IA brief: SEC examiners give first look at hedge fund exam findings

By Guest Contributor
February 11, 2014

By Jason Wallace, Compliance Complete

NEW YORK, Feb. 11 (Thomson Reuters Accelus) - Last week, representatives of the Securities and Exchange Commission gave the first of many reports concerning its “presence exam” initiative for conducting initial regulatory exams of private advisers, and reported a lower rate of deficiencies compared with regular exams. The panel highlighted exam findings and staff observations concerning investment conflicts, marketing, valuation and custody.

The Dodd-Frank Act required approximately 1,500 private advisers to register with the SEC in 2012 – resulting in a current population of approximately 4,000 registered private advisers.

In response to the registration requirement, the SEC created the presence exam initiative, a plan designed to exam a significant percentage of the new registrants. The SEC has conducted approximately 250 audits and is within reach of their goal of visiting 25 percent of the firms within 2 years of launch, according to information presented at the SEC’s 2014 Compliance Outreach Program national seminar.

In a 2012 letter to firm principals, the SEC presented five key focus areas for the presence exams. They include; marketing, portfolio management, conflicts of interest, safety of client assets and valuation.

A typical presence exam will take 90 days from start to finish, approximately half of a routine exam due to the focus on one or two of the initiative’s key areas. The deep dive into certain focus areas has not only created a quicker process but is also producing fewer deficiency letters. The SEC is only issuing deficiency letters for about half of the exams – compared to 80 percent of regular or routine exams. According to Ashish Ward, Exam Manger for the SEC’s National exam program in Los Angeles.

The SEC exam staff has identified exam deficiencies and general observations for four of the focus areas. Mr. Ward highlighted these in the context of hedge fund advisers; they include but are not limited to:

  1. Investment Conflicts: The exam staff is looking for two types of conflicts — conflicts in the actual investment as well as fees and expenses.

    A conflicted transaction can take many forms, but may include a portfolio company or adviser investing in companies where they have interest, whether through ownership or third-party service providers. The SEC is scrutinizing relationships or investments where the manager stands to benefit.

    Fees and expenses charged need to be properly disclosed. The SEC has found lack of disclosure, not limited to the practice of expense shifting. The shifting entails taking certain expenses from the adviser and moving them to the fund. An example would be the automation of certain standard firm practices or outsourcing traditional back office functions without proper disclosure.

  2. Marketing: The exam staff has found marketing to be the largest area of concern for hedge funds. According to Mr. Ward, marketing seems to be the number one deficiency area for these advisers.

    The SEC has found that advisers stretching for capital may overstate or omit material facts when marketing or advertising. There have also been cases of misleading performance data found. In addition to the violations of the adviser advertising Rule 206(4)-1, Mr. Ward also spoke of a prohibited process in which the fund or manager is selling private fund interests without the use of a registered Broker-Dealer to sell those interests.

  3. Valuation: The SEC exam staff is looking for a reasonable and fully disclosed process when it comes to the valuation of illiquid securities and holdings. The SEC has seen inadequate policies and procedures with respect to valuation during the initiative along with the lack of involvement of the compliance department in the process. The panel also recommended that the methodology included in the policies should be asset or sector specific. Ward made it clear that inadequate controls in general have been found when it comes to valuation.
  4. Custody: The SEC has a goal of ensuring that assets are safe, and the testing and reviews of a firm’s custody obligations will be part of the examination. According to the panel, firms are not adequately identifying their clients, causing the firm to miss the custody rule obligations. For example, clients are not receiving audited financials when required or the firm is not adhering to the surprise audit requirement for the fund.

The panel also stressed the compliance obligations of private advisers. A chief compliance officer must completely understand the firm’s business. This not only gives the CCO a level of comfort when exam time comes, but is reassuring for the examiners. A CCO must ensure senior management support and their integration into the compliance process as well.

The initial findings are just the start of the reporting phase according to Ward; he said the SEC will continue to inform the private adviser space with potential risk alerts and guidance. The future risk alerts will most likely be topic by topic.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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