SEC Examinations: A More Hostile Approach?

            The SEC examination staff’s use of a new letter request directed to registered investment advisers signals a more hostile approach to industry participants, and raises the risk of unjustified adverse findings of deficiency.  There are two important aspects of the letter, which was sent to an unidentified firm by the SEC’s New York Regional Office sometime in August 2007. See http://nscp.org/media/sec_request_list-aug2k7.pdf.

 

A.        Proof that Policies and Procedures Have Been Implemented

 

            First, the letter highlights the importance of demonstrating compliance with Rule 206(4)-7 under the Investment Advisers Act of 1940 (“Advisers Act”).  The Rule requires advisers to adopt and implement policies and procedures reasonably designed to prevent violation of the Advisers Act and related rules. The letter states that besides producing the policies and procedures themselves, advisers should be able to demonstrate “output” from the application of such policies and procedures “to the daily work flows of the Adviser,” including but not limited to “exception reports, together with documentation of follow-up work; completed compliance checklists; reconciliations; management reports; documents containing supervisory approval of overrides in various areas; warning or sanction notices to staff that violated a policy or procedure; results of any related analyses or self-assessments of the effectiveness of” the policies and procedures, the internal audit reports, and so on.” The letter threatens that “Failure to provide information that documents how your compliance program operates in practice may result in our concluding that the Adviser has a weak or ineffective risk management and control processes; and, are not in compliance” with the Rule.  This part of the letter emphasizes the SEC’s apparent belief that many advisers are creating unimplemented policies and procedures, in violation of the Rule. Based on the explicit threat contained in the letter, the SEC is likely to, at a minimum, issue notices of deficiency to non-compliant firms, and at worse, refer the matter to the Enforcement staff.

 

            B.        Improper Requests to Create Documents

            

            The letter also requires registrants to provide narrative descriptions of certain business activities and practices.  Specifically, the letter asks for: a ‘written summary of any business transactions, investment opportunity, deal, side deal, arrangement, or similar matter that, since [DATE], the Adviser was asked to consider but rejected because the proposal was deemed inadvisable, inappropriate, unethical, or possibly illegal. The summary should include a detailed description of the matter, the name and contact information of all involved firms and persons, and the reason(s) for the      proposal being rejected. The letter also asks for “a description of how the following investment strategies are monitored Short Sales, Futures and Options, Derivatives, and Other Forms of Leverage.”   Further, it asks for “lists” of clients and former clients, wrap fee programs, and open and closed positions that were “most profitable” and “least profitable.”  

 

            The burdensome nature of the SEC’s requests for the creation of narrative descriptions and lists is troubling.  Further, these requests are made without authority.  The SEC cannot require registrants to create documents not included among the books and records required to be kept and maintained by the Advisers Act.  See Rockwell Int'l Corp. v. H. Wolfe Iron & Metal Co., 576 F. Supp 511, 513 (WD Penn. 1983) (a party "cannot be compelled to create, upon the request of the plaintiff, documentary evidence which is not already in existence in some form); see also Order Granting Approval to Proposed Rule Change by the NASD, File No. SR-NASD-99-07 (Sept. 2, 1999) (noting that rules governing discovery during arbitration proceedings do not “require customers to create documents that do not otherwise exist”). The SEC’s authority to request this information is otherwise suspect because none of the requested information appears to relate to any specific statute or rule.  Moreover, the request for information about third party requests to engage in unethical or improper transactions wrongly implies that advisers are approached to engage in such transactions on a widespread basis.

 

            Given the SEC’s lack of authority to require the production of information in the form of a narrative description or list, advisers should emphasize the voluntary nature of their response to any such request.  Doing this will allow advisers to argue that they are entitled to receive “cooperation credit” regarding any findings of deficiency that are issued.  Convincing the SEC examination staff that an adviser is entitled to cooperation credit may convince them not to refer such findings to the Enforcement staff.   Further, to the extent advisers are unwilling or unable to provide the requested information, the staff should not issue findings of deficiency on this basis, given the SEC’s lack of authority.  Advisers should consider vigorously contesting any related deficiency findings. 

Comments

[thomson]

hi
This is james, this will allow advisers to argue that they are entitled to receive “cooperation credit” regarding any findings of deficiency that are issued.Convincing the SEC examination staff that an adviser is entitled to cooperation credit may convince them not to refer such findings to the Enforcement staff.
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james

sale by owner

[Muliya]

Good post.