SEC Lays Out Advisor Exam Priorities for 2013

Marketing/Performance

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. Conflicts of Interest Related to Allocation of Investment Opportunities

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

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.