• SEC Audits and Examinations of Investment Advisors
  • February 27, 2006 | Authors: Robert P. Bramnik; Frederick R. Ball
  • Law Firm: Duane Morris LLP - Chicago Office
  • You Have Registered, Now What?

    Effective as of February 1, 2004, advisors to and sponsors of most hedge funds and private trading funds were required to register as investment advisors under the Investment Advisers Act of 1940 (the "Advisers Act").1 The SEC informally estimates that approximately 4,000 persons and entities have now registered. Beyond the regulatory requirements imposed by the Advisers Act and related rules (including maintaining books and records, filing and disseminating a standard disclosure document (Form ADV) and compliance with SEC rules respecting the advisory business (such as restrictions on incentive-based compensation and on advertising)), registration carries with it a strong likelihood that one day, perhaps when you least expect it, the regulators will come calling at your door. In addition, failure to comply with regulatory requirements poses the risk of civil and criminal penalties.

    The purpose of this Alert is to explain the different types of SEC audits and examinations as well as other regulatory "visits" and provide an overview of "do's and don'ts" when the SEC, FBI or other regulators invite themselves to your offices.


    Under authority of Section 204 of the Advisers Act, the SEC may inspect all federally-registered investment advisers2 at any time. The SEC's Office of Inspections and Audits and a staff of hundreds of examiners audits and examines not only investment advisors, but also registered broker-dealers and investment companies, for compliance with the federal securities laws.

    While the majority of these examinations are routine, the potential for serious adverse regulatory consequences flowing from any examination is real. Moreover, audits, examinations and investigations "for cause" present more immediate and significant concerns. While SEC Examiners are the most frequent government visitors to investment advisors, other government agencies may seek documents and information as well.

    The Regulators Are at the Door

    SEC Examinations

    There are two generic types of SEC examinations: "routine" periodic inspections and "for cause" inspections. Beyond "examinations," the SEC may also initiate "investigations," which can also generate inspections, audits and requests for documents, as well as subpoenas for testimony.

    In an inspection or examination, the SEC may inspect all records of the advisor, even business records which are not required to be created. In other words, if an advisor creates a business record, the SEC may inspect it. While SEC examiners may ask questions concerning how records are created and maintained, where and how they are stored and similar administrative questions, they may not take testimony from the advisor's employees, nor is the inspection authority so broad that examiners may ask the advisor unrelated questions about its business activities.

    So-called routine examinations, in turn, are generally divided into three informal categories - "regular exams," "sweeps" and "statistical exams." The regular exam is designed to review the advisor's overall compliance with the book and recordkeeping obligations imposed under the Advisers Act as well as test to ensure that the advisor's business is operating in compliance with the substantive requirements of the Advisers Act - and covers a broad range of books and records, including the advisor's Code of Ethics and its Written Supervisory and Compliance Procedures.

    In past years, the SEC Staff employed a three-year cycle for such examinations (so that an advisor could anticipate an SEC visit approximately once every three years) - that has changed. The Staff now reviews advisors and puts them into different risk profiles. Those in a higher risk category can anticipate more frequent examinations, while those in the lowest risk category may not be examined as frequently. Moreover, particularly at the low-risk end, an examination might not be comprehensive. For example, on occasion the SEC Staff will request that an advisor produce copies of certain specified books and records, but not visit the firm in person, assuming that the requested documents are produced in a timely fashion.

    In the typical sweep, the SEC Staff will examine a broader and larger group of advisors, but review only the books and records concerning a specific issue. These examinations give the SEC a better opportunity to review the industry as a whole and how it is dealing with a specific issue (or issues). As one might expect, adverse regulatory actions more frequently result from sweeps than from regular examinations.

    The final type of routine examination is the statistical exam, in which the Staff examines a sample of low-risk advisors. These lower profile examinations give the Staff a basis for comparison with high-risk advisors and permit the Staff to better determine industry norms and to learn about new industry developments.

    As its name suggests, the for cause examination means that the Staff has a basis for concern that a problem exists either at or involving an advisor. Depending on the circumstances of the cause, these examinations may focus on one or two specific areas of business or on specific advisory customers, or may constitute a broad and deep review of all of a firm's books, records, policies and procedures.

    When SEC examiners arrive at an advisor's offices (there is frequently prior notice, either by telephone or by a letter, advising of the upcoming examination and/or requesting certain documents), you should always ask if the examination is routine or for cause. If the latter, you should immediately call your attorney or Compliance Director. All communications between the advisor's employees and the examiners should be monitored. Of course, registrants should cooperate with the SEC Examiners. At the same time, care should be taken to ensure that questions of employees relate to process and the creation and maintenance of books and records and the firm's compliance rules and Ethics Code.

    Regardless of the nature of the SEC's examination, copies of books and records which are copied for the Staff should be maintained and Counsel should be consulted immediately if the examiners suggest that there is an issue, or a problem, even if it appears to be a good faith disagreement over the interpretation of a single regulatory requirement.

    Although the SEC may initiate administrative disciplinary proceedings in the event that it finds serious deficiencies in the course of an examination, it will more often issue a "deficiency letter" which apprises the advisor of areas in which the Staff believes that the advisor is not in compliance with applicable law and regulations, and gives the advisor an opportunity to take corrective action and report back to the SEC Staff with respect to its corrective actions. Counsel should participate in this process from inception.

    SEC Investigations

    Once the SEC has issued a Formal Order of Investigation, its designated officials are authorized to compel sworn testimony and to require the production of documents beyond the books and records of an advisor. However, persons who are required to testify in the course of an SEC Investigation have a number of procedural rights beyond those of an individual or firm that is being examined.

    These rights include a right to Counsel, a right to assert Constitutional and other recognized privileges, and witnesses (including Counsel) may examine the Order of Investigation (which may, in turn, provide insight into the purpose of the inquiry and give Counsel critical information). An examination may be conducted as part of an Investigation. This is not always the case, since a firm which is being examined has fewer procedural rights than persons who receive subpoenas in an SEC Investigation.

    A frequent result of an SEC Investigation of an investment advisor is a formal disciplinary proceeding. These may be "administrative" (they are not brought in a court, but rather are heard by an SEC employee who serves as an "administrative law judge") or may be brought in United States District Court, seeking injunctive relief as well as a broad range of potential ancillary sanctions. As with any government action against an entity, Counsel should be consulted at the earliest possible opportunity.

    In addition to the SEC's regulatory right to books, records and compelling testimony in cases when it is investigating potential criminal conduct, the SEC may involve the Department of Justice ("DOJ"). The DOJ has two other powerful tools for gathering information.3

    Grand Jury Subpoena

    Grand juries are empowered to issue subpoenas requesting either testimony, the production of documents (or tangible objects), or both. In general, a grand jury is empaneled to investigate potential violations of the criminal laws. As such the scope of material to which it is entitled is extremely broad. Proceedings before grand juries are secret unless and until an indictment comes down. However, that does not prevent those testifying or providing documents to the grand jury from speaking with or providing those same documents to Counsel or others.

    If you receive a grand jury subpoena, you should contact Counsel as soon as possible. Counsel will need to determine whether there are potential conflicts and whether additional Counsel may be needed.

    It should be noted that there is no Fifth Amendment privilege that would protect the production of documents by a corporation. The Fifth Amendment privilege also does not protect documents sought from individuals unless the mere production of those documents would somehow be incriminating. However, individuals may be entitled to Fifth Amendment protections with regard to testimony.

    Search Warrants

    Targets of a search warrant rarely have advance warning that they are about to be the subject of a search and seizure pursuant to a warrant. As in the instance of a grand jury subpoena, if you are the subject of a search warrant, you should contact Counsel as soon as possible.

    As a general proposition, anyone confronted with a search warrant must allow the agents to search for the specific items listed on the warrant at the specific location(s) identified in the warrant. However, no one is required to assist the agents in executing the warrant. Thus, while an employee may not delay or interfere with the search, an employee is not required to assist in the search, engage in an interview or even answer questions which the SEC or other federal agent may ask in the course of an "examination" or execution of a warrant.

    You should not instruct your employees that they cannot talk to agents during a search. That may be construed as obstruction of justice. However, your Counsel may advise employees that employees are not required to speak to investigators and that the company would prefer that any employee who decides to speak with an investigator have Counsel present. It is usually in the best interest of the company to agree to provide Counsel for the employee.

    Some basics regarding search warrants are:

    • Contact Counsel immediately;
    • Obtain a copy of the search warrant;
    • Identify the agents and the agency involved;
    • Provide only the specific items identified in the search warrant;
    • Assign one or more employees to take detailed notes of the agents' activities;
    • Obtain a receipt or a copy of an inventory for all property taken;
    • Do not interfere with the search; and
    • You are not required nor are your employees required to speak with agents unless you or they want to. Do not instruct your employees not to speak with an agent. Rather, have Counsel speak to all employees.

    1SEC Release No. IA-2333 (December 2, 2004), which is available at www.sec.gov/rules/final/ia-2333.htm

    2Investment advisors with less than $ 25 million under management are neither required nor permitted to register with the SEC. They are, however, subject to the registration requirements of each state in which they conduct their advisory business.

    3Not all investigations by the DOJ are initiated by an SEC referral. Some may be initiated by the FBI or other federal agency. In some instances, a state's Attorney General may initiate an investigation using these same tools.