Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News July 27, 2015 Issue

Mock Exams: Find Deficiencies Before the SEC Does

Would you rather find your firmís deficiencies yourself or have examiners find them? If your answer, like that of many advisers, is the former, consider conducting a mock SEC examination.

A mock exam, which can be conducted by a compliance consultant, a law firm or by the advisory firm itself, is basically a rehearsal of the real deal: "Examiners" will arrive at your firm and, just like real examiners from the SECís Office of Compliance Inspections and Examinations, will spend whatever time is necessary to comb through documents and interview staff to make sure your firm is in compliance with securities laws and regulations.

The difference, however, is that unlike OCIE examiners, mock examiners actually work for and are paid by your firm. Any deficiencies they find, and that the firm subsequently fixes, are deficiencies not likely to cause your firm any problems during the real exam or in any agency follow-up visits.

Costs and benefits

The two basic questions any firm needs to answer†before embarking on a mock examination are who is going to conduct the exam, and what it will cost. The answers, as with many business decisions, depend on a number of factors: the size of the firm, the depth and breadth of the examination you want conducted, and the benefits you want from the exam.

Whatever you decide, allow yourself enough time for a mock exam to be completed and to fix any problems that are uncovered, said Day Pitney counsel Eliza Sporn Fromberg. Since the endeavor may take anywhere from a few days to several weeks to complete, allow about six months to conduct the exam and make fixes, she said. "The worst thing would be to finish the mock exam without time left to fix the problems it uncovered, leaving them for the real examiners to find."

As for cost, most consulting firms and law firms will negotiate with you, said Mayer Brown attorney Adam Kanter. You can also contain costs by having the mock†examiners limit themselves to only the past three or six months of business activity, rather than the past year or two typically covered by an SEC examination, he said. Another possibility he suggested would be limiting the mock exam to only one area of the your firmís activity where you have particular concerns.

Make sure that any mock examiners you hire are well versed in the kind of business your advisory firm does, said Wilmer Hale partner Matthew Chambers. "You donít want an adviser that works primarily with mutual funds to be examined by a consulting firm or law firm more familiar with private funds," he said. "Similarly, even within private funds, there are different types Ė hedge funds, private equity funds, real estate funds. Try to match the consultant or law firm to the kind of business you do."

Itís not a bad idea to conduct a mock exam every three to five years, whether you are expecting a real exam or not, said Kanter. Your regular annual reviews conducted pursuant to Rule 206(4)-7, the Compliance Program Rule, can be a starting point for a mock exam, particularly if they resulted in modifications to your compliance program to correct a deficiency. A mock exam can be a good venue to test whether the changes you made were effective, he said.

The players

Consider the following mock exam options:

  • Do it yourself. The biggest advantage here is that, of course, you will save the money of hiring a consulting firm or law firm. In addition, no one knows your firm and its risk areas like you do, said Fromberg. On the other hand, you can still use that internal expertise in conjunction with a third party that brings a fresh perspective to what your firm does, said Chambers. "Still, doing it yourself is better than not doing it at all."
  • Hire a compliance consultant. The big advantage many compliance consultants bring to mock examinations is that they hire a lot of former SEC examiners. When those former examiners visit your firm, they will be conducting a mock version of the exams they conducted for real when they were employed at the agency. So firms hiring them will provide a very credible facsimile of what can be expected from real examiners.
  • Hire a law firm. A law firmís chief advantage is that its involvement can be used to argue in court or†before an administrative proceeding that the results of the mock exam are privileged information, said Chambers. That means the results will be considered as "work product" and therefore immune from the legal discovery process Ė in laymenís terms, there is a greater chance that the mock exam results would be considered confidential material.
  • Use a law firm/consulting firm combo. This may be the most effective option Ė although possibly,†depending on negotiations, also the most expensive. By hiring the law firm first, the argument that the exam results are privileged can be made, and by having the law firm hire the compliance consultant, the expertise of past examiners may still be tapped.

The exam itself

Where should mock examiners begin their scrutiny? This is where involving the firmís compliance department can make all the difference, said Fromberg. "If there were compliance problems in the past, the compliance department would know, and they should ask the mock examiners to look for those to make sure they were appropriately fixed," she said.

In addition, chief executive officers and other internal executives, simply from their day-to-day involvement with the firm, may have "an inkling" as to where there may be problems, Fromberg said, and can direct those conducting the mock exam to those areas, or request, after seeing initial results, that they dig deeper into certain parts of the firm.

Mock examiners, just like real SEC examiners, will send a firm a document request list several weeks prior to the exam visit. But just like real examiners, they may ask for other documents during the visit. Get a sense of which documents they may ask for, as well as topic areas within your firm that they will pay attention to, by using the following as guides:

  • Past deficiency letters. If your firm went through a prior SEC exam and received a deficiency letter, you can be fairly certain that the examiners coming to visit you now will have reviewed those letters Ė and will make a point of checking those areas to ensure that problems have not resurfaced, Fromberg said.
  • OCIE priorities list. Each year, OCIE issues a priority list of the activities it plans to scrutinize. For instance, in recent years, the priority list has mentioned alternative risk investments, dual registration and fee†selection as areas it plans to focus on. It would make sense, then, for mock examiners to review that list as a guide for their own audit.
  • Your own compliance policies and procedures. Expect real examiners to make sure that your firmís compliance policies and procedures are complete, and that the firm follows through on any procedures it promised in the compliance manual. A well-known compliance statement is that any practices a firm says it will follow, must be followed Ė even if that practice is not required by securities laws and/or regulations. Simply stating in a firmís compliance policies and procedures that a particular practice will be done opens it up for checking by examiners Ė who will note any failure to follow through on what your firm itself promised.