If they haven’t already, SEC-registered hedge funds will have to huddle with their lawyers, compliance officers and other key staffers over another regulatory headache—SEC exams via the National Exam Program (NEP). The news came last week in a letter from Drew Bowden, the acting national associate director overseeing investment advisers for the Office of Compliance Inspections and Examinations (OCIE).The letter, dated October 9 and available online, was sent “to provide you with information about upcoming examinations of certain newly registered investment advisers,” according to the letter. “The Presence Exams initiative will take place over the next two years and it has three primary phases: engagement; examination; and reporting.”
Firms will be contacted again if they have been selected for an examination.
The letter specifies the Engagement Phase as an effort to inform registered firms about their obligations and to alert them to the NEP’s outreach; a Compliance Outreach Program targets senior officers at firms with a forum to foster effective compliance practices via discussions about compliance issues and with SEC staff. “The program features both regional meetings at various locations across the country and national seminars in Washington D.C.,” according to the SEC.
The Examination Phase will encompass one or more of the following “higher-risk areas,” according to the letter:
- Marketing: “NEP staff will review marketing materials to evaluate whether the investment adviser has made false or misleading statements about its business or performance record; made any untrue statement of a material fact; omitted material facts; made any statement that is otherwise misleading; or engaged in any manipulative, fraudulent, or deceptive activities. In addition, NEP staff will review how investment advisers solicit investors for the private funds they manage, including the use of placement agents.”
- Portfolio Management: “NEP staff will review and evaluate investment advisers’ portfolio decision-making practices, including the allocation of investment opportunities and whether advisers’ practices are consistent with disclosures provided to investors.”
- Conflicts of Interest: “The NEP staff will review the procedures and controls that advisers use to identify, mitigate, and manage certain conflicts of interest within their firms. Some areas of the conflicts of interest that NEP staff will review includes: allocation of investments, fees, and expenses; sources of revenue; payments made by private funds to advisers and related persons; employees’ outside business activities and personal securities trading; and transactions by advisers with affiliated parties.”
- Safety of Client Assets: “Registered investment advisers that have ‘custody’ of client assets must take specific measures to protect client assets from loss or theft. NEP staff will review advisers’ compliance with the relevant provisions of the Advisers Act and related rules that are designed to prevent the loss or theft of client assets. When obtained, NEP staff also will review independent audits of private funds for consistency with the Advisers Act custody rule.”
- Valuation: “Investment advisers must have effective policies and procedures regarding the valuation of client holdings and assessment of fees based on those valuations. NEP staff will review advisers’ valuation policies and procedures, including their methodology for fair valuing illiquid or difficult to value instruments. NEP staff also will review advisers’ procedures for calculating management and performance fees, and allocation of expenses to private funds.”
After an on-site examination, NEP staff will tell firms whether or not there is a problem or two that needs to be fixed. If there are deficiencies that can be dealt with quickly, firms will be asked to “undertake corrective action,” the SEC says.
“If serious deficiencies are found, in addition to sending an examination summary letter, NEP staff may refer the problems to the Commission’s Division of Enforcement, or to a self-regulatory organization, state regulatory agency, or other regulator for possible action.”
Once the examination phase is over, the Reporting Phase kicks in and the NEP’s observations will be sent to the SEC and made public.
“These observations may include common practices identified in the higher-risk focus areas, industry trends, and significant issues,” the SEC says. “In sharing examiners’ observations from Presence Exams, the NEP staff hopes to encourage firms to review compliance in these areas and to promote improvements in investment adviser compliance programs.”
While many recently registered firms anticipated the exams, there are many questions left unanswered.
The regulators have not specified how past disciplinary actions against a hedge fund will affect the decision by the SEC/NEP to conduct an examination. Also, does the SEC/NEP have enough human resources in place to conduct lots of exams? Will the information in the recently filed Form PFs be used as part of the examination?
For the hedge funds, they will have to devote more staff resources, time and energy to preparing for an SEC exam that may not happen. And, if they do not have a chief compliance officer yet, they will have to find one soon or assign someone within the firm to take on this huge responsibility.
To say the least, meeting the new demands that come from SEC registration will be tedious and time consuming for those many firms that play by the rules and work very hard to reap rewards for their investors.
The main consolation prize for the good firms is that this new environment puts shady firms on notice that a reactivated regulator is watching and willing to take action on behalf of investors.
Let’s just hope the SEC examiners get there in time.
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