More On Legal & Compliancefrom The Advisor's Professional Library
- Client Communication and Miscommunication RIA policies and procedures must specify what type of communications should be retained. The safest course of action is for RIAs to retain all communicationsto clients, from clients, and about client accounts. To comply with fiduciary obligations, communications must be thorough and not mislead.
- Books and Records Rule Thorough and complete books and records enable RIAs to demonstrate that they have fulfilled their fiduciary obligations to clients and complied with applicable rules and regulations.
The Securities and Exchange Commission released late Thursday its examination priorities for this year, which cover a wide swath of issues including fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest and technology controls.
Specifically for advisors and broker-dealers, the agency also highlights the “ongoing risks”—which include safety of assets and conflicts of interest—and “emerging risks”—such as new advisor registrants as well as dually registered advisors—the staff will focus on.
Carlo di Florio, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), said in a statement that the exam priorities reflect areas that the SEC “perceives to have heightened risk.”
The priorities cover a wide range of issues at financial institutions, including broker-dealers, advisors, clearing agencies, exchanges and self-regulatory organizations, investment companies, hedge funds and private equity funds and transfer agents, di Florio said.
Priorities for advisors and broker-dealers include:
— For investment advisors and investment companies–presence exams for newly registered private fund advisers, and payments by advisers and funds to entities that distribute mutual funds;
— For broker-dealers—sales practices and fraud, and compliance with the new market access rule.
For advisors specifically, the exam guidance states that SEC staff anticipates that the “ongoing risks” selected as focus areas for investment advisors and investment companies in 2013 will include:
As it has in the past, the staff will continue to utilize a risk-based asset verification process to confirm the safety of client assets and compliance with custody requirements. The staff will review the measures taken by registrants to protect client assets from loss or theft, the adequacy of audits of private funds, and the effectiveness of policies and procedures in this area. Recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under Advisers Act Rule 206(4)-2.
Conflicts of Interest Related to Compensation Arrangements
The staff will review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present. These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties.
Marketing and performance advertising is an inherently high-risk area due to the highly competitive nature of the investment management industry. Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices. The staff will also focus on the accuracy of advertised performance and also review changes in advertising practices related to the JOBS Act, which requires modification of the rules restricting general solicitations.
Advisers managing accounts that do not pay performance fees (e.g., most mutual funds) side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face unique conflicts of interest. While reviewing portfolio management practices, the staff will confirm that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts, such as certain private investment vehicles, and registered investment companies, or other non-incentive fee-based accounts, with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.
Fund governance and assessing the “tone at the top” is a key component in assessing risk during any investment company examination. The staff will confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.
New and emerging risks for investment advisors and investment companies, according to the SEC, are as follows:
New Registrants—Since the effective date in early 2012 of Section 402 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, approximately 2,000 investment advisers have registered with the SEC for the first time. The vast majority of these new registrants are advisers to hedge funds and private equity funds that have never been registered, regulated, or examined by the SEC. The IA-IC Program therefore intends to launch a coordinated national examination initiative designed to establish a meaningful presence with these newly registered advisers. The initiative is expected to run for approximately two years and consists of four phases.
Dually Registered IA/BD—Due to the continued convergence in the investment adviser and broker-dealer industry, the IA-IC Program will continue to expand coordinated and joint examinations with the BD Program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals. For example, it is not uncommon for a financial professional to conduct brokerage business through a registered broker-dealer that she does not own or control and to conduct investment advisory business through a registered investment adviser that she owns and controls, but that is not overseen by the broker-dealer. This business model presents multiple conflicts.
“Alternative” Investment Companies—The investment advisor/investment company (IA-IC) Program is focusing on the growing use of alternative and hedge fund investment strategies in open-end funds, exchange-traded funds (ETFs) and variable annuity structures. More specifically, the staff will assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel and back offices are staffed, funded and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
Payments for Distribution in Guise—The IA-IC Program is focusing on the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same. These payments go by many names and are purportedly made for a variety of services, most commonly revenue sharing, sub-TA, shareholder servicing, and conference support. The staff will assess whether such payments are made in compliance with regulations, including Investment Company Act Rule 12b-1, or whether they are instead payments for distribution and preferential treatment.