examination and enforcement programs.

Prior to an examination of a private fund adviser that files Form PF, OCIE staff generally reviews the adviser’s Form PF filing as a part of a routine pre-examination evaluation. This review, in conjunction with other data sources, provides OCIE staff with an understanding of the nature of an adviser’s business and investment strategy.

I did not find this to be the case. The Form PF data is locked away from OCIE and examiners need permission to access the data. At least that was the case in the Boston office six months ago.

It’s good that potentially sensitive data is hard to access. That was supposed to be the case with Form PF data. Examiners are already deep into a fund manager’s business operations do the Form PF data would not likely contain any secrets that the examiners are not already looking at.

The examiners will compare the Form PF data to what shows up in due diligence reports, pitch books, offering documents, operating agreements and books and records. Exam staff will look for discrepancies between an adviser’s Form PF filing and any publicly-available documents related to the adviser, including Form ADV.

According to the report, the SEC is collecting Form PF data on 21,542 funds. Of those, 2,888 are large private equity fund advisers (over $2 billion in RAUM) of a pool of 7,004 private equity funds. There are 1,397 real estate funds reporting with $354 billion in RAUM.

Sources:

Annual Staff Report Relating to the Use of Data Collected from Private Fund Systemic Risk Reports 2014 (.pdf)

The SEC Has Seen Your Private Equity Fees And Is Not Happy With Them

money penny

According to a story in Bloomberg, the Securities and Exchange Commission has examined about 400 private equity firms and found that more than half have charged “unjustified fees and expenses without notifying investors”. The editor decided to change the headline from “unjustified” to “bogus”.

Fees and expenses charged by a fund manager to investors in the fund is always a conflict. The manager is taking cash from the limited partners.

The first question is whether the fees and expenses are adequately disclosed in the private placement memorandum or the partnership agreement. Most funds give the manager broad discretion to charge expenses for managing the investments to the investors in the fund. I have a hard time believing that over 50% of fund managers are charging expenses that are not permitted by the fund documents.

The story used “unjustified” when disclosing what the “person with knowledge of the SEC’s findings” stated about the fees. That may be more about the SEC not being happy with the fees charged, not necessarily that the fund manager is not legally entitled to the fees.

The second issue to think about with fees is whether the fees distort behavior. Certainly, a fund manager could be tempted to operate its private equity investments in a way that maximizes its fee revenue. That may cause the manager to make decisions that are in its best interest and not necessarily in the best interest of the fund investors. If a fund manager earns a fee for raising additional debt for a portfolio company, but not for raising additional equity. You might think the fund manager would be inclined to more often raise debt instead of equity.

To counter that inclination, private fund mangers earn the best returns by deliver great returns to their investors. Most managers earn a carry, taking an extra piece of the profit for good returns to investors. Taking a fee in the short term would hurt the long term, bigger return.

Compliance has a role to monitor fees to make sure they comply with the disclosures and legal agreements. It also has a role to monitor whether the nature of the additional fees distorts behavior in a way that could be perceived as adverse to investors.

The story mentions three types of bogus fees:

miscalculating fees,
improperly collecting money from companies in their portfolio and
using the fund’s assets to cover their own expenses

One is failing to comply with the documents. Two is a potential disclosure failure. Although, the SEC may be expecting more specific disclosure than exists in the fund documents. Three may be a difference of opinion by the SEC over what should be a fund expense and what should be a management company expense.

As for expenses, the story mentions the Clean Energy Capital case where the SEC has accused the fund manager of grossly over-allocating expenses to the fund instead of the management company.

References:

What Are the Implications of the SEC’s New Private Fund Exam Unit

Greg Roumeliotis and Sarah N. Lynch are reporting in Reuters that the Securities and Exchange Commission has formed a new group dedicated to the exam of private equity and hedge funds. This new private fund unit will be co-chaired by Igor Rozenblit and Marc Wyatt. Rozenblit is coming from the asset management unit of the SEC’s enforcement division and is a former private equity professional. Wyatt joined the SEC in 2012 as a private funds examiner and formerly worked for hedge funds.

Based on the private fund managers I have spoken with that have been subject to a SEC exam, nearly all have found that the examiners knew little about private equity, real estate, or more exotic hedge funds. Examiners’ knowledge seems mostly limited to retail investment advisers, mutual fund advisers, and basic hedge funds.

I assume the new unit will be largely focused on education. I’ve heard Rozenblit speak and he certainly understands how private equity works and where enforcement should focus. I think he will offer great insight for examiners.

Assuming this story is true, I expect there will be significant changes to the exam process for private fund managers. The document request letters have often been a poor fit for private equity funds. Some even show a complete misunderstanding of how a private equity fund operates. That leads to lots of time wasted by examiners and fund managers subject to examination.

References:

Exclusive: SEC forms squad to examine private funds by Greg Roumeliotis and Sarah N. Lynch

Get Ready for the SEC to Knock on Your Door

Grim Reaper Door Knocker

With the SEC’s presence exam initiative for new registrants and the Never-before-examined initiative for existing registrants, the odds have never been greater that the SEC will knock on your door and start an examination. I’ve also heard from a friend that the SEC is coming in for a full blown examination of her firm. (I also heard an SEC examiner mention that they are going to try to ferret out private fund managers who did not register.)

Obey the Boy Scout Motto and be prepared.

Prepare an introductory presentation. As I discussed last week, start drafting that presentation now, before the SEC knocks on the door. Circulate it broadly to get comments. Review it each quarter to keep it up-to-date. You are not going to have enough time to create presentation once you get SEC’s knock on your door.

Practice getting the documents ready for an exam. Grab a recent SEC document request list and give yourself a week to get all of the documents assembled. You may find it hard to answer some of the questions, so you can change your record-keeping process to address a likely question. You will also have a stockpile of documents ready to go when the SEC shows up.

Prepare some key employees. Look at your organization and figure out who the SEC examiners are likely to ask to speak with. They will want senior people in key risk areas. Valuation will be a big area for most real estate funds and private equity funds. Grill your valuation person so he or she is able to give a thoughtful presentation on your firms valuation process. Figure out who will do will being grilled by the SEC examiners and who will do poorly. Better to have that information now than in the crush of an SEC examination.

Prepare an examination procedure. Layout who gets notified and who is responsible for the various aspects of the examination. Think about where you want the examiners to sit while they are on site. Think about how you want to prepare and deliver documents.

References:

Create an Introduction for the SEC
SEC document request list examples compiled by Compliance Building

Create an Introduction for the SEC

Welcome SEC Examiners

The chances are greater than ever that the Securities and Exchange Commission will show up in your lobby. Be prepared and have an introductory presentation for them.

The SEC’s Office of Compliance Inspections and Examinations is continuing on its presence exam initiative. Those exams are shorter which means the examiners can get to more fund managers. For those fund managers that registered before Dodd-Frank, OCIE is rolling out its new Never-Before Examined Initiative.

An introductory presentation is your chance to tell the examiners the story of your firm and the story of your compliance program. If done well, it can show the examiners that you are thoughtful about compliance and keep the examination focused on the right issues.

It’s not an investor pitch. You’re not trying to convince the examiners to invest with you. You are trying to convince them that there is no fraud, deception or manipulation at your firm.

Organize the presentation around a powerpoint and use it as your storyboard. The Chief Compliance Officer should lead the presentation. It may be useful to have one or two key employees present who are involved in the compliance program to help answer questions and take notes.

Put the powerpoint together today. Don’t wait for the SEC document request letter. You will be too busy gathering documents to put together the presentation. You can update the presentation each quarter to keep it up to date. When the SEC says they are coming, you merely need to polish the presentation and not create it from scratch.

Two good starting points are an investor pitch and annual meeting materials. Those should have background information and current investment information that you will want to include. Then you can layer in the compliance program information.