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SEC Announces 2014 Examination Priorities for Investment Advisers




by:
Thomas M. Devaney
Sheppard, Mullin, Richter & Hampton LLP - New York Office

Jung Yeon Son
Sheppard, Mullin, Richter & Hampton LLP - Palo Alto Office

 
January 22, 2014

Previously published on January 17, 2014

On January 9, 2014, the Securities and Exchange Commission released its examination priorities for 2014 (the “2014 Exam Priorities Release”), covering a wide range of issues at financial institutions, including investment advisers and investment companies, hedge funds and private equity funds.  The 2014 Exam Priorities Release highlights a number of areas and key risks that the SEC will be monitoring and examining in 2014.  The SEC has identified the following core risk areas for investment advisers:

  • Safety of Assets and Custody—Through the National Exam Program (the “NEP”), the SEC’s Office of Compliance Inspections and Examinations has identified the following common failures relating to the custody rule under the Investment Advisers Act of 1940 (the “Advisers Act”):

    • failures to realize that the investment adviser has custody;

    • failures regarding the surprise exam requirement or failures to comply with the audited financials rule;

    • failures regarding the qualified custodian requirement; and

    • failures regarding the “audit approach”.

  • Conflicts of Interest Inherent in Certain Investment Adviser Business Models—The SEC notes that non-compliance with the Advisers Act often arises from unaddressed conflicts of interest, identifying the following common types of conflicts related to investment advisers and investment companies:

    • Compensation arrangements for the adviser, with a particular focus on undisclosed compensation arrangements and their effect on recommendations made to clients;

    • Allocation of investment opportunities;

    • Controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts;

    • Risk controls and disclosure, particularly for illiquid investments and leveraged investment products and strategies; and

    • Higher risk products or strategies targeted to retail (and especially retired or elderly) investors.

  • Marketing/Performance—The SEC notes that it will review the accuracy and completeness of advisers’ claims about their investment objectives and performance.  Of particular note for advisers to hedge funds and private equity funds, the SEC has indicated that it will seek to review the use and disclosure of composite performance figures, performance record keeping and compliance oversight of marketing.

The SEC has also identified new and emerging issues and initiatives and policy topics in this release, including the following that relate to investment advisers:

  • Presence Exams—The SEC will continue the 2012 initiative to examine a significant percentage of the advisers registered since the effective date of Section 402 of the Dodd-Frank Act. (The vast majority of these new registrants are advisers to hedge funds and private equity funds that were not registered or regulated by the SEC prior to the Dodd-Frank Act and that have never been examined by the SEC.)  The five key focus areas of these examinations are:

    • marketing,

    • portfolio management,

    • conflicts of interest,

    • safety of client assets, and

    • valuation.

  • Never-Before Examined Advisers—This SEC initiative will address advisers that have never been examined and are not part of the presence exam initiative. The SEC will utilize a number of strategies to conduct focused, risk-based examinations of the adviser population that has been registered for more than three years but has not yet been examined by the NEP.

  • Wrap Fee Program—The SEC will assess whether advisers are fulfilling their fiduciary and contractual obligations to clients and will review the processes in place for monitoring wrap fee programs recommended to advisory clients, related conflicts of interest, best execution, trading away from the sponsor, and disclosures.

  • Quantitative Trading Models—The SEC will examine investment advisers with substantial reliance on quantitative portfolio management and trading strategies and assess, among other things, whether these firms have adopted and implemented compliance policies and procedures tailored to the performance and maintenance of their proprietary models, including such procedures as (i) evaluating if any models are used to manipulate the markets, (ii) reasonably review or test the models and their output over time, (iii) maintaining proper documentation within required books and records, and (iv) maintaining a current inventory of all firm-wide proprietary models.

  • Payments for Distributions in Guise—The SEC will continue its review of the variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same. The SEC will assess whether such payments are, in fact, payments for distribution and preferential treatment.

  • Securities Lending ArrangementsThe SEC will examine securities lending arrangements to determine whether they comply with exemptive orders and evaluate consistency with relevant no-action letters.

We also note that OCIE and the Asset Management Unit of the SEC’s Division of Enforcement will conduct a compliance outreach program for chief compliance officers and other senior personnel of investment advisers and investment companies on January 30, 2014 at the offices of SEC’s headquarters in Washington, D.C. The agenda for the day-long program will cover OCIE’s examining priorities for 2014, private fund advisers, registered investment companies, the role of the chief compliance officer (“CCO”), and asset valuation issues. In person attendance is limited to 500 persons, but others may view the webcast at www.sec.gov.  Investment adviser and investment company CCOs will be given priority for in person attendance if the program exceeds its 500 in person cap. You can obtain additional information about the outreach program through ComplianceOutreach@sec.gov.



 

The views expressed in this document are solely the views of the author and not Martindale-Hubbell. This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.
 

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Author
 
Thomas M. Devaney
Jung Yeon Son
Practice Area
 
Securities
 
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