What Do Fund Managers Need to Know About the SEC Presence Exams – Key Considerations and Topics
By Christopher Lombardy, Kinetic Partners
In October 2012, the SEC notified newly-registered private fund managers of the SEC’s Office of Compliance Inspections and Examinations’ (“OCIE”) new strategy for its National Examination Program (“NEP”). The examination program would include the “Presence Exams” of investment advisers who registered with the SEC in accordance with the relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The SEC indicated that Presence Exams would be conducted in three phases, including an engagement phase, an examination phase, and a reportable phase.
The OCIE identified the following key focus areas for Presence Exams in its October 2012 letter: (i) marketing; (ii) portfolio management; (iii) conflicts of interest; (iv) custody; and (v) valuation. Based on Kinetic Partners’ experience, these continue to be the areas of focus for the OCIE’s examiners.
The SEC has followed through with its Presence Exam strategy including providing continued engagement with the industry (through a variety of speeches by senior level personnel) and reporting (through such speeches and also through publication of NEP “Risk Alerts”).
Many registered investment advisers that have never experienced a regulatory examination often wonder about the process and experience of a Presence Exam. In general, the designated Chief Compliance Officer (“CCO”) of an adviser will be contacted by the SEC and notified that the SEC will be conducting an examination.The SEC frequently will request a conversation with the CCO and other principals of the firm in order to gain an overall description of the adviser’s business, strategy and compliance infrastructure. This initial conversation usually will be followed by a document request list that specifies a number of documents that the adviser will need to provide to the SEC prior to an onsite visit.
The documents requested may include, but not be limited to:
- Compliance policies and procedures and evidence of periodic reviews of such policies and procedures.
- Conflict and/or risk assessment log and evidence of performance of an annual assessment.
- Offering documents and marketing materials relating to private or registered funds advised by the adviser.
- Audited financial statements of the funds.
- Various logs (including compliance breaches and gifts and entertainment), as well as notification of any compliance breaches by employees.
- Information about an adviser’s clients or fund investors.
- Reports from fund administrators, prime brokers and/or custodians.
- Reports relating to trade activity (e.g., actual trade activity, trade aggregation and allocation).
- Record of proxy votes and corporate actions.
- Records of the personal trades or private investments of employees.
- Records of any client or investor complaints.
We have found that prompt submission of the information requested provides the OCIE with a sense that the adviser is organized and prepared for the examination.It is therefore essential that registered investment advisers have a clear understanding of the “Books and Records Rule” (Rule 204-2 of the Investment Advisers Act of 1940) in order to develop an appropriate system for recordkeeping in accordance with the specifics of the Rule.
Following the production of the documents requested by the SEC, the SEC typically will perform an onsite visit.In a Presence Exam, the SEC usually will be onsite at the adviser’s premises for a period that may range from two to three days to a week.The OCIE has expressed its intention to generally be onsite for only a few days in a Presence Exam; however, adverse findings or red flags can require further need for review and an additional length of stay.
Generally, at the conclusion of the onsite portion of the Presence Exam, the SEC will conduct an exit interview with the adviser to notify the adviser of the general findings from the exam and to describe any deficiencies.In a significant number of the examinations, the SEC will generate a “Deficiency Letter” that describes those areas where an adviser needs improvement based on the results of the examination. The exit interview is also an opportunity for the adviser to update the SEC as to any changes it may have made to its compliance or operations infrastructure as a result of points raised by the SEC during the onsite portion of the exam.Advisers generally will be expected to respond to a Deficiency Letter within 30 days of its receipt.
Although it is anticipated that most Presence Exams will conclude with an exit interview followed by a written Deficiency Letter, the SEC can conduct further review of an adviser, or perhaps even refer a matter to the SEC’s Enforcement Division, if there is a lack of a strong culture of compliance, serious deficiencies in the adviser’s compliance program, or securities law violations.
Key Focus Areas in a Presence Examination
As mentioned earlier, the SEC has identified key focus areas for an examination:
It is almost certain that the OCIE will request to review an adviser’s advertisements or “Marketing Materials.” It is important to recognize what can be deemed Marketing Materials. Marketing Materials can include a slide deck or pitch book, due diligence questionnaire (DDQ), request for proposal (RFP), periodic investor letters, presentations used at conferences, websites and social media sites, and articles published in periodicals.
Marketing Materials used by a private fund adviser to market the private fund should be consistent with the terms and information in the relevant fund’s confidential offering memorandum and the fund’s governing documents. Inconsistencies between disclosure to investors and the adviser’s compliance documents or actual practice can be viewed as violations of the SEC’s “Advertising Rule” (Advisers Act Rule 206(4)-1), and/or the antifraud prohibitions of Advisers Act Rule 206(4)-8 (anti-fraud in connection with pooled investment vehicles) and other related antifraud rules. In order to avoid such mistakes, it is essential that an adviser have policies and procedures that require the review and approval of Marketing Materials by the CCO prior to use. Advisers should also strongly consider having their outside legal counsel or compliance consultants review Marketing Materials prior to use.
In addition to inconsistencies in Marketing Materials, another common deficiency concerns a lack of appropriate disclaimers on Marketing Materials. Disclaimers are particularly important when performance-related information is included. Past performance results should be shown net of fees and an adviser must maintain supporting data for the performance disclosure. Advisers should also be aware of relevant no-action letters that discuss issues around the use of specific trade examples, hypothetical or back-tested performance returns, the portability of a track record from one adviser to another, the use of comparable indices, and the need to disclose relevant risks and conflicts.
It is important that an adviser’s investment strategy is consistent with the investment strategy described to fund investors or managed account clients in a fund’s confidential offering memorandum or an investment management agreement, respectively.Consent from investors or clients may be required if an adviser deviates from its disclosed investment strategy. In addition, the SEC (as well as the National Futures Association (the “NFA”), the self-regulatory body for the Commodity Futures Trading Commission (“CFTC”), for those advisers that are also registered as a commodity pool operator (“CPO”) or commodity trading adviser (“CTA”) with the CFTC) will review trade and investment aggregation and allocation among multiple funds and/or client accounts.Advisers should treat clients fairly when allocating investment opportunities that are eligible for multiple clients. If an adviser deviates from pro-rata (i.e., fair and equitable) allocation amongst client accounts when it appears that pro-rata allocation is appropriate, it is important for the adviser to document the reason(s) for the deviation from pro-rata allocation.
Conflicts of Interest
An adviser should continuously attempt to identify conflicts related to its business. In addition to conflicts related to the allocation of investment opportunities described above, another key conflict of interest is the allocation of expenses between the adviser and the private fund(s) or client account(s) that it advises, rather than allocating such expenses to the adviser itself. Expenses that are charged to private funds and client accounts should be clearly described in the relevant offering documents and/or investment management agreement. In addition, the SEC typically will not apply a concept of “materiality” in connection with fund expenses and may require the adviser to reimburse a de minimis expense item that the SEC alleges was misapplied to the fund in contravention of the adviser’s disclosures and/or compliance procedures.
Personal trading and investments by employees will likely be an additional area of review by the SEC when reviewing conflicts of interest.An adviser’s Code of Ethics is required to address employee personal trading and private investing. An investment adviser has a fiduciary duty to its clients to put the interests of its client first. Evidence of front running an investment opportunity or of an employee taking advantage of an investment opportunity to the detriment of the fund or managed account client will most likely be deemed a serious issue and a breach of the adviser’s fiduciary duty.Advisers may need to consider whether consultants or independent contractors or individuals from other organizations who share office space with the adviser should be subject to the adviser’s compliance policies and procedures or, at the minimum, the adviser’s Code of Ethics which includes policies regarding personal securities trading.
Safety of investor assets will continue to be a key focus by the SEC and many investors, as well.Advisers to private funds are deemed to have “custody” of their investors’ pooled assets and therefore, will be required to meet certain provisions of the Advisers Act’s “Custody Rule” (Advisers Act Rule 206(4)-2).Such requirements include maintaining securities and funds with a qualified custodian (e.g., a bank or registered broker-dealer) and ensuring that the private funds advised by the adviser are independently audited in accordance with US GAAP and that such audited statements are delivered to investors within 120 days (180 days for fund-of-funds) of the fund’s fiscal year end. In addition, there is an increased focus on the controls around the movement of funds out of a private fund (e.g., multiple approvers and the involvement of fund administrators).
Advisers that invest in hard-to-value or illiquid assets should have a thorough valuation policy and should review such policy on a regular basis. It is important that advisers adhere to their valuation policy and document any deviation from the policy. Key considerations include disclosure of valuation methods to investors and the appropriate calculation of fees related to the valuation of assets. A number of enforcement actions have been brought by the SEC regarding violations relating to valuation.
Other Key Areas of Focus
In addition to the topics described above, we believe that it is important for a registered investment adviser to carefully review the following areas of its compliance program: the use of independent research consultants and expert network groups, discussions and meetings with employees of public companies, the use of social media and value-added investors (i.e., investors who have more than just a capital stake in the fund).
What Should I Do Now?
Registered investment advisers need to recognize that compliance is an essential part of day-to-day business operations.We believe that advisers should consider compliance in all aspects of their business, including trade and investment activity, marketing, operations, accounting, business continuity planning, and personal trading and investing by employees. Management, as well as all employees at investment advisory firms, should continuously think about the need to identify risks and conflicts and address them appropriately.
Registered investment advisers should assume that is likely they will be examined by the SEC (and potentially other regulators such as the NFA) and that they should maintain a sound compliance infrastructure with compliance policies and procedures tailored to their business. Such policies and procedures must be reviewed and tested, and documentation should be maintained of such reviews and tests. Employees should be trained periodically on the importance, and requirements, of the adviser’s compliance program. It also is essential that senior management exhibit a clear “tone at the top” when it comes to compliance (evidenced by, for example, senior management’s attendance at the adviser’s annual compliance training meeting and other periodic compliance meetings).
CCOs should educate the employees of their firm and involve them in compliance as much as possible. Training and educating the members of your firm will hopefully not only facilitate better preparation for a regulatory exam, but allow the firm to operate more efficiently.
Chris Lombardy is a member of Kinetic Partners US, LLP and heads the regulatory consulting practice in New York. The regulatory consulting group at Kinetic Partners is comprised of regulatory experts and compliance specialists. Kinetic works with hundreds of investment advisers and private fund managers, both domestically and internationally, to help them meet their regulatory obligations and reduce their compliance risk profile. Kinetic’s services include assisting investment advisers with SEC or state registration process, developing policies and procedures with clients, assisting clients with annual reviews, performing mock examinations, compliance control testing, specialized compliance reviews, and regulatory examination support.