Examinations and Audits – Page 4

Never Been Examined by the SEC? Look in the Lobby

SEC Seal 2

With the flood of new registered investment advisers after the enactment of Dodd-Frank, the Securities and Exchange Commission launched the presence exam program. The goal was to get to a big chunk of the newly registered fund managers. What got left out was the big chunk of investment advisers who had never been examined. That is about to change.

The SEC announced a new initiative directed at never-before examined registered investment advisers. It looks a lot like the presence exams.

The letter highlights five high-risk areas that are likely to be the focus of the exam:

Compliance program
Filings/disclosure
Marketing
Portfolio management
Safety of Client assets

The presence exam initiative was planned to have a two year life and that life is just about expired. The SEC’s exam priorities for 2014 identified the never-before examined as a priority area for the SEC this year. So it’s no surprise that this new initiative is being rolled out.

The only surprising thing is that it lacks a snappy title like “presence exam.” The “Never-Before Examined Initiative” lacks pizazz.

Letters were sent out this week. So if you fit into that category of advisers who registered before 2011 and have not had an SEC exam, look in the mail for your letter.

What can you do if you get one of the letters? Prepare for the exam. Grab one of the sample SEC request letters and give yourself a week to pull the information together.

References:

SEC Document Request Letters

Stack of Papers

As a fund manager one of the best ways to be prepared for a visit from the Securities and Exchange Commission is to practice. You should grab a recent document request from a SEC examination. Then give yourself one week to pull all the requested information together in a coherent package.

I put together a collection of SEC Document Requests. Hopefully you might find this collection useful.

By doing a practice run, you will have a collection of documents ready to go if the SEC suddenly arrives. You may also find some weak spots in your internal records.

It gives you a chance to make sure that you know who in the firm is responsible for maintaining the information and that they will keep it update.

Of course, the document request letters vary greatly from the books and records requirements in SEC Rule 204-2. I expect we may see some changes in that rule after the SEC has run through its presence exam program and digested the record-keeping of private funds.

So far, I have ~~seven~~ ~~nine~~ 10 request letter examples plus links to 3 more on IA Watch, but I’m looking for more. If you have an document request example and are willing to share it, you can send it to [email protected]. I will always delete any information about the firm and I will only publish any additional information about the letter that you consent to.

References:

SEC Examination Document Request on Compliance Building
SEC Rule 204-2

Photo of Stack of Papers is by Jenni From the Block
CC BY

OCIE Director Drew Bowden On Exams, CCO liability and more

ia watch ia week

IA Watch was able to get Drew Bowden, the Securities and Exchange Commission’s Director of the Office of Compliance Inspections and Examinations, to sit down for an interview. “The best thing [CCOs] can do is to be organized, be responsive and be helpful to the examination staff”. This can be measured by how timely you produce requested documents. “It’s most helpful” when firms begin an exam by educating examiners “about the nature of their business [and] what they’re trying to accomplish from a business perspective,”

Portions of the interview are available for your viewing:

IA Watch Interviews Drew Bowden, Part 1

IA Watch Interviews OCIE Director Drew Bowden, Part 2

References:

IA Watch Exclusive: OCIE Director Drew Bowden talks exam do’s and don’ts, CCO liability and more (subscription required)

SEC Exam Priorities for 2014

SEC National Exam Program

Last year the Office of Compliance Inspections and Examinations at the Securities Exchange Commission laid out their examination priorities for 2013. Apparently, it is now an annual event. OCIE published its 2014 Examination Priorities.

For advisers and fund managers the priorities list three core risks:

Safety of Assets and Custody
Conflicts of interest in the business model
Marketing and performance

There are six new and emerging issues and initiatives. For most private equity and real estate funds, there is nothing new here.

Never-before examined advisers
Wrap fee programs
Quantitative trading models
Presence exams
Payments for distribution
Fixed income investment companies

We know the SEC has been trying to get in the door at lots of newly registered fund managers and has been using the presence exams model. As of September 30, the SEC had conducted over 200 presence exams, which apparently is on track to touch 25% of the newly registered advisers. A commendable goal.

Under the Policy topics there is something that caught my eye:

“Alternative” Investment Companies. The staff will continue its assessment of funds offering “alternative” investment strategies, with a particular focus on: (i) leverage, liquidity and valuation policies and practices; (ii) the staffing, funding, and empowerment of boards, compliance personnel, and back-offices; and (iii) the manner in which such funds are marketed to investors. The staff will additionally review the representations and recommendations made regarding the suitability of such investments.

There is no color to the term “alternative” so it could encompass private equity and real estate funds.

References:

The SEC is coming! The SEC is coming!

PEI PFC Forum 2013

These are my notes from the Private Fund Compliance Forum 2013. They are live notes, so please excuse my typos.

One thing that this past year has shown us is that at some point or another, sooner rather than later, the SEC will come knocking. This session will show you how to effectively prepare for their
arrival.

Tracey M. Chaffin, CFO & Partner, Pamlico Capital
Theodore E. Eichenlaub, Principal, ACA Compliance Group
Blair Flicker, General Counsel, Insight Venture Partners
Kelly S. Hale, Director of Compliance, TA Associates
Lois Towers, Chief Compliance Officer, Pantheon Ventures

Have your policies and procedures organized and available for ready access. Don’t have policies that you can’t or won’t follow. You’ll need some evidence that you are following the policies and procedures.

Prepare with a mock exam. Have key employees sit down and subject themselves to an interview. It will help you to see which employees will shine and which need more preparation.

Try a dry run with a document request letter. Grab one of the presence letters and pull all the documents requested.

Prepare an introductory presentation.

Who you are
how you make money
who are the key employees
what is your business model

This presentation can steer them away from issues that are not applicable to the firm’s business model. Don’t use an investor pitch, although you can use key parts. You want to introduce the firm. You want to stay away from portfolio details and past performance. It’s good to have some meet and greet with senior people. Having senior people introduce themselves helps to show to the SEC that you are taking compliance and the SEC presence seriously.

Make sure you have a log of every document you give them and keep a duplicate copy. If you provide documents electronically, its better to produce them in pdf instead of native format.

You can make some documents subject to a FOIA request. You can request that everything is subject. The process is detailed.

Alert employees to the upcoming visit from the SEC. Clean desks, don’t leave documents on the copier, and don’t talk about deals in public places.

Dedicate a room for them. You can lock it for them at the end of the day. The room need not be in the center of the operations. It may be better to keep them off to the side so they are not exposed to things that may inadvertently catch the examiners attention. Designate one person to be available at all times. Generally it’s the CCO.

Be aware that the examiner may not be able to accept food or beverages. Maybe a cup of coffee. So be careful about being too cordial.

Coach your employees before they sit down with the examiners. Have the answers be concise and brief. Make sure the employees are willing to respond to multiple questions that are similar. The examiner may not understand the response.

You should request an exit interview. It is very useful.

What to do if an investor asks for a copy of the deficiency letter? Don’t deliver a copy, but provide a summary. A deficiency letter is not public. Don’t misrepresent the nature of the exam or the contents of the letter.

You have 30 days to respond to the SEC deficiency letter.

Don’t Overstate Assets Under Management

over inflate

I’ve said it before: Don’t overstate assets under management. You need to keep records on your calculations and be able to prove the calculations.

Umesh Tandon ran Simran Capital Management and was trying to land California Public Employees’ Retirement System (CalPERS) as a client. The problem was that CalPERS required prospective investment advisers to have at least $200 million in assets under management.

According to the SEC Order, Tandon lied and stated that his firm met that test. In reality, the firm had only $80 million in assets under management. The Firm’s Form ADV stated that the firm had $102 million in assets under management.

Once that line was crossed, the firm used overinflated statements of assets under management when pitching other clients.

Then the SEC examiners showed up and popped the bubble. Now Tandon is barred from the securities industry and has to pay a substantial fine.

Sources:

2013 SEC Examination Priorities

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.

Valuations and the New Presence Exams

sec-seal

I’ve come across a new document request list for a presence exam from the SEC’s Atlanta Regional Office. The exam period for the letter begins March 31, 2012 – the Dodd-Frank deadline for new advisers to register with the SEC. The SEC has said presence exams will target new advisers or those that manage private funds. The exams also may focus on just one or two topics.

Previously, I posted an examination letter that focused on fees. This new letter focuses on valuations.

The letter requests investment committee minutes, valuation policies and procedures, any models used in valuing investments, and any third party valuation reports.

Time to sit down and run through a mock document request again.

Sources:

New Document Request List for Presence Exams

We’ve had the first siting of the new document request letter for the new presence exams. IA Watch has obtained a copy of the letter issued from the Atlanta Regional Office.

This letter sets the exam period to start on March 30, 2012. That addresses some concerns that the SEC would look at period prior to a firm’s registration as an investment adviser.

It’s clear from the request list that the examiners will be looking closely at fees. Among the items is a “schedule of fees earned by the Adviser from each portfolio company and whether they were credited back to clients. It goes on to ask for all compensation received by the adviser, besides management and performance fees. Further, it asks for the total expenses reimbursed by each portfolio company.

Notably missing from the letter are items related to marketing, custody, portfolio management, and valuation. You may remember that the SEC’s Presence Exams are set to concentrate on five areas:

marketing
portfolio management
conflicts of interest
safety of client assets
valuation

It looks like this Atlanta RO letter is focused on conflicts of interest. I’m going to guess that this document request is just one of several versions, with each version concentrating on different area.

Sources:

The New SEC Presence Exams

The Securities and Exchange Commission has started it Presence Exams process. I have copies of letters from the New York Regional Office and the Boston Regional Office. The Presence Exams is part of an initiative to conduct “focused, risk-based examinations of investment advisers to private funds that recently registered with the commission.”

The SEC has broken the Presence Exams initiative into three phases: Engagement, Examination, and Reporting. This matches up with the preview offered by Carlo di Florio at PEI’s Private Fund Compliance Forum.

I assume the letters are part of the engagement phase. They include a long list of reference materials about the Investment Advisers Act and compliance.

The SEC has broken the examination phase into 5 higher risk areas for review:

marketing
portfolio management
conflicts of interest
safety of client assets
valuation

I assume the other regional offices have sent out the same letter. Please let me know if your firm has received one and if it’s different from the New York or Boston letters. You can leave a comment or email to [email protected].

Sources: