Category: Examinations and Audits

In a surprisingly early announcement, the Securities and Exchange Commission’s Division of Examinations has released its 2024 examination priorities just two weeks into the start of its fiscal year. I’m used to seeing this released months into the fiscal year.

“Since the publication of our fiscal year 2023 priorities approximately eight months ago, we have advanced our mission as reflected in this year’s priorities, which provide both continuity and change to reflect a fluid and evolving economic and regulatory landscape. Given the shorter interval in between the publication of our priorities, several initiatives and focus areas from last year remain as fiscal year 2024 priorities.”

I’m focused on the private funds section.

1. The portfolio management risks present when there is exposure to recent market volatility and higher interest rates. This may include private funds experiencing poor performance, significant withdrawals and valuation issues and private funds with more leverage and illiquid assets.
2. Adherence to contractual requirements regarding limited partnership advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.
3. Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets, calculation of post commitment period management fees, adequacy of disclosures, and potential offsetting of such fees and expenses.
4. Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.
5. Conflicts, controls, and disclosures regarding private funds managed side-by-side with registered investment companies and use of affiliated service providers.
6. Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements.
7. Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.

Of these seven, only #3: fee calculation and #6: custody) carry over from last year.

I’m curious about Form PF. Exam staff typically have, in the past, had limited access to Form PF data.

Sources:

• SEC Division of Examinations Announces 2024 Priorities

The Securities and Exchange Commission tries to be transparent about the areas of examination. The Division of Examinations publishes its exam priorities each year. Of course, in practice it may vary from region to region and examiner by examiner. A new risk alert focuses on what an registered investment adviser should expect from an exam.

As it has stated many times over the years, the Division once again states in the Risk Alert that it takes a “risk-based approach” to selecting exam targets. The Division also adds in that a firm could be picked because of the interest in a particular compliance risk area (a sweep exam?), or a tip, complaint, or referral (a for-cause exam).

The Division does list 11 factors for selecting an adviser for examination:

1. prior examination observations and conduct, such as when the staff has observed what it believes to be repetitive deficient practices during more than one review of a firm, significant fee- and expense-related issues, and significant compliance program concerns;
2. supervisory concerns, such as disciplinary history of associated individuals or affiliates;
3. tips, complaints, or referrals involving the firm;
4. business activities of the firm or its personnel that may create conflicts of interest, such as outside business activities and the conflicts associated with advisers dually registered as, or affiliated with, brokers;
5. the length of time since the firm’s registration or last examination, such as advisers newly registered with the SEC;
6. material changes in a firm’s leadership or other personnel;
7. indications that the adviser might be vulnerable to financial or market stresses;
8. reporting by news and media that may involve or impact the firm;
9. data provided by certain third-party data services;
10. the disclosure history of the firm; and
11. whether the firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks.

I think the key for most firms is number 5: How long has been since you’ve had an exam. If it’s been at least six years, the clock is ticking. If it’s been seven years, have a stack of documents ready.

To help you with that stack of documents, the Risk Alert includes an attachment with the staff’s typical initial request for documents and information.

I think it’s great that the SEC published this information. I do find it strange to be labeled as a “Risk Alert.” Those are usually to highlight areas where the Division is seeing problems in examinations. I find it hard to believe that registered investment advisers are being surprised that examiners are knocking on their doors or surprised at the scope of information. It can be a lot. In my recent exam I produced over 800 documents.

Sources:

• Risk Alert: Investment Advisers: Assessing Risks, Scoping Examinations, and Requesting Documents
• 2023 Examination Priorities

The Securities and Exchange Commission’s Division of Examinations has published its 2021 examination priorities.

The big headline is a greater focus on climate-related risks as part of information security and operational resiliency.

“Building on the efforts noted above concerning our business continuity plan outreach related to the pandemic, the Division will shift its focus to whether such plans, particularly those of systemically important registrants, account for the growing physical and other relevant risks associated with climate change. The scope of these examinations will be similar to the post-Hurricane Sandy work of the Division and other regulators, with a heightened focus on the maturation and improvements to these plans over the intervening years. As climate-related events become more frequent and more intense, we will review whether systemically important registrants are considering effective practices to help improve responses to large-scale events.”

The other big focus looks like it will be Regulation BI and Fiduciary Duty compliance.

“The Division will focus on compliance with Regulation Best Interest, Form CRS, and whether registered investment advisers have fulfilled their fiduciary duties of care and loyalty. The Division will examine whether firms are appropriately mitigating conflicts of interest and, where necessary, providing disclosure of conflicts that is sufficient to enable informed consent by retail investors.” 

The new addition to the priorities is looking at LIBOR.

“The Division will continue to engage with registrants through examinations to assess their understanding of any exposure to LIBOR, their preparations for the expected discontinuation of LIBOR and the transition to an alternative reference rate, in connection with registrants’ own financial matters and those of their clients and customers.”

The rest looks like perennial items that a carry-over from the 2020 Examination Priorities.

Private funds are still on the list. The Division will always been focused on the disclosure of fees and conflicts for private fund managers. The Division detailed some very specific types of funds that are in its crosshairs.

One is private funds that invest in structured products, such as collateralized loan obligations and mortgage backed securities. The Division wants to see if these funds have higher risk of non-performing loans and loans with higher default risk. Fund mangers need to be sure that the default risk is being disclosed to investors. Sounds like the Division is going to be very focused on those disclosures.

The Division highlighted four other private fund specific items:

1. preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals;
2. portfolio valuations and the resulting impact on management fees;
3. adequacy of disclosure and compliance with any regulatory requirements of cross trades, principal investments, or distressed sales;
4. conflicts around liquidity, such as adviser led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund.

That last one looks very specific. I suspect the SEC has found some fund restructurings that it doesn’t like. Those may be more prevalent as a result of the pandemic.

Sources:

• SEC Division of Examinations Announces 2021 Examination Priorities
• 2021 Examination Priorities
• OCIE’s 2020 Examination Priorities

The SEC’s Office of Compliance Inspections and Examinations issued a new Risk Alert: Observations from Examinations of Investment Advisers Managing Private Funds.

OCIE highlights three areas of noncompliance in the Risk Alert:

1. conflicts of interest,
2. fees and expenses, and
3. misuse of material nonpublic information.  

OCIE lays out some of the conflicts that are particular to private funds. Allocation of opportunities takes the first spot. A bad thing is allocating limited opportunities to higher fee-paying clients. An ancillary bad thing is not disclosing that allocation policy to investors.

Along with allocation comes co-investment. The Risk Alert notes that some fund managers were not following their co-investment procedures are were not adequately disclosing policies on co-investment.

Some of the more significant deficiencies include unfair allocations of investment opportunities, inequitable fees, insider transactions with service providers and portfolio companies, preferential liquidity rights, secondary transactions, impermissible expenses, valuation, and unlawful access to proprietary systems.   

Fees and expenses have long been a focus for examinations of private funds. To some extent, that was the fault of fund managers. They were less clear about fees and related-party transactions than they should have been. The Risk Alert runs through the typical list of items that fund manager compliance professionals have been focusing on for the last several years.

I would guess that OCIE published the Risk Alert because OCIE is planning to start another round of fund manager exams.  

Sources:

• Risk Alert: Observations from Examinations of Investment Advisers Managing Private Funds
• SEC censures private equity and hedge fund managers over fees
• SEC Finds Common Compliance Problems with Private Fund Managers

Early this year, the SEC’s Office of Compliance Inspections and Examinations announced its 2020 examination priorities. One item was “Risk, Technology, and Industry Trends.” One risk mentioned was LIBOR transition.

[A]s our registrants and other market participants transition away from LIBOR as a widely used reference rate in a number of financial instruments to an alternative reference rate, OCIE will be reviewing firms’ preparations and disclosures regarding their readiness, particularly in relation to the transition’s effects on investors. Some registrants have already begun this effort and OCIE encourages each registrant to evaluate its organization’s and clients’ exposure to LIBOR, not just in the context of fallback language in contracts, but its use in benchmarks and indices; accounting systems; risk models; and client reporting, among other areas. Insufficient preparation could cause harm to retail investors and significant legal and compliance, economic and operational risks for registrants

https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2020.pdf

OCIE has followed up with this initiative and released a Risk Alert on LIBOR transition. OCIE indicates that it is starting a sweep of examinations of to assess firms’ preparedness for the discontinuation of LIBOR.

• The firm’s and investors’ exposure to LIBOR-linked contracts that extend past the current expected discontinuation date, including any fallback language incorporated into these contracts;
• The firm’s operational readiness, including any enhancements or modifications to systems, controls, processes, and risk or valuation models associated with the transition to a new reference rate or benchmark;
• The firm’s disclosures, representations, and/or reporting to investors regarding its efforts to address LIBOR discontinuation and the adoption of alternative reference rates;
• Identifying and addressing any potential conflicts of interest associated with the LIBOR discontinuation and the adoption of alternative reference rates; and
• Clients’ efforts to replace LIBOR with an appropriate alternative reference rate.

OCIE also included a sample document request list.

Sources:

• Risk Alert Examination Initiative: LIBOR Transition Preparedness
• OCIE 2020 Exam Priorities

The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations announced its 2020 examination priorities. OCIE has been publishing its examination priorities annually in an effort to enhance the transparency of its examination program and to provide insights into its approach to examination. With its current risk-based approach, the exam priorities highlight areas that OCIE thinks present greater potential risks to investors and the integrity of the U.S. capital markets.

OCIE identified eight overarching priority areas

1. Retail Investors, Including Seniors and Those Saving for Retirement – OCIE again will focus on the protection of retail investors, including the various intermediaries that serve and interact with retail investors and the investments marketed to, or designed for, retail investors. Examinations in these areas will include reviews of disclosures relating to fees, expenses, and conflicts of interest.

2. Information Security – OCIE will continue to prioritize cyber and other information security risks across the entire examination program.

3. Financial Technology and Innovation, Including Digital Assets and Electronic Investment Advice – OCIE will keep a close eye on those in the digital asset space, as well as RIAs that provide services to clients through automated investment tools and platforms, often referred to as “robo-advisers.”

4. Focus Areas Relating to Investment Advisers, Investment Companies  – OCIE will continue its risk-based examinations for each type of these registered entities. In particular, examinations of registered investment advisers will focus on RIAs that have never been examined, including new RIAs and RIAs registered for several years that have yet to be examined. These examinations will include RIAs advising retail investors as well as private funds.  Investment company examinations will focus on mutual funds and exchange-traded funds, the activities of their RIAs, and the oversight practices of their boards of directors. 

5. Focus Areas Relating to Broker-Dealers, and Municipal Advisors – OCIE will continue its risk-based examinations for each type of these registered entities. Broker-dealer examinations will focus on issues relating to the preparation for and implementation of recent rulemaking, along with trading practices. Municipal advisor examinations will include review of registration and continuing education requirements and municipal advisor fiduciary duty obligations to municipal entity clients.

6. Anti-Money Laundering Programs – OCIE will continue to review for compliance with applicable anti-money laundering requirements, including whether entities are appropriately adapting their AML programs to address their regulatory obligations.

7. Market Infrastructure – OCIE will continue its focus on entities that provide services critical to the functioning of our capital markets, including clearing agencies, national securities exchanges, alternative trading systems, and transfer agents. Particular attention will be focused on the security and resiliency of entities’ systems.

8. FINRA and MSRB – OCIE will continue its oversight of the Financial Industry Regulatory Authority by focusing examinations on FINRA’s operations, regulatory programs, and the quality of FINRA’s examinations of broker-dealers and municipal advisors. OCIE will also continue to examine the Municipal Securities Rulemaking Board to evaluate the effectiveness of its operations and internal policies, procedures, and controls.

As for private funds, on page 16 of the Priorities:

“OCIE will continue to focus on RIAs to private funds that have a greater impact on retail investors, such as firms that provide management to separately managed accounts sideby-side with private funds. Moreover, OCIE will review RIAs to private funds to assess compliance risks, including controls to prevent the misuse of material, non-public information and conflicts of interest, such as undisclosed or inadequately disclosed fees and expenses, and the use of RIA affiliates to provide services to clients.”

As for examination coverage:

“OCIE has increased its examination coverage of RIAs over the past several years from 10 percent in FY 2014 to a high of 17 percent in FY 2018. OCIE’s coverage of RIAs in FY 2019, a year in which the RIA population continued to increase and the SEC experienced a 35-day lapse in appropriations, was 15 percent.”

If these priorities sound familiar, they are not very different from the 2019 priorities. I think that’s because it’s the right set of priorities using a risk-based approach.

The 2021 priorities may change with the regulatory pipeline. The changes in marketing and Regulation BI will alter the compliance landscape.

Sources:

• SEC Office of Compliance Inspections and Examinations Announces 2020 Examination Priorities
• 2020 Exam Priorities
• SEC’s 2019 Exam Priorities