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Trends & Developments - June 2014 - The Value of a Mock SEC Inspection

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Since the enactment of the Dodd Frank Wall Street Reform and Consumer Protection Act replaced the private fund exemption under the Investment Advisers Act of 1940 (the “Advisers Act”), requiring investment advisers with $150,000,000 in private fund assets and $100,000,000 for all other advisers to register with the SEC, it seems as though a day does not go by without reading or hearing about a private fund manager being examined by the SEC and cited for numerous compliance failures.  

This often results in the private fund adviser hiring an outside consulting firm to remediate the SEC’s findings and, in more serious situations, paying a fine and retaining the consulting firm to monitor firm activity for a period of time. The downside is the harmful impact that results from both the negative press release and the adviser’s requirement to disclose the event in all of its disclosures documents, such as Form ADV, responses to DDQs and RFPs, etc. This can be very costly both from a monetary perspective and the loss of a potential investor into one of the managed funds due to the required disclosures. In addition, it’s a very time-consuming process that keeps the adviser from doing what it does best, which is manage client assets.  

It is also easily avoidable. 

The best approach to see if your compliance program is up to SEC and industry standards is to engage an independent consulting firm with the requisite expertise to conduct a mock SEC inspection. I would also like to note that this goes hand-in-hand with recent comments made by SEC Commissioner Daniel Gallagher to permit private third parties to examine registered advisers, as the SEC is not able to receive federal funding to hire the requisite number of examiners to adequately implement the SEC’s Office of Compliance Inspections and Examination (“OCIE”) National Examination Program objectives.   While there has been no definitive decision made yet, Mary Jo White, SEC Chairwoman, did not object to the idea of using third parties or a self-regulatory organization, such as FINRA, to do the work of the SEC.   

What Is a Mock Inspection and How Does It work?

A mock inspection involves examining the operations of the financial services firm by looking at the internal controls that are designed to reasonably ensure compliance with the firm’s regulatory responsibilities and  performing similar functions as the SEC would during an examination.

How it works is an independent consultant initiates the process by selecting one of the first-day letters used by the SEC in the past for the specific type of financial services advisers (such as private capital, hedge fund, fund of funds, hedge fund of funds, mutual fund, ETF, or wealth management and managed account platform managers (sponsored and unsponsored), etc.).  The purpose of a first-day letter is to notify the adviser of the timing of the examination (in the case of the SEC) and to request certain documentation required to be maintained, in accordance with SEC record retention rules and regulations, based on the advisory services provided and type of client(s).  The next step in the process is to interview key employees in critical operations, such as portfolio managers, traders, CCO, CFO, CEO, COO, marketing, etc.  This will provide useful insight into a number of different areas, such as:

  • whether critical employees, some with supervisory oversight (which has larger regulatory failure to supervise implications), understand the firm’s compliance procedures and corresponding controls.  If employees do not understand the firm’s procedures, they are more than likely not following those procedures.  This may suggest inadequate or no firm-wide training has occurred or employees are simply not complying with procedures, 
  • uncovering potential new conflicts of interest not previously identified either because employees are engaging in activity not contemplated by the procedures or due to a change in business objectives, operations or law,
  • whether the procedures are reasonably designed to detect, prevent and remediate (as necessary) actual and potential conflict of interest, as required under law.

At this point in the mock engagement, the consultant would perform forensic testing by selecting a representative sample of data in key high risk areas, such as:

  • employee personal and insider trading,
  • firm-wide trading activity (both client and proprietary) for best execution and potential conflicts of  interest,
  • adherence to investment guidelines and restrictions (including client, statutory and self-imposed),
  • soft dollar arrangements (third-party and proprietary),
  • use of research networks,
  • expenses charged to private funds and portfolio companies of private capital funds compared to fund disclosure documents,
  • third-party solicitors,
  • consistency of disclosures,
  • client assets safeguards,
  • privacy of client data, and
  • cyber security, including vendors depending on the type of information retained by the vendor.   

These are just some the common high risk areas to test; this is not an exhaustive list as the type of investment vehicle managed will drive the testing.

The last step in the inspection process is to compare firm activities to procedures and applicable federal securities laws to ensure the compliance procedures address all areas of governing law.   The compliance program rules under the Advisers Act (Rule 206(4)-7) and Investment Company Act of 1940 (Rule 38a-1) for registered funds require compliance programs to address, at least, all the applicable rules and regulations under the Advisers Act and for registered funds all applicable federal securities laws.

Upon the conclusion of the analysis, a gap analysis is provided to senior management with corresponding alternative recommendations on how to remediate. The independent consultant performing the engagement often assists in the implementation process of senior management approved recommendations to reasonably ensure they are implemented as intended. 

What are the Benefits of the Mock Engagement?

Our experience has shown that going through this process is beneficial to financial services firms because it prepares them for when the SEC eventually sends that first-day letter.   This process is very instrumental in assisting advisers in fulfilling the requirements under the SEC compliance program rules to annually evaluate their compliance programs for adequacy, accuracy, and effectiveness of implementation of procedures. A mock inspection can also be of value to newly registered advisers to ensure they are prepared for when the SEC performs a different type of limited review applicable to new advisers or a “presence examination.”   The SEC performs a presence examination to determine whether the registered adviser had a compliance program already in place and fully tested prior to submitting a request for registration.

It is important to note that it is more likely the SEC will view advisers that obtain an “independent” evaluation of their program and advisory operations as part of an ongoing process to establish a “nothing-to-hide” culture of compliance from the top down.


Trends & Developments June 2014

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