The examination staff in the New York Regional Office of the Securities and Exchange Commission (the “SEC”) has recently been using a new and expanded form of request letter in connection with its periodic examinations of registered investment advisers (the “Request Letter”). The SEC’s New York Regional Office generally provides a copy of the Request Letter to the adviser two weeks prior to the start of the examination, and asks that the adviser have available the requested documents or information to the examination staff at the outset of the examination. The Request Letter used by the New York Regional Office has varied over the past several years. The most recent version requests several new categories of information that are noteworthy.
The Request Letter is only directly applicable to registered investment advisers in the SEC’s New York Region. However, because the Request Letter reflects the focus of the SEC’s examinations, and potentially the SEC’s enforcement activities, all investment advisers should be aware of it. Investment advisers should review their compliance policies and procedures in light of the new items sought by the Request Letter. Because of the breadth of the Request Letter, we anticipate that many firms will need to consider whether new or revised policies and procedures are appropriate. The issues relating to insider trading are particularly significant and should be carefully considered by all advisers. In addition, the new items sought by the Request Letter may implicate the SEC’s new anti-fraud rule 206(4)-8, which applies to all investment advisers to “pooled investment vehicles,” including hedge funds, private equity funds and venture capital funds.
Some of the areas of new and increased focus in the Request Letter are discussed below. Please note that this is not a list of all areas that are covered by the Request Letter.
The Request Letter significantly expands the scope of information sought with respect to the potential misuse of material, non-public information. The Request Letter asks advisers to provide information concerning:
- A list of employees, employees' relatives, investors, and clients of the adviser that serve as officers or directors of public companies. If the adviser permits such service, the adviser will need to consider adopting policies and procedures to restrict and monitor contact between covered persons and portfolio managers and traders.
- A list of companies where an adviser's employees or affiliates serve on a creditors' committee.
- A list of all corporate insiders, hedge fund executives or brokerage executives that have invested in any of the adviser's private investment funds during the examination period. For any such investors, the subscription documents are requested along with a statement of any such investor's ownership interest in the fund.
- A list of access persons that invested in private placements or hedge funds during the examination period, including the date of the investment and the name of the company.
- Copies of procedures regarding adding or removing securities from the restricted and watch lists, identification of individuals with access to the lists, a description of controls on access to the lists, and copies of the lists themselves.
- A list of joint ventures or any other businesses in which the adviser or any officer, director, portfolio manager, or trader participates or has any interest (other than their employment with the adviser), including a description of each relationship.
There have been a number of SEC enforcement actions brought alleging insider trading and market manipulation in connection with offerings of private investments in public equities (“PIPEs”). The Request Letter asks for a significant amount of information related to PIPEs in which the adviser’s clients have invested, including detailed trade information for all PIPE transactions in spreadsheet format, a list of all PIPE transactions offered during the examination period, all confidentiality agreements entered into, a journal of securities borrowed by the adviser’s clients in connection with PIPEs offerings, and a description of the services and compensation of finders, brokers, promoters or other third parties involved with PIPEs offerings in which the adviser’s clients invested. For PIPE transactions offered to the adviser that the adviser declined to participate in, the Request Letter asks for the justification for the decision not to participate. The Request Letter also requests information on any compensation received by the adviser, its access persons, or affiliates involved with the PIPE transactions.
The SEC staff has typically requested information about trade allocations, best execution, soft-dollar arrangements and other brokerage issues. The Request Letter expands the trade allocation information requested to cover secondary offerings in addition to initial public offerings. The name of the trade order management systems used by the adviser is requested, along with a description of any circumstances under which a portfolio manager could trade outside the system. Additional requests in the Request Letter include:
- The hard dollar cost of each product or service for the current year to date and the previous year.
- Information about commission recapture programs.
- A list of electronic communications networks ("ECNs") used to execute trades during the examination period.
- A copy of any commission schedules that were in effect, including the use of ECNs.
- A written description of any step-out arrangements used by the adviser, and the purpose of such arrangements.
- Information about broker-dealers that have referred clients or investors to the adviser, including a list of all business relationships with such broker-dealers.
Conflicts of Interest
The Request Letter expands the scope of information sought with respect to conflicts of interest, asking for:
- A description of the process for obtaining client approval of principal transactions, such as electronic delivery, and an indication of the frequency of the review process for principal transactions.
- Additional information concerning certain service providers' arrangements with an adviser (for instance, the Request Letter asks if any broker-dealer or registered representative used by the adviser has an investment in any pooled investment vehicle advised by the adviser).
- A “catch-all” request asks whether there are any arrangements that the adviser has with any broker-dealers and/or registered representatives during the period that are otherwise not covered by the request.
- A list of all independent research providers and a list of the issuers that the research providers provided research on, including details about the format and date of delivery of the research, and an indication of whether the research provider and its affiliates are investors in pooled investment vehicles managed by the adviser or its affiliates.
The Request Letter asks for a list of all “one-on-one” meetings with public company management at conferences sponsored by brokers, including the date of the meeting, the names and titles of employees who attended, the name of the broker, and the names of the corporate insiders and their companies. In light of the prevalence of such meetings and conferences, this request may create a significant new record keeping step for many firms.
Portfolio Management Processes and Structure
The Request Letter asks for identification of all individuals involved in the portfolio management process. It asks for a list of portfolio managers who make investment decisions for more than one type of client (e.g., funds, advisory clients, hedge funds, etc.), along with an identification of the clients.
The Request Letter asks for a list of the adviser’s ten most profitable positions and ten least profitable positions during the examination period.
Short Sales/Futures and Options/Derivatives
The Request Letter asks for a description of how the following investment strategies are monitored for compliance: short sales, futures and options, derivatives and other forms of leverage.
Sub-Advisers/Fund of Funds Managers
The Request Letter asks for a description of all business activities (e.g., securities-lending, client referrals, principal trades, etc.) between the adviser and/or its affiliates and the money managers and/or their affiliates recommended by the adviser to manage client portfolios. The Request Letter also asks: (1) if the adviser has access to the clients’ accounts managed by sub-advisors; (2) for documentation of due diligence reviews of recommended money managers; and (3) for information about any directed brokerage arrangements with clients.
A list of valuation methods is requested for each type of security held by client accounts during the examination period. A list of all securities internally priced by the adviser also is requested. With respect to securities that were fair-valued, the Request Letter asks for detailed data in spreadsheet form as to the date of acquisition, purchase price, basis for determining value, and copies of any relevant valuation committee minutes. Also requested is information about any changes in the pricing of such securities and data with respect to any sales of such securities. Finally, the Request Letter asks for a list of securities for which the price provided by a pricing service was overridden, and the justification for such override.
With respect to private funds and funds of funds, the SEC staff asks that the custodian of each such fund provide a confirmation of all positions, including cash balances and short positions, as well as any loans or other creditor positions it has outstanding with the fund. Access to the reconciliation of portfolio securities transactions for the funds/clients during the examination period also is requested, as is a list of the adviser’s employees who have the authority to order clients’ funds or securities withdrawn from the client’s accounts.
The SEC staff appears increasingly interested in performance advertising and marketing. The Request Letter asks for detailed information about any benchmark index, including any internally constructed benchmark, to which fund performance has been compared. Dealer-only pieces used during the examination period are requested. The Request Letter asks for a list of registered representatives who have referred investors or clients to the adviser during the examination period and for the terms of the compensation, along with a list of all entities involved in marketing and distribution of the funds. A list of all RFPs completed by the adviser during the examination period also is requested.
Prior request letters had sought exception reports, but the Request Letter expands the focus on such “outputs” of the compliance program. There is a general request for a copy of a completed exception report to demonstrate the effectiveness of the compliance program for each area referenced in the Request Letter. Additional specific requests for compliance reports include requests for:
- A list of any reports prepared by external auditors relating to the adviser’s privacy compliance efforts.
- A list of compliance breaches involving PIPEs.
- A schedule of internal audit reviews.
- A list that describes any mandatory training of personnel regarding compliance issues.
- A list of employees subject to disciplinary action, including the reason for the action and the date.
- A log, if maintained, of any shareholder correspondence for advisory clients and hedge fund investors during the examination period.
- Documentation to substantiate the adviser's or fund's oversight of service providers.
- Information with respect to any compensation, whether direct or indirect, received by the adviser from any of its client's service providers.
Advisers to Pooled Investment Vehicles
The Request Letter asks advisers to pooled investment vehicles to provide:
a) a complete description of all positions held in side pockets or special situation accounts, with their valuations on the date of the related calculation of net asset values;
b) a list and description of all side agreements/arrangements in which investors are participants; and
c) a description of business activities of the adviser affiliated with each fund that are not covered by the required compliance programs of such advisers and oversight by the CCO.
If someone other than the adviser maintains records regarding interests of investors in a pooled vehicle managed by the adviser, the Request Letter asks for confirmation from that entity of:
- the total number of shares outstanding if the fund is in corporate form;
- the total number of limited partners; and
- the most recently calculated value of each limited partner’s interest in the fund.
Alternative Investment Vehicles
A list of all privately offered hedge funds in which the adviser’s clients or funds purchased an interest during the examination period is requested. Sections 13 and 16 Filings All Schedule 13D, 13G and 13F filings, as well as filings on Forms 3, 4, and 5 are requested, in electronic format.
Bankruptcy Workout-Related Investments
The Request Letter asks advisers to identify any securities held in a client account during the past two years that were involved in a bankruptcy workout. In addition, it asks for identification of all accounts that held equity or fixed income positions in those issuers at the time of bankruptcy filing are requested, with portfolio holdings reports.
Code of Ethics
The Request Letter also seeks documentation from the adviser demonstrating how its code of ethics on personal trading is made available to the public. (Presumably, this refers to an adviser’s obligation to include disclosure in its Form ADV Part II about making its code of ethics available to investors.)
Registration and Disclosures
The Request Letter also asks the adviser for the names and titles of the individuals responsible for updating and approving disclosure documents, including the Form ADV, and the names and titles of the individuals responsible for ensuring compliance with the firm’s policies and procedures.
With respect to proxy voting, the Request Letter asks whether or not the adviser has delegated proxy voting authority to a third party, for the name of any such third party, and for a copy of any policy addressing who is the responsible party for voting the proxies with respect to securities on loan.
Gifts and Entertainment
The SEC staff had previously asked for logs of gifts and entertainment received by the advisers. The Request Letter asks for logs of gifts and entertainment provided by advisers during the examination period.
The Request Letter asks for a list of all political and charitable contributions made by the adviser or any of its related persons (e.g., its officers and non-administrative employees).
Privacy of Client Information
The Request Letter also asks for documentation regarding encryption of electronic customer information located in or transmitted through systems or facilities vulnerable to access by unauthorized individuals. This includes email sent to places beyond the adviser’s control and any disks stored at outside vendors’ storage facilities.
The Request Letter being used by the SEC’s New York Regional Office expands the scope of the information requested at the outset of a periodic examination of a registered investment adviser. While some of the additional information requested may be maintained in the ordinary course by many registered advisers, other such information may not be maintained and may not even be available. It may be difficult for firms, and particularly smaller firms, to pull together the responsive information in the two-week period from the date of the Request Letter. It is unclear whether this form of the Request Letter will continue to be used, and how the SEC staff will respond to advisers whose books and records do not capture the information requested. The staff of the SEC appear willing to discuss the scope of these requests if there are items that would be unduly burdensome. Advisers should review their compliance programs to understand the applicability of each of the new issues and areas of focus to the adviser’s particular business.