Category: Examinations and Audits

Mock Audit: Successfully Maneuvering Your Way Through an SEC Exam

These are my notes from the “Mock Audit: Successfully maneuvering your way through an SEC exam” session at the Private Fund Compliance Forum 2012. These are my raw notes, so please excuse the typos and rambling.

Moderator: 

Panel Members:

There has been a dramatic increase in the SEC’s understanding of private equity and private fund managers. They are developing the internal expertise and understand the business and risks of the business. Of course, it depends on the individual examiner.

It’s a good idea to give them an introduction to the business. You can help frame the exam and their focus. It’s great to run an introductory message to the SEC. You can share the operations, investment strategy, key personnel, and risks.

There has been a push by the SEC headquarters to standardize the exam process. Historically it varied dramatically from SEC Regional Office to Regional Office. The first level of standardization is the document request letter. It has largely been standardized across the country.

An exam can last from a few days to several months. It depends whether they actually come to the office and the type of exam.

The SEC will contact limited partners. As part of the asset verification program, the SEC will compare the firm records to the account records.

How can a firm prepare for a SEC exam?

You are never going to be fully prepared. You are always going to get a deficiency letter. You need to show your compliance program. At least show that you are trying.

One panelist recommended Bates stamping all of the documents. Always keep a duplicate copy and inventory what you give them. One panelist shared an anecdote that a client received a deficiency letter for not delivering a requested document. Even though the client thought they had deliver it, the client had bad records and could not prove that they had given it.

Will an exam address issues for things that occurred before registration? The SEC will likely start from the registration date. If you have the records and information for pre-registration and readily available, then give it to them. If it’s hard, then push back.

Be scrupulously honest. Covering up a problem will often be worse than the underlying problem.

Cooperate. Don’t say no. Try to find what they are looking for and a different way to deliver it or otherwise address the concern.

Do confirm that the exam request came from the SEC. There have been cases of impersonation.

Find a model request list and try to produce all of the information as quickly as possible.

It’s good to have counsel involved in the SEC exam. However, too much lawyer involvement can be a red flag to the SEC. The CCO should always be in the room during an SEC interview.

Make sure you have a point person for the SEC. Best that it be the CCO, but if not available make sure someone else is.

Take time during the day to stop in and ask the examiners if they are getting everything they need and if they are missing something.

Take advantage of an exit interview with the SEC examiners.

Often the SEC examiners will send a draft of the deficiency letter for comment by the firm. You have 30 days to respond to the deficiency letter.

Historically, the typical routine exam will result in a deficiency letter 95+% of the time. The no action letter comes in only1% to 3% of the time.

The most common deficiencies are disclosure issues in the Form ADV, marketing issues, Code of Ethics issues, and the compliance program itself.

Side letter compliance is something unique to private funds.

 

SEC’s National Exam Program Overview

The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) mission is to protect investors through its nationwide examination and inspection program. Examiners in Washington DC and in the SEC’s 11 regional offices conduct examinations of the nation’s registered entities. Besides investment advisers, OCIE also examines broker-dealers, transfer agents, investment companies, the national securities exchanges, clearing agencies, the nationally recognized statistical rating organizations, SROs (Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board), and the Public Company Accounting Oversight Board. That’s a lot of ground to cover.

OCIE recently released its National Exam Program Overview (.pdf). The first 23 pages ramble on about the statutory and regulatory framework. The good stuff starts on page 24 with a description of the inspection and examination process.

  1. Overview
  2. Scope
  3. Scheduling Fieldwork
  4. Entrance Interviews
  5. Document Requests
  6. Questions
  7. Exit Interviews/Exit Conference Calls
  8. Results

The staff may identify compliance deficiencies or internal control weaknesses. If this is the case, the staff generally will provide the registrant with a deficiency letter identifying the problems, asking the registrant to take remedial steps, and requesting that the registrant provide a written response. Examinations often conclude with a deficiency letter.

It’s a good roadmap to help prepare your firm for when the SEC inevitably comes knocking on your door.

Sources:

SEC Sweep Letter for Private Equity Funds

The San Francisco Office of the SEC has an informal inquiry into the valuations of private equity funds. IA Watch has received a copy of the sweep letter from the Division of Enforcement directed to a private equity fund manager.

Some highlights in the request:

  • All formation and offering documents for the fund, including private placement memoranda, limited partnership agreements, and operating agreements
  • List of investors and capital commitments
  • List of all investments, realized amount, and gross IRR
  • All communications with investors regarding fund performance
  • Support for valuations of the fund assets for the most recent fiscal year

It seems to be a fairly short list for an SEC document request. But any SEC document request is intimidating.

The request shouldn’t be construed as indication that there has been a violation of the federal securities law. It’s indication that the SEC is continuing to look for funds and managers that manipulated valuations.

Sources:

What is the SEC Looking For With Private Fund Managers

IA Watch published a few recent document request letters in connection with SEC examinations of investment advisers. One is a document request letter sent to a private fund manager (sub. required).

These are some of the items requested that caught my attention:

  • Organizational chart showing ownership percentages
  • investment strategy
  • Amount of adviser’s equity interest
  • Amount of adviser’s affiliated person’s interest
  • Specific exemptions from registration under the Securities Act
  • Services the adviser is providing
  • Amount of leverage, both explicit (on-balance sheet) and off-balance sheet (futures and certain other derivatives)
  • Account statements sent to investors
  • Names of investors who purchased and redeemed an interest in the fund during a specific period
  • Description of all positions held in side pockets or special situation accounts
  • Side agreements in which investors are participants

It’s clear from the letter that examiners are focused on custody issues and side pocket issues.

The SEC has been up front about this. The custody rule may be a headache, but its intended to prevent another Madoff. By getting account statements directly from the custodian instead of the adviser, you have a control in place to prevent fraud.

Sources:

Core Initial Request for Information from Investment Advisers

sec-sealThe SEC’s Office of Compliance Inspections and Examinations has published its Core Initial Request for Information for Investment Adviser Examinations.

The initial phase of an examination includes a review of the firm’s business and investment activities, its organizational affiliations and its corresponding compliance policies and procedures. The staff will request information and documents and speak with the firm’s employees to ensure an understanding of the firm’s business and investment activities and the operation of its compliance program. Using the information obtained, the staff will assess whether the firm’s compliance policies and procedures appear to effectively address the firm’s compliance risks. This work includes testing the firm’s compliance program in particular areas.

The following points provide an overview of the core information the staff requests:

  • Certain general information to provide an understanding of the firm’s business and investment activities, including organizational charts, demographic and other data regarding advisory clients, and a record of all trades placed for its clients (trade blotter).
  • Information about the compliance risks that the firm has identified (e.g., an inventory of compliance risks) and the written policies and procedures the firm has established and implemented to address each of those risks to provide an understanding of the firm’s compliance risks and corresponding controls.
  • Documents relating to the results of and output from the various transactional (quality control) and period (forensic) testing conducted to provide an understanding of how effectively a firm has implemented its compliance policies and procedures. This includes the results of any compliance reviews, quality control analyses, surveillance, forensic or transactional tests the firm has used to determine if activities have been performed as expected and to identify activities or transactions that have fallen short of or breached related policies and procedures.
  • Information regarding the results of any tests and follow-up actions taken by the firm to address shortfalls or breaches revealed by such tests to provide an understanding of steps taken by the firm to address the results of compliance reviews, quality control, forensic or transactional tests conducted. This information might include, for example, warnings to or disciplinary action of employees, changes in policies or procedures, redress to affected clients, or other measures.
  • Information to perform testing for compliance in various areas.

http://www.sec.gov/info/cco/requestlistcore1108.htm