With even tougher SEC scrutiny imminent, can a mock examination help you prevail?

Securities Litigation Alert

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March 30, 2012 is only six months away.  That’s when investment advisers can expect to face a new and more challenging regulatory environment.  By March 30, 2012, the new regulations will require hedge funds and investment advisors, previously exempt from registration, to register and provide substantial disclosure about their business and employees.  Accordingly, we can expect SEC examinations of investment advisers to be more frequent and thorough than in years past.

 

What is it exactly that has caused the increased scrutiny?  And, in light of the increased scrutiny, what should investment advisers do differently to prepare?

 

The new regulatory landscape

 

Recently, several developments have changed the regulatory landscape. 

 

First, beginning March 30, 2012, title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) will eliminate an exemption that many advisers to private funds had used to avoid registration.  As a result, most hedge fund and private equity advisers with more than US$150 million in assets under management must register with the SEC using the newly unveiled version of Part II of Form ADV.1 

 

Second, earlier this year, the US Securities and Exchange Commission announced changes to Part II of Form ADV that will require hedge funds to provide, in “plain English” and narrative form, significantly more information than they had been required to disclose before.  This includes providing details about the way they conduct their business, ownership data and the identity of suppliers of key services, profiles of their personnel, training programs, compliance policies and infrastructure, valuation mechanisms, fund-specific risk factors and fees. 

 

Finally, advisers will also be required to maintain records including trading and investment positions, types of assets held, trading practices and other information the SEC deems necessary for the protection of investors.

 

The SEC intends to use these disclosures as part of its risk-based approach to choosing examination targets.  This is partly due to the additional information the SEC will have, which will enable them to identify in advance areas warranting review.  For example, SEC examiners now ask for regular access to advisers’ C-level executives in order to get a feel for the firm’s investment philosophy and how the tone at the top communicates the importance of company-wide regulatory compliance.

 

Another reason we can expect greater scrutiny through more exhaustive examinations is that the SEC is also hiring more personnel from the financial services industry, and is expanding their internal training programs to enhance the expertise of its examination staff.  The SEC is dispatching Division of Enforcement specialists to help examiners and to foster intra-agency cooperation.  

 

What should investment advisers do?

 

In light of all this, what should investment advisers do, if anything?

 

Act preemptively: don’t wait for the SEC to contact you

 

Investment advisers should not wait to be contacted by the SEC to begin planning an examination strategy or assembling a response team.  When the SEC decides it wants to conduct an examination, it usually provides only minimal notice.  Often, the lead time is short, and continuances are not always granted.  Moreover, fund managers with no regulatory reporting experience may not have the infrastructure to gather the required information in such a short period of time.  

 

To ensure they can meet the SEC’s reporting demands and respond to examinations in an effective manner, all investment advisers – even those that filed Form ADVs before Dodd-Frank – should regularly test their data gathering and the efficiency of their compliance procedures via mock examinations or similar exercises before they receive notice from the SEC that it wishes to conduct an examination.

 

Enlist experienced help for a mock examination

 

All of this means an adviser should strongly consider enlisting experienced professionals with the appropriate knowledge.  Finding the right help is not as easy as it sounds.  One of the key issues to consider is whether it is prudent to keep communications between the investment adviser and the experienced professional confidential. 

 

For this reason, an organization should strongly consider retaining a law firm to conduct the mock examination.  By retaining a law firm, the organization maintains the option of tailoring the examination process in such  a manner that will shield the results of the mock examination under the attorney-client privilege and work product doctrines.  This still leaves open the possibility of retaining a compliance firm.  When a compliance firm is retained through the law firm, all of the compliance firm’s work product may also be protected by the attorney-client and work product privileges. 

The mock examination

 

Any mock examination should achieve several goals:

  • Thorough examination of policies and procedures.  Before the mock examination, the investment adviser should work with counsel to identify and review key documents pertaining to the hedge fund’s policies and procedures with an eye toward identifying areas in need of revision and/or adjustment.  Counsel should also perform tests to help determine if the compliance system is effective and not being subverted through some means that may be difficult to detect.
  • Thorough interview of key decision makers.  Counsel should then identify the “response team,” i.e., generally the manager, general counsel and chief compliance officer, if any, who will be on the front line should the SEC come calling.  It is critical that the response team make a good first impression with the SEC.  Its members will work constructively with the examiners.  To prepare, they will need to hone their presentation skills and ensure they are fully briefed on the company compliance program and all relevant issues.
  • Move toward compliance.  Counsel retained by the company to advise on compliance should inform the investment adviser of identified risks and holes in the compliance program, if any, and then help the organization stay on track to achieve compliance by a feasible date. 

 

Err on the side of caution in preparing for SEC scrutiny

When conducted properly, mock examinations can educate investment firms about the new regulatory landscape’s requirements and prepare firms to take preemptively any corrective action that may be necessary.  In addition, by retaining counsel, an organization maintains the option to disclose or withhold the results of the mock examination, as appropriate. 

 

There is as yet no industry consensus around these issues, and official guidance is hardly crystal clear.  In areas where the guidelines for data are opaque, it is best to err on the side of caution.  By retaining experienced counsel, an investment advisor ensures it is in the best position to prepare for the coming increased scrutiny.

 

For more information about potential SEC scrutiny of investment advisers, please contact Perrie Weiner

 

Please see our breaking reports about the implications of the Dodd-Frank Act here

 


1 While some hedge funds with fewer than US$150 million of assets under management may be able to opt out of SEC registration, this does not insulate them from investigations.  Under the new law, these funds would still be subject to certain lessstringent reporting rules designed to help the SEC's enforcement operations.  States, meanwhile, could impose their own registration requirements for these advisers, and the SEC has said it could conduct examinations if it suspects problems.