FinancialServices

SEC private fund adviser examsWhat to expect from the agency’s more stringent, risk-based approachby Danielle Ryea and Daniel New

The implementation of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) means that private fund advisers must register with the US Securities and Exchange Commission (SEC) and meet more stringent regulatory and disclosure standards. The law affects private equity fund advisers and hedge fund advisers with more than US$150 million in assets under management (AUM). These firms must be registered with the SEC by 30 March 2012. Foreign advisers should review the new registration exemption criteria to determine if they are required to register under the Advisers Act and therefore subject to SEC examinations (see inside sidebar).

In parallel with the implementation of new SEC rules under Dodd-Frank, the SEC’s Office of Compliance Inspections and Examinations (OCIE) has revised its approach to examinations to make them more stringent. Since the rebranding of OCIE as a National Examination Program, it is now more robust, staffed with examiners with industry expertise and specialized knowledge in valuation, quantitative trading and structured products. These examiners, while new to the SEC examination protocol, are not new to Wall Street — so high-quality questions with real insight into how the industry operates should be expected.

In addition to enhanced examination staff, OCIE has solidified its risk-based examination approach. Long gone are the days of firms being randomly selected for examinations. Advisers are now selected based on certain factors that may indicate the firms’ risk to clients, investors and the market. These risk factors can include a large volume of AUM, numerous industry affiliates, use of complex investment strategies and products and the firm’s regulatory history.

In addition, the use of a risk-based examination approach means that OCIE devotes more resources, earlier on, to identify the adviser’s high-risk areas before and during the on-site examination. So while advisers may initially receive a broad document request letter, they should expect specific follow-up conversations and document requests that increasingly focus on the adviser’s weak compliance points.

March 2012

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Four types of examination scrutinyBroadly speaking, OCIE conducts three types of exams — each with a different degree of scrutiny — depending on how long the adviser has been registered, the time elapsed since the last SEC exam and internal staffing resources.

The most common of these exams is the “routine” examination. This type of examination will include an on-site review of the adviser’s main compliance and operational areas: its compliance program, brokerage and trading, valuation, advertising and marketing, portfolio management and conflicts of interest. These examinations are generally announced in advance with a phone call and an initial request for documents to be provided before the examination team arrives on-site. Items that may be on an initial document request include:

• Compliance policies and procedures

• Annual compliance review documentation

• Custody arrangements

• Code of ethics

• Best execution review documentation

• Trade blotter

• Portfolio management/investment committee meeting minutes

• Sample of advertising and marketing materials and pitch books

• Solicitation agreements

• Business continuity and/or disaster preparedness

• Organization charts and employee lists

• Customer and investor complaints, pending litigation and regulatory actions

Another type of examination is the “risk-targeted” examination, formerly referred to as a “sweep” exam, in which OCIE focuses on a specific issue in the industry and conducts a targeted review of selected advisers to look for indications of commonality or diversity within the industry. In 2010, for example, OCIE conducted a series of risk-targeted exams with multiple advisers on structured products for retail investors. These examinations generally begin with a narrowly focused initial document request list and tend to stay centered on one or two issues throughout the examination. It is not uncommon for the SEC to publish a summary report highlighting the general findings and industry practices that resulted from the targeted review, without identifying the specific advisers that were included in the review.

Additionally, OCIE will conduct “cause” examinations of advisers on the basis of a tip, complaint or referral. The tip or complaint may come from any individual; referrals, instead, come from other regulatory or government agencies. These examinations may begin with a standard request list that is amended to include specific document or information requests. Examinations of this type will likely not be announced to the adviser in advance.

Although OCIE will generally not disclose the type of examination, the scope of the initial document request usually offers a clue:

• A broad document request letter is a good indication the examination is “routine.”

• A more specific document request that relates to a particular industry practice and is received by others in the adviser’s peer group indicates a “risk-targeted” examination.

• A document request letter that addresses only a few specific items may indicate a “cause” examination.

There is a fourth type of exam, but it serves mainly as a tool for OCIE to ascertain how urgently it needs to examine a recently registered adviser. This is typically used for advisers who have never been the subject of an examination and signals a sort of “welcome to registration” to the newly registered adviser. This “light touch” examination typically consists of a phone call and limited document request, usually asking for 10 or so items, designed to provide the examination staff a big picture view of the adviser’s operations and activities. This type of review typically results in either a full-scope on-site examination or a letter stating that OCIE has no further questions. Newly registered advisers should take advantage of this light touch examination and collaborate with the examination team to identify ways to strengthen their policies and procedures and general compliance culture.

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Examination phasesPerhaps the most difficult phase of an examination is when the examination staff is on-site at the adviser, typically referred to as “fieldwork.” It is not unusual for the examination fieldwork to last four to eight weeks although it will vary by regional office. A significant factor is whether the examination team must travel for the fieldwork.

After the on-site phase, the examination staff will continue to review documents, conduct research and vet issues from the SEC regional office as the examination report and deficiency letter, if any, are drafted. From there, the examination report and deficiency letter go through a supervisory review. Finally, the examination team will conduct an exit interview with the adviser, and a deficiency letter, if any, will be issued. The entire examination process can take six or more months.

The number of examination staff on-site will depend on the size of the adviser and the complexity of its operations. Mid-size advisers should expect at least three OCIE staffers while large, global advisers should expect twice that number, sometimes including an exam manager (formerly called a branch chief).

Going forward, it is clear that more and more private fund advisers will receive greater examination scrutiny. But the consequent potential for decreased systemic risk and increased confidence on the part of investors and counterparties will be a significant benefit for the industry as a whole. How Ernst & Young can help

Ernst & Young’s Regulatory Compliance practice has significant experience assisting hedge funds, private equity funds, asset managers and investment advisers in assessing, designing and implementing compliance programs that are responsive to today’s challenging and rapidly changing business and regulatory environment. Our clients benefit from the cross-disciplinary subject matter knowledge, hands-on experience and practical approach to problem-solving we bring to each engagement. If you would like to discuss our regulatory compliance advisory services, please contact the following professionals:

Danielle Ryea is an executive in the Financial Services Office of Ernst & Young LLP. Danielle is based in New York and can be reached at +1 212 773 0160 or danielle.ryea@ey.com.

Daniel New is an executive director in the Financial Services Office of Ernst & Young LLP. Daniel is based in Boston and can be reached at +1 617 585 0912 or daniel.new@ey.com.

Foreign private advisersPursuant to the Dodd-Frank Act, the SEC changed the criteria for the foreign adviser exemption.

To be eligible for the foreign private adviser exemption, an adviser must:

• Have no place of business in the US

• Have, in total, fewer than 15 US-based clients and investors in private funds

• Have less than US$25 million AUM attributable to US-based clients and investors in private funds

• Not hold itself out to the public as an investment adviser in the US

SEC private fund adviser exams

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