Preparing for SEC Visit: How to Conduct "Mock" Exam
With the Securities and Exchange Commisison's deadline for private funds to register just around the corner, advisers are quickly getting ready to do a lot more than just fill out paperwork.
Hedge funds are preparing for the time when representatives from the SEC walk into their offices wanting to ensure that what they are legit based on the new regulatory requirements -- and are following solid IT and operations procedures. Hedge fund advisers who manage over $150 million in hedge fund assets have until March 31 to register, which then gives the SEC carte blanche to inspect just how "clean" they are under the hood.
The reason for the exam can range anywhere from a simple as a routine matter to as provocative as an investor complaint or a particular area of "concern or deficiency" the SEC wants to investigate. The regulator can also show up with a week's notice, a day's notice or even no notice. Bottom line: the adviser won't have sufficient time to shore up or fix any shortcomings before someone from the Office of Compliance Inspections and Examinations comes knocking on its doorstep.
One way hedge fund advisers are preparing: they are conducting mock exams --or trial runs of sorts--to catch any shortcomings before the SEC finds them. "It's not a matter of if they will show up but when," says Michael Madigan, director of Chelsea Technologies, a technology hosting and integration firm in New York specializing in the alternative investment space. "We have seen the number of mock exams soar over the past few months."
Smaller-sized hedge funds shouldn't think they will be exempt from an exam. The SEC's exam unit has come under plenty of criticism for being short-staffed and slow to take action except for investigating the most egregious of offences at the largest firms. But the regulatory agency is eager to turn a new leaf and to that end is seeking a lot more funding from Congress to do its job well. That means put all funds on notice.
"The SEC won't discriminate in favor of bypassing smaller funds and the newly registered ones are likely to be targeted first," says Gary Swiman, principal and head of the compliance practice at C&A Consulting, a New York- based financial services consultancy.
The more efficient and detailed the mock exam the more likely the hedge fund will be prepared on the spot for any questions the SEC might pose; guessing or even sounding a bit uncertain won't cut it and could easily arouse the SEC's suspicions and result in even further scrutiny. The SEC could decide to either censure a firm, fine it, or in a worse case scenario, limit their business or even shut it down.
So what's a hedge fund manager to do? For starters, says Madigan, the adviser needs to designate a mock exam manager -- someone who is willing and able to put together a program of just what the firm needs to do. Such a task will likely fall on a dedicated chief compliance officer or chief operating officer who also has compliance responsibilities.
Next up: Rounding up the director of operations, chief compliance officer and director of technology to ensure the firm's procedures have been well-documented. That documentation needs to include how the firm has set up contingency plans in the event of a natural or other unforseen disaster, data access policies, data security and email retention. "Hedge funds need to present a clear explanation of data redundancies and hot sites as well as any procedures they have set up to limit access to customer files and trading information," says Madigan. "Regulators want to ensure that the firm put care and order into its redundancy plans and will also ask to review the policies for user network authentication, access to data and data retention." The SEC reserves the right to ask for data at any time, even after an exam.
Having a solid compliance manual in place or even more thorough documentation for each business line and function won't necessarily be a panacea. It's just the tip of the iceberg in avoiding further SEC scrutiny. For one, the hedge fund adviser has to prove it can fulfill everything it promises in technological sophistication. An SEC examiner could easily ask to see an email communication or other data on the spot and require the hedge fund to mimic a network outage to see how rapidly data can be retrieved.
"The messaging might sound great, but if the IT director neglected to actually test the disaster recovery plan, the hedge fund could easily find out it doesn't work," says Madigan. "That's a hedge fund's own disaster in the making in front of an examiner."
Ensuring a solid IT infrastructure may seem difficult -- and costly -- but proving one has solid front, middle and back-office operation can prove even more challenging. That is because there are even more areas ripe for glitches -- and they can be far harder to predict. It is challenging to have the proper connectivity in place among different systems, says Swiman.
One potential landmine: fair trade allocation. "The SEC will want to be reassured that an investment manager who is overseeing a hedge fund and separately managed account won't randomly favor one fund over another or a separately managed account when it comes to dividing an executed order," says Swiman. "The firm needs to have appropriate documentation to prove that it followed its procedures which could involve allocating the order on a prorata or other documented basis depending on the size of the assets of the fund involved."
Yet another area for concern: valuation of hard-to-price securities. "The firm needs to show it has a valuation committee to address the methodology used to price non-exchange traded financial instruments and to ensure that the exact same instrument receives an identical price regardless of the fund which trades it," says Swiman. "The SEC won't look kindly to different valuations for the same instrument."
Nor will the SEC be too happy if the fund uses a far-fetched price. "The SEC could ask the fund adviser to actually make calls to broker-dealers and verify whether it can prove that the value is an executable price --aka it can sell the security at that valuation or close to it," says Swiman. "The regulator could also require the adviser to produce the minutes of a meeting of its valuation committee to substantiate the reason it overrode one price in favor of another."
Steven Yadegari, executive vice president and general counsel of New York-based investment adviser Cramer Rosenthal McGlynn LLC, recommends that mock exams review and validate the results of what a firm has done in previous periodic internal compliance tests. "A fund manager's procedure may requiring filling out a form to demonstrate the soft-dollar eligibility of a research or brokerage service under the statutory safe harbor provided by the Securities Exchange Act of 1934." The mock examiner could review that such documentation is in fact being completed and is consistent with the law and regulatory guidance on the use of client-commission dollars." The safe harbor refers to the types of research which can be paid for using commission dollars.
Even the most technologically and operationally prepared hedge fund advisers could find themselves facing a common yet preventable problem: the ill-preparedness of their staff. "The SEC could easily want to meet with directors of different departments to ask what their roles are and how they meet the compliance requirements of their individual positions at the firm," says Yadegari. "Operations, portfolio managers and IT directors "should be prepared to clearly explain their overall responsibilities and applicable compliance responsibilities to any SEC examiner," A mock examination could include similar interviews to prepare for such a possibility. Half-baked and inconsistent responses aren't an option could send the SEC a red flag that further examination of a particular area is required.
Hedge fund advisers who are concerned about whether they could do the mock exam on their own should consider hiring a third-party which can provide graded valuation of each business line and suggestions on how to fix any shortcomings. For Chelsea Technologies, a score of under 100 means below average, 100 to 200 will be average and anything over 300 is above average.
Hedge fund advisers should also allocate sufficient time to conduct the mock exam. "It could take anywhere from as little as two weeks to as long as a month depending on the value of assets under management, the number of functions which must be reviewed and just how technologically and operationally sophisticated each area is," says Madigan. "Firms must also leave themselves enough breathing space to correct problems in time." That breathing room could mean at least six months depending on the assets under management and the number of functions which need correcting.
Last but not least, consultants recommend documenting the results of any mock exam and the steps taken to fix any shortcomings. "The SEC will look a lot more kindly to firms which acknowledge any gaps up front and even more importantly show they either have or will take immediate action to correct them," says Swiman." Bottom line: honesty -- and a proactive gameplan will go a long way to mitigating any concerns the SEC might have about whether the firm can monitor itself and its progress in improving their oversight.
The pricetag: mock exams aren't cheap. They could cost anywhere from as little as $10,000 to as much as over $100,000 for a large-size fund. But they will likely end up being well worth the money spent.
"Fund advisers shouldn't view mock exams as a way to simply check off boxes that they have met the SEC's requirements," says Swiman. "They should consider the benefit to being prepared for any even greater source of anxiety- the savvy and demanding plan sponsor or investor performing a due diligence review."
With pension plans, endowments and other types of institutional investors now opting to invest a greater percentage of their assets in alternative investments, hedge fund advisers need to take their "need to know" under consideration when completing on-site visits and filling out due diligence questionnaires. "Sophisticated plans are well-aware of their fiduciary responsibility to investors and aren't afraid of asking the same tough questions an SEC examiner will," says Swiman. "In a world where finding alpha has become a bit commoditized, having immediate answers on technological and operational matters can mean the difference between winning and losing a multimillion dollar capital committment."
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com)