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SEC (Securities and Exchange Commission) Focuses on Alternative Funds

SEC to Conduct Sweep Exams of Alternative Funds

OCIE announced that it is finalizing an initiative to conduct a national sweep exam of retail alternative funds, indicating that it will target 15 to 20 fund complexes in its first phase, which will likely begin in summer or fall of this year. The sweep will focus on liquidity, leverage and board oversight of retail alternative funds. OCIE noted that it is prioritizing these exams due to the significant asset growth of alternative products in recent years and the growing number of retail investors.

While one of OCIE’s goals is to ensure that alternative funds are complying with the Investment Company Act of 1940 (the Investment Company Act), the exams will allow the staff to identify areas where it believes managers may need additional guidance and to inform the Division of Investment Management and SEC commissioners of such need.

Source: SEC to Conduct Sweep Exams of Alt Funds, Ignites, Beagan Wilcox Volz (March 19, 2014).

OCIE Observations of Due Diligence Practices for Selecting Alternative Investments

Prior to announcing the sweep exams, OCIE observed the due diligence practices of more than ten SEC-registered investment advisers that manage or recommend alternative investments to their clients. OCIE summarized its findings in a Risk Alert dated January 28, 2014. In that Risk Alert, the staff analyzed how advisers (i) performed their due diligence, (ii) identified, disclosed, and mitigated conflicts of interest, and (iii) utilized experienced investment teams when evaluating complex investment strategies and fund structures.

The Risk Alert reminded investment advisers that they are fiduciaries who must act in the best interest of their clients. Such fiduciary duties require the advisers to determine whether a recommended investment (i) meets the client’s investment objectives and (ii) is consistent with the investment principles and strategies disclosed by the manager of the alternative investment to the adviser (as set forth in private offering memoranda or other offering material provided by the manager).

The Risk Alert provided an analysis of several industry trends and practices that comply with the requirements under the Investment Advisers Act of 1940 (the Advisers Act) and the federal securities laws. For example, the Risk Alert noted that advisers are: (i) negotiating with managers of alternative investments to obtain more information through requests for position-level transparency and, occasionally, the use of a separately managed account structure; (ii) using third party service providers to supplement their analyses or validate previously-received information regarding alternative investments; (iii) performing additional quantitative analysis and risk measures to supplement traditional investment-level decision-making processes; and (iv) enhancing and expanding due diligence processes to include onsite visits and reviews of policies and procedures, legal documents, liquidity of the portfolio, and financial statements. These trends allow advisers to understand and identify potential risk indicators, which subsequently allow advisers to conduct additional analysis and make appropriate changes in response to their findings.

The Risk Alert also discussed some areas where the staff identified material deficiencies or control weaknesses in the exams, including failing to: (i) include the due diligence policies and procedures for alternative investments in the adviser’s annual review of the policies and procedures required by Rule 206(4)-7 under the Advisers Act; (ii) make disclosures to clients that were consistent with actual practices; (iii) properly describe the due diligence process in marketing materials provided to clients; (iv) require detailed and accurate documentation of due diligence processes; and (v) conduct periodic reviews of service providers.

Finally, the Risk Alert discussed the obligation that all advisers adopt and enforce a written code of ethics setting forth a minimum standard of conduct for supervised persons and addressing personal securities trading by those persons. The staff noted that allowing an adviser’s access persons to invest in a limited offering with preferential investment terms creates a conflict of interest, which may influence the adviser’s due diligence processes and, ultimately, harm a client.

Source: Office of Compliance Inspections and Examinations National Exam Program Risk Alert, Investment Adviser Due Diligence Processes for Selecting Alternative Investments and their Respective Managers, Volume IV, Issue 1 (January 28, 2014).

Copyright © 2020 Godfrey & Kahn S.C.National Law Review, Volume IV, Number 121



About this Author

Chris Cahlamer Investment Management Attorney

Chris Cahlamer is the team leader of the firm’s Investment Management Practice Group, where he practices in investment management and securities law, focusing on investment companies, investment advisers, regulatory examinations, new product development, SEC compliance and reporting obligations, CCO support, private fund formation and operation, investment company reorganizations, investment advisor mergers and acquisitions, and general corporate and board fiduciary issues.

Chris earned his law degree, summa cum laude, at Marquette University Law School. While there, he...

Susan Hoaglund, Investment Management Attorney, Godfrey Kahn law firm

Susan Hoaglund is a member of the Investment Management Practice Group. Susan provides advice to investment advisers, investment companies, broker-dealers and banks regarding legal, regulatory and compliance matters.