SEC Announces Examination Priorities for 2013 for Investment Advisers and Investment Companies

February 28, 2013

On February 21, 2013, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations published its examination priorities for 2013 in a release (“Release”) intended to communicate to investors and registrants areas that are perceived by the SEC staff to have heightened risk. While the Release covers issues related to a variety of financial institutions, issues related to investment advisers and investment companies figure prominently. And while the Release identifies some expected and familiar areas of focus for investment advisers and investment companies (such as conflicts of interest, new registrants and custody of client assets), other areas are noteworthy as well, including:

  • SEC staff discussions with senior management and board members of registrants (including funds) to assess enterprise risk;
  • SEC staff evaluation of information received by fund boards and the reasonableness of board reviews;
  • Scrutiny of payments made by advisers and funds to distributors and other financial intermediaries, and review of other compensation and fee arrangements; and
  • Focus on the use of “alternative” and hedge fund strategies by registered funds.

This Alert focuses on the examination priorities of the SEC staff with respect to investment advisers and investment companies. For a discussion of the examination priorities for broker-dealers and others, please see our separate Legal Alert on this subject.

“Market-Wide” Examination Priorities

The SEC’s examination program is divided into four distinct program areas: 1) investment advisers and investment companies; 2) broker-dealers; 3) clearing and transfer agents; and 4) market oversight. The Release first lays out risk areas and examination priorities that apply across all four program areas, and then enumerates risks faced by registrants in the specific program areas. The Release identifies the following risk areas and examination priorities as applicable to registrants in all four program areas:

  • Fraud detection and prevention. The staff will continue to seek to identify market participants engaged in fraudulent or unethical behavior. We understand that the staff intends to continue using and enhancing its risk and quantitative analytics, among other things, in this regard.
  • Corporate governance and enterprise risk management. The staff will continue to meet with senior management and boards of registered entities to discuss enterprise risk and, in particular, how entities manage various types of risk, including financial, legal, compliance, operational and reputational risks. The staff’s stated goals are to (i) understand firms’ approach to enterprise risk management; (ii) evaluate firms’ “tone at the top;” and (iii) initiate a dialogue on key risks and regulatory requirements. Notably, the staff will achieve these goals through discussions with independent board members, among others. Additionally, the staff will continue to conduct “discovery reviews” of registrants. The stated goals of these reviews are to inform examination policy, rulemaking efforts and joint monitoring efforts with other regulators.
  • Conflicts of interest. The staff will focus on specific areas of conflicts of interest, the steps firms have taken to mitigate conflicts, the sufficiency of disclosures made to investors about conflicts and firms’ overall risk governance framework to manage conflicts on an ongoing basis.
  • Technology. In light of recent market events and developments, the staff may examine technology systems for operational capability, market access and information security, including risks of system outages and data integrity compromises.

Priorities Specific to Investment Advisers and Investment Companies

Familiar and Anticipated Topics

Several of the risk areas in the Release noted for investment advisers and investment companies for 2013 have been areas of focus in the past. Specifically, the staff will continue to focus on the following:

  • Compliance with custody requirements. The staff will focus on issues raised by the new custody rule, including whether advisers are appropriately recognizing that they have custody of a client’s assets and complying with “surprise exam” requirements and the “qualified custodian” provision.
  • Marketing and performance. The staff will focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the methods used for calculating performance, and related disclosures and compliance with record-keeping requirements.
  • Conflicts of interest related to side-by-side management. The staff will examine investment advisers’ management of accounts that do not pay performance fees side-by-side with accounts that do pay performance fees to confirm that the adviser has controls in place to monitor such management, particularly where the accounts have the same portfolio manager.
  • Dual registrants. The staff will continue to coordinate and organize joint-program examinations of dual registrants and distinct broker-dealer and investment advisory businesses that share financial professionals. In particular, the staff will focus on the conflicts of interest present in this business model and how the conflicts, as well as the issues raised by the different standards applicable to advisers and broker-dealers, are addressed and monitored.

The Release also identifies areas of focus that are not surprising given the SEC’s rulemaking during the last few years. In particular, the Release notes the staff’s initiative to establish a “meaningful presence” with the approximately 2,000 investment advisers, mainly hedge fund and other private fund advisers, that registered with the SEC for the first time as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These “presence exams” are expected to run over a period of two years and to culminate in a report to the industry on the staff’s observations. Examinations of private fund advisers will be prioritized where the staff has identified higher risks to investors relative to other new registrants or perceives indicia of fraud or other wrongdoing. In the last year, new registrants received letters from the Office of Compliance Inspections and Examinations regarding the presence exams and outlining the staff’s initiative in this regard. A number of advisers have already undergone such an exam. In addition, Andrew Bowden, Deputy Director of the Office of Compliance Inspections and Examinations, has stated that the staff will continue to use “sweep” examinations of private fund advisers to identify potential issues across registrants.

The Release also notes that the staff will evaluate compliance with recent amendments to the money market fund rules and the “pay-to-play” rule governing political contributions.

Other Noteworthy Areas of Scrutiny and Related Observations

As noted at the outset, the Release identifies several areas of focus that may present challenges to registrants in 2013 and should be considered carefully. These areas, and the language the Release uses to discuss them, also may well send a message about the staff’s concerns about and relationship with the industry. Of particular note are the following:

  • Governance and risk management. As noted above, as a market-wide priority, the staff intends to assess registrants’ overall risk management, and intends to do so through discussions with senior management and board members. The Release specifically and prominently mentions independent board members in this regard, and goes on to state that the discussions are designed to better inform examinations of the registrants. The discussions could of course yield information for the SEC’s enforcement staff as well, particularly given the recent trend of enforcement staff participation in the examination program. We understand that the staff may be primarily focusing on larger fund complexes in this endeavor at this time. Management and board members, particularly independent fund board members, who deal with risk management issues from an oversight standpoint and may not engage on these issues on a daily basis, will want to prepare for and conduct these discussions carefully.
  • Fund governance. Under the heading “Fund Governance,” the Release states that the staff will “confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.” This statement could be read to suggest that the staff’s examination will include a review of not only the adequacy of the information that is provided to a fund board, but also the adequacy and the outcome of the board’s consideration of that information. Regardless, advisers and fund boards will want to take note of this statement and will want to ensure that their communications and deliberations are fulsome and appropriately documented.
  • Payments for Distribution in Guise.” The Release states that the staff is focusing on the “wide variety” of payments made by advisers and funds to distributors and intermediaries, and identifies this as a “new and emerging” risk. The Release states that “these payments go by many names and are purportedly made for a variety of services, most commonly revenue sharing, sub-TA, shareholder servicing, and conference support.” In addition to assessing whether such payments are made in compliance with applicable rules and are not payments for distribution and preferential treatment, the staff will focus on the adequacy of the disclosure made to fund boards about these payments and boards’ oversight of the same. Although Andrew Bowden, of the Office of Compliance Inspections and Examinations, has been quoted as saying that the review of these payments is mainly a fact-finding mission and that the staff does not “have any preconceived [conclusions] other than trying to learn what is going on,” the language of the Release implies that the staff may already be skeptical of such arrangements. Registrants will want to take particular note of that skepticism and should be aware that these payments may well be subject to heightened scrutiny by the staff — particularly where the payments might serve purposes in addition to those for which they are “purportedly” made.
  • Other compensation arrangements. Perhaps showing a similar skepticism about other industry payments, the Release states that the staff will review financial and other records to identify “undisclosed compensation arrangements” and the conflicts of interest they present, including the receipt of payment by firms for services “allegedly provided” to third parties, such as funds or fund platforms. Again the language of the Release may imply that the staff has already reached a conclusion about these types of payment arrangements, and registrants will want to take note of this.
  • “Alternative” funds. The Release states that the staff is focusing on the growing use of alternative and hedge fund strategies in open-end funds, exchange-traded funds (“ETFs”) and variable annuity structures. We understand that the staff continues to have concerns about the suitability of many of these strategies for retail investors in addition to the valuation, liquidity and other issues the strategies present. In addition to evaluating policies and procedures about these strategies, and notably, the Release states that the staff will evaluate whether fund boards are appropriately staffed to handle these new strategies.

Other Program-Specific Priorities

As noted above, in addition to identifying examination priorities specific to investment advisers and investment companies, the Release outlines examination priorities for other registrants. One such priority that may be of particular interest to advisers given the recent trend to outsource certain middle and back office functions of affiliated service providers is outsourcing by transfer agents. The Release indicates that the staff will examine whether transfer agents that outsource services have implemented effective formal written policies and procedures and appropriate service level agreements that assist the transfer agent in monitoring its service providers, assuring its regulatory obligations are being met, and allowing for timely and accurate production of books and records. To the extent other SEC registrants outsource certain of their activities, the staff may focus on this aspect of their business as well.

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Please feel free to reach out to your regular contacts at the Firm if you have any questions about the matters addressed in this Alert. In addition, you are welcome to contact the members of the Firm’s Investment Management Practice Group named above.


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This article was originally published by Bingham McCutchen LLP.