On October 9, 2012, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) sent a letter to newly registered investment advisers (i.e., investment advisers to private funds that registered with the SEC as a result of the Dodd-Frank Act) introducing its new National Exam Program (“NEP”) initiative. According to the letter, the NEP will be conducting focused, risk-based “presence exams” of newly registered investment advisers over the next two years to protect investors and maintain market integrity. For more information on the impact of the Dodd-Frank Act on the registration of investment advisers, please see the June 29, 2011 Davis Polk Client Memorandum, SEC Issues Final Rules Implementing Dodd-Frank Amendments to the Investment Advisers Act of 1940.
The NEP’s “presence exams” initiative has three primary phases: (i) engagement, (ii) examination and (iii) reporting. In the ongoing engagement phase, the NEP staff is engaging in a nationwide outreach to inform newly registered investment advisers about their obligations under the Advisers Act and related rules, the presence exams initiative and OCIE’s practice of engaging directly with investment adviser’s senior management. As part of this phase, the NEP staff has published various compliance materials on the SEC’s website.
In the examination phase, the NEP staff will review one or more of the following “higher-risk” areas of the business and operations of an investment adviser that is selected for examination:
- Marketing: The investment adviser’s marketing materials and the manner in which it solicits investors for private funds (including the use of placement agents).
- Portfolio Management: The investment adviser’s portfolio decision-making practices, including decisions with respect to investment allocations and whether the practices are consistent with disclosures provided to investors.
- Conflicts of Interest: The investment adviser’s procedures and controls to identify, mitigate and manage certain conflicts of interest, including investment allocations, allocations of fees and expenses, sources of revenue, payments made by private funds to the investment adviser and its related persons, outside business activities, personal securities trading and transactions by the investment adviser with affiliated parties.
- Safety of Client Assets: The investment adviser’s compliance with the custody rule under the Advisers Act and, if available, independent audits of the investment adviser’s private funds for consistency with the custody rule.
- Valuation: The investment adviser’s valuation policies and procedures, including its methodology for fair valuing illiquid or difficult to value investments and its procedures for calculating management and performance fees and allocating expenses to private funds.
The letter reminds newly registered investment advisers that, as part of the examination process, they will be required to provide the NEP staff with access to all requested advisory records (including the records and reports of any private funds that receive advice from the investment adviser), subject to attorneyclient privilege under certain circumstances. In addition, similar to traditional SEC examinations, the NEP staff may issue a deficiency letter to the investment adviser and, if serious deficiencies are found, may refer the matter to the SEC’s Division of Enforcement or to a self-regulatory organization, state regulatory agency or other regulator for possible action.
Finally, in the reporting phase, the NEP staff will report its observations to the SEC and the public, including common practices identified in the higher-risk focus areas, industry trends and significant issues.
The NEP staff will contact investment advisers separately if their firm is selected for examination.