In the FY 2017, the SEC examined approximately 15% of all registered investment advisers, up from 8% just five years ago.
SEC Chairman Jay Clayton has said that in fiscal year 2018, the Office of Compliance Inspections and Examinations (Ocie) planned to increase its number of inspections of registered investment advisers. The number of exams has trended upwards in recent years.
The National Exam Program completed more than 2,100 exams of registered investment advisers last year, a nearly 46% increase over 2016. To continue to examine more registered investment advisers, which includes hedge funds, there has been a trend for the SEC to rely on the use of remote exams; this trend is expected to continue.
Marc Elovitz, a partner at Schulte, Roth & Zabel, observes that over the past few years the exam process has become more automated, reducing the need for examiners to be on-site. “The SEC examiners used to be on-site with a manager for weeks or months on end because that’s where the data was. Everything is electronic now, so managers are on-site for less time, if they come on-site at all,” he says.
Schulte partner Brian Daly agrees there is a growing trend for remote SEC exams, particularly with non-US registrants.
“There are a large number of registered investment advisers in London and Hong Kong and other global financial centres, and remote exams of managers in those areas have begun.”
Daly believes that with the SEC trying to get to more managers, the use of remote exams will continue, and likely increase. “In determining which managers to examine, the SEC will rely on the risk rating to figure out who will be examined. The SEC will also use the remote exams to assess firms and then go on-site to firms considered higher risk,” he says.
On this trend, Keith Marks, executive director and general counsel at Ascendant Compliance Management, also notes it has allowed the SEC to increase their exams numbers and assess the culture of compliance at firms without having to travel on-site.
Because the SEC’s electronic exam process has improved, Norm Champ, partner at Kirkland & Ellis and former director
of the Division of Investment Management at the SEC, says the electronic exam system has gotten better. “The electronic production of documents by registrants speeds up the process because it’s easier to access documents and review them.”
Colleen Montemarano, a senior consultant at NorthPoint Compliance, has also seen more remote examinations and notes that these exams tend to be more focused than on-site exams. “We also find that there tends to be fewer interviews in the remote exam than during the on-site exams.”
With a more focused scope of a remote exam, Marks says document requests are geared more towards giving the examiners exactly the information they want to know. “The examiners are asking firms upfront to explain how their compliance programme operates. They are looking at how they
manage their code of ethics practices and policies. They’re looking at higher risk areas like trading practices, insider trading risk, allocation of expenses between funds and presentation
of performance by fund managers. Look at compliance and risk to get to higher risk areas.”
“Our exam was pretty narrowly focused,” notes the GC of a $5.7bn New York-based hedge fund manager. “Our financials were the main focus, so they asked to see our trade blotter, our trade errors logs, and all documentation we had outlining our valuation process and backing up our calculations. With compliance, the only thing they asked was to see we corrected issues they found during our last exam and they wanted to see any reports we had on our annual compliance review.”
As the chances increase that an exam is coming, it becomes more important for hedge fund managers to properly prepare for an examination. When it comes to remote exams, preparation should be the same as with any other type of exam, with the exception that managers should be prepared to provide written responses to the SEC’s questions. The best preparation advice is to always be prepared, Daly advised. “In preparing for any exam, whether it will be remote or on-site, managers need to assume the examiners are coming in next week.”
Montemarano advises managers to use SEC document request lists and exam priorities statements to review all relevant documents. She also advised managers not to give too much information.
One hedge fund GC/CCO says: “Our prep included ensuring our documents were ready to be sent and that they were in the SEC-requested format. We have thorough records of our compliance program ready for review.”
The general counsel of a $3.4bn long/short equity hedge fund adds he cannot stress enough the importance of document organisation. “During our exam, we produced more than 50,000 pages of documents and it was all organised, filed and mapped back to the SEC’s document request list. We take a very aggressive approach to being very well organised, and being very responsive helped get them out of the door very quickly,” he notes.
Hedge fund managers should be sure to have the proper records supporting the compliance work done throughout the year to more readily organise a response, recommends Jason Ewasko, compliance director and chief compliance officer of outsourced CCO firm Cipperman Compliance Services. “You want to have all of your documentation prepared.
Everything should be easily accessible and formatted to the SEC’s specifications; this way, when a request comes in, you can respond immediately. That’s important, not just to keep the exam moving, but to make sure the examiners don’t get the impression that there’s something wrong at your firm.”
Managers need to be prepared to punctually deliver the basic exam request responses. “You should have your documents on deck and ready to go,” the hedge fund GC/CCO says. “If your docs are prepared, they are properly formatted and you send them in a timely manner, that will make the exam go much more smoothly.”
During remote exams, Marks says examiners are asking managers for a cataloguing of all of their investors. “They want to see the time periods of investor participation in a fund and their individual performance, so managers need to have investor information readily available and up-to-date.”
He adds that examiners are looking for logs of all presentations provided to prospective investors that show performance.
“That ties into the new recordkeeping rule that took effect on 1 October requiring managers to keep specific records of each person they gave performance figures to. The SEC is tracking new rules like that in their exams.”
Managers should also review public lists of document requests to get a better understanding of what the SEC typically looks for and to make sure those documents are ready to be submitted.
The long/short equity hedge fund GC says another good place to start in keeping the firm prepared for an examination is to review the most recent Ocie exam priorities letter and any other alerts issued by the SEC to get an idea of what examiners will be looking for. “You know they will be looking at current hot-button issues like cyber-security, cyber protection and protection of personal identifying information.
They want to know how your processes are being guarded against attacks and how you are protecting client money. There’s also a laser focus, especially in the private funds universe, on MNPI and insider trading.”
In preparing for an exam, he adds his firm has broken down its compliance programme into two categories: core compliance and trading compliance. In her experience preparing for an SEC exam, Meredith Simmons, CCO at Mason Capital, notes: “My expectation is, and really the expectation of any registered fund manager should be, that the SEC can come and examine the firm at any time.”
Simmons says she has become much more rigorous about writing everything down and recording every compliance step taken at her firm. “I document all of our processes and procedures. I broke down our compliance manual into discreet procedural steps so we have not just the ‘what’ but also the ‘how’ documented and it has been a very beneficial step.
I also created a compliance worksheet for each month so the work we do is easy to check off and document and easy to show to the regulators. And that makes the exam process go much more smoothly because it better answers the questions examiners will have about your compliance programme.”
When preparing for a remote exam, managers should also consider how to present their firm and to effectively communicate the firm’s business practices, operations and fund strategy. This is usually accomplished through a “day one” slide presentation.
Mock exams are also a helpful tool for managers to uncover any potential issues that could come up during an SEC exam.
As there is a higher chance of miscommunication with a remote exam, because of the inability for both parties to read each other during interview, Kirkland & Ellis’s Champ stresses the importance of keeping an open dialogue with examiners during a remote exam.
“You want to have as much dialogue with the examiners as you can, even though everything is happening remotely,” Champ says. “You want to follow up and be responsive and be sure that you know what’s happening.”
Montemarano agrees communication is critical during a remote examination. “You want to respond to any requests in a timely manner, even if it’s just to make a phone call to let examiners know you can’t speak at a certain time or that you won’t be able to produce certain documents by the requested time and making arrangements to submit the documents when you can.”
The hedge fund GC/CCO says he ensures to continuously follows up with examiners to make sure they have everything they need, that they don’t have any questions and that there are no issues. “With a remote exam, you don’t have someone in your office looking at things so it’s impossible to get a read on how things might be going so it’s so important to keep following up with them and checking to see if they have everything they need. You really need that ongoing dialogue with a remote exam.”