On March 21, 2011, Carlo V. di Florio, the SEC’s Director of the Office of Compliance Inspections and Examinations, gave a speech in which he indicated that the SEC would focus on the following nine areas in examinations of investment advisers:
1. Valuation – a top priority, particularly when the IA manages assets that are difficult to value (e.g., alternative investments that do not routinely trade on exchanges or other established markets). SEC will review the IA’s policies and procedures regarding valuation of managed assets.
2. Conflicts of Interest – SEC will review procedures used by an IA to identify, disclose, and manage conflicts. Conflicts mentioned included allocations, analysis of insider trading, side letters, best execution, directed brokerage, and soft dollar issues.
3. Portfolio Management – SEC will test whether the strategy presented to investors is actually being carried out by the advisers.
4. Performance and Advertising Issues – If applicable, SEC will review any performance calculation and the presentation of that performance in any offering materials.
5. Asset Verification – If an adviser has custody, SEC may verify assets and controls for safeguarding assets. This analysis may include a determination of whether an adviser who says it does not have custody actually does have custody (e.g., check writing authority, power of attorney, and/or general partner to a hedge fund).
6. Risk Management – how the adviser takes and manages risk.
7. Business Continuity/Disaster Recovery – This is an item that should be in every SEC-registered adviser’s policies and procedures manual. The Director cited the recent natural disasters in Japan and New Zealand.
8. Use of Social Media – The use of social media, including websites, blogs, twitter, etc., may increase an adviser’s compliance risks. The Director cited stock picks, links to other products and services, and the difficulty in providing proper disclosures as areas that may be problematic.
9. Small Niche Mutual Funds or ETFs – These investments are subject to unusual or obscure risks where small events can have huge effects. Again the SEC will consider an adviser’s risk management procedures.
If an IA is not an SEC-registered IA, it is must be subject to an examination program conducted by your state securities regulator; therefore, a state-registered IA should also be preparing for an examination by considering the above items.
Many of the above items should be considered and/or included in an adviser’s policies and procedures manual or the new narrative version of Part 2 of Form ADV.
