Hot Topics to Cover in Your Next Mock Exam

Recent examinations by the Securities and Exchange Commission (“SEC”) focused on a number of initiatives including presence exams, newly-registered advisers and firms that had been registered for a number of years but never examined. With these initiatives completed or coming to an end, exams on key topics such asprivate equity, valuations, conflict of interest disclosures andcybersecurity are getting more attention. Although only the SEC only examines about 10% of registrants annually, firms should assume that they will be one of them and prepare accordingly.

One of the best ways to prepare is to hire a law firm or compliance consultant to perform a mock exam; see our previous article, 7 Tips to Get the Most Out of Your Mock Examination, for useful considerations when planning a mock exam. In addition, firms might consider emphasizing the following hot topics in their next mock exam:

  1. Cybersecurity. The SEC is increasingly concerned with the security of client and firm information stored electronically, as well as the risk of cyber-attacks. Many firms already have policies and procedures in place for handling data loss, but as cyber-related crimes become more commonplace and sophisticated, policies must be reviewed and updated regularly. Recently, the SEC stated that an outdated policy, or one that fails to protect sensitive or confidential data, could be construed as a possible violation of federal securities laws.
  2. Advertising/Marketing. SEC exams always cover advertising and marketing activities. Firms should remember that any piece that is distributed to more than one person is subject to the SEC’s advertising rules (this could encompass market commentary, client/investor letters and other routine outreach and reporting).   In particular:
    • Content should be balanced and accurate;
    • Opinions should be clearly stated;
    • Support for factual statements should be maintained in the firm’s files;
    • Performance information should include appropriate disclosures and records of calculations should be kept.

Recent exams indicate that the SEC closely scrutinizes performance numbers, asks for backup documentation and seeks confirmation that materials are approved by compliance.

  1. Fees and Expenses. Private equity firms, particularly, should prioritize fee and expense structures and how they are disclosed. The SEC carefully examines these and, indeed, has shown some skepticism about common and expected practices (see our article on best practices for disclosure of private equity fees and expenses). Firms should review and, as necessary, revise funds’ offering documents, ADV disclosures and firm policies to address current regulatory and investor expectations.
  2. Safety of Client Assets and Custody. The SEC routinely examines firms’ custodial arrangements for compliance with the custody rule (see our primer). Recently, this has become such a concern the SEC that released a Risk Alert on the subject and recurring or serious issues have been referred to enforcement (see SEC v. Water Island Capital, SEC v. Sands Brothers Asset Management). Though simple on its face, there are some pitfalls that can be avoided by implementing clear policies and procedures in this important area.
  3. Personal Trading. The SEC always reviews firm policies and access persons’ personal trading. Of particular concern is whether these policies and procedures mitigate the potential for conflicts of interest with client trading. Firms should ensure that they have complete records of all access persons’ accounts, holdings and trades, including any required preapprovals.
  4. Insider Trading. Insider trading is at the top of the SEC’s priority list and will likely remain there for the foreseeable future (see our primer on detecting and preventing insider trading). Especially since the Newman decision clarified the elements and proof required for a criminal conviction (see our analysis and next steps), firms can expect SEC staff to be extremely thorough in examining a firm’s insider trading policies and procedures. Firms should consider activities that create risk, such as using expert networks, deals with public companies and any other situation in which the firm may receive, even inadvertently, material non-public information. Once these risks are identified, policies and procedures should be reviewed and upgraded as needed to meet any new or changing risks.
  5. Conflicts of Interest. A constant concern for the SEC, every mock exam should closely review:
    • Risk controls;
    • Allocation of investment opportunities;
    • Compensation arrangements;
    • Disclosure of side-by-side management of asset and performance based fee accounts;
    • Any other potential conflicts of interest, depending on the firm’s business strategies.
  6. Internal Reviews. Interestingly, there is no requirement in the Advisers Act or rules to document annual or other reviews. However, the SEC usually asks for such documentation in an examination. Firms that have not previously documented annual or interim reviews should begin doing so (see our tips for conducting the annual review); all firms should ensure that their documentation is available to produce in an exam and perhaps consider enhancements to their reviews and reporting processes.


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