The Situation: The Office of Compliance Inspections and Examinations ("OCIE") of the U.S. Securities and Exchange Commission has released its 2019 Examination Priorities.
The Result: The Report details key areas where OCIE currently intends to focus its examination resources in 2019. The Report's key areas that should be of particular interest for private fund advisers (e.g., advisers to real estate, hedge, private equity, and venture capital funds) include fees and expenses, conflicts of interest, portfolio management and trading, digital assets, and cybersecurity.
Looking Ahead: While, of course, advisers should be vigilant in identifying and correcting all deficiencies whether or not those deficiencies are among the Report's focus areas, investment advisers to private funds would likely also benefit from examining their policies and procedures in the key focus areas noted above.
On December 20, 2018, the Office of Compliance Inspections and Examinations ("OCIE") of the U.S. Securities and Exchange Commission released its 2019 Examination Priorities, in which OCIE detailed key areas where OCIE currently intends to focus its resources in 2019.
The Report contains many of the same priorities that were included in the 2018 Examination Priorities but with an increased focus on conflicts of interest matters and portfolio management issues. The Report's key areas that should be of particular interest for private fund advisers (e.g., advisers to real estate, hedge, private equity, and venture capital funds) include fees and expenses, conflicts of interest, portfolio management and trading, digital assets, and cybersecurity.
The below key focus areas from the Report are of particular relevance for private fund advisers but do not include every area in the Report or every key area addressed in the Report that may be relevant to private fund advisers (e.g., the focus on never before or not so recently examined advisers and municipal advisers). Further, advisers should be aware that the priorities identified in the Report are not exhaustive, and therefore advisers should be vigilant in identifying and correcting all deficiencies whether or not those deficiencies are among the Report's focus areas (e.g., in the annual reviews of their compliance policies and procedures as required by Rule 206(4)-7 under the U.S. Investment Advisers Act of 1940 ("Advisers Act")).
The Report reminds advisers that, since the publication of OCIE's 2018 exam priorities, OCIE has published five risk alerts: electronic messaging risk-based exam initiatives relating to registered investment companies, including risks and conflicts for investment advisers that manage private funds side-by-side with registered investment companies the cash solicitation rule best execution advisory fee and expense compliance issues. It would behoove advisers to review those risk alerts to see if they raise any issues of noncompliance.
Key Focus Area 1: Fees and Expenses
OCIE will continue to review fees charged to advisory accounts to ensure compliance with client agreements and firm disclosures. OCIE intends to select firms with practices or business models that may create increased risks of inadequately disclosed fees, expenses, or other charges. Because of the varying charges borne by private funds (e.g., management fees, carried interest/performance fees, and reimbursement of certain expenses of the funds' advisers), advisers to private funds should compare their funds' fee and expense agreements and disclosures against the amounts charged to their funds. They should take this action to ensure that the types of expenses charged to their funds can fairly be said to have been appropriately disclosed to investors and, in the case of fees, have been calculated in accordance with the applicable fund agreements/disclosures.
For background, see OCIE's 2018 risk alert titled "Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers."
Key Focus Area 2: Conflicts of Interest
OCIE cited the use of affiliated service providers and products, securities-backed non-purpose loans and lines of credit, and the borrowing of funds from clients as focus areas for exams. As many private funds use service providers that are affiliates of the funds' managers (e.g., affiliated property managers in real estate funds), advisers to private funds should review their disclosures to fund investors in their Form ADVs and client documents to ensure that appropriate disclosures about those relationships have been made.
Key Focus Area 3: Portfolio Management and Trading
OCIE will review portfolio management practices, including practices related to trade execution and the allocation of investment opportunities. OCIE will also review portfolio recommendations to assess, among other things, whether investment or trading strategies: (i) are suitable for and in the best interest of investors; (ii) are experiencing any style drift; (iii) include any new, risky products or investments without adequate disclosure; and/or (iv) have been adequately monitored for risk. Notably, the Report refers to a side-by-side management risk under the heading "Mutual Funds and Exchange Traded Funds," where the Staff says that it will focus on risks related to those managers that advise both registered investment companies and private funds with similar investment strategies.
Private fund advisers should review their Form ADVs and fund documents to ensure that those documents contain adequate disclosures about their portfolio management practices. They should also review their trading and transaction records and disclosures to ensure that their portfolio management practices are consistent with their disclosures.
Key Focus Area 4: Digital Assets
OCIE will continue to monitor digital assets (including regulatory compliance where such assets are "securities"). In particular, OCIE will conduct high-level inquiries in order to identify and assess firms that offer, sell, trade, and manage digital assets. OCIE will conduct examinations of firms actively engaged in the digital asset market, focusing on areas such as portfolio management and trading, safety of client assets, pricing of client assets, and compliance and internal controls.
Private fund advisers that are engaged, or are considering becoming involved, with digital assets should review compliance with the Advisers Act (and other U.S. securities laws) as they relate to digital assets, especially the application of the custody rule to different types of digital assets, the adequacy of disclosures in offering materials, and policies and procedures related to both the pricing of digital assets and related personal securities transactions.
The SEC staff has released various public statements and speeches regarding securities law issues related to digital assets, including SEC Chairman Jay Clayton's December 2017 "Statement on Cryptocurrencies and Initial Coin Offerings" and the June 2018 speech by William Hinman, Director of the SEC's Division of Corporation Finance, titled "Digital Asset Transactions: When Howey Met Gary (Plastic)."
Key Focus Area 5: Cybersecurity
OCIE will focus on cybersecurity practices, in particular at investment advisers with multiple branch offices, and will continue to focus on policies and procedures related to governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, and incident response.
Private fund advisers should review their cybersecurity policies and procedures, in conjunction with SEC guidance regarding cybersecurity matters (see, e.g., OCIE's 2015 Cybersecurity Examination Initiative, OCIE's August 2017 "Observations from Cybersecurity Examinations." OCIE's May 2017 "Ransomware Alert" and "Cybersecurity, the SEC and You").
Three Key Takeaways
- All investment advisers should review the entire Report, since it describes key areas where OCIE currently intends to focus in 2019 (e.g., conflicts of interest).
- Investment advisers to private funds may want to pay special attention to the Report's discussion of fees and expenses, conflicts of interest, portfolio management, and trading, digital assets, and cybersecurity.
- Investment advisers to private funds should also review OCIE's recent risk alerts, which cover topics such as electronic messaging, best execution, and advisory fees and expenses
The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firm with which they are associated.
Michael Butowsky is an Of Counsel at Jones Day. He has more than three decades of experience providing U.S. securities regulatory and transactional legal advice to a broad spectrum of financial services industry participants, including investment advisers, private investment funds, broker-dealers, registered investment companies, BDCs and others. His practice focuses principally on: investment advisers (including U.S. registration, compliance, disclosure, and trading issues); the formation of and ongoing U.S. regulation of private investment funds (such as hedge funds, private equity funds, and venture capital funds); advising broker-dealers with respect to trading issues (such as soft dollar arrangements); and advising financial services industry participants and operating companies with respect to investment company, investment adviser, and broker-dealer "status" issues.
Emily O. Harris is an Associate with Jones Day. She has more than a decade of experience representing investment advisers, private funds, broker-dealers, and operating companies on a broad range of U.S. regulatory and corporate matters. Her practice covers: the formation, marketing, operation, and U.S. regulation of private funds (including hedge funds, funds of funds, hybrid funds, private equity funds, and venture capital funds); U.S. registration and compliance issues regarding investment advisers; broker-dealer "status" issues; sales of registered investment advisers; and investment company "status" matters. She also advises clients on forming investment entities for, and regulatory compliance with respect to, investments in cryptocurrencies and related assets.
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