Investment Adviser Act Audits: OCIE Deputy Director Norm Champ Explains What Examiners Are Looking For When Conducting Examinations
On Tuesday, July 12, 2011, Norm Champ, Deputy Director of the Office of Compliance Inspections and Examinations (“OCIE”) of the U.S. Securities and Exchange Commission, provided the keynote address at the Practising Law Institute’s Twelfth Annual Private Equity Forum in New York on the topic of “Investment Adviser Act Audits: What is the SEC Looking For?”
Deputy Director Champ confirmed that under Dodd Frank OCIE will continue its responsibilities over FINRA, the exchanges, investment companies, transfer agents, clearing firms, investment advisers, and hedge and private equity funds. The Deputy Director touted Director Carlo V. di Florio’s reinvigoration of OCIE and its concentration on building upon “what it does well” and remedying “what it did not do well” in the wake of the Madoff scandal. Specifically, he focused on di Florio’s efforts to “turn a confederation of regional examination programs” into a “national program” and OCIE’s compilation of an examination manual (currently unissued but in the second draft phase), efforts aimed at removing the inconsistency both examiners and examinees have experienced from different regional examination offices in the past. Importantly, Deputy Director Champ revealed a new collaborative relationship that Director Robert Khuzami and Director di Florio have fostered between the Division of Enforcement and OCIE. Specifically, Champ described the monthly joint meetings between Enforcement and OCIE, where examiners and staff discuss past and current examinations and issues “can get escalated if necessary.”
Deputy Director Champ also detailed OCIE’s “risk based” examination processes, whose “main mission” he defined as “protecting investors” — rather than focusing on systemic risk — through four basic tenets: (1) promoting compliance; (2) finding fraud; (3) monitoring market risk; and (4) assisting in the formulation and revision of SEC policy. He highlighted the new resources, both technological and administrative, that have been dedicated to helping OCIE achieve its mission, including the Risk and Surveillance Unit’s use of private databases and new media services both in monitoring firms and in developing risk ratings (conceding that news reports likely will lead to examinations) and the new Oracle-based examination workbooks, specialized working groups, “higher capacity computers,” and shorter (2-3- rather than 60-page) reports. He also explained that OCIE’s new “risk based” examination policy eliminates cycle exams, prioritizes examinations and re-examinations of “high risk” targets, and includes ongoing re-evaluation of ratings based upon examination performance. Yet, “so as to not fall in love with its own risk-rating system,” OCIE will continue to conduct random examinations of both “low” and “high risk” firms.
Despite these changes, the Deputy Director’s explanation of the mechanics of OCIE examination (initiation by telephone call, letter, or surprise visit, followed by a request for documents and information and an inspection) suggests that the examination process itself largely will remain unchanged and consistent with our past experiences. As for the examinations themselves, he explained that while audits generally function to ensure “someone is watching the store,” there are six areas upon which examiners focus when conducting examinations: (1) Control Environment; (2) Valuation; (3) Performance and Advertising; (4) Portfolio Management; (5) Conflicts of Interest; and (6) Asset Verification.
OCIE’s analysis of firms’ Control Environments focuses on ensuring the existence of sufficient compliance controls — namely “risk, compliance, legal, and audit” functions with substance (i.e., real authority, information sharing, and testing/sampling) and accountability (e.g., problems escalated? to whom? problems addressed/resolved?). The Deputy Director cautioned examinees about looking “too slick,” revealing examiners’ general skepticism that the “better the dog and pony show the worse the compliance program.”
The Deputy Director’s comments on Valuation, Performance and Advertising, and Portfolio Management centered on the accuracy and supportability of valuations and warned against manipulating performance statistics in marketing materials. The Deputy Director expressed concern with investments/strategies that did not comply with marketing materials, offering documents, or promises made to investors, revealing that firms “should not be surprised” if investor clients are called as part of this process.
As we all have seen in response to the Madoff scandal, Asset Verification has become an integral part of the examination process; but the Deputy Director did confirm that where recently every asset has been subject to examination, OCIE is now just “sampling” assets and conduction additional follow-up where necessary.
In wrapping up his remarks, Deputy Director Champ most broadly discussed Conflicts of Interest, spotlighting examinations of how firms “identify, manage, address, and disclose” conflicts. He said examiners are looking not only for manager conflicts with investors (e.g., allocating assets or costs to manipulate performance statistics or fees) but also conflicts between investors of same or different investments (e.g. preferential rights, side letters) and conflicts with third parties (e.g., sub-managers who charge a higher fee because of personal relationships). He strongly recommended that conflicts be examined in terms of an investment’s life-cycle, due to the specific conflicts that can arise at various stages of the investment process; and he reinforced that, once a conflict is identified, it must be timely, fully, and accurately disclosed.