The SEC Office of Compliance Inspections and Examinations (“OCIE” or the “Staff”) released its 2016 Exam Priorities recently, as applicable to examined registrants other than national securities exchanges.
Exam Priorities are always a reflection of current trends and news and, in recent years, also reflected the SEC’s expanded capabilities for monitoring market activity through data analytics.
The three key themes and many of the individual focus items for 2016 are much the same as last year. Here are some highlights of the differences in the 2016 Exam Priorities:
- Fees and Expenses: The Staff’s focus on the adequacy of fee and expense disclosures and practices is now relevant, not just in private equity, but in all private adviser exams. Hedge fund managers are well advised to revisit policies and disclosures in this area with counsel promptly.
- Private Fund Advisers: Moving beyond fees and expenses, the Staff announced the revival of its interest in controls and disclosure associated with side-by-side management of performance fee and pure asset-based fee accounts. In the past, the Staff’s interest in this topic pertained to conflicts of interest created for advisers by the differing fee structures and equitable treatment of clients that pay fees on differing bases. While considering this topic during your annual compliance program review, it may be advisable also to revisit whether and how your policies and disclosures address any conflicts raised by the introduction of the same strategy in different product structures (e.g., fund versus managed account), or new products in slightly differentiated strategies (e.g., new fund with stronger short bias or greater position concentration than flagship fund).
- ETFs: Focus will be on compliance with exemptive relief and regulations, and all manner of operating issues, including unit creation and redemption, sales and trading practices, concentration, primary and secondary market trading risks, and risk disclosure and suitability, particularly as it relates to niche, leveraged or inverse ETFs. The SEC is interested in proactive regulatory efforts regarding ETFs for several reasons, including (i) the increasing number of ETFs and related assets under management becoming very significant to investors and markets; (ii) the considerable subset of publicly traded securities that ETFs represent, such that trading practices and patterns involving ETFs relate to the Staff’s continued interest in market-wide issues; and (iii) the variety among exemptive relief pursuant to which various ETFs operate, leading the Staff to wish to review the effectiveness of the array of conditions arising under this relief, and that ETFs have evolved beyond plain vanilla index funds, now incorporating a wide variety of alternative investment strategies, which may implicate the use of complex derivatives and raise liquidity concerns.
- Variable Annuities: The Staff’s focus for the variable annuities sector will be on suitability of sales to retirement investors and the adequacy of disclosure and supervision relating to sales. This interest is related to OCIE’s main theme of protecting retail retirement investors. We note that, separately, the Commission is also proactively studying recent innovative product development trends among variable annuities, such as hybrid annuities that offer both variable and index linked returns. Variable annuities are two-tier investments that provide access to underlying mutual funds, so regulatory initiatives impacting retail funds will also generally impact variable annuities.
- Public Pension Plan Advisers: The Staff announced its intention to focus on this subsector of advisers with respect to pay-to-play, gifts and entertainment abuses, and other “key risk areas.” The announcement does not elaborate on what other key risk areas may be. Such advisers would be prudent to review relationships with public pension plan clients carefully for other sources of potential conflicts of interest.
- Reg SCI: OCIE will focus on whether entities covered by Regulation Systems Compliance and Integrity have established and enforced written compliance policies and procedures designed to ensure the integrity, security and resiliency of computing infrastructure. The covered entities are self-regulatory organizations, certain alternative trading systems, plan processors, and certain exempt clearing agencies.
- New and Complex Products: SEC’s data analytics program will now be aimed at detecting the promotion of new, complex and high-risk products so as to examine sales practice and fiduciary issues related to same.
- Private Placements: OCIE will focus on private placements, including under Reg D and the EB-5 Visa Program, to assess compliance with due diligence, disclosure and suitability requirements.
As always, the Priorities list is not exhaustive and the Staff is free to, and they will, follow where produced examination materials and interviews lead them.
We take this opportunity to remind our investment adviser clients that ADV annual updates are due within 90 days of your fiscal year end (or March 30, 2016, for most advisers, who lose a day off the normal deadline because of the leap year), and that compliance programs must be reviewed annually and updated to reflect changes in law and regulation, as well as changes in your organization and operations. Advisers that used non-law-firm service providers to accomplish registration and that have not discussed their ADV disclosures and/or compliance program with counsel are well advised to plan a review with counsel at this time. Discrepancies between operations and either disclosures or policies may become actionable violations, even if the statute or rules would not otherwise prohibit the adviser’s conduct.
Comments or questions regarding this client alert may be directed to the authors. Sandra Poe is the co-chair of Reed Smith’s Private Fund Formation and Counseling Practice. Tom Conner and Matt Bromberg are partners in the firm’s Investment Management Group.
Access the 2016 Exam Priorities by downloading the .PDF below.