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News May 4, 2015 Issue

OCIE Turns Its Attention to Never-Before-Examined Investment Companies

Mutual funds, open-end funds and other investment companies that have never been examined should start getting a bit nervous: Examiners may be coming.

The SEC’s Office of Compliance Inspections and Examinations created some buzz last year with its examinations of never-before-examined advisers. Apparently considering that program a success, the agency in January announced that in 2015 it would do the same with never-before-examined investment companies. In an April 20 National Exam Program risk alert, OCIE put some detail behind that announcement, letting the investment fund community know just what areas would be covered by the examinations.

In recent years, OCIE has been plagued by a shortage of examiners – something the SEC is seeking to address in its 2016 budget request (ACA Insight, 4/27/15). In order to get the most bang from its examination buck, it has developed innovative methods of determining just which advisers and funds should be examined. Many of these methods are based on risk, often determined by computer models. Other examinations are based on new developments that call for attention, such as cybersecurity.

"The primary focus is on the following types of funds: open-end funds (i.e., mutual funds); closed-end funds; and underlying insurance funds," OCIE said in the new risk alert. "The emphasis will be on registered investment company complexes that were launched one or more years ago." It did not state just when in 2015 such examinations would start or if they have, in fact, already started.

"We welcome OCIE publishing information regarding its planned areas of focus for targeted exams, as this information enables other registrants that may not be visited as part of a review to assess their own operations, with a focus on those areas that are of interest to the SEC," said an Investment Company Institute spokesperson.

The initiative will probably make investment companies who have never been examined "a bit nervous," said Wilmer Hale partner Douglas Davison. "Those that are small shops may have the same person in charge of compliance and in charge of other responsibilities, and now they will need to prepare for an exam and handle document requests."

Investment companies should consider the following, he said, to make the preparation somewhat smoother:

  • Identify who will be the lead person when the  examiners arrive. This could be the person currently in charge of compliance, but does not have to be. The ideal person will be someone with a patient temperament, articulate, and who is up to speed on the subject matter, or can quickly find appropriate answers to examiner questions.
  • Get the paperwork in order. Funds should be able to determine from the given topic areas listed below just what types of documents will probably be asked for. "Funds should not wait. They should get the right documents in order now," Davison said.
  • Conduct a mock exam. This involves having a consulting firm or law firm play the role of SEC examiners and conducting an exam just as the real examiners would.

What examiners will examine

What the risk alert did reveal, in some detail, were the "higher-risk areas" that examiners will focus on, and listed five specific ones. Each examination will focus on two or more of the following areas:

  • Compliance programs. Examiners will look at both fund and adviser compliance programs in regard to four specific areas: proxy voting policies and procedures for portfolio securities, proxy voting policies and procedures for fund shares, timeliness and accuracy of registration statements and other periodic report filings, and codes of ethics for identifying and mitigating conflicts of interest. "Rule 38a-1 under the Investment Company Act requires each fund to adopt and implement policies and procedures reasonably designed to prevent the fund from violating the federal securities laws," OCIE said. "The policies and procedures must provide for the oversight of compliance by the fund’s investment advisers, principal underwriters, administrators and transfer agents … through which the fund conducts its activities."
  • Annual advisory contract review. Examiners will scrutinize fund advisory contracts, including sub-advisory contracts, to determine "the adequacy of the basis for the board’s determination of whether the advisory fee is fair and reasonable; and … the management of any adviser’s conflicts of interest with respect to its obligations to the fund and the fees it receives."
  • Advertising and distribution of fund shares. Examiners will assess a fund’s policies, procedures and controls in regard to the review and approval of advertising materials. They will also "review fund disclosure of breakpoints and the practical application of any procedures in place to assess whether and to what extent breakpoints are correctly applied and monitored," OCIE said. Fund marketing materials are subject to statutory and regulatory restrictions, unless eligible for an exemption or exception.
  • Valuation of portfolio assets and NAV calculation. Examiners will review fund valuation and NAV calculation methodology policies and procedures and practices, as well as the board’s processes for carrying out valuation oversight. A fund’s NAV is required to be calculated using, for portfolio securities with readily available market quotations, the current market value of those securities. For securities and assets for which market quotations are not readily available, fair value must be determined in good faith by the fund’s board.
  • Leverage and use of derivatives. Examiners will look at three areas here: compliance with asset coverage requirements under Section 18 of the Investment Company Act, asset segregation in relation to SEC staff-issued guidance, and whether funds’ disclosures "appropriately convey the funds’ use of derivatives and the associated risks with such investments," OCIE said. Section 18 restricts the amount of borrowing by open-end and closed-end funds in order to protect fund investors from "excessive borrowing by funds that would increase the speculative character of fund shares and to ensure that funds operate with adequate reserves."

OCIE cautioned that "examiners may select additional topics based on operational and other risks identified by the staff during the course of the examination."