2013 sec presence exams— field observations

12 PREA Quarterly, Summer 2013

By eliminating the fewer-than-15-client exemption from

registration under the Investment Advisers Act of 1940, as

amended, the Dodd-Frank Wall Street Reform and Consum-

er Protection Act of 2010 caused many previously unregis-

tered private fund advisers to register with the Securities and

Exchange Commission.1 It has now been more than a year

since the initial registration deadline—March 30, 2012—for

these newly registered private fund advisers, and the SEC

staff has been carrying out a program of focused Presence

Exams of these advisers. This article describes the SEC Pres-

ence Exam Program and summarizes some of our observa-

tions regarding the SEC staff’s findings, comments, and focus

during these exams.

Sec presence exam BackgroundEvery registered investment adviser is subject to examina-

tion by the SEC through the Office of Compliance Inspec-

tions and Examinations and its National Exam Program.

Typically, an investment adviser will receive only one to

two weeks’ notice before the SEC staff arrives on-site to

begin the examination process. As part of these examina-

tions, the SEC staff requests and reviews the books and

records of the adviser, interviews various personnel, and

attempts to determine if the adviser is complying with the

numerous rules and regulations of the Advisers Act. For

routine SEC examinations, the SEC staff is commonly on-

site at the adviser’s offices between two and six weeks or

longer, depending on the size of the adviser and complex-

ity of its operations.

On October 9, 2012, the OCIE issued a letter to senior

executives or principals of newly registered advisers describ-

ing a new Presence Exam initiative by the SEC.2 This initia-

tive is intended to (1) familiarize newly registered investment

advisers with the NEP and the OCIE, as well as the advisers’

duties under the Advisers Act; (2) examine these advisers to

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ESec presence exams—Field Observations

promote compliance with the Advisers Act and certain areas

the SEC deems of particular importance for newly registered

advisers; and (3) upon completion of the Presence Exam

initiative, report to the SEC and the public on observations

made during these examinations. The initiative is expected to

last approximately two years.

The SEC noted five areas of particular focus for its Pres-

ence Examinations: marketing, portfolio management, con-

flicts of interest, safety of client assets, and valuation. In our

experience, the SEC staff has indeed focused on these areas,

spending, on average, two to five days on-site at each advis-

er’s office. By conducting quicker high-level exams, the SEC

staff is able to visit many newly registered advisers in shorter

periods of time.3

According to the SEC, the Presence Exam initiative also

seeks to help newly registered investment advisers comply

with a “new” and unfamiliar area of the law. To this end, the

SEC “publicize[s] best practices and [offers] staff guidance in

a number of areas.”4 In particular, advisers should be on the

lookout for risk alerts,5 as well as general compliance out-

reach materials.6

2 0 1 3

1. See US Securities and Exchange Commission, “SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act,” press release 2011-133, June 22, 2011, www.sec.gov/news/press/2011/2011-133.htm.2. See US Securities and Exchange Commission Office of Compliance Inspections and Examinations, Letter to Senior Executives or Principals of Newly Registered Investment Advisers, Oct. 9, 2012, www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.3. See US Securities and Exchange Commission, “Testimony on SEC Budget,” by Chair Mary Jo White, May 7, 2013, www.sec.gov/news/testimony/2013/ts050713mjw.htm; see also “Where the SEC Action Will Be,” June 23, 2013, online.wsj.com/article/SB10001424127887323893504578555990184592624.html.4. See US Securities and Exchange Commission, “Doing the Right Thing: Compliance That Works for Investors,” speech by Commissioner Luis A. Aguilar, April 18, 2013, www.sec.gov/news/speech/2013/spch041813laa.htm.5. See US Securities and Exchange Commission, Office of Compliance Inspections and Examinations, “Public Alerts, Reports, and Letters,” www.sec.gov/about/offices/ocie/ocie_guidance.shtml.6. See US Securities and Exchange Commission, “Investor Alerts and Bulletins,” www.sec.gov/investor/alerts.shtml; see also ibid; US Securities and Exchange Commission, “Doing the Right Thing: Compliance That Works for Investors,” speech by Commissioner Luis A. Aguilar, April 18, 2013, www.sec.gov/news/speech/2013/spch041813laa.htm.

nabil SabkiLatham & Watkins LLP

Stephen p. winkLatham & Watkins LLP

nicholas m. lookLatham & Watkins LLP

Stefan paulovicLatham & Watkins LLP

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ducting these transactions for its own account rather

than “for the account of others” because the fund

whose portfolio companies are generating these fees

is under common control with the adviser, and (3)

the policy reasons for registration as a broker do not

apply where the recipient of the transaction fees is

already subject to fiduciary duties. At the time of this

writing, it is not clear to what extent such arguments

will be persuasive to the SEC staff.9 It should also be

borne in mind that broker status determinations will

also turn on the specific facts of given arrangements.

The stakes are high, as acting as an unregistered

broker may not only subject an adviser to sanctions

by the SEC but also could grant counterparties a po-

tential right to rescission.10 Thus, until the SEC staff

provides more clarity as to the scope of permitted

activities, or the SEC provides exemptive relief for

certain limited broker activities at some point in the

future, advisers should carefully consider their port-

folio company transaction fee arrangements in light

of currently applicable regulatory requirements.

n Custody. Approximately one-third of all recent SEC

examinations have noted some form of custody-related

Learning from Experience and Looking ForwardSince the SEC announced the Presence Exam Pro-

gram, many advisers have undergone Presence Ex-

ams, and notable points have emerged. Drawing on

firsthand experience and public statements of the

SEC staff, we summarize below some of the SEC

staff’s findings, comments, observations, and focus

during these Presence Exams.

n Transaction-Based Compensation. The SEC

staff has observed that some private fund advisers

(and/or their affiliates or personnel) receive transac-

tion-based compensation “for purported investment

banking or other broker activities relating to one or

more of the fund’s portfolio companies.”7 The SEC

staff has requested advisers receiving these transac-

tion fees to provide a detailed legal analysis as to

why they do not fall within the definition of a “bro-

ker” under the Securities Exchange Act of 1934, as

amended.8 We understand that advisers have provid-

ed a range of responses, including that (1) the man-

agement/advisory fee otherwise payable by the fund

to the adviser is offset or otherwise reduced by such

transaction fees, (2) the adviser is effectively con-

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7. See US Securities and Exchange Commission, “A Few observations in the Private Fund Space,” speech by David W. Blass, April 5, 2013, www.sec.gov/news/speech/2013/spch040513dwg.htm. Among the fees observed by the SEC staff were “fees the manager directs a portfolio company of the fund to pay directly or indirectly to the fund’s adviser or one of its affiliates in connection with the acquisition or disposition (including an initial public offering) of a portfolio company or a recapitalization of the portfolio company.” Such fees, according to Blass, were described as “compensating the private fund adviser or its affiliates or personnel for ‘investment banking activity,’ including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions.”8. Section 15(a) of the Exchange Act requires that persons engaged in broker activity must register with the SEC pursuant to Section 15(b) of the Exchange Act unless an applicable exemption is available. In general, a “broker” is any person “engaged in the business of effecting transactions in securities for the account of others.” Although the Exchange Act and the rules promulgated thereunder do not specifically define “effecting transactions” or “engaged in the business,” the SEC and the SEC staff have taken a very expansive view of the scope of those terms. In his speech, Blass reiterated that the SEC and the SEC staff have consistently viewed transaction-based compensation as the “hallmark” of broker activity and cautioned that the receipt of transaction-based compensation coupled with the types of activities being performed may trigger the requirement to register with the SEC as a broker under the Exchange Act.9. See US Securities and Exchange Commission, “A Few observations in the Private Fund Space,” speech by David W. Blass, April 5, 2013, www.sec.gov/news/speech/2013/spch040513dwg.htm. Blass acknowledges that no broker registration requirement appears to be triggered where the advisory fee is wholly reduced or offset by the amount of the transaction fee but calls into question the argument that these transactions are not conducted “for the account of others” as the fund and the recipient of the transaction fee “are distinct entities with distinct interests.”10. Section 29(b) of the Exchange Act provides that contracts made in violation of the Exchange Act shall be void in respect of the

“rights of any person who, in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract.”11. See US Securities and Exchange Commission office of Compliance and Inspections, national Exam Program Risk Alert:“Significant Deficiencies Involving Adviser Custody and Safety of Client Assets,” Vol. III, Issue 1, March 4, 2013, www.sec.gov/about/offices/ocie/custody-risk-alert.pdf.12. See Advisers Act Rule 206(4)-2(d)(2).13. See Advisers Act Rule 206(4)-2(a)(4).14. See Advisers Act Rule 206(4)-2(a)(1).15. See Advisers Act Rule 206(4)-2(b)(4).


PREA Quarterly, Summer 2013 15

issue or written comment.11 The deficiencies gener-

ally fall into four categories: (1) failure by an adviser

to recognize that it has “custody” as defined under the

custody rule,12 (2) failure to comply with the rule’s “sur-

prise exam” requirement,13 (3) failure to comply with

the “qualified custodian” requirement,14 and (4) failure

to comply with the “audit approach” for pooled invest-

ment vehicles (the Private Fund Audit

Exception).15 The Risk Alert issued by

the SEC highlights specific deficien-

cies found, which should help advisers

identify and address these issues. For

most advisers of real estate, private

equity, hedge, and other private funds,

many of the deficiencies stemmed from

the adviser’s failure to comply with the

Private Fund Audit Exception or sur-

prise audit requirement for co-invest

funds or employee, friends and family

funds that are smaller in size. Histori-

cally, such vehicles have generally not

required audits, on the assumption

that if investors in these smaller vehi-

cles did not want to incur the cost of an

audit or a surprise audit, the SEC staff

would not object. The SEC staff has

since made it very clear that if an ad-

viser has custody over a private fund’s

assets (e.g., by virtue of being a general

partner or managing member of the

private fund), the adviser must comply

with the custody rule requirements re-

gardless of the size of the fund or the

desire of the underlying fund investors.

n Expenses and Allocation of Expenses. Presence Exams have fo-

cused on fund and adviser expenses.

A primary inquiry has been whether

expenses are being allocated fairly

and equitably among the adviser’s

funds (including its sponsored or

managed funds). Advisers should

carefully consider whether they are

allocating expenses fairly and equitably among their

funds and consider if any fund is bearing a dispro-

portionate share of expenses. For private fund ad-

visers, the allocation of broken-deal expenses merits

particular attention. Many advisers make a practice

of rolling broken-deal expenses into the next con-

summated deal. This may be appropriate so long as



guaranties of the principals of the fund’s general

partner. In cases where a significant giveback ob-

ligation has built up (based on the performance of

the overall fund portfolio) and not enough capital

remains on the general partner’s balance sheet to

cover the giveback obligation, the SEC staff has

specifically inquired how the general partner in-

tends to meet the obligations.16

n E-mail Requests. Advisers are required to

keep certain books and records under the Advisers

Act, and the SEC staff has indicated that it expects

advisers to retain all e-mail communications that

relate to such books and records. Given the SEC

staff’s position, many advisers have implemented

policies and procedures to retain all e-mails.17 On

several recent occasions, the SEC staff has request-

ed that an adviser produce all e-mails for certain

senior personnel for a two- to three-month period.

The SEC staff will generally allow advisers to with-

hold e-mails that are attorney-client privileged

as long as a log of such e-mails not produced is

provided to the SEC. Most advisers that have been

subjected to e-mail production have commented

that such production can be very time-consuming

and expensive. Advisers should advise all employ-

ees that e-mails are subject to SEC examination

and that employees should treat e-mail as a formal

and recorded method of communication.

n Scope of Review. Many advisers were sur-

prised when the SEC staff requested books and

records that predated the date of the adviser’s ini-

tial registration. While in most instances the SEC

staff has acknowledged that books and records

that predate the registration date of the adviser are

not expected to comply with specific Advisers Act

rules (e.g., the advertising rules), the SEC staff has

the series of deals is made for the same fund. How-

ever, rolling broken-deal expenses from one fund

into another fund is generally problematic because

a different set of investors would bear such expenses.

The SEC staff has also expressed concern over

whether expenses are appropriately allocated

to a given fund. For example, an adviser should

not attempt to push down management company

overhead expenses to a fund. Expenses should be

charged to a fund only if the fund’s organizational

documents clearly permit the fund to bear such

expenses. As a result of SEC staff findings in Pres-

ence Exams, some advisers have been required to

reimburse expenses considered by the SEC staff to

have been inappropriately charged or allocated to

the fund.

n Portfolio Company Expenses. In most Pres-

ence Exams for private fund advisers, the SEC

staff has specifically asked advisers to provide a

schedule of all expenses the adviser or its affiliates

charge to portfolio companies (e.g., monitoring

fees, transaction fees, and early termination fees),

as well as the percentage of such fees that offset

management fees. The SEC staff is very focused on

confirming that such fees have been clearly dis-

closed to investors.

n General Partner Givebacks. In a few recent

exams, the SEC staff has closely scrutinized the

operation of general partner giveback provisions.

A general partner giveback obligation is generally

a mechanism whereby, at the end of a fund’s life

(or at certain interim points), a private equity fund

manager is contractually bound to return to fund

investors any excess carried interest that was pre-

viously distributed to the manager. Such giveback

obligations are typically backed up by personal

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16. We are aware that many private fund managers voluntarily escrow certain amounts to cover future potential giveback obligations. In such situations, the SEC staff has generally not raised any concerns.17. See The Association of the Bar of the City of new York, Committee on Investment Management Regulation, letters to the Securities and Exchange Commission, May 11, 2005, www.sec.gov/rules/petitions/petn4-503.pdf, and nov. 15, 2005, www.nycbar.org/pdf/report/Investment_Regulation.pdf.



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generally insisted on reviewing such documents.

to date, we are not aware of any adviser receiv-

ing a deficiency letter from the seC staff relating

to noncompliance with the advisers act rules that

stemmed from records that predated the adviser’s

registration with the seC. nonetheless, many ad-

visers found it disconcerting to be asked to pro-

duce offering memorandums, pitch books, and

other materials that predated registration dates.

n Tone at the Top. a common theme during seC

exams is a focus on the “tone at the top.”18 it is not

necessarily just the senior compliance personnel

in the spotlight; “[a] firm’s senior leadership must

be visible and vocal advocates for a strong culture

of compliance.”19 accordingly, all senior principals

should be prepared to answer questions during

seC examinations, including questions about how

they help promote a culture of compliance at the

firm and provide adequate resources for the com-

pliance function. a “culture of compliance,” partic-

ularly at the top, is an important quality that every

adviser should embrace.

as presence examinations continue, advisers

should expect the seC staff to become even more

familiar with and focused on the private fund in-

dustry. this may well lead to additional issues and

areas of concern that were not previously raised

by the seC staff. similarly, the seC staff’s current

focus on broker-dealer registration concerns in

connection with the receipt of transaction-based

fees has been considered a sea change, given how

prevalent such arrangements have long been in

the industry.

Conclusion the seC continues to perform presence exams and

most likely will continue to provide guidance to

newly registered investment advisers, either through

public speeches or writings, as the seC uncovers

new areas of general concern (e.g., transaction-

based fees). Based on our experience during the

first phase of presence exams, we have found that

the seC staff has been helpful and encouraging to

advisers that have been open and cooperative with

the seC staff. our sense is that, in general, the first

round of presence exams has been productive for

both the seC staff (as they learn more about the pri-

vate fund industry) as well as the newly registered

advisers (as they learn to operate under the advisers

act). however, advisers should not get complacent

on the basis of a smooth presence exam (nor indeed

at any time). Routine seC examinations are much

more thorough and time-consuming than presence

exams. advisers should maintain a thoughtful focus

on compliance, both in anticipation of eventually

receiving a full routine seC examination and as a

matter of sound practice. n

Nabil Sabki is a Partner in the Chicago office, Stephen

P. Wink is a Partner in the New York office, Nicholas M.

Look is an Associate in the Orange County office, and

Stefan Paulovic is an Associate in the New York office

of Latham & Watkins LLP.

18. see Us securities and exchange Commission, “national exam program director Carlo V. di Florio to Leave seC,” press release 2013-80, May 2, 2013, www.sec.gov/news/press/2013/2013-80.htm; Us securities and exchange Commission, national exam program office of Compliance inspections and examinations, “examination priorities for 2013,” Feb. 21, 2013, www.sec.gov/about/offices/ocie/national-examination-program-priorities-2013.pdf; Us securities and exchange Commission,

“examinations by the securities and exchange Commission’s office of Compliance inspections and examinations,” Feb. 2012, pg. 25, www.sec.gov/about/offices/ocie/ocieoverview.pdf; Us securities and exchange Commission, “speech by seC staff,” speech by Carlo V. di Florio, Jan. 31, 2012, www.sec.gov/news/speech/2012/spch013112cvd.htm.19. see ibid; see also Us securities and exchange Commission, “doing the Right thing: Compliance that Works for investors,” speech by Commissioner Luis a. aguilar, april 18, 2013, www.sec.gov/news/speech/2013/spch041813laa.htm.

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2013 sec presence exams— field observations

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