How to cope with an SEC exam

Going through a Securities and Exchange Commission exam has become an unavoidable part of managing a private investment vehicle.

Nearly all private fund advisors have gone through at least one exam since 2012, when registration became compulsory for advisors with at least $150 million in assets under the Investment Advisers Act of 1940. While general partners have become familiar with the process, they need to make sure they are always prepared.

“You should be ready for an SEC exam at all times,” says Todd Cipperman, founding principal at Cipperman Compliance Services, an outsourced compliance services firm. “It means the documents should always be ready to go. Make sure you’re doing your annual testing, your compliance review.”

If an advisor has deficiencies from past exams or complaints, it must have addressed them. He adds: “your marketing materials are one of the first things that the SEC looks at. They shouldn’t be misleading.”

The chance of advisors going through a second or follow-up exam has risen under the new administration. In June 2017, shortly after he was named chairman, Jay Clayton testified to Congress that the SEC planned to increase its examination of investment advisors by 20 percent in fiscal year 2017 and by another 5 percent in fiscal year 2018.

“Registered investment advisors now manage more than $70 trillion in assets, which is more than three times 2001 levels,” he said before the Senate’s subcommittee on financial services and general government committee on appropriations.

In 2016, the SEC reassigned about 100 staff to the national examination program’s investment advisor examination unit, which along with the introduction of efficiencies will eventually contribute to that 20 percent increase, he said.

“I expect that for at least the next several years we will need to do more each year to increase the agency’s examination coverage of investment advisors in light of continuing changes in the markets,” Clayton added.

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Although the way exams are being conducted has slightly evolved in the past six years, the goal has remained the same: to make sure advisors follow securities law and respect their fiduciary duty so that investors are protected.

The SEC declined to comment for this article but a person familiar with the Office of Compliance Inspections and Examinations notes that it typically looks for a detailed overview of how a business operates and wants to identify where risk lies at a specific firm.

To prepare themselves, fund advisors can get information on specific areas of focus, which the OCIE publishes on a yearly basis and which in recent years have included cybersecurity, anti-money laundering, conflicts of interest, fees and expenses, co-investments and valuation. However, the list of priorities isn’t always specific to private funds.

Jason Brown, a private investment funds partner with Ropes & Gray, adds that fund advisors can obtain information from their external counsel who may have worked on previous exams with other clients.

“They should have a recent request letter, they should prepare a slide deck for their presentation in advance, but most importantly, they should be aware of the key issues in their business,” he says.

This helps advisors understand what the SEC is looking for and even possibly collect documents in advance and be ready to go.

Usually an exam starts with a short phone call from the SEC letting an advisor know the Commission will be conducting an exam and sending a request letter within the next 24 hours or so. The requests in the letter vary greatly in length and the advisor has about one to two weeks to respond. This stage of the process has remained more or less the same since exams began.

However, Brown notes a relatively new step for the SEC – which happens often, but not always – is to set up a second much longer phone call with the firm’s chief compliance officer, the founder and the general counsel, before the on-site portion of the exam. “That phone call is pretty substantive, often a couple of hours,” he says. “The SEC digs in deep in that call.”

This phone call is followed by a second request for documents, with the next step a visit to the firm’s premises. “By the time the SEC comes, it could be four to six weeks from the beginning of the exam,” he adds. The goal of the second phone call is to help the SEC when it arrives.

While the length of the on-site portion of the exam depends on variables including the complexity of the organization, on average, they last about a week. When the exams started, the Commission could be on site for months, particularly for large firms.

After the on-site piece, there’s a series of requests and responses that go back and forth. Again, the number of follow-up requests can vary widely, depending on the examiner and the issues arising. It’s also not uncommon for the SEC to stay silent in between requests, sometimes for a couple of months.

This is the most common procedure but the format of exams can differ – for example, exams can be done solely by mail and phone calls.

Cipperman adds that he has seen an increase in the number of exams conducted.

“We’re seeing probably the same number of traditional exams, which last about a week, but we’re also seeing more higher-level exams such as phone exams or exams that last only two days,” he says. “They are more targeted-risk exams but preparation should be the same.”

At the end of the visit, the agency will conduct an exit interview, giving advance notice of what will be in the comment letter. The exit interview is also a chance for the Commission staff to confirm the facts they have gathered.

From the first phone call to the exit interview, the whole process can take on average six months. It has taken up to a year with some advisors but that includes months of lull when the SEC might not be corresponding with the advisor.

“The average private fund exam lasts about six to eight months,” says Eva Carman, a partner with Ropes & Gray and co-chair of the firm’s securities and futures enforcement practice. “Funds that have novel structures or products tend to last longer. The standard routine private equity exams have become shorter over time.” Within a few business days after the exit interview, the SEC sends the advisor a deficiency letter, explaining areas that needs improvement.

“The deficiency letter touches on the areas where the SEC believes you haven’t complied with the law,” Brown says. An advisor generally has 30 days to reply to the letter, but can arrange for an extension if they need more time to address the issues. The reply can take many different forms. “You’re telling the SEC what you are going to do and/or whether you disagree with the SEC’s position.”

The person familiar with OCIE says that a good practice is for firms to start addressing a known issue with the correct action before the exam is over.

The enforcers

There’s also the possibility of being referred to enforcement if the OCIE considers an advisor has infringed the law. Enforcement is a completely separate process.

The SEC exam has become much smoother and the different offices are much better co-ordinated, experts say, resulting in exams throughout the country looking more uniform than they used to be in the early days.

“The examiners are up to speed,” says Bronwyn Bailey, vice-president of research and investor relations at the American Investment Council, which represents the GP community. “They’re much more educated about private equity than when the presence exams started. Everyone has become a little smarter on this topic.”

She adds that the industry has matured, and GPs have hired compliance consultants or their own CCOs. “They now know what to expect when the SEC comes to the door,” she says.