On February 7, 2017, the Securities and Exchange Commission’s (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) released a list of five compliance topics that are the most commonly identified topics “in deficiency letters that were sent to SEC-registered investment advisers.” OCIE published this list in a National Exam Program Risk Alert in order to help advisers who are conducting their annual compliance reviews.
The first compliance topic was compliance with the Compliance Rule, Rule 206(4)-7, which requires an investment adviser to create and execute written policies and procedures that are reasonably tailored to prevent the investment adviser and its supervised persons from violating the Advisers Act and to detect potential violations. The rule also requires an investment adviser to review the sufficiency of its policies and procedures at least annually and to appoint a chief compliance officer. According to OCIE, common violations of the Compliance Rule include not having a compliance manual that is reasonably suited to the adviser’s method of doing business, failure to conduct annual reviews or annual reviews that did not cover the sufficiency of the investment adviser’s policies and procedures, failure to follow policies and procedures, and compliance manuals that are outdated.
The second topic that OCIE identified was compliance with the Advisers’ Acts rules on regulatory filings. For example, Rule 204-1 provides that investment advisers must make amendments to their Form ADV on at least an annual basis, and the amendments must be made “within 90 days of the end of their fiscal year and more frequently, if required by the instructions to Form ADV.” For investment advisers to private funds, Rule 204(b)-1 provides that an investment adviser must file a Form PF if the investment adviser is advising a private fund or fund with assets of $150 million or more. Finally, Rule 503 of Regulation D of the Securities Act of 1933 provides that issuers of private funds must file a Form D, and investment advisers usually file the Form D for their private fund clients. OCIE determined that the most frequent violations of these rules were inaccurate disclosures on Form ADV Part 1 or Part 2A, late modifications to Form ADVs, faulty and late Form PF filings, and faulty and late Form D filings.
OCIE also determined that compliance with the Custody Rule is a common shortcoming revealed in its examinations. The Custody Rule provides that an investment adviser has custody of client funds or securities if “it or its related person holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them.” Once an investment adviser has custody of client funds or securities, it must follow a number of procedures designed to shield client funds and securities from unlawful conduct or financial troubles the adviser is experiencing. OCIE found that common violations of the Custody Rule included advisers failing to realize that they could have custody because of online access to client accounts or because of certain powers over client accounts, such as powers of attorney or acting as trustees of clients’ trusts. If an adviser has custody, then it is required to conduct a surprise examination.
OCIE also found that compliance issues with the Code of Ethics Rule are frequent in its examinations. The Code of Ethics Rule provides that an investment adviser must create and enforce a code of ethics. The code of ethics should set a standard of business conduct that all of the investment advisers supervised persons must comply with, and obligate an investment adviser’s “access persons” to occasionally identify their personal securities transactions and holdings to the chief compliance officer or other designated persons. It must also obligate access persons to receive the investment adviser’s permission to invest in an initial public offering or private placement. An investment adviser must also ensure that all supervised persons have a copy of the code of ethics and that the supervised persons acknowledge their receipt of the code of ethics in writing. Finally, an investment adviser is required to give a report of its code of ethics in its Form ADV Part 2A. According to OCIE, common violations of the Code of Ethics Rule include failure to disclose who the access persons are, lack of required information in codes of ethics, late reports of transactions and holdings by access persons, and failure to include a report of the code of ethics in Form ADV Part 2A.
The fifth and final compliance issue that OCIE identified was compliance with the Books and Records Rule. The Books and Records Rule provides that investment advisers must “make and keep certain books and records relating to their investment advisory business, including typical accounting and other business records as required by the Commission.” Frequent violations of the Books and Records Rule included failure to keep all required records, inaccurate or outdated books and records, and the fact that some investment advisers kept records that were not consistent with each other.
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