(Article from Registered Funds Alert, May 2017)
For more information, please visit the Registered Funds Alert Resource Center.
In February the Staff of the SEC’s Office of Compliance Inspections and Examinations (the “OCIE Staff”), issued a National Exam Program Risk Alert (“Risk Alert”) presenting the five compliance topics most frequently identified in deficiency letters that were sent to SEC-registered investment advisers. The Risk Alert sampled over 1,000 examinations of SEC-registered investment advisers conducted over the two years prior to its release. The deficiencies and weaknesses concerned certain requirements of the Investment Advisers Act of 1940, as amended, related to:
- compliance requirements under Rule 206(4)-7;
- required regulatory filings;
- custody requirements under Rule 206(4)-2;
- code of ethics requirements under Rule 204A-1; and
- books and records requirements under Rule 204-2.
Although the Risk Alert is focused on investment advisers, boards and investment advisers of registered funds should be aware of these issues.
Compliance
The Risk Alert highlighted a frequent lack of attention to maintaining up-to-date and tailored compliance policies. Specifically, the OCIE Staff detailed the frequent occurrence of compliance manuals that are “off-the-shelf” template manuals. These types of manuals generally are not reasonably tailored to the investment adviser’s business practices because they fail to take into account important individualized business practices such as the investment adviser’s particular investment strategies, types of clients, trading practices, valuation procedures and advisory fees. Relatedly, many such policies are not reviewed annually or updated in response to changes in strategies, personnel or applicable regulations. As registered funds are required to adopt compliance policies and procedures under Rule 38a-1, and the SEC is increasingly requiring specific policies and procedures under new SEC rules, such as the recent liquidity risk management rule, it is important for an investment adviser to have an established process for developing and updating its compliance manual to ensure it is appropriately tailored to its business. Similarly, boards are required to approve compliance policies and procedures and should have an understanding of the investment adviser’s process.
Regulatory Filings
With respect to regulatory filings, the Risk Alert focused on inaccurate disclosures and untimely amendments to disclosures. The OCIE Staff noted that investment advisers made inaccurate disclosures on Form ADV Part 1A or in Form ADV Part 2A brochures, such as inaccurately reporting custody information, regulatory assets under management, disciplinary history, types of clients and conflicts. Many investment advisers also failed to amend promptly their required disclosures as a result of material changes.
Custody
The OCIE Staff found that investment advisers frequently did not recognize that they may have custody as a result of having (or related persons having) powers of attorney authorizing them to withdraw client cash and securities, including when investment advisers or their related persons served as general partners of pooled investment vehicles, or having access to online accounts using clients’ personal usernames and passwords. The Risk Alert also highlighted that for many firms, surprise audit examinations did not meet the requirements of the custody rule, for technical reasons and also because surprise examinations were not actually being conducted on a “surprise” basis (e.g., exams occurred during the same month every year). The Risk Alert highlights that custody issues continue to be a focus of OCIE Staff, several years after the Madoff scandals, and this focus almost certainly carries over to examinations of registered funds.
Code of Ethics
The OCIE Staff reported that many investment advisers’ codes of ethics were deficient because they failed to identify all access persons, specifically call for review of holdings and transactions reports submitted by access persons, or did not identify the specific submission deadlines for such reports, as required. Further, the Risk Alert observed that certain access persons submitted transactions and holdings less frequently than required and that many investment advisers’ ADVs did not include descriptions of the firm’s code of ethics.
Books and Records
The Risk Alert observed that certain investment advisers had errors and omissions in their books and records, such as inaccurate fee schedules and client records or stale client lists. Additionally investment advisers commonly failed to maintain all the books and records required by the rules, such as trade records, advisory agreements and general ledgers.
Takeaways
The findings of the Risk Alert are helpful in understanding the issues on which the SEC is currently focused. Investment advisers, whether or not they have been examined, would be well advised to review their policies and practices and in light of the Risk Alert’s findings. Further, the Risk Alert can be useful in reviewing a registered fund’s compliance as well. Funds have many similar requirements under the 1940 Act and, as a result, have their own policies and procedures that should be reviewed. Though they are separate from the investment adviser’s policies, they generally are administered by the fund’s investment adviser. If the investment adviser has issues with its own policies, it’s possible that such issues could impact any funds managed by the investment adviser as well.