Division Risk Alert: Exam Observations of Newly Registered Advisers
Main Contributor: Gretchen Sturdivan, CSCP Creative Director & Compliance Manager
Background
Registering with the Securities and Exchange Commission is no simple task. Not only do you need to draft critical compliance documents (ADV, Form CRS, Policies and Procedures) that are tailored to your firm, but you also need to have a grasp on the Investment Advisors Act of 1940 and all other relevant regulations. The “newly registered” status has piqued the interest of the Division of Exams (the “Division” or “EXAMS”) since 2013, with the number of SEC-registered advisers increasing by more than 20% within the past five years. With this exam initiative, EXAMS is aiming to ascertain a firm’s culture of compliance and assess its overall risk. This risk alert summarizes their key findings from the examinations conducted on new advisors and provides your firm with an opportunity to learn about the findings and implement changes now before the Division comes knocking on your door.
What the Division is Looking For
When the Division reviews your risk assessment, they want to see if it adequately addresses the firm’s conflicts of interest and how you mitigate those risks through your compliance program. They want to see whether firms have:
Identified and addressed conflicts of interest.
Provided clients with full and fair disclosure of all material facts relating to the advice provided.
This will call into play your ADV, especially Form CRS, and your marketing materials.
Adopted effective compliance programs – which means your firm has:
Adopted and implemented written policies and procedures reasonably designed to prevent violations of the Advisers Act,
Reviewed the policies and procedures annually for the adequacy and effectiveness of their implementation, and
Designated a Chief Compliance Officer responsible for administering the firm’s policies and procedures.
What an Exam Would Cover
We know the drill for SEC Exams – a request letter is delivered, you produce the requested documents to cover the requested time period, key professionals are interviewed, additional information may be requested, and then you receive a final deficiency letter. However, if you are a newly registered adviser and have not been through the examination process, the Division did put together an Exam Brochure that breaks down the purpose and process of exams. Keep in mind that the interview process assists the staff in assessing the firm’s culture of compliance and “tone at the top” among executives. Your compliance program and role as the CCO should build this culture by enforcing well-designed and tailored policies and promoting open communication. As far as generating documents is concerned, we will list the typical requests the Division highlights in this risk alert.
General Information Regarding Business Operations
Organizational charts
Documentation to support eligibility for SEC registration
Information about ownership and control of the adviser and its affiliates
Information about current and former advisory personnel (reasons for departure as well)
Financial information, including the balance sheet, trial balance, and income statement
Information about any threatened, pending, or settled litigation or arbitrations involving the adviser or any of its supervised persons
Advisory Client Account Information
Advisory services provided (i.e., portfolio management, financial planning, and/or bundled wrap fee arrangements)
Types of client accounts services (i.e., individual, defined benefit retirement plan, registered fund, or private fund)
Advisory authority to trade in the account (i.e., whether discretionary)
Advisory personnel who oversee/service the account
Assets under management advised by the firm
Third-party service providers (i.e., custodians, administrators, auditors)
Investment strategies (i.e., global equity, high-yield, aggressive growth, long-short, or statistical arbitrage)
They will often ask for copies of contracts, agreements, or third-party account statements
Information Regarding the Compliance Program
Risk management practices and framework
Internal controls (i.e., written policies and procedures and code of ethics)
Information to Facilitate Testing for Portfolio Management and Trading
Records of clients’ securities holdings and transactions (i.e., account statements and trade blotter)
Marketing Materials Used to Solicit New and Existing Clients
Disclosure documents
Pamphlets, social media, mass mailings, websites, and blogs
Staff Observations from Recent Exams
Deficiencies seem hard to avoid. Despite having a well-designed compliance program, there will sometimes be missing pieces or oversights. When the Division has examined newly registered advisers, they have found deficiencies and issues in three main areas: (1) compliance policies and procedures; (2) disclosure documents and filings; and (3) marketing. Policies are a very common place for deficiencies among all advisers. So much so that the Division published its observations in 2020 for everyone to see and learn from. Yet, it remains a consistent place of weakness. Below are more observations, specific to newly registered advisers that can serve as a guidepost to improve your policies and procedures before an exam:
Policies did not adequately address certain risk areas applicable to the firm (i.e., portfolio management and fee billing)
Procedures are omitted to enforce stated policies (i.e., the policy is to seek best execution but you don’t have any procedures in place to periodically and systematically evaluate broker execution)
Policies were not followed by employees (typically because they were not trained or polices were not consistent with business operations)
Annual Compliance Reviews as a whole did not address the adequacy of the policies and procedures or the effectiveness of their implementation.
Off-the-shelf manuals were used and not tailored to the firm
Sufficient resources were not devoted to complying with their own policies or ensuring employees understood the policies (i.e., when a CCO wears too many hats and can’t focus on compliance)
Had undisclosed conflicts of interest created by the multiple roles and responsibilities of employees carrying out the assigned duties and conflicts were not mitigated
Outsourced certain business and compliance functions without performing due diligence and ensuring that the duties they performed were in line with the firm’s policies
Business Continuity Plans and Succession Plans were not adequate
Disclosure documents provide another area for risk and examination concerns. This includes your ADV Part 2A Brochure and Form CRS. The staff observed disclosure documents that contained omissions or inaccurate information and/or were filed untimely or not at all. It’s critical that your firm read the instructions for all of the disclosure documents and follow them as prescribed. Further, ensure they are consistent with each other and the firm’s current business practices. Most importantly, if you cannot avoid a conflict, make sure to fully disclose it. The disclosure omissions and inaccuracies the Division notes in this risk alert were related to advisers’:
Fees and compensation
Business operations (including affiliates, other relationships, number of clients, and assets under management)
Services offered to clients, such as disclosure regarding advisers’ investment strategy (including the use of models), aggregate trading, and account reviews
Disciplinary information
Websites and social media accounts, and
Conflicts of interest
This brings us to marketing. The Division has provided little to no additional guidance in interpreting the new Marketing Rule that went into effect last November. The way we will learn about best practices and mistakes will be through examination deficiencies and risk alerts. It could be cause for excitement to see it mentioned in this risk alert and hope for helpful tips, but alas, it is very general. Nevertheless, here is what the Division has observed:
Marketing materials that appeared to contain false or misleading information, including:
inaccurate information about employee experience or credentials
third-party rankings
performance
Advisers were unable to substantiate factual claims
Our suggestion at SCS would be to ensure your disclosures are tight and accurately match the data presented. If you have statements of fact, make certain you have the documentation to substantiate the claim. If you are not able to substantiate a statement, don’t use it. Often, remarks go unchecked in presentations you’ve used since the beginning of time, but if you want to talk about how you’ve outperformed the benchmark for the last 5 years, you need to have documentation to support that claim. While we don’t have a lot to go off of with the new rule, it’s a good idea to refer back to the general prohibitions and avoid providing inaccurate or misleading statements. Also, please refer to our blog posts on compliant advertising for additional framework and guidance.
Conclusion
While this risk alert was focused on issues, they have seen in newly registered adviser exams, they definitely apply across the board, regardless of how long you’ve been in business. The Division wants to engage with advisers to promote adherence to compliance regulations with the ultimate goal of protecting investors. The exam issues noted here are fairly straightforward and require due diligence on the firm’s part to match up policies with actual practices and accurately present all of the data and performance you put out into the world. It’s easy to miss small details, but the point is to build a strong compliance program that mitigates the risks specific to the firm’s operations and educate your employees so that the culture is inherently compliant. Your firm, new or old, will be set up for success when you enter an examination with Division staff.