Best Practices for Preparing for SEC Examinations

Best Practices for Preparing for SEC Examinations

January 17, 2024

In a panel discussion during the Stout Summit: Investment Funds and Alternative Assets 2023, Joel Cohen, Managing Director in Stout’s Disputes, Claims, & Investigations group and New York Regional Leader, led a discussion on the current state of regulation, enforcement, and litigation as it relates to private funds.

The following excerpt has been edited for length and clarity. The excerpt features the insights of Carmen Lawrence (Partner, King & Spalding) and Colleen Kilfoyle (Managing Director and Head of Litigation, Sculptor Capital).

Joel: What are some best practices for preparing for examinations?

Carmen: It’s crucial to prepare adequately. Examinations provide the SEC with insights into an entity’s culture of compliance, impacting the scope and timing of future exams.

The SEC begins preparing for an exam by examining various aspects, including your website; tips, complaints, and referrals within their system; social media presence; articles about your entity; your Form ADV; and other relevant filings. To be adequately prepared, it’s vital to stay informed about the SEC’s expectations, which they communicate through speeches, enforcement actions, and risk alerts.

Moreover, understanding the interpretation of the standard of conduct for investment advisors, as outlined by the Commission, is pivotal. This interpretation encompasses the obligation of fiduciary duty, of loyalty and care, and other essential aspects that the SEC considers when evaluating compliance matters.

You need to ensure that your policies and procedures, as well as your internal controls, align with your business operations. Many smaller firms may start with off-the-shelf policies and procedures, which is a reasonable starting point. However, these should be customized to fit your specific business needs.

Equally important is making sure that your employees are well-versed in your legal obligations and your policies through comprehensive training. Additionally, it’s crucial to maintain your books and records in an orderly fashion.

Once you’re notified of an impending examination, it’s essential to understand the type of examination, such as whether it’s a presence exam, especially for new registered advisors, a sweep exam focused on specific risk areas, or a routine or for-cause examination. Assign a responsible person, typically a senior member of the compliance or legal department, to manage the process, and prepare your C-suite personnel for the kickoff interview. You should be able to articulate their roles and responsibilities and answer questions related to the areas identified in your notice.

Prepare your personnel, such as notifying your office or areas where examiners will be present. This ensures that people are cautious about what they say, even in public spaces like restrooms and lobbies. Additionally, you should review prior deficiencies, which are sometimes left unaddressed. Examiners often check whether you’ve complied with previous exam deficiencies, so be ready to explain any delays in remediation.

Manage the examination process and provide comfortable and adequate space for examiners. Inadequate facilities or uncomfortable conditions can hinder the process rather than expedite it.

Analyze examination requests for common themes can help identify areas of focus or concerns, allowing you to address them early on. If you suspect that examiners have concerns, don’t hesitate to engage outside counsel. They can help clarify any misunderstandings or misguided paths examiners may be pursuing.

Respond comprehensively to deficiency letters. Focus on explaining why you believe you didn’t violate the Advisors Act and what steps you’ll take to rectify the situation. This comprehensive response is essential if the examination is referred to enforcement. While not all examinations result in referrals, it’s important to be prepared for the possibility.

Joel: How does preparing for an exam happen in practice?

Colleen: In practice, I recommend conducting mock exams with a third party, including document collection, interviews, and analysis. Legal oversight can help maintain privilege and ensure a thorough evaluation.

Additionally, utilizing your internal audit team for special audits in areas of examiner focus can help identify weaknesses before facing regulators. Regular policy and procedure reviews, coupled with approval processes for material changes, ensure that your policies evolve with your business and are well understood by key personnel.

A critical question arises regarding whether to self-report identified issues to examiners upon their arrival or wait until they discover them. This decision can be complex and requires careful consideration.

A significant aspect of the discussion regarding whether to self-report issues revolves around documenting the efforts made in remediating issues, with your compliance team being responsible for this documentation. This approach helps avoid waiving privilege if you decide to self-report and ensures that you’ve fully and contemporaneously documented your actions. To put it simply, if you don’t write it down, you haven’t done it, which underscores the importance of thorough documentation.

Joel: What are the SEC’s upcoming examination priorities?

Carmen: Now, regarding the SEC’s examination priorities, they recently issued their 2024 exam priorities, aligning them with their fiscal year end to provide advanced notice to regulated entities.

These priorities cover a wide range of areas for both investment advisors and advisors to private funds.

For all investment advisors, the SEC’s focus is on assessing adherence to the duty of care and duty of loyalty. This includes evaluating how investment advice is provided concerning specific products, strategies, account types, and client types. They will particularly scrutinize complex products, derivatives, illiquid products, unconventional strategies, and services to senior clients. The SEC is interested in understanding how firms determine if investment advice aligns with the client’s best interests, such initial and ongoing suitability determinations, seeking best execution, cost-benefit assessments, and management/disclosure of conflict of interest.

Conflicts of interest are a pervasive theme across various aspects of their examination priorities. They will also assess the adequacy of conflict-of-interest disclosures made to investors and ensure that all material facts are provided to enable informed consent.

Compliance programs, including their alignment with business, compensation structures, market risk, and marketing rule compliance, valuation, and safeguarding controls will be examined.

For advisors to private funds, additional areas of focus include portfolio management risks related to market volatility and interest rates, adherence to contractual requirements involving limited partnership advisory committees, accurate calculation and allocation of fees and expenses, due diligence practices in private equity and venture capital, conflicts of interest disclosure, custody rule compliance, and adherence to Form PF and related policies and procedures.