May 24, 2018

Six Essential Regulatory Examination Articles for Private Fund Managers

According to the SEC’s Fiscal Year (FY) 2019 “Congressional Budget Justification Annual Performance Plan,” the SEC’s Office of Compliance Inspections and Examinations (OCIE) conducted 2,114 investment adviser examinations in FY 2017 and an estimated 2,120 examinations in FY 2018. For FY 2019, OCIE is requesting resources to conduct 2,160 investment adviser examinations – a nearly 2-percent increase year-over-year. In its “2018 National Exam Program Examination Priorities,” OCIE signaled that its critical priority areas include (1) the protection of retail investors; (2) compliance and risks in critical market infrastructure; (3) a focus on the Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board; (4) cybersecurity; and (5) anti-money laundering. See “Retail Investors Top List of OCIE 2018 Exam Priorities” (Mar. 8, 2018). In light of this, the Hedge Fund Law Report is highlighting six articles from its historical archives that provide guidance on regulatory examination issues facing private fund managers. Next week (the week starting May 28, 2018), the HFLR will resume its normal weekly publication.

Usable Lessons and Proven Survival Techniques From the Hedge Fund Examination Trenches

A 2014 program presented by the Regulatory Compliance Association reviewed the experiences of several in-house legal and compliance practitioners with SEC and NFA examinations. The program also provided an overview of key substantive issues that are likely to be addressed in those exams, including insider trading and expert networks; trade and investment allocations; expense allocations; marketing documents; high-frequency trading; cybersecurity; social media; and broker-dealer registration. The program was moderated by Christopher M. Wells, partner at Proskauer, and featured Cynthia Marian, then-vice president, chief compliance officer (CCO) and deputy general counsel (GC) of Tinicum; Dianne Mattioli, then-CCO of Hedgemark Securities; Mark Polemeni, then-CCO of asset management at Citadel; and Catherine Smith, GC of Guidepoint Global. Although the program dates from 2014, the issues raised and guidance offered by the participants remain relevant to fund managers today. This article highlights the key points raised by the panel. See “Practical Guidance From Former SEC Examiners on Preparing for and Surviving SEC Examinations” (Sep. 1, 2016); and our three-part series “What Do Hedge Fund Managers Need to Know to Prepare for, Handle and Survive SEC Examinations?”: Part One (Feb.  3, 2011); Part Two (Feb. 10, 2011); and Part Three (Feb. 18, 2011).

Are Hedge Fund Managers Required to Disclose the Existence or Outcome of Regulatory Examinations to Current or Potential Investors?

Perhaps the most onerous obligation for any SEC-registered investment adviser is the duty to prepare for, manage and survive SEC examinations. Newly registered private fund advisers in particular must think about (1) examination preparedness; and (2) examination management and survival. This article seeks to assist advisers in designing an investor disclosure strategy concerning regulatory examinations. In doing so, it discusses the three types of SEC examinations and circumstances under which advisers may, or may not, be required to disclose the existence or outcome of those examinations; the five primary sources of a fund manager’s potential obligations to disclose the existence or outcome of an examination; how advisers can reconcile the privileged information rights often granted to large investors in side letters with their fiduciary duty to make uniform disclosure to all investors; and whether fund managers must disclose deficiency letters to current or prospective investors, along with how such disclosures should be made. See our three-part series on steps an exempt reporting adviser must take to transition to SEC-registered investment adviser status: “Registration Triggers and Building a Compliance Department” (Oct. 5, 2017); “Adopting Compliance Policies and Procedures” (Oct. 12, 2017); and “Regulatory Filings, Updates to Fund Documents and Preparation for SEC Examination” (Oct. 19, 2017).

How Hedge Fund Managers Can Prepare for SEC Remote Examinations

In an effort to reach more hedge fund managers and other registered investment advisers, the SEC is conducting more inspections and examinations, reassigning staff to handle increased workload and deploying additional resources, such as its National Exam Analytics Tool and the Office of Risk and Strategy. See “Effects of Expanding SEC Investment Adviser Examinations” (Mar. 24, 2016). Another tool in the SEC’s arsenal is its ability to review hedge fund managers and investment advisers remotely in lieu of conducting an onsite examination. This process broadens the SEC’s overall reach, but it also allows the regulator to focus on particular issues. Hedge fund managers must therefore remain wary of the unique risks inherent to remote exams. This two-part series discusses the SEC remote examination landscape. The first article outlines the reasons the SEC conducts remote examinations and delineates the differences between remote and in-person exams. The second article discusses the risks of a remote exam and best practices for a hedge fund manager in preparing for and enduring a remote exam. For more on preparing for SEC examinations, see “Current and Former Regulators Advise Hedge Fund Managers on How to Prepare for SEC Exams” (Feb. 18, 2016); and “Hedge Fund Managers Advised to Prepare for Imminent SEC Examination” (Jan. 28, 2016).

Three Steps in Responding to an SEC Examination Deficiency Letter and Other Practical Guidance for Hedge Fund Managers From SEC Veteran and Eversheds Sutherland Partner John Walsh

Almost all U.S.-based fund managers will at some point have to interact with the SEC. To prepare for those interactions, fund managers should understand the expectations, operations and motivations of the SEC. Few understand these dynamics – and how they relate to fund managers – better than Eversheds Sutherland partner and former SEC official John H. Walsh. Among other accomplishments during his 23-year tenure at the SEC, Walsh played a key role in creating the Office of Compliance Inspections and Examinations (OCIE); designed and implemented the SEC’s securities compliance examination practices; and served as OCIE’s acting director in 2009. In an interview with the  Hedge Fund Law Report, Walsh discussed his work at the SEC and provided guidance on how fund managers should interact with the regulator. This article presents his views on these issues. See “Is a Hedge Fund Manager Required to Disclose the Existence or Substance of SEC Examination Deficiency Letters to Investors or Potential Investors?” (Jun. 1, 2011).

Practical Guidance for Hedge Fund Managers on Preparing for and Handling NFA Audits

A hedge fund manager may be subject to CFTC jurisdiction and registration as a commodity pool operator (CPO) or commodity trading adviser (CTA) if it uses derivatives or trades in commodities. CFTC-registered CPOs and CTAs are required to become members of the National Futures Association (NFA) and, as such, are subject to NFA rules and regulations and to periodic audits. This article highlights the key points raised by a panel that reviewed the nuts and bolts of an NFA audit, NFA compliance programs and common audit issues; offered strategies for preparing for and surviving an audit; and summarized recent CFTC guidance that affects CPOs and CTAs. See “NFA Workshop Details the Registration and Regulatory Obligations of Hedge Fund Managers That Trade Commodity Interests” (Dec. 13, 2012); and our two-part series “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do”: Part One (Feb. 23, 2012); and Part Two (May 10, 2012).

Is This an Inspection or an Investigation? The Blurring Line Between Examinations of and Enforcement Actions Against Private Fund Managers

The most significant impact of SEC registration on a private fund adviser is that the adviser becomes subject to inspection by the SEC’s Office of Compliance Inspections and Examinations. The greatest risk arising from an examination is that the inspection staff decides to refer a finding from an inspection to the Division of Enforcement (Enforcement) for an investigation. Despite the severe collateral consequences that can befall a fund manager simply from the initiation of an investigation, divining whether the staff is contemplating an Enforcement referral is a surprisingly elusive proposition. In this guest article, Mark K. Schonfeld and Kenneth J. Burke, partner and then-associate, respectively, at Gibson Dunn & Crutcher, discuss the increasing risks of SEC examinations becoming enforcement investigations and practical strategies for fund managers to anticipate and mitigate those risks. See also our two-part series on “Steps Advisers Can Take to Minimize the Risk That a Routine SEC Examination Ends With a Referral to Enforcement”: Five Key Priorities for OCIE (Jan. 4, 2018); and Examination Process, Interview Preparation and Remediation Considerations (Jan. 18, 2018).