Preparing for an SEC Examination June 22, 2010 Paula Bosco, Chief Compliance Officer, New Mountain Capital Alan Halfenger, Chief Compliance Officer, Bain Capital Theodore E. Eichenlaub, Partner, ACA Compliance Group Nothing herein should be construed as legal advice or as a legal opinion for any particular situation. Information is provide d for general guidance and should not be substituted for formal legal advice from an experienced securities attorney. “A strong and reinvigorated SEC will be on the beat like never before to catch wrongdoers.” -Mary Schapiro, SEC Chairman Source: Practicing Law Institute’s “SEC Speaks in 2009” Program, Washington, DC. February 6, 2009. Agenda Types of Exams being Conducted Staying Prepared before an Exam is Announced Preparing for an Upcoming Exam What to do during an Exam What to do after an Exam Current Exam Focus Areas Types of Examinations Being Conducted The SEC’s Office of Compliance Inspections and Examinations is currently conducting the following types of examinations of its registrants: 1. Cause Examinations 2. Frequent Routine Examinations of Higher-Risk Firms 3. Examinations of Lower-Risk Firms on a Random Basis 4. Sweep Examinations 5. “Get to know you” Exams/RAVEs Cause Examinations • Often referred to as “TCR” examinations (Tips, Complaints, and Referrals) • Can be triggered by a number of factors, including: – Complaints from clients/investors – Complaints from current/former employees – Media reports – Findings from other SEC examinations (e.g., e-mails) Cause Examinations • The SEC has stated it will increase the amount of cause examinations conducted by its Staff • Characteristics of cause examinations: – Numerous requests targeted at suspected problem areas – Firms receive little, if any, notice: “We simply show up, because if there are allegations of wrongdoing we don’t want to give firms a good deal of lead time to clean up” -Gene Gohlke, Associate Director, SEC’s Office of Compliance Inspections and Examinations Source: Practicing Law Institute Investment Management Conference, April 9, 2010, quoted in Investment News. Frequent Routine Examinations of Higher-Risk Firms • The SEC has stated that it will conduct frequent (every three years) examinations of firms that it considers higher risk. Some determinants of risk include: – Assets under management – “Higher risk” characteristics, such as industry affiliations, solicitation arrangements, managing LP’s, having custody of client assets, etc., as disclosed in Part I of a firm’s Form ADV – Whether a firm is newly registered – Risk rating assigned following previous SEC examination Frequent Routine Examinations of Higher-Risk Firms • Characteristics of routine examinations of higher-risk firms: – Firms may or may not be given notice – General Document Request List, possibly with some additional items relating to the firm’s specific risk areas • The SEC’s goal has been to examine 1/3 of higher-risk firms every year. However, in 2009, the SEC only examined 22% of higher-risk firms. Examinations of Lower-Risk Firms on a Random Basis • The SEC has stated that it will still examine lower-risk firms on a random basis to ensure that all firms get examined • Firms will generally be given notice • Examinations will be general in nature • If strong controls are found, these types of examinations should require less on-site time - generally dependent on the size and complexity of the firm Sweep Exams • The SEC has reduced the number of sweep exams in recent years • The process of recent sweep examinations: – An SEC Regional Office sends a targeted request for documents to anywhere from 10-50 firms that it believes engage in whatever practices are being examined by the sweep – Based on firm responses, SEC staff may do an on-site review of a selected group of advisers – Examination will focus on targeted area, but may expand • The SEC’s New York office recently sent a shortened, targeted request list to approximately 50 advisers in the region who had never been examined by the SEC. The advisers were given 10 days to respond. Get to know you/RAVES • Short, one-day or half-day examinations • The purpose is to assess the risks of firms with which the SEC is not familiar • Limited in scope • Typical for newer registrants that have not been previously examined Other Exam Issues and Trends • Fewer overall exams but longer, more in-depth exams • The SEC is making an effort to hire examiners with expertise in and familiarity with complex financial instruments, investment strategies, etc. • Increase in surprise exams • Examiners will be more aggressive and skeptical than before: “We are approaching firms with professional skepticism . . . At the end of the day, we are not paying a social call.” -Thomas Piccone, Assistant Regional Director, SEC’s Denver Regional Office Source: SEC Staff Provide Sneak Peak at 2010 Exam Priorities. Ignites.com. January 29, 2010. Agenda Types of Exams being Conducted Staying Prepared before an Exam is Announced Preparing for an Upcoming Exam What to do during an Exam What to do after an Exam Current Exam Focus Areas Compliance/Policies and Procedures Manual • Most important document to provide to SEC • SEC compares practices to written policies and procedures • Policies and procedures should be concise • Not desk-top procedures • No regurgitation of rules and regulations with generic “we will act in clients’ best interest” policy • Not a static document – Keep the Manual up to date! Documentation of the Annual Compliance Program Review • A focus area for SEC examiners • A thoughtful review will assist advisers during examinations • Written documentation is not required by the rule, but reports are being completed by peers and it is probably an expectation of the SEC • Documentation includes: – Written report – Memoranda to senior management – Amendments to policies and procedures – Documentation of presentation to senior management Internal Control Response • Part of risk-based examination methodology • First part of SEC document request list • Reflection of the “tone at the top” and strength of adviser’s procedures to guide its advisory activities “So we’re very much interested in understanding what are the problems a firm has found, how have those problems been resolved, what sort of escalation procedure is in place for dealing with exceptional types of problems … And we do that as a way of getting additional assurance that, OK, the program … appears to be effective, it’s working, it’s identifying issues. And that those issues are being dealt with. It’s … to help us gauge the effectiveness of the firm’s compliance program.” -Gene Gohlke, Associate Director SEC’s Office of Compliance Inspections and Examinations Source: What Matters Most to SEC Examiners, Ignites.com, December 14, 2007. Past Deficiency Letters • A focus area for SEC examiners • Review any past correspondence from the SEC and your responses • Reconcile your responses to your current practices and thoroughly review any differences • Not a “3 strikes and you’re out” mentality any longer! Other Helpful Hints • Place documents that rarely change (e.g. offering materials, contracts, organization charts, etc.) in a central compliance file for easy access to the information • Review current SEC document request lists • Stay abreast of hot topics • Conduct Internet searches on your firm • Perform the same tests the SEC performs • Undergo a Mock SEC Exam • Should a firm self-report issues? Agenda Types of Exams being Conducted Staying Prepared before an Exam is Announced Preparing for an Upcoming Exam What to do during an Exam What to do after an Exam Current Exam Focus Areas SEC Document Request List • Review the document request list to determine any focuses • Assign out portions of the document requests to appropriate individuals • Organize each response in separate folders numbered to correspond with the document request list • Draft an aggregate formal response to all items that are “Not Applicable” Designate a Contact Person • Appoint one person to administer the examination – Typically CCO or other senior member of Compliance Department • This person will be responsible for: – Gathering information requested by the SEC – Reviewing documents before they are produced to assure that they are accurate and that irrelevant or privileged documents are not inadvertently produced – Maintaining a record of all documents requested by the SEC and the documents produced in response to those requests – Arranging for, attending, and keeping detailed notes of employee interviews conducted by SEC staff – Communicating with the SEC before, during, and after the exam More Preparation Tips • Arrange for comfortable facilities for the staff – Internet, telephone, and printer access • Inform and prepare employees – Consider and assess who the examiners may interview – Conduct mock interviews • Review past deficiencies and ensure they have been addressed • Review policies and procedures contained in the Compliance Manual to refresh understanding of responsibilities • Review compliance “hot topics” and recent regulatory developments – consider any potential focus areas Types of Exams being Conducted Staying Prepared before an exam is Announced Preparing for an Upcoming Exam What to do during an Exam What to do after an Exam Current Exam Focus Areas Introductory Meeting • Standard SEC request: – “Soon after the staff begins its fieldwork, the staff would like to speak with at least one member of senior management to obtain an overall view of the Adviser’s organization, business, and control environment and compliance culture.” • Every adviser should take advantage of this opportunity to demonstrate to the SEC its “culture of compliance.” This internal controls presentation (see slide 16) should focus on: – Compliance resources – Lines and frequency of reporting – Adviser’s responses to compliance violations – Openness with regulators Introductory Meeting, cont. • Senior management’s commitment to compliance is an important aspect of any firm’s culture of compliance. A strong “tone at the top” can be demonstrated by: – Senior management’s presence at the introductory meeting – Regular communication of this commitment to employees and any associated documentation • Attendance at training sessions • Periodic emails to employees “Berkshire can afford to lose money, even lots of money; it can’t afford to lose reputation, even a shred of reputation…There is plenty of money to be made in the center court. There is no need to play around the edges.” -Warren Buffett, Chairman of Berkshire Hathaway “The Oracle of Omaha’s Latest Riddle.” New York Times. April 10, 2005 Establish a Good Working Relationship with the Examiners • Have the contact person touch base with the examiners at least twice per day to answer questions and discuss outstanding requests • Throughout the exam, educate the examination staff and encourage open dialogue • Remain courteous throughout the exam and avoid confrontation and intimidation “We cannot allow examiners to be intimidated. I have been very disturbed at how some law-breakers, people running serious frauds, tried to intimidate SEC examiners . . . this conduct is so unacceptable and abnormal that you can expect examiners to view it as a red flag suggesting there are substantive problems at the firm. Trying to cover up violations with intimidation will not work.” -John Walsh, Acting Director of SEC’s Office of Compliance Inspections and Examinations Remarks at 2009 NSCP National Meeting. Philadelphia, PA. October 5, 2009. Responding to On-Site Document Requests • Expect additional document request lists after the initial document request list • Attempt to negotiate down overly burdensome requests on initial and supplementary document request lists • Ensure that the Contact Person notifies Department Heads and others in a timely manner in order to produce the documents requested • Prompt, clear, and complete responses to document requests will typically lead to a shorter examination • Consider FOIA Treatment Employee Interviews • Ensure that the CCO is present during all interviews • Bring relevant materials (org charts, etc.) to the interviews • Do not answer questions if you do not know the answer • Invite consultants and/or outside counsel to join interviews and to be involved with the examination “Interviews are a key part of the examination process…Coupled with reviews of documents, interviews help us be sure that we have an accurate view of the operations and compliance controls at a firm. An examination without an interview is like a movie without sound — you can’t get a fully accurate sense of the picture without it.” -Lori Richards, Former Director SEC’s Office of Compliance Inspections and Examinations Source: SEC Scrutinizing PMs Over Insider Info. Ignites.com. May 29, 2007. At the Conclusion of the Exam • Ensure all requested documents have been provided and all questions have been addressed • Usually the examination staff will offer to conduct an exit interview at the conclusion of the on-site portion of the exam • During the exit interview, demonstrate commitment to compliance function, provide additional proof of any positions or claims, and correct any misunderstandings • Don’t be afraid to clarify issues that are conveyed as deficiencies What NOT to do during an Examination • Falsify or backdate records • Respond to problems with • Make employees mysteriously indifference unavailable • Break promises you made to • Get your facts wrong, or worse, the examination team or past intentionally lie to the examination teams examiners • Withhold records without • Have employees argue with telling the examination team each other, challenge each you were going to do so other’s authority, or mutually • Attempt to intimidate the slough off responsibility in the examiners examiner’s presence Agenda Types of Exams being Conducted Staying Prepared before an exam is Announced Preparing for an Upcoming Exam What to do during an Exam What to do after an Exam Current Exam Focus Areas SEC Examination Exit Procedures • Most SEC exams conclude within 90 days from last day of the on-site portion of the SEC’s review • Examiners are supposed to contact registrants when an examination extends 120 days beyond the on-site visit and alert them to the status of the examination • OCIE procedures allow examiners to conclude an exam without an exit interview when the examiners refer their findings to the Division of Enforcement or when an examination results in no findings. Exceptions may also be made for sweep examinations. Results and Response • 3 Actions: deficiency letter, no further action letter, enforcement • Escalation of Issues – Pushing-back – Contact another SEC Office? – Another letter/additional correspondence • When to use the SEC’s Examination Hotline • Most effective ways to respond to deficiency letters Agenda Types of Exams being Conducted Staying Prepared before an exam is Announced Preparing for an Upcoming Exam What to do during an Exam What to do after an Exam Current Exam Focus Areas Custody and Safeguarding Client Assets • New Custody Rule (effective March 12, 2010) – Reaction to Madoff and other Ponzi Schemes – Requires advisers who maintain custody of client assets to take additional steps to ensure the protection and integrity of such assets • Asset Verification – Examiners will reach out directly to custodians, counterparties, and clients – Document request lists often ask for assistance in obtaining confirmations directly from custodians and counterparties – Examiners will generally not reveal which clients they intend to contact “The days when we could conduct verification on the premises of a single firm – looking at correspondence on letterhead, requesting manually signed documents, or downloading through a firm’s computers – are behind us. Modern verification requires us to reach out directly to counterparties, custodians, and clients.” -John Walsh, Acting Director SEC’s Office of Compliance Inspections and Examinations Remarks at 2009 NSCP National Meeting. Philadelphia, PA. October 5, 2009. Insider Trading • Reaction to recent high-profile insider trading cases • Recent SEC examination tactics: – Examiners will request “Top 10 Winners and Losers” lists and compare those to press releases on companies traded – Examiners will inquire about relationships with friends and family in the securities industry – Testing information barriers within a firm and internal controls around the flow of material non-public information – Review of employee e-mails and instant messages • “All e-mails sent/received from the date of the announcement of the SEC examination to present” “…large scale insider trading by industry professionals is as serious as organized crime, extortion, and similar misconduct…” -Robert Khuzami, Director, SEC’s Division of Enforcement Remarks at AICPA National Conference on Current SEC and PCAOB Developments. Washington, DC. December 8, 2009. Other Current SEC Focus Areas • Valuation • Pay-to-Play • Complex financial instruments (e.g., derivatives) • Target-Date Funds • Disclosures of investment practices to investors • Compliance resources • Marketing & Advertising • Annual compliance program review “To put it bluntly, the world of compliance in 2008 is dead . . . I can assure you, the examination program is changing and will continue to change” -John Walsh, Acting Director SEC’s Office of Compliance Inspections and Examinations Remarks at 2009 NSCP National Meeting. Philadelphia, PA. October 5, 2009. Questions?
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