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The best defense is a good offense: Preparing for an SEC Presence Exam

Steven Gatti, Partner and Polly Snyder, Counsel

Clifford Chance

Q3 2013

 

According to Securities and Exchange Commission (SEC) statistics, over 1,000 private fund managers registered with the SEC by the Dodd-Frank Wall Street Reform and Consumer Protection Act deadline. The SEC's Office of Compliance Inspections and Examinations (OCIE) is targeting these newly registered advisers as part of a special examination program. The SEC has stated that its "Presence Exam" program is designed to help new advisers adjust to being regulated, as well as to expose compliance and control weaknesses. History has demonstrated, however, that exams are often preludes to enforcement actions. Examining newly registered advisers is a top SEC priority, and advisers should be actively preparing for them in order to mitigate enforcement risk.

The Presence Exam Program

The SEC announced the Presence Exam Program in October 2012. The program includes: (1) initial engagement with, and education of, new registrants; (2) Presence Exams; and (3) analysis and reporting of SEC findings. OCIE has explained that the exams are to be "risk-based" and designed to assist new advisers in promoting a compliance culture, preventing fraud, and monitoring risk. The Presence Exam Program is expected to run over the next two years, with the bulk of the exams taking place over the next year.

The Presence Exam Experience

A Presence Exam starts by OCIE notifying the firm, and providing the firm with a detailed request for documents and narrative responses. The requests are usually drawn from publicly available information about the firm (e.g., Form ADV, website, etc.). Some Presence Exam requests are narrowly focused on specific issues, while others cover a broader range of topics. OCIE has been enforcing relatively strict information production deadlines, but also allowing firms to produce documents on a rolling basis. Exams run the smoothest where the firm designates a point person (usually the Chief Compliance Officer or General Counsel) to coordinate with the examiners regarding interviews and information requests.

Once it has reviewed the materials, OCIE examiners will arrive onsite, usually at a pre-determined date and time. The examiners typically begin by meeting with the point person to get an overview of the business and operations, in an effort to fine tune the scope of the examination. Examiners often request an office walk-through to get a feel for the firm's organization, work flow and control environment. During the remaining onsite phase, examiners review additional records and interview personnel involved in key business lines and functions, as well as members of senior management. The onsite phase could last days or weeks depending on the size and complexity of the business and the preparedness of the adviser.

The adviser should anticipate ongoing communications with the OCIE staff after the onsite phase, as staffers seek to tie up open issues and requests. Ultimately, an exit interview will be scheduled, either in person or by phone. At this meeting, the examiners will present their preliminary findings and will provide the firm an opportunity to respond. The exit meeting is a key opportunity to frame the examiners' report and to resolve purported deficiencies.

The Focus of Presence Exams

OCIE has indicated that Presence Exams will substantively focus on risk-based compliance areas, tailored to the risk profile of the individual firm, as well as areas of regulatory priority. Top OCIE examination priorities have emerged in the October 2012 letters, in published 2013 National Examination Priorities, and through the experiences of advisers who have been examined. Among the areas of focus, which advisers should consider in evaluating their policies and procedures, are:

  • Control Environment – OCIE has stressed that evaluating the "tone at the top" is a key component in assessing risk. Firms must demonstrate a compliance culture at all levels of the institution.
  • Performance Advertising/Marketing – OCIE has identified performance advertising and marketing as "inherently high risk areas." Aberrational performance is seen as a potential indicator of fraudulent or weak valuation practices. OCIE has focused on the use of hypothetical, projected, and related performance marketing, the assumptions or methodologies used, disclosure, and record keeping compliance.
  • Conflicts of Interest – Conflict of interest identification and mitigation, as well as disclosure to investors, are central to the OCIE exam program. The staff has placed an emphasis on conflicts relating to compensation arrangements, including undisclosed fee or solicitation arrangements, allocation of investment opportunities among clients, soft dollars, personal trading, information barriers, and the use of research and information sources, such as expert networks.
  • Valuation – The SEC has brought a number of enforcement actions recently involving valuation practices, particularly with respect to illiquid and hard to value securities.
  • Asset Safeguarding and Verification – The SEC is also focused on the measures taken by advisers to protect client assets against loss or theft, on the adequacy of audits, and on compliance with the SEC's Custody Rule. Underscoring the importance of this issue, an OCIE March 2013 risk alert announced that current Presence Exams revealed significant compliance deficiencies in the custody area.

Preparing for Your Presence Exam

Private fund advisers must understand at the outset that SEC investigations and enforcement action flow directly from the exam program. Even in supposedly targeted exams like those under the Presence Exam program, examination staff may quickly expand the scope to cover a broader range of the adviser's business activities, and, in some cases, refer deficiencies to the SEC's Enforcement Division. Enforcement referrals have been on the rise in recent years, reflecting efforts by the SEC to formalize and enhance cooperation between OCIE examiners and enforcement staff. In turn, enforcement activity involving investment advisers is at record high, exhibiting a 30% increase in the last few years. Moreover, the new SEC Chairman Mary Jo White has indicated that increasing the number of investment adviser exams (and obtaining funding for more examiners) is a top SEC priority. New firms should operate under the assumption that they will be examined within the next twelve months.

We have found that the most effective way to mitigate enforcement risk flowing from examinations is to prepare in advance. Firms should ensure that they have the appropriate systems and controls in place to comply with the Investment Advisers Act of 1940, and that these procedures are being followed. There is no substitute for testing these systems and controls – and addressing any potential deficiencies – before the OCIE examiners arrive.

One method of doing so is to engage in a simulated or "mock" examination. A simulated examination permits firms to conduct a focused, tangible review of their systems, and to remediate and enhance their programs proactively. In addition, a mock exam familiarizes firm personnel with the SEC examination process, and what will be expected of them. This is critical because how a firm conducts itself during an OCIE exam, including the performance of its personnel, can impact the SEC's findings and the length of its inquiry. In short, how an advisory firm handles the examination process can positively affect the outcome by assuring OCIE staff that the firm has a culture of compliance.

 

steven.gatti@cliffordchance.com

polly.snyder@cliffordchance.com

www.cliffordchance.com

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