On Feb. 7, 2017, the Securities and Exchange Commission's (SEC's) Office of Compliance Inspections and Examinations ("OCIE") published a risk alert outlining the five most frequent compliance topics identified in deficiency letters sent to SEC-registered investment advisers.
The information is intended to assist advisers as they prepare for their compliance reviews. Therefore, advisers should review their compliance programs and related policies and procedures with particular focus on the topics noted in the alert and make improvements as necessary.
Specifically, OCIE identified deficiencies or weaknesses in the following five areas:
- Rule 206(4)-7 under the Investment Advisers Act of 1940 (the "Advisers Act"), also known as the "Compliance Rule."
- Required regulatory filings.
- Rule 206(4)-2 under the Advisers Act, known as the "Custody Rule."
- Rule 204A-1 under the Advisers Act, or the "Code of Ethics Rule."
- Rule 204-2 under the Advisers Act, known as the "Books and Records Rule."
Compliance Rule
The Compliance Rule requires an adviser to meet several regulatory conditions in connection with its business of rendering investment advice to clients. These include:
- Adopting and implementing written policies and procedures reasonably designed to prevent the adviser's violation of the Advisers Act and related SEC rules.
- A review of the adequacy of the policies and procedures and the effectiveness of their implementation on a basis no less frequently than annually.
- Designating a chief compliance officer ("CCO"), who is responsible for administering these compliance policies and procedures.
OCIE staff provided some possible instances of deficiencies or weaknesses with respect to the Compliance Rule. For example, a deficiency could arise as a result of a compliance manual that is not reasonably tailored to the adviser's specific business practices, including sections intended to address individualized practices such as particular investment strategies, types of clients, trading practices, valuation procedures and advisory fees. As a result, advisers should be aware that "off the shelf" compliance manuals may not be adequately tailored to address their individual business practices.
Regulatory Filings
This compliance topic related to the accurate completion and timely filing of certain regulatory submissions advisers must provide to the SEC. The alert mentioned various filing requirements, such as advisers' annual Form ADV update, Form PF and Form D filings. In this regard, OCIE indicated that it has identified deficiencies or weaknesses that included inaccurate disclosures in Form ADV filings, untimely Form ADV amendments, and incorrect or untimely Form PF and Form D filings.
Custody Rule
The Custody Rule applies to advisers with custody of client cash or securities, and the rule includes several requirements designed to protect client assets from unlawful activities or financial problems of the adviser. Specifically, an adviser is considered to have custody if it or its related persons directly or indirectly hold client funds or securities, or have any authority to obtain possession of them, such as an adviser serving as the general partner, managing member or other comparable position of a pooled investment vehicle.
OCIE noted the following deficiencies or weaknesses with respect to the Custody Rule: advisers who did not recognize that they may have custody due to online access to client accounts; advisers who obtained surprise examinations that failed to meet the rule's requirements due to the failure to provide the accountants with a complete list of accounts over which the adviser had custody or otherwise failed to meet the rule's requirements (e.g., the surprise examinations may not have been conducted on a "surprise" basis); and advisers that did not recognize they may have custody as a result of certain authority over client accounts (e.g., advisers that were granted powers of attorney over a client's account authorizing them to withdraw client cash and securities have custody of that account's assets).
Code of Ethics Rule
The Code of Ethics Rule requires an investment adviser to adopt and maintain a code of ethics, which must meet several requirements, including establishing a standard of business conduct that the adviser requires of all its supervised persons; requiring an adviser's "access persons" to periodically report their personal securities transactions and holdings to the adviser's CCO or other designated persons; and requiring access persons to obtain the adviser's preapproval before investing in an IPO or private placement.
Deficiencies or weaknesses with respect to the Code of Ethics Rule identified by OCIE included not identifying all of an adviser's access persons, omitting required information in the code of ethics, untimely submission of transactions and holdings by access persons, and a failure of the adviser's Form ADV to describe the code of ethics and indicate that the adviser's code of ethics is available to clients upon request.
Books and Records Rule
Finally, the Books and Records Rule requires advisers to make and keep certain books and records relating to their investment advisory business, including typical accounting and other business records as required by the SEC.
Deficiencies or weaknesses noted with respect to the Books and Records Rule included:
- The failure to maintain all required records.
- Books and records that are inaccurate or not updated.
- Inconsistent recordkeeping practices (e.g., some advisers maintained contradictory information in separate sets of records).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
