SCS Exam Observations

Main Contributor: Elizabeth Cope, CPA, CSCP, CIPM, CEO & Lead Consultant

SCS’ Perspective from SEC Exams in 2023

The most common question we receive from clients is “When am I going to be examined?” Unfortunately, there is no crystal ball to predict this for advisers. The best advice we have is to assume it could be any day. You can feel prepared by sticking to the following basic compliance program elements:

• maintain policies and procedures that are tailored to your firm,

• train staff on their requirements and responsibilities,

• conduct a robust annual review to test the adequacy of your policies, and

• review conflicts within the firm to make sure they are either being avoided or mitigated through policies and/or disclosures.

We have seen an uptick in examinations for advisers who manage private funds and those who have either never been examined or have not had an exam in a very long time. Some of the common deficiencies we have seen are:

1. Removing hedge clauses from client agreements. The SEC used to be okay with a hedge clause as long as there was language in the agreement that made it clear that the client’s rights were not waived as a result. The Heitman no-action letter was one that advisers relied upon for this allowance, which the SEC withdrew and has since indicated that having any language that waives the adviser's liability is misleading and is in violation of Section 206 of the Investment Advisers Act of 1940. In our experience, the SEC isn’t expecting advisers to re-paper existing contracts but rather correct going forward.

2. Inconsistency with policies or not including necessary policies. The SEC is gaining sophistication as it relates to the adviser’s policies and procedures, as they are getting more granular with their expectations. This has been and will continue to be a common deficiency. Therefore, it’s imperative your firm review its policies regularly and get more than one set of eyes on them to ensure they are consistent with your Firm’s practices, cover all the risk mitigation processes, and are tailored to your Firm’s practices.

3. Mutual fund share class review. If you recommend mutual funds for client portfolios, the SEC expects procedures for how the firm monitors new recommendations and holdings for clients who transfer in legacy holdings. The firm needs to evaluate whether the share class being held in the client portfolio is the least expensive option and if it’s not, have a process to ensure that the firm converts to a cheaper share class or has a reasonable basis (documentation) to support that it’s still in the client’s best interest.

4. Inconsistent or missing disclosures. This is another common deficiency that has always existed, at least since I’ve been consulting. The key is to have a robust process of reviewing your regulatory filings and disclosures to ensure all material conflicts are being disclosed and the information is consistent with your Firm’s business. The disclosure documents can always benefit from multiple sets of eyes on them.

5. Lack of due diligence. We have seen deficiencies as they relate to a lack of due diligence on portfolio companies for private equity and venture capital firms or a process that isn’t clearly defined in the Firm’s policies. Further, when advisers recommend more complex structures to their clients, such as structured notes or private placements, they are receiving deficiencies if they either don’t have a due diligence process to ensure it is in their client’s best interest or that the process is not clearly outlined in the Firm’s policies and procedures.

6. Late or missing regulatory filings. Firms have been receiving deficiencies for either not filing or filing late forms, such as the 13F, 13H, and Form PF. Make sure your firm has a compliance calendar of required filings and a process to ensure timely and accurate filings.

Conclusion

It’s not a matter of “if,” but “when.” All investment advisers registered with the SEC will be examined at some point and this is not a fear-driving statement. It’s part of the ride. The Annual Review requirements have increased with regulations, but the basics remain the same. Maintain a strong compliance program at your firm with cohesive policies, filings, annual review documents, and training information. Ensure you are maintaining documentation to support your annual review and decisions made throughout the year that may fall outside of your policies. This will ensure that you are not only able to provide the required request items to the SEC but also that you can easily support yourself during an interview. With these elements in place, you can find more peace when thinking about and experiencing an examination.