United States: Under The Looking Glass: SEC Targets Newly Registered Private Equity Fund Managers In Annual Investment Advisor Compliance Examination Process

Last Updated: September 12 2013
Article by Norman J. Harrison

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) amended a provision of the Investment Advisers Act of 1940 (Advisers Act) that had provided most private equity fund managers with an exemption from U.S. Securities and Exchange Commission (SEC) registration. Previously, an advisor with fewer than 15 clients was not required to register with the SEC. Most private equity fund managers qualified for the exemption because the term "client" referred only to the number of funds managed by the advisor, not to the number of investors in the funds.

Dodd-Frank eliminated the broad 15-client exemption,1 and, as a result, most private equity fund managers now must register with the SEC if the manager has more than $110 million in assets under management.2 The SEC's Office of Compliance Inspections and Examinations (OCIE) recently reported that approximately 2,000 investment advisors have registered for the first time under Dodd- Frank. OCIE has made clear that it will devote significant resources to compliance examinations of these new registrants In releasing its Examination Priorities for 2013, OCIE announced a new Presence Exam initiative focused on newly registered firms. The program will run for approximately two years and will involve examinations of a "substantial percentage" of the recent registrants, as well as reports to the securities industry on the Staff's findings. The Presence Exam program will concentrate primarily on the following operational and compliance issues:

In its Examination Priorities for 2013, OCIE's National Examination Program (NEP)4 describes four initiatives that will guide its activities this year:

The first initiative relates to fraud detection and prevention. The NEP announced plans to apply enhanced quantitative and qualitative risk-based tools that are designed to detect fraudulent or unethical behavior.

The second NEP initiative will concentrate on registrants' corporate governance and enterprise risk management (ERM) practices. This will include discussions with board members and senior management, as well as an examination of internal audit functions and key risk management and internal control practices. In addition, the NEP staff will engage in "discovery reviews" of specific issues that are relevant to the SEC's rulemaking efforts, as well as to its joint monitoring and enforcement exercises with other regulators. This year's target areas will include tri-party repurchase transactions and practices, as well as registrants' business continuity plans.5

A third examination initiative will involve an assessment of registrants' procedures for managing potential conflicts of interest. Conflicts take many forms in the investment arenaâ€"including, for example, transactions with affiliated parties, allocations of investment opportunities among separately managed funds, outside business interests of fund principals and directors, and allocations of operating expenses among separately managed funds. The NEP will examine the potential conflicts that the registrant has identified, the steps taken to mitigate them, and the accuracy and completeness of disclosures to investors.

The fourth NEP initiative involves the use of technology by registrants. This focus arises partly from the high-profile disruptions of trading markets in recent years caused by technological failures, as well as from concerns that regulators may not have sufficient insight into the impact on market pricing transparency of highly automated trading technologies and forums such as dark pools. Specific examination issues will include operational capability, market access, information security (including risks of system outages) and data integrity.

By rigorously implementing well-designed compliance and ERM programs, all registered investment advisors and investment companies, not only those recently registered under Dodd-Frank, can achieve the important dual objectives of (i) lowering their risk profile and (ii) preparing to successfully navigate an SEC examination. Registrants should be mindful of a few key principles when examining their current level of preparedness:

1. Remember that compliance, risk management and governance are important. Advisors should implement compliance policies and procedures that are relevant to their size and strategy, as opposed to adopting an off-the-shelf template that might be wholly irrelevant in some respects and incomplete in others. OCIE examiners will expect to find evidence that policies and procedures are followed, documented or embodied in reasonably designed electronic controls and reporting tools. As noted, OCIE also is interested in learning more about steps registrants have taken to design comprehensive ERM programs and to develop risk mitigation plans. In order to be effective, such plans should involve an allocation of responsibility and shared commitment among the investment team, the finance team, and compliance and administrative personnel.

2. Address three major areas of supervisory concern: conflicts, custody and valuation. One clear message in both the NEP and the Presence Exam initiative is that regulators are concerned about three risk categories in which investors' assets or returns may be compromised in ways that may not be apparent: conflicts, custody and valuation. With respect to conflicts, for example, if a fund manager unfairly allocates investments to funds or investors that pay a higher incentive fee than other comparably situated investors that pay a lower fee (or perhaps none at all), the fund manager has put its own interests ahead of its clients' interests. OCIE examiners will also be seeking to identify circumstances in which advisors have failed to comply with the Advisers Act's custody rules and thereby have placed investors' assets at risk without their knowledge. With respect to valuation, a biased application of fair value accounting rules under Accounting Standards Codification Topic 820, "Fair Value Measurement," may unfairly treat both existing investors (that will pay excessive performance fees if illiquid securities are overvalued) and prospective investors (that will be making an investment decision based on overstated return calculations). A well-designed compliance program will enable advisors to manage these risks and reduce their exposure to disputes with investors and regulators.

3. Pay attention to fraud and corruption risks. The OCIE remains highly focused on identifying fraudulent and deceptive practices, including, for example, sales fraud by broker-dealers (including affinity fraud, deceptive practices targeted at seniors and unsuitable recommendations of higher risk instruments); money laundering; bribery and corruption;6 and violation of pay-to-play rules. Here as well, advisors can mitigate risks by implementing policies, procedures and internal controls relating to higher risk areas such as investment suitability, customer worth, suspicious activity identification and transactions with government officials.

4. Consider the benefits of conducting a due diligence examination of your own business. Investment funds regularly conduct extensive due diligence on companies, individuals and markets with the objective of identifying and pricing risk. Fund managers can best prepare for an OCIE examination by applying the same disciplined, risk-based assessment to their own operations, with the same goal: Manage risk and realize a corresponding return on investment. Once key risk exposures are highlighted and ranked, perhaps with the support of outside advisors, the firm can develop effective mitigation plans.

As OCIE's Examination Priorities document makes clear, the SEC believes that registrants should take a comprehensive approach to managing financial, legal, compliance, operational and reputational risks and that firm leadership should set an appropriate "tone at the top." Fund managers also should bear in mind that the OCIE often serves, in effect, as an extension of the SEC's Division of Enforcement, as OCIE often refers issues to Enforcement for investigation that are uncovered during an examination. As a result, in addition to ensuring that they are well-prepared for an SEC examination, fund managers that invest the time and resources to comprehensively manage risk also can significantly reduce the threat of wrongdoing that could jeopardize investor relationships and even the survival of the firm.


1. Dodd-Frank also added several new but more narrowly tailored categories of exemption from registration. These include, for example (i) managers that advise only venture capital funds and (ii) "foreign private advisors," defined as advisors that have no U.S. place of business and have fewer than 15 clients (including investors, not only funds) in the United States.

2. The Financial Services Committee of the U. S. House of Representatives recently passed H.R. 1105, which would exempt from registration private equity funds that have not borrowed and do not have outstanding a principal amount of debt exceeding twice their invested capital commitments.

3. This involves the functions that, depending on the advisor's structure and strategy, include portfolio construction, position limits, trade authorizations, execution/capture, errors, settlement, reconciliation, allocation, best execution, use of "soft dollars," cross trades, separate accounts and valuation of illiquid positions.

4. The NEP covers all regulated entities examined by OCIE, which, in addition to registered investment advisors, includes investment companies, broker-dealers, and clearing and transfer agents.

5. This issue gained visibility in the wake of Superstorm Sandy last year, when many investment firms encountered unanticipated obstacles in deploying their recovery plans.

6. These risks arise in at least two contexts for private equity and hedge fund managers: directly, if an advisor or its agent pays bribes to secure investments by sovereign wealth funds or other government-controlled enterprises; and indirectly, if a portfolio company controlled by the fund engages in conduct that violates the Foreign Corrupt Practices Act or other anticorruption laws.

The views expressed herein are those of the author and do not necessarily represent the views of FTI Consulting, Inc. or its other professionals. (c)FTI Consulting, Inc., 2013. All rights reserved.

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