Exam recap: What’s hot during OCIE exams

Be aware that examiners may question your logic for placing clients in certain share classes

Don’t expect the SEC to admit to conducting new sweep exams but sources are telling sister publication RCW that OCIE’s looking at compliance with the liquidity risk management rule and how advisor’s handle sweep accounts.

Yes, sources report that OCIE has launched a sweep of sweep accounts – where advisors often park their clients’ cash. Examiners, we’re told, want to see if an advisor has considered a better cash equivalent product for clients and are aware that bank affiliates are making interest on those accounts.

The second ongoing sweep asks advisors to share copies of their compliance P&Ps for the liquidity risk management rule as well as an example of a liquidity report, sources say.

The merry-go-round spins

RCW also hears of two other topics that OCIE’s looking into. One is use of alternative data. “It’s becoming much more mainstream in investment management,” one source said. The concern is that the data could be misused to trade on material, non-public information. Shops that use such data would be wise to have compliance P&Ps to govern their use, as well as to do some testing to confirm the data aren’t being misused.

Another OCIE topic is how firms will be handling the migration away from LIBOR. The expectation is that firms that don’t use an alternative to the London Interbank Offered Rate benchmark may have to re-paper their contracts when LIBOR fades away.

A CCO boasted to RCW that her firm received a no-findings letter after its recent exam, “which I’ve been wishing for my entire [professional] life,” said the veteran of many SEC exams.

“Examiners are looking for two things. Outright fraud or incompetence. And they’ll know within the first hour” on site if your firm comes up short on either one, said the CCO. Once satisfied neither problem resides at a firm, expect examiners not to dig too deeply and to move on to the next registrant as OCIE attempts to seal as many exams as possible, the CCO added.

Of course, this viewpoint could be shaped by the region where you live and the makeup of your exam team.

Best execution

A CCO reported that examiners from the Boston region were “coming down” hard on advisors’ best ex analysis. A major takeaway from this CCO’s recent exam is that your best execution committee needs to consider qualitative data (such as share class options) besides just quantitative factors (like cost of trades, timing of trades) in its best ex analysis.

Another exam, this time in the south, attests that the SEC is not finished with the mutual fund share class allocation issue. Be sure to have a process in place to regularly monitor what share class makes the most sense for your clients.

“It’s not a one and done” analysis, said Karen Huey of Professional Compliance Assistance in Woodstock, Georgia. If a client’s account experiences few trades in a year, the cheapest share class may not make sense for that person, she argues. Be aware that examiners may question your logic for placing clients in certain share classes. You’d be helped by having documentation that weighs the frequency of trading in a client’s account, she added. Return periodically to your analysis as trading trends change during the year.

We’ve noted that custody remains an OCIE hot topic. A CCO in the Midwest confirms that custody occupied a major portion of the IA’s recent exam.

Examiners wanted the firm to verify receiving account addresses for all money transfers, even journals. They expected custody P&Ps to state that the firm reviews receipt addresses for standing letters of authorization. “That was a big deal for them,” said the CCO. You may consider adding P&P language stating that you review receipt addresses for journals, wires, ACH requests and checks. “They want that to be specifically stated” in firm P&Ps, the CCO quoted examiners as saying.

Lightning fast trade analysis

An advisory firm that went through an exam out of the SEC’s Philadelphia Regional Office reports examiners focused on marketing, private funds, custody and trading. The CCO was impressed at the speed the examiners demonstrated when doing a “forensic analysis of the trade blotter.” Questions shot back fast, especially around cross-trades. “They were identifying [transactions] quickly,” noted the CCO.

Examiners sought financial statements, ledgers and shareholder reports for the private funds the advisor manages. They did “a very thorough review of private funds,” said the CCO. Expect questions about your basis for calculating fees.

More than one source warns that if your calculations and documentation around fees aren’t nailed down, you may well be directed to return money to clients. One exam ended with the advisor being told to distribute hundreds of thousands of dollars back to clients. The number was reduced only after the advisor challenged the assessment.

Katie Mogan, a senior compliance consultant with SEC Compliance Solutions in Boston, told of one exam in which the SEC required a small advisor to refund fees charged between the time a client terminated and the advisor unlinked from the client’s custodial account. This proved to be a big expense for the firm. Have a process to quickly pro-rate, stop or refund such fees after a client terminates, she advises.

Affiliate transactions

Multiple sources recount how examiners drilled down into Investment Company Act Section 17 during recent exams. Examiners took “a very rigid view of the law,” stated a CCO. Section 17 broadly prohibits affiliated transactions.

Ensure your P&Ps for Section 17 compliance are working, that you’re “adequately” monitoring them and amending the procedures as your organization grows and adds affiliates. “This is an area where the CCO should really pay attention to when they’re going through their annual review,” stressed one source. A CCO added that if you have any doubts about your Section 17 compliance, consider asking the SEC for exemptive relief.

Another area to step lightly is with proxy disclosures. Mogan relays how one advisor drew examiner questions for voting in opposition to management when its proxy P&Ps disclosed that the advisor votes with management. The firm lacked documentation to explain why it ignored its own P&P.

Tip: Create an Excel spreadsheet to document when you vote contrary to your own proxy P&Ps, recommends Mogan.

A new document request letter obtained by RCW includes a robust example of how the examination team would like to see a firm’s trade blotter laid out. Valuation and portfolio management sparked examiner interest. They wanted to see “monthly performance returns of each fund/client as well as the returns for the accounts’ comparable indices or benchmarks.”

Three inquiries dealt with crypto assets. Examiners wondered if the firm knew of any staff that was managing or recommending the assets “through their outside business activities.”

Tip: Go through a recent OCIE document request letter and be sure the top dozen or so topics cited happen to also appear in your day one PPT presentation for examiners. A CCO reported this seemed to impress examiners.

Pay attention to OCIE’s recent risk alerts and annual exam priorities “because they really do tie to what they’re examining,” Huey recommends.

This article originally appeared in sister publication RCW