[ by Howard Haykin ]

The SEC Examination Priorities for 2013, released Thursday, details critical elements of the Agency's National Examination Program ("NEP").  The SEC's Office of Compliance Inspections and Examinations ("OCIE"), headed by Director Carlo di Florio, is responsible for the NEP. 

On Friday, we covered "NEP-Wide Initiatives" or what the SEC refers to risk areas and exam priorities applying to nearly all types of registrants.     [Click to read: Story, "OCIE Priorities..." 2/22/13]

Today, we begin with the SEC's "Program Area Specific Initiatives", as it pertains to Investment Advisers and Investment Companies -

the first of 4 classifications of financial entities registered with the Commission:

• Investment Advisers and Investment Companies. ("IAs", "ICs")
• Broker-Dealers.
• Market Oversight Entities (SROs, Exchanges).
• Clearing and Settlement Firms.

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Investment Adviser-Investment Company (IA-IC) Exam Program.    

This program has primary exam authority for about 11,000 registered investment advisers and 800 registered investment company complexes.   Collectively, these entities manage nearly $50 trillion for investors.

A.  IA-IC Program Examination Focus Areas.   Scope of an IA-IC exam is generally limited to the issues and business practices of the registrant that are perceived by t he staff to present the highest risks to investors and the integrity of the market.  Thus, the scope of exams will vary from registrant to registrant. Nevertheless, across the program, there are certain issues that predominate.  In addition to the specific risk areas unique to each registrant, the staff will consider the following focus areas when scoping and conducting examinations in 2013.

► The staff anticipates that "ongoing risks" in 2013 will include ...

Safety of Assets.  The staff will continue to utilize a risk-based asset verification process to confirm the safety of client assets and compliance with custody requirements. They'll identify and assess steps taken by registrants:  (i)  to protect client assets from loss or theft;  (ii) to conduct adequate audits of private funds;  and,  (iii)  maintain effective pols and procedures in this area. 

Investment Advisers were found to frequently have issues relating to custody and safety of client assets under Advisers Act Rule 206(4)-2 (the “Custody Rule”).   This has prompted examiners to determine whether advisers are: 

• appropriately recognizing situations in which they have custody as defined in the Custody Rule;
• complying with the Custody Rule’s “surprise exam” requirement;
• satisfying the Custody Rule’s “qualified custodian” provision; and.
• following terms of the exception to the independent verification requirements for pooled investment vehicles.

Conflicts of Interest Related to Compensation Arrangements.    The staff will review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present. These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms.  Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.

Marketing/Performance.    Marketing and performance advertising is an inherently high-risk area due to the highly competitive nature of the investment management industry. Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices. The staff will also focus on the accuracy of advertised performance, including hypothetical and back- tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements.  Where feasible, the staff will also review changes in advertising practices related to the JOBS Act, which requires modification of the rules restricting general solicitations.

Conflicts of Interest Related to Allocation of Investment Opportunities.   Advisers managing accounts that do not pay performance fees (e.g., most mutual funds) side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face unique conflicts of interest. While reviewing portfolio management practices, the staff will confirm that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts, such as certain private investment vehicles, and registered investment companies, or other non-incentive fee-based accounts, with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.

Fund Governance.    Fund governance and assessing the “tone at the top” is a key component in assessing risk during any investment company examination.  The staff will confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.

►  The staff anticipates that "new and emerging risks" for IA-ICs in 2013 will include:

New Registrants.    Since the effective date in early 2012 of Section 402 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, approximately 2,000 investment advisers have registered with the SEC for the first time.  The vast majority of these new registrants are advisers to hedge funds and private equity funds that have never been registered, regulated, or examined by the SEC.  The IA-IC Program therefore intends to launch a coordinated national examination initiative designed to establish a meaningful presence with these newly registered advisers. The initiative is expected to run for approximately two years and consists of four phases: (i) engage with the new registrants; (ii) examine a substantial percentage of the new registrants; (iii) analyze our examination findings; and (iv) report to the industry on our observations. In addition to the new registrant initiative, the IA-IC Program will also prioritize examinations of private fund advisers where the staff’s analytics indicate higher risks to investors relative to the rest of the registrant population, or there are indicia of fraud or other serious wrongdoing.

Dually Registered IA/BD.   Due to the continued convergence in the investment adviser and broker- dealer industry, the IA-IC Program will continue to expand coordinated and joint examinations with the B-D Program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals.  For example, it is not uncommon for a financial professional to conduct brokerage business through a registered broker-dealer that she does not own or control and to conduct investment advisory business through a registered investment adviser that she owns and controls, but that is not overseen by the broker-dealer.  This business model presents multiple conflicts. Among other things, the staff will review how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.  In addition, the staff will review dually registered firms’ policies and procedures to understand if such policies and procedures provide guidelines for when a financial professional makes a securities recommendation to a customer with a broker-dealer account versus an investment adviser account.

 “Alternative”  Investment  Companies.    The IA-IC Program is focusing on the growing use of alternative and hedge fund investment strategies in open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures. More specifically, the staff will assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.

Payments for Distribution in Guise.   The IA-IC Program is focusing on the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same. These payments go by many names and are purportedly made for a variety of services, most commonly revenue sharing, sub-TA, shareholder servicing, and conference support.  The staff will assess whether such payments are made in compliance with regulations, including Investment Company Act Rule 12b-1, or whether they are instead payments for distribution and preferential treatment.

►The staff anticipates that "Policy Topics" for IA-ICs will include:

Money Market Funds.   Recent amendments to Investment Company Act Rule 2a-7 require money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, including changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks. Among other things, the staff will review whether firms are conducting stress testing, what factors they are considering in the stress testing, and the results of the stress testing.

Compliance with Exemptive Orders.    Where applicable, the staff will focus on compliance with previously granted exemptive orders, such as those related to closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds.

Compliance with the Pay to Play Rule.   To prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices), the SEC recently adopted and subsequently amended, the Pay to Play rule. The staff will review for compliance in this area, as well as assess the practical application of the rule.