United States

Is your fund prepared for the SEC’s heightened regulatory focus?


Changes stemming from the Dodd–Frank Wall Street Reform and Consumer Protection Act and other fallout from the financial crisis mean that hedge and private equity funds face a higher degree of scrutiny from the SEC than ever before.

The SEC has added examiners and is performing significantly more exams – in fact, they are on pace to perform 4,000 exams at hedge and private equity funds for 2013. Funds that were not previously required to register with the SEC now must. And even funds that are not required to register are still open to regulatory attention from the SEC.

As a result of increased examination of hedge and private equity funds, the number of cases involving such funds that have been referred to the SEC’s enforcement division has approximately doubled in recent years. In 2007, the enforcement division pursued 79 such cases, representing about 13 percent of its caseload. In 2012, the enforcement division pursued 147 of these cases, comprising nearly 25 percent of its caseload. That number is expected to continue to trend up.

More exams, more enforcement

Hedge and private equity funds should also note that the enforcement division has established a specialized Asset Management Unit, which is solely focused on pursuing investigations of investment advisers. This unit is staffed largely with personnel hired from hedge and private equity funds, giving it the specialized experience necessary to pursue its investigations.

Also, the way in which the examination and enforcement divisions coordinate activities has changed. Previously, examiners would complete their investigation and then decide whether to refer a fund to the enforcement division. Now, examiners will often coordinate with the enforcement division during the exam. It is now more common for an attorney from the enforcement division to join an examination to help focus the examiners’ efforts on those areas of most interest to the enforcement division.

Hot-button issues

Both the examination and enforcement divisions are focusing their attention on certain key areas, including:

  • Valuations, particularly of illiquid securities
  • The treatment of fees and expenses, including inappropriately charging management expenses to investment funds, failure to clearly and accurately disclose fees, or improper allocation of fees and expenses among accounts and clients (often to favor high-value  clients over other clients)
  • Related party transactions and conflicts of interest
  • The adequacy of compliance policies and procedures, including the appointment of a knowledgeable compliance officer, and the conduct of annual compliance reviews
  • Various Custody Rule violations

Exams moving faster, focused on risk

Not only is the SEC examining more funds, the way those exams are conducted has changed and the pace at which they proceed has accelerated. Previously, the SEC attempted to put all funds subject to exam on a recurring schedule, and would then subject each to the same exhaustive checklist-based approach. This made it easier for funds to anticipate whether, when and how they would be examined.

Now, under its new Presence Exam approach, the SEC is using a risk-based model both in targeting funds for examination and in determining how they will be examined. Using information from ADV filings and other public information, the SEC is targeting funds based on a wide variety of criteria ranging from their business model and performance returns compared to the market. In October of 2012, the SEC began sending letters to registrants about their new Presence Exam process which identified key areas on which examiners would focus. Those areas included:

  • Marketing materials and approaches used to solicit investors (including the use of placement agents). The SEC Staff will consider misstatements, important omitted facts and any misleading facts or statements to be a fraudulent or deceptive activity.
  • Portfolio management practices (especially allocation of investment opportunities among funds)
  • Conflicts of interest (including transactions with related persons and fee and expense allocations)
  • Custody of client assets Valuations

Be prepared

With the SEC now casting a much wider examination net, the odds of a fund facing examination have gone up considerably. By taking certain basic steps, funds can be better positioned to respond to exams.

Be prepared in advance. If your fund is chosen for examination, you will have only a few days to respond to the initial document request and will likely have examiners on site within a week. If you are not prepared to present the information examiners require quickly and accurately, the examiners have the authority to start rummaging through your records to find it. This leads to an assumption that your firm’s compliance activities maybe undisciplined, which will only heighten their focus and result in additional testing and reviews.

The following are questions COOs should consider in order to be prepared for an examination:

  • Do you know where and how to gather all key documents that an examiner might request? Identify those documents now, determine how they can be generated and complied quickly and be prepared to deliver them in a timely fashion. The faster and more thorough your response to the document request, the better.
  • Are you ready to explain your fund to examiners? Every fund is unique. If you can offer the examiners a clear, cogent overview of your fund’s strategies, investments, relationships with affiliated parties and other key information, not only will it make their exam easier, it will reinforce a positive impression of your operations.
  • Have you checked for holes in your compliance efforts? If there’s a problem with your compliance program, it’s better to find it before the examiners do. Consider working with outside counsel or a consultant to conduct a mock examination. That way you can identify gaps in your compliance program and address them in advance.
  • Are your people ready? One person, probably your COO, should spearhead the exam effort, from responding to the document request to sitting in on all meetings with the examiners on site. That way you can ensure a coordinated response and also can identify and respond to possible issues as they emerge.
  • Also, prepare your other officers for interviews with examiners. They are likely more used to focusing on investment returns and customer relationships, not on compliance issues. By helping them understand the specific risk issues on which examiners are likely to focus and the compliance programs your firms has in place to deal with them, you can help keep the exam on track.
  • When the SEC Staff is onsite, they will have follow-up questions daily. Make it a point to document their questions and requests when asked. Then, ensure you respond within 24 hours of their request or sooner. If the request will take longer, prep the SEC Staff for that and explain why.

Heightened SEC attention is a fact of life for all funds. By understanding the new risk-based nature of the SEC’s exam and enforcement approach, by vetting your current compliance effort to identify and address weaknesses before an exam and by being ready to respond to an exam quickly and efficiently, you can significantly reduce your fund’s risks.

Final thoughts

The SEC has no problems releasing news of compliance failures to the public. Further, the SEC has the power to find individuals culpable for compliance failures, not just the firm as a whole. In addition to reducing the reputational or individual risk of a failed examination, fund managers should also think of best practices and heightened institutional investor due diligence as they design, implement and monitor an effective and efficient compliance program. 

Contributed by Lindsey Simon, founder, Simon Compliance. For further information, please contact John Hague, partner, national financial services industry leader, RSM US LLP, 312.634.3354.