United States

Is an SEC exam inevitable?


The Securities and Exchange Commission (SEC) is going to great lengths to reign in any discrepancies of valuation or misinformation that firms may be presenting in their marketing materials. Private equity and hedge fund firms are especially on high alert of when, not if, the SEC is going to be knocking on the door to perform an examination.

The SEC has traditionally examined, fined and ultimately, shut down firms for fraud and the most egregious behaviors of some in the securities industry, but now seem to be focused on more mainstream day-to-day business.

"There's been a significant evolution of the SEC's focus, said Eva Ciko Carman, Partner, Ropes & Gray LLP at RSM's Sixth Annual Investment Industry Summit in New York City. "The past two years, they have increased radically, in terms of their sophistication. We've seen them come to the very heart of subtle issues very early on."

The shift in focus from fraudulent activity to conflicting activity was noted by all members of the panel of experts at the Summit.

"There has been a significant increase of enforcement actions year-over-year, with 24 actions this year and 16 actions taken last year," according to Colin Sanderson, partner, Eastern region private equity services leader at RSM LLP.

Examiners are being hired from within the industry and now have the ability to discover where discrepancies may arise. They are looking much more closely at allocation of expenses, the use of fees, question of marketing issues, such as testimonials from portfolio companies, and who should pay for jet plane travel. These conflict cases are more challenging to pursue, but the SEC has made it clear that investors are not to be misled, and they need to know where their money is being spent.

Private equity and hedge fund firms should take action prior to an examination, from running mock examination scenarios to role-playing with employees, making sure answers are at their fingertips, according to Marc D. Powers, Partner, BakerHostetler. "More and more, we see referrals from OCIE to the Division of Enforcement coming out of routine exams."

Experts agree that having a written compliance manual is not enough. It's important for employees to understand why these policies exist, not just that they do exist.

"Training needs to be done internally or by bringing in very competent outside counsel to educate your employees on insider trading, market manipulation or market abuse," said Jeffrey C. Morton , Partner, ACA Compliance Group. "There is no mandate for it, but from an examiner's perspective, it is expected."

Ropes & Gray's Carman emphasized the need to prepare in advance, for firms to get their hands on an exam, to pull the records, figure out existing issues and remediate them. "If you're fortunate enough to have not been examined, it is very likely you will be examined sometime in the next 24 months," she said.

For further information, please contact Colin Sanderson, partner, RSM LLP, 212.372.1216.