Earlier this year, officials in the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) announced the office’s plan for a coordinated series of examinations of a significant portion of the over 1,500 advisers to hedge funds and private equity funds that became registered investment advisers since July 21, 2011 – the effective date of the Dodd-Frank Act. The officials indicated that the examination program would focus on the unique risks presented by the private equity fund and hedge fund industries.
More recent statements indicate that each of these examinations will likely be limited to only a few areas, unless a significant issue is discovered. The OCIE is calling these “presence exams” because they are designed to establish a presence with the new registrants. In an October 9, 2012 letter to these recently registered advisers (available here), the OCIE has identified the following areas of focus:
Marketing materials and practices, including the use of placement agents
- Portfolio management and trade allocation
- Conflicts of interest
- Safety of client assets
These examinations are expected to last from two days to a week and will conclude with the usual post-examination process, which can include a no further action letter, a deficiency letter, a conference call or meeting highlighting the seriousness of noted deficiencies, or a referral to the SEC’s Division of Enforcement.
Since OCIE’s goal is to examine 25% of the new registrants over the next 18 to 24 months, newly registered advisers to private equity funds and hedge funds should consider making the following preparations now, with a view to identifying and addressing any problem areas.
Review and Update Compliance Policies
Registered investment advisers are required by Rule 206(4)-7 to adopt and implement written policies designed to comply with the Investment Advisers Act and the rules the SEC has promulgated under the Act. Rule 206(4)-7 also requires an annual review of the policies and their effectiveness and the appointment of chief compliance officer. Rule 204A-1 requires registered investment advisers to adopt a code of ethics prescribing standards of business conduct for supervised persons and addressing personal securities trading by them. These policies should be reviewed to make sure that they meet the SEC’s requirements, that their procedures have been followed and that there is evidence that they have been distributed to supervised persons. While it is important to follow existing policies, if actual practice has departed from the requirements of the policies, consideration should be given to revising the policies, to the extent that such revisions are consistent with the SEC’s requirements.
Make Sure Your Records are in Order
Registered investment advisers are required to comply with the specific record-keeping requirements of Rule 204-2. The books and records relating to the areas of OCIE focus described above – such as identifying and remediating conflicts of interest or documenting due diligence on transactions and valuations – should be reviewed to make sure they are accurate and up-to-date and satisfy the requirements of Rule 204-2. They should also be easily accessible. This step should be done now since you may not have sufficient time after you receive notice of an examination. The OCIE’s October 9, 2012 letter indicates that an adviser selected for examination should receive a document request list from the OCIE only about one to two weeks before an examination begins.
Review Marketing and Advertising Materials
Marketing materials should be reviewed to make sure they accurately describe your actual practice. Do they accurately reflect the fund’s strategy and investment process? Do they accurately describe side letters, fees, expense allocations, the use of finders and the participation of affiliated entities? Do they identify the conflicts presented by the type and structure of the fund, the fund’s fee structure and the participation of affiliated entities? To the extent that your actual practice departs from the description in your marketing materials, the materials should be revised for use going forward.
Keep Current on SEC Developments
The OCIE’s areas of focus may change as its examination program unfolds. Changes can be monitored by reviewing speeches by OCIE personnel on the SEC’s website and by reviewing the SEC’s press releases on enforcement actions brought against advisers, also on the SEC’s website. (For example, see the materials on the National Exam Program and related matters here.)
If an OCIE examiner perceives risk during an examination, there is an increased likelihood that the examiner will look deeper for more information. If an examiner finds compliance controls are weak in certain areas, the OCIE staff will focus in on potential rule violations that are implicated by those weaknesses.
The OCIE estimates generally that about one out of ten investment adviser examinations is referred to the SEC Enforcement Division. Being proactive and prepared for the likelihood of an examination provides an opportunity to identify and remediate any problems before they are identified by the SEC. It will also help demonstrate that a private fund adviser has a positive compliance culture.
Please Note: this Alert is not intended to be a comprehensive guide on how to prepare for an OCIE examination. It is merely intended to suggest certain precautionary measures that an adviser can take now in advance of being selected for an examination.