Recently, several developments have changed the
First, beginning March 30,
2012, title IV of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank) will eliminate an exemption that many advisers to
private funds had used to avoid registration. As a result, most hedge
fund and private equity advisers with more than US$150 million in assets under
management must register with the SEC using the newly unveiled version of Part
II of Form ADV.
this year, the US Securities and Exchange Commission announced changes to Part
II of Form ADV that will require hedge funds to provide, in "plain English" and
narrative form, significantly more information than they had been required to
disclose before. This includes providing details about the way they
conduct their business, ownership data and the identity of suppliers of key
services, profiles of their personnel, training programs, compliance policies
and infrastructure, valuation mechanisms, fund-specific risk factors and
will also be required to maintain records including trading and investment
positions, types of assets held, trading practices and other information the
SEC deems necessary for the protection of investors.
The SEC intends to use these disclosures as part of its
risk-based approach to choosing examination targets. This is partly due
to the additional information the SEC will have, which will enable them to
identify in advance areas warranting review. For example, SEC examiners
now ask for regular access to advisers' C-level executives in order to get a
feel for the firm's investment philosophy and how the tone at the top
communicates the importance of company-wide regulatory compliance.
Another reason we can expect greater scrutiny through
more exhaustive examinations is that the SEC is also hiring more personnel from
the financial services industry, and is expanding their internal training
programs to enhance the expertise of its examination staff. The SEC is
dispatching Division of Enforcement specialists to help examiners and to foster
What should investment advisers do?
In light of all this, what should investment advisers do,
Act preemptively: don't wait for the SEC to
Investment advisers should not wait to be contacted by
the SEC to begin planning an examination strategy or assembling a response
team. When the SEC decides it wants to conduct an examination, it usually
provides only minimal notice. Often, the lead time is short, and
continuances are not always granted. Moreover, fund managers with no
regulatory reporting experience may not have the infrastructure to gather the
required information in such a short period of time.
To ensure they can meet the SEC's reporting demands and
respond to examinations in an effective manner, all investment advisers - even
those that filed Form ADVs before Dodd-Frank - should regularly test their
data gathering and the efficiency of their compliance procedures via mock
examinations or similar exercises before they receive notice from
the SEC that it wishes to conduct an examination.
Enlist experienced help for a mock
All of this means an adviser should strongly consider
enlisting experienced professionals with the appropriate knowledge.
Finding the right help is not as easy as it sounds. One of the key
issues to consider is whether it is prudent to keep communications between the
investment adviser and the experienced professional confidential.
For this reason, an organization should strongly consider
retaining a law firm to conduct the mock examination. By retaining a law
firm, the organization maintains the option of tailoring the examination
process in such a manner that will shield the results of the mock
examination under the attorney-client privilege and work product
doctrines. This still leaves open the possibility of retaining a
compliance firm. When a compliance firm is retained through the
law firm, all of the compliance firm's work product may also be protected by
the attorney-client and work product privileges.
The mock examination
Any mock examination should achieve several goals:
Err on the side of caution in preparing for
When conducted properly, mock examinations can educate
investment firms about the new regulatory landscape's requirements and prepare
firms to take preemptively any corrective action that may be necessary.
In addition, by retaining counsel, an organization maintains the option to
disclose or withhold the results of the mock examination, as appropriate.
There is as yet no industry consensus around these
issues, and official guidance is hardly crystal clear. In areas where the
guidelines for data are opaque, it is best to err on the side of caution.
By retaining experienced counsel, an investment advisor ensures it is in the
best position to prepare for the coming increased scrutiny.
Also check our other
articles on the Dodd-Frank Act rules.
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