(Article from Registered Funds Regulatory Update, October 2023)
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The SEC’s Division of Examinations recently released a Risk Alert that provides a high-level overview of its risk-based approach to selecting advisers for examination and determining the scope of the examination and identifies certain categories of documents typically requested in examinations. As stated in the Risk Alert, the Division conducts examinations for several reasons, including to: (i) promote compliance; (ii) prevent fraud; (iii) monitor risk; and (iv) inform policy (i.e., the SEC’s rule-making agenda). The Division has annually examined in recent years approximately 15% of all registered investment advisers.
Selecting Advisers for SEC Examination and Determining the Scope of the Examination
The Risk Alert noted that its risk-based selection approach is dynamic, which allows it to adapt to “changes in market conditions, industry practices, and investor preferences.” Specifically, when selecting advisers to examine, the Division considers factors, such as which advisers provide services, recommend products, or otherwise meet criteria relevant to the focus areas described in the Division’s published annual priorities. The Risk Alert noted certain general factors in its risk-based selection process, including: (i) prior examination observations and conduct, such as when the Staff has observed what it believes to be repetitive deficient practices during more than one review of a firm, significant fee- and expense-related issues, and significant compliance program concerns; (ii) supervisory concerns, such as disciplinary history of associated individuals or affiliates; (iii) tips, complaints, or referrals involving the adviser; (iv) business activities of the adviser or its personnel that may create conflicts of interest, such as outside business activities and the conflicts associated with advisers dually registered as, or affiliated with, brokers; (v) the length of time since the adviser’s registration or last examination, such as newly registered advisers; (vi) material changes in an adviser’s leadership or other personnel; (vii) indications that the adviser might be vulnerable to financial or market stresses; (viii) reporting by news and media that may involve or impact the firm; (ix) data provided by certain third-party data services; (x) the disclosure history of the firm; and (xi) whether the firm has access to client and investor assets and/or presents certain gatekeeper or service provider compliance risks.
According to the Risk Alert, once an adviser is selected for examination, additional risk assessment is conducted to determine the scope of the examination, such as selecting particular areas of the business that examiners will review. Therefore, the scope of an examination, and consequently the documents requested, will vary from examination to examination depending on the adviser’s business model, associated risks, and the reason for conducting the examination.
Categories of Documents Typically Requested in Standard SEC Examinations
While examinations will vary, the Risk Alert noted commonalities among tested areas, such as “reviewing advisers’ operations, disclosures, conflicts of interest, and compliance practices with respect to certain core areas, including, but not limited to, custody and safekeeping of client assets, valuation, portfolio management, fees and expenses, and brokerage and best execution.”
The Risk Alert included a chart of information typically requested during an exam, though the information is not comprehensive and, as noted in the Risk Alert, the chart does not include information requested particular to advisers to private funds or certain other advisers with additional characteristics. Such information includes: (i) general information (e.g., organizational information, disclosures and filings, and legal and disciplinary history); (ii) information regarding the compliance program, risk management, and internal controls (e.g., annual compliance reviews, valuation processes, advisory fee calculations, and information processing, reporting, and protection); (iii) information to facilitate testing with respect to advisory trading activities (e.g., client account information, portfolio management information, brokerage and trading, conflicts of interest, and insider trading); and (iv) information to perform testing for compliance in various areas (e.g., marketing and advertising, financial records, and custody).
Investment Advisers: Assessing Risks, Scoping Examinations, and Requesting Documents, SEC Risk Alert (Sept. 6, 2023), available at: https://www.sec.gov/files/risk-alert-ia-risk-and-requesting-documents-090623.pdf.