Carlo V. di Florio, Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE) recently announced the staff’s intention to examine, during the next two years, about 25 percent of the investment advisers required to register with the SEC subsequent to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank). This group of approximately 1,500 registrants primarily consists of investment advisers to hedge funds and private equity companies. Prior to the enactment of Dodd-Frank, such advisers were able to avoid SEC registration by reliance upon the 15-client, non-public adviser exemption under the Investment Advisers Act of 1940. That exemption from investment adviser registration was eliminated by the Dodd-Frank legislation.
The SEC announced the targeted examination program to such registered investment advisers by letter in October. The letter reportedly stated that the examinations will primarily focus on valuation, marketing, portfolio management, conflicts of interest, and asset verification. According to the SEC, initial OCIE examinations of hedge fund and private equity company advisers revealed significant concerns with respect to overstated management fees, improperly computed asset valuations, and conflicts of interests which were not properly disclosed to fund investors. Generally, the deficiencies noted within examinations of newly registered advisers consist of inadequate books and records and ineffective or non-existent supervisory controls.
Another purpose of this directed examination program according to the Director is to educate this class of investment advisers on what is expected of them as registrants under the Advisers Act.
Newly registered advisers subject to their first SEC examination are encouraged to fully cooperate and provide accurate and complete information requested by the OCIE. Such cooperation and the providing of accurate and complete information will help in maintaining a working relationship with the OCIE and possibly avoid enforcement action by the SEC against the registrant that can result when there is a lack of cooperation or failure to provide truthful responses.
According to the OCIE, the staff’s capabilities in examining this class of adviser registrants has been greatly assisted by the recent hiring of examiners from the private sector who have experience as hedge fund managers or as other specialists in the hedge fund industry. As the history of certain notorious hedge fund managers such as Bernie Madoff has proven, the OCIE’s examination program is only as good as its examiners. Having examiners who have been active in the operations of hedge fund managers should provide the OCIE with the ability to examine advisers of hedge fund and private equity companies in a more competent and efficient basis.