The Office of Compliance Inspections and Examinations (OCIE) of the Securities and Exchange Commission (SEC) recently released its examination priorities for 2015 for investment advisers, broker-dealers and transfer agents (2015 Exam Priorities). This article focuses on the 2015 Exam Priorities insofar as they impact private equity fund managers that are registered with the SEC as investment advisers. We also highlight aspects of OCIE’s examination priorities for 2013 and 2014 that will remain important considerations for these private equity fund managers.
Key Takeaways for Private Equity Managers from the 2015 Exam Priorities
While private equity managers can expect OCIE examinations to focus on matters not explicitly mentioned among the 2015 Exam Priorities, certain of the priorities stand out as being of particular concern for managers of private equity funds.
Fees and Expenses − Of particular significance to private equity fund managers in the 2015 Exam Priorities is its focus on fees and expenses. This concern initially surfaced for private equity fund managers during the SEC’s Presence Exam Initiative and was the subject of a well-publicized speech by OCIE Director Andrew Bowden in May 2014. In this speech, Bowden indicated that when OCIE examined the ways private equity fund managers handle fees, OCIE identified what it believed to be violations or material weaknesses in controls more than 50 percent of the time. Click here for access to our article on this topic. Private equity fund managers should take this area very seriously.
Cybersecurity – If they have not done so already, private equity fund managers should focus on cybersecurity, which was listed as an examination priority for 2015. As a further indication of the emphasis on this area, on Feb. 3, 2015, OCIE released its Cybersecurity Examination Sweep Summary highlighting the compliance issues facing advisers and broker-dealers in addressing cybersecurity concerns. OCIE examiners can be expected to specifically look at the firm’s governance and supervision of their information systems, operational capabilities, security and ability to respond to sudden system failures. A firm’s compliance policies and procedures must contain tailored measures dealing with cybersecurity risks.
Multiple Offices – In addition, private fund managers that operate from more than one office should note that “branch office” operations are also included as an examination priority for 2015. Private equity fund managers should take steps to ensure that their compliance policies and procedures are understood and followed throughout each office. As part of these procedures, chief compliance officers should consider making periodic in-person visits to each office.
Proxy Voting – The 2015 Exam Priorities include review of investment advisers’ compliance with their fiduciary duties in voting proxies on behalf of clients (i.e ., their private funds) pursuant to Rule 206(4)-6 under the Investment Advisers Act of 1940, as amended (Advisers Act). Registered investment advisers are required to adopt and implement policies and procedures reasonably designed to ensure that they vote client securities in the best interest of clients. For example, many private equity fund managers vote the securities of their funds’ portfolio companies, and their compliance policies and procedures should contain appropriate provisions tailored to their specific circumstances (including how they address any material conflicts of interest).
Some Lessons from the 2014 and 2013 OCIE Examination Priorities Documents
The 2015 Exam Priorities differ from the comparable lists that OCIE released in 2014 and 2013. For one thing, in 2014 and 2013 OCIE included separate lists of priorities explicitly targeted at investment advisers, while the 2015 Exam Priorities generally combine the priorities for investment advisers, broker-dealers and transfer agents under broader topical headings. For another, many of the 2013 examination priorities that reappeared in 2014 (e.g ., conflicts of interest in private equity, custody, marketing/performance) are not explicitly mentioned among the 2015 Exam Priorities. Nevertheless, the following areas that were addressed in the 2014 and/or 2013 priorities lists are among those that can be expected to remain a concern in OCIE’s regulatory compliance examinations.
Safety of Assets and Custody – The 2014 and 2013 examination priorities both expressed the SEC’s serious concerns over noncompliance with Rule 206(4)-2 of the Advisers Act (Custody Rule). Additionally, OCIE issued a risk alert on custody issues in 2013 after finding extensive problems with Custody Rule compliance among private fund managers in OCIE’s presence exams. Furthermore, a significant number of 2014 cases involved Custody Rule issues, and the SEC’s Enforcement Division recently brought a case seeking serious penalties for alleged repeated violations of the Custody Rule. Click here for access to our article on this case. Private fund managers should make sure that their compliance procedures appropriately identify and deal with custody issues and that these procedures are being carefully followed.
Conflicts of Interest – Both the 2014 and 2013 examination priorities lists included conflicts of interest as a concern, and highlighted the following issues:
- Compensation arrangements, particularly undisclosed compensation arrangements, (a focus which is reflected in the continued emphasis on fees and expenses of private equity fund managers)
- Allocation of investment opportunities
- Controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts
- Risk controls and disclosure
Marketing and Performance – In the SEC’s examination priorities for both 2014 and 2013, the SEC highlighted concerns relating to investment advisers’ marketing and performance. SEC staff will continue to review for accuracy and completeness statements of performance and investment objectives. Advisers must be particularly prepared for scrutiny of published performance figures, the efficacy of compliance personnel’s oversight of marketing, and the adviser’s compliance with performance recordkeeping requirements under the Advisers Act.
The recent case against F-Squared Investments, Inc. (F-Squared), illustrates the continued focus on this area. On December 22, 2014, the SEC announced a settlement with F-Squared, a registered investment adviser which, through various affiliates, provides specialty index products covering a range of asset classes and, separately, provides investment advisory services relating to those products, including advisory services to a private fund. The SEC alleged, among other things, that F-Squared falsely advertised a successful seven-year (2001-2008) track record when, in fact, the advertised strategy did not even exist during that period of time. The SEC further alleged that F-Squared falsely promoted its backtested performance data as “not backtested,” and that, in creating this track record, F-Squared had applied buy and sell signals to create the false impression that the strategy would have significantly outperformed the S&P 500 Index.
In the settlement, F-Squared consented to an extensive set of admissions and agreed to a cease-and-desist order. F-Squared also agreed to retain an independent compliance consultant and to pay $35 million (including a civil penalty of $5 million). (The co-founder and then-CEO of F-Squared is no longer the CEO, and the SEC is pursuing a separate case against him.)
While this case does not involve a private equity sponsor, a corresponding focus on advertising materials should be expected in examinations of private equity fund managers. OCIE examination staff will carefully review the accuracy and completeness of claims about investment objectives and performance. OCIE staff can be expected to review and test:
- any hypothetical and back-tested performance;
- use and disclosure of composite performance figures;
- compliance with performance recordkeeping requirements; and
- compliance oversight of marketing.
Private equity fund managers should make sure that their compliance procedures contain appropriate provisions to address these areas, and that the procedures are followed.
Corporate Governance and Enterprise Risk Management – Enterprise risk management appears on both the 2014 and 2013 OCIE examination priorities lists.
Typically, upon commencement of the onsite portion of an SEC examination, OCIE staff will first meet directly with the firm’s senior officers, including the chief compliance officer. In addition to trying to assess the “tone at the top,” the staff will want to discuss how the firm identifies and mitigates material conflicts of interest and legal, compliance and operational risks that may be inherent in its business model. SEC examiners have previously noted that they find it helpful to be given upon their arrival an introductory presentation that provides them with a clear understanding of the adviser’s business and operations, an overview of its compliance program and a description of key compliance risks previously identified by the firm and its strategy for resolving or mitigating them. Click here for access to our article on this topic.
Additionally, compliance personnel should perform, at least annually, a comprehensive assessment of the firm’s legal, compliance and operational risks. This assessment should include careful documentation of findings. Compliance personnel should consider and document any remedial actions that may be necessary (e.g., an amendment or supplement to the firm’s compliance program).
Never-Before-Examined Advisers – The SEC will continue its initiative to address advisers that have never been examined. OCIE has stated that this initiative includes focused, risk-based examinations of the adviser population that has been registered for more than three years but has not yet been examined.
Other Areas of Interest – In addition to the foregoing, OCIE examiners can be expected to continue to have a focus on portfolio management, valuation and broker-dealer issues. These have been the subject of past SEC exams, settlements and enforcement actions, and private equity managers and their compliance personnel should remain diligent in regard to these aspects of their compliance obligations.