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SEC Announces Examination Strategy for Newly-Registered Investment Advisers
06/13/2012
Kit Addleman, Evan Hall, Taylor H. Wilson

In recent public speeches and correspondence, senior officials at the Securities and Exchange Commission (the “SEC”) have provided details regarding an examination strategy that will be applied to newly-registered investment advisers.1 Under this strategy, a new registrant may be subject to examination by the SEC as early as the fall of 2012. Accordingly, newly-registered advisers should be proactive and prepare to respond to SEC document and information requests.

New Three-Fold Examination Strategy

Officials with the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) have outlined a recently-commenced three-part examination strategy that was developed in order to better understand the risks presented by private investment funds.

  • Part One: Begin an “initial phase of industry outreach and education.” The SEC has already commenced this step, which it will continue to pursue through speeches and other communications, including an anticipated “open letter” to all newly-registered private fund advisers by the end of the summer outlining the examination system and the expectations of examiners.
  • Part Two: Coordinate examinations of a “significant percentage” of newly-registered private fund advisers, beginning as early as the fall of 2012. In these examinations, examiners will focus on areas of highest risk in order to “risk-rate” the newly-registered private fund advisers. The examinations will occur over a 12- to 24-month time period.
  • Part Three: Publish “after-action” reports on the general risks and issues identified in the examinations.

Potential Areas of Risk Subject to Examination

Generally, the SEC will conduct examinations with a view to the applicable provisions of the Investment Advisers Act of 1940 and related rules adopted by the SEC. Notably, such provisions require adoption of certain policies and procedures to help manage and mitigate risk, an annual review of such policies and procedures, maintenance of organized books and records for the required time periods, adoption of a code of ethics, appointment of a chief compliance officer and compliance with various applicable advertising rules.

The SEC also will conduct examinations in light of a private fund adviser’s role as a fiduciary to its funds. Three issues that SEC officials have specifically noted in the context of these fiduciary duties are:

  • the charge and allocation of fees and expenses;
  • the identification, management and disclosure of conflicts of interest, particularly where fund professionals either co-invest with clients or take on roles of responsibility at portfolio companies; and
  • the general implementation and practice of independent risk assessment and management policies.

Identification of Candidates and the Scope of Examinations

The SEC will proceed under the new examination strategy with the goal of identifying firms and practices that present the greatest risk to investors and capital markets. In order to identify such firms and practices, the SEC will receive input from filed Forms ADV and PF as well as a number of other sources, including industry media coverage. Further, the SEC has specifically noted certain risk characteristics that it will consider in identifying candidates for examination, including:

  • material changes in business activities;
  • changes in key personnel; and
  • anomalies in key metrics, such as fees, performance and disclosures, compared to peers and previously-disclosed information.

Once the SEC has identified a candidate for examination, the scope of the examination will seek to answer a number of questions focused on, among other issues:

  • the private fund adviser’s process for identifying and assessing both current and future risks and conflicts;
  • whether the private fund adviser’s policies and procedures are effective, well-managed and adaptable;
  • whether fund strategies make sense and are easy to understand;
  • the clarity of investor disclosures with respect to ancillary fees, management fee offsets and fee allocations;
  • the management of any actual or potential inter-product conflicts;
  • the risks that arise at various stages of the life cycle of a fund when seeking additional capital;
  • the sophistication, reliability and transparency of fund valuation and compliance processes; and
  • management’s overall attitude towards the examination process, compliance and risk management.

In light of this recent guidance and the potential for examination as early as the fall of 2012, newly-registered private fund advisers are encouraged to begin preparing for an examination. SEC officials have noted that proactive advisers that thoughtfully identify conflicts are much less likely to draw scrutiny. Examiners will likely look favorably upon an examination candidate who has information and records organized such that it can deliver a prompt response to any inquiry. Further, strong disclosures, where necessary, and even strong physical security of the premises may earn favorable marks from examiners.

For additional information regarding the foregoing, please contact one of the attorneys listed below:

Taylor H. Wilson
214.651.5615

 

Evan K. Hall
214.651.5831

Katherine Addleman
214.651.5783

Richard M. Fijolek
214.651.5570

 

Vicki L. Martin-Odette
214.651.5674

Rick A. Werner
212.659.4974

David Siegal
212.659.4995
david.siegal@haynesboone.com

 

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1 Transcripts of recent public speeches by Norm Champ, SEC Deputy Director of OCIE, and Carlo V. di Florio, SEC Director of OCIE, are available at http://www.sec.gov/news/speech/2012/spch051112nc.htm and http://www.sec.gov/news/speech/2012/spch050212cvd.htm, respectively.