Even as the coronavirus disrupts many conventions and traditions of the financial services industry, one regulatory ritual has continued, albeit in digital form: the Securities and Exchange Commission’s compliance examinations with registered investment advisers.
A review of recent enforcement actions and exam priorities offers some insight into what areas of a firm are most exposed.
These examinations, which are now conducted virtually by the SEC’s Office of Compliance Inspections and Examinations, or OCIE, have highlighted some of the new risks faced by investment firms when it comes to compliance in an economy convulsed by the coronavirus.
A review of recent enforcement actions and OCIE exam priorities offers some insight into what areas of a business are most exposed, and what actions may ultimately protect the firm from investor or regulatory backlash for any issues of noncompliance. Among the SEC’s questions: Are a firm’s holdings fairly valued, and is the firm able to meet redemption requests? Have pandemic policies been developed?
Many groups have prepared for what is the unavoidable call or email from the SEC. Some firms have upgraded or added talent to their back-office compliance function, while others have undertaken a mock examination. Nearly all have consulted with outside counsel.
We expect that the SEC will understand that advisers could require more time for a response as many managers are experiencing profound and unexpected business challenges amid the pandemic.
Regardless of the approach taken, here are some of the topics the SEC may consider during the health crisis:
- Are investment values reasonable and is there evidence of trading on nonpublic information? This should come as no surprise to investment advisers – valuation risk was always the top priority for OCIE, and the health crisis just makes it more important given the growing number of companies suffering financial losses. The current market environment heightens the risk that a general partner might overstate the firm’s investment values as a means of masking poor performance. Policies and procedures around a group’s valuation of securities are expected to be followed, especially amid volatile market pricing. Changing a set valuation policy without a supportable reason could alert the regulators of possible reporting fraud.
This is particularly important when investment performance has suffered coronavirus-related losses or when the general partners intend to raise capital. And during the SEC’s late-May coronavirus call, regulatory officials cited the agency’s increased attention to “friendly broker quotes” or transactions among market “affiliates,” which may suggest investments have not been fairly valued.
With more firms struggling to perform in a difficult market and to raise assets, the SEC is on alert for brokers that may be incentivized to trade using nonpublic information. For example, looming facility or store re-openings, pending health patents and access to personal protective equipment supplies are especially important in light of the coronavirus. And the SEC even commented on its ability to monitor bad behavior in what has long been a favorite communication technique on Wall Street: the Bloomberg chat room.
- Will funds be able to meet redemption requests? The health crisis has spooked some investors, leaving them with a reduced appetite for risk. While governing documents detail internal fund policies around investor redemptions and restrictions, investment managers may be faced with widespread redemption requests as investment values decline.
And this could lead to a scenario where investors have little to no access to cash during a time when they may need it the most. Examiners will look for situations where investment managers have strayed from set redemption guidelines. Policies around lock-up periods, side pocket arrangements and notice requirements are expected to be examined to protect investor interests.
- Have pandemic policies been developed? Long after COVID-19 is brought under control, the virus will remain a risk, particularly around weak health systems, in areas with high population density and poverty, and in communities with political instability. And the threat of another pandemic will leave a lasting sting to savvy investors who seek solid pandemic policies and procedures. Business continuity plans, market intelligence and alternative data, and IT infrastructure and cybersecurity may be prioritized.
These are all areas that mattered before the onset of the coronavirus but may now matter more. Many investors have added these questions to their investment criteria to assess firms’ blind spots and to determine whether their investment strategy is worth ascribing to. We believe the SEC will expect groups to carefully measure these risks and those that have already developed sound business practices will be positioned well. Issues will arise when there was no plan in place, the plan is outdated or no longer relevant, or, worse, when a good plan was not followed.
The takeaway
At the end of the day, the SEC aims to ensure transparency and clear and consistent reporting. By putting in place institutional-quality processes throughout the organization, investment firms better ensure compliance with regulatory requirements.
