The question that hangs over every private fund CCO and GC’s head: When will the firm face an SEC exam?
There’s no surefire way to predict whether the SEC’s Division of Examinations will select your firm. However, the Division recently provided insight into how it assesses risk, selects advisers for examination, scopes the examinations, and requests documents in a September 6, 2023 Risk Alert.
While established registered investment advisers (RIAs) and fund managers may be aware of much of this selection criteria, Paul Hastings noted the Division’s release might “further level the playing field on such understanding” for emerging firms.*
Below, you’ll find an overview of the Risk Alert, as well as links to helpful resources.
Selecting advisers for exams
The Division takes a risk-based approach to choosing advisers to examine.
According to the Risk Alert, there are more than 15,000 advisers managing over $115 trillion in AUM registered with the SEC, and the Division examines about 15% of all advisers each year.
The Division refers to its risk-based approach as “dynamic,” meaning the approach changes depending on market conditions, industry practices, and investor preferences.
Reasons the Division might select an adviser to examine include, but are not limited to:
- A firm’s risk characteristics
- Tips, complaints, or referrals
- The Division’s interest in a particular compliance risk area
Within the Division’s selection process, it will consider which advisers provide certain services, recommend certain products, or otherwise meet criteria relevant to the focus areas described in the Division’s annual priorities.
In reviewing firm-specific risk factors, the Division may consider:
- Prior exam observations and conduct, such as observations by the staff of what it believes to be repetitive deficient practices during more than one review of a firm, particularly related to significant fee- and expense-related issues, and significant compliance program concerns.
- Supervisory concerns, such as the disciplinary histories of associated individuals or affiliates.
- Business activities of a firm or its personnel that may create conflicts of interest, such as outside business activities and the conflicts associated with advisers dually registered as, or affiliated with, brokers.
- The length of time since a firm’s registration or last examination (with a particular interest in newly registered advisers).
- Material changes in a firm’s leadership or other personnel.
- Indications that an adviser might be vulnerable to financial or market stresses.
- Reporting by news and media that may involve or impact a firm.
- Data provided by certain third-party data services.
- The disclosure history of a firm.
- Whether a firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks.
Determining the scope of an exam
The Division also takes a risk-based approach to determining the scope of an exam once it selects an adviser. Because the Division chooses particular areas to review, the scope and the documents requested vary from one firm to the next.
That said, exams typically include the Division reviewing the firm’s:
- Operations
- Disclosures
- Conflicts of interest
- Compliance practices with respect to certain core areas, including but not limited to, custody and safekeeping of client assets, valuation, portfolio management, fees and expenses, and brokerage and best execution
Requesting documents
A firm will receive a notification letter from the Division with an initial request for documents and information.
An initial document request typically encompasses:
- General information to provide the staff with an understanding of the adviser’s business and investment activities, such as organizational information, business and operations information, disclosures and filings, and legal and disciplinary information.
- Information regarding the adviser’s compliance program, risk management, and internal controls, starting with the compliance risks the adviser has identified.
- The written policies and procedures the firm has adopted and implemented to address each of the identified risks.
- Information to facilitate testing with respect to advisory trading activities, such as information about the firm’s current and past advisory clients and accounts, portfolio management, brokerage and trading, and conflicts of interest and insider trading policies.
- Information for the staff to perform its own compliance testing, such as the firm’s financial records, custodial information, and marketing and advertising materials.
Refer to the September 6, 2023 Risk Alert for a more in-depth look at typical, initial document requests.
Key resources
- September 6, 2023, Risk Alert: Investment Advisers: Assessing Risks, Scoping Examinations, and Requesting Documents
- 2023 Examination Priorities
- 2024 Examination Priorities
- March 27, 2023, Risk Alert: Observations from Examinations of Newly Registered Advisers
Is your firm prepared?
In K&L Gates’ article, Road Map for an Examination: SEC Examination Risk Alert Lays Out SEC Examination Strategy Considerations, the law firm outlines several steps RIAs can take given the information gleaned from the Risk Alert.* They can choose to perform mock exams, hire third parties to perform compliance risk assessments or training, and review and update their policies and procedures in light of the Division’s current exam priorities.
Through these steps, your firm can determine whether it’s able to produce initial documents efficiently, which helps it establish a cooperative relationship with the SEC. If your firm is unable to respond quickly, it may be a sign that your legacy tools and processes fall short.
Stay tuned
Stay tuned for more in-depth information on SEC rules and how Insight, Ontra’s AI platform powering the private fund lifecycle, can help private fund managers comply with investor and regulatory obligations.
*The law firms referenced in this article have no affiliation with Ontra, and neither Ontra nor such firms promote or endorse the other’s products or services.
