Earlier this year, Kinetic released an article about upcoming planned exams by the Securities and Exchange Commission (“SEC”) for newly registered advisers. Now the Office of Compliance Inspections and Examinations (“OCIE”) is geared up for Fall 2012 and ready to strike. Kinetic has noticed a sudden increase in client SEC examinations within recent weeks. What do you need to know in order to be prepared for an SEC exam?
First things first
At the outset, inform the examiners who should be the firm’s contact person for the exam. The contact person should be in charge of gathering the information set out in the document request list prior to the SEC’s visit. There is an expectation that the firm will be able to provide “accurate, responsive information in a timely way.” Generally, the SEC provides two weeks’ notice prior to arriving, but some firms have stated that the SEC showed up with as little as three business days’ notice! Keep in mind, the SEC will likely request that some information be sent to them prior to arriving on-site. These preliminary information requests will include documents that should be readily available, such as fund offering documents, investment management agreements, service provider agreements, organization charts, fund audited financial statements for the most recent fiscal year, and marketing materials such as team biographies, pitch-books, DDQs, etc. The remainder of the requested items should be provided to the SEC staff on the first day of the exam.
The SEC may request a conference call with senior management – the CCO or portfolio managers – before the on-site exam. Senior management should prepare for such a telephone interview just as they would for the actual exam. This may involve drafting a brief description of your firm, include all employees in a narrative, and be prepared to provide the SEC staff with an overall view of the firm’s organization, business, compliance program and culture. Expect to receive questions about the fund structure and strategies, service providers and reasons for any change in service providers (especially auditors), fund audit opinions, directorships and any other conflicts of interest.
“Tone at the top”
Prepare all compliance infrastructure documents to ensure that a “tone at the top” setting in your firm exists and present it as such to the SEC. Make sure that the compliance documents are tailored to your business and that you have implemented all procedures contained within them. The SEC has always been concerned about whether the firm and employees are following the policies as laid out in the manuals. A common finding of exams is that firms either have inadequate written policies or do not properly implement the policies and procedures they claim to have. At a recent public forum, the SEC stressed that, going forward, “risk management” will be one of the focus areas of exams. As such, document the results of any risk assessments that you have performed and identify controls to mitigate any risks to your firm and its business. Documentation around annual compliance reviews, or any SEC mock exams, will prove useful in this respect.
From recent SEC exam request lists, we have most frequently seen questions around the following:
The SEC will want to understand if the funds run parallel to each other or if they each have a separate strategy. Be sure to describe how funds interact with one another and any affiliated entities to the manager.Marketing. The SEC may want to see your marketing materials for existing investors, including disclaimers, as well as any advertisements used to solicit prospective investors. You will also be asked to furnish supporting documentation for all performance information used in your marketing literature. Even though Form ADV is available to the SEC, they will want to see your copies as distributed to investors. Ensure that the information provided in your marketing literature, offering documents and the Form ADV, is consistent.
The SEC will carry out testing of your trading activities. For this purpose, they will require the trade blotter, including all trade errors, cancellations, re-bills and reallocations. These may relate to current as well as former investors and accounts. A trade errors log, which includes details of how each error was resolved, should be maintained and provided to the examiners if requested.
In addition to your valuation policy, the SEC will also want to see whether you are independently testing prices received from pricing services. Any Valuation Committee meeting minutes and all records of pricing related discussions should be preserved for this purpose.
Be prepared to turn over your management company and fund accounting books: general ledger, trial balance, disbursements, cash receipts, cash flow statements and the like. Further information requests can relate to loans, promissory notes, etc.
The SEC often asks if key members of your firm belong to any organizations that are worth disclosing to the SEC. If so, the appropriate personnel should be ready to discuss the relevant memberships.
Conflicts of interest
At recent discussions, the SEC has highlighted that “conflicts of interest” and “allocation of expenses” between funds, and also between the funds and the adviser, will be key areas of focus. Provide to the SEC staff your Code of Ethics and insider trading policies and procedures. You may be required to explain the process used to monitor and control the receipt, flow and use of non-public information, including any restricted, watch or grey lists. If you have any fee splitting or revenue sharing arrangements, the SEC may want to test whether, in practice, the firm conforms to the provisions of the agreements in place.
During the on-site exam, the SEC staff will interview persons responsible for functions such as risk management, portfolio management, trade execution, research, back office/administration, information technology, anti-money laundering and marketing. You should prepare your staff for the possibility of being interviewed, and remind them to review the firm’s compliance policies and procedures relevant to their job. Staff should be honest with the exam team and talk openly about the firm’s operations. Use the SEC’s questions as opportunities to explain the business, its risks and the relevant controls. If a problem is identified during the exam process, talk to the exam team and discuss how you are going to remedy it.
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