T he investment management industry has every few years. The - PDF document

G Investment Management Alert March 2006 Compliance Reminder: Conducting Your First Internal Compliance Manual Review T he investment management industry has every few years. The examinations are designed recently become the subject of increased primarily to determine whether investment regulation by the Securities and Exchange advisers are complying with the Investment Commission (the “SEC”). Regulations adopted on Advisers Act of 1940 and its rules and regulations February 5, 2004 required that federally registered (the “Advisers Act”). When an examination investment advisers designate a chief compliance begins, it is likely that the SEC staff will initially officer and adopt a manual of comprehensive request a copy of the adviser’s Form ADV and its compliance policies and procedures by October 5, compliance manual and use these two documents 2004. The regulations also required that as a road map to be followed during the investment advisers review the effectiveness of examination. Your internal audits will be the first their compliance policies and procedures within 18 step towards ensuring your compliance with the months of the date of their adoption of a roadmap you will have provided the SEC, and will compliance manual and annually thereafter. Many allow you to be prepared for the SEC staff when investment advisors adopted a manual of they arrive. Below is a brief outline of some compliance policies and procedures on October 5, important areas that the SEC staff has highlighted 2004, and are now required to conduct their 18 as areas of concern; particular attention should be month internal review. paid to these issues when conducting your internal compliance review. A lthough it may appear that the Internal Controls and Supervisory compliance review is a mere formality, Procedures. the potential benefits of such internal reviews are compelling. Annual internal audits, The SEC staff have stated that their primary coupled with remedial action when necessary, can focus will be on an adviser’s controls and be very useful in dealing with the SEC, which will procedures and that “where those controls are soon be conducting a review of its own. An SEC found to be weak and ineffective, or non-existent, registered investment adviser is generally subject to an adviser will be considered high-risk, and will an on-site examination by the SEC Office of have more frequent and in-depth exams.” During your internal examination you should seek to Compliance Inspections and Examinations once This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. L Roseland, New Jersey Telephone 973.597.2500 65 Livingston Avenue www.lowenstein.com 07068-1791 Fax 973.597.2400

G ensure that (i) each employee has a current copy of Books and Records. your compliance manual and is familiar with the The Advisers Act requires advisers to make and procedures therein, (ii) the procedures in your keep true, accurate, and current certain books and compliance manual accurately reflect the practices records relating to their investment advisory that are followed by each employee, and (iii) each business. An adviser who reluctantly or slowly employee has a supervisor providing clear produces requested materials during an SEC oversight of such employee’s work. Discuss with examination will likely be deemed high-risk, and employees their current practices, whether such face the prospect of more frequent and in-depth practices are consistent with the compliance exams. An adviser that produces incomplete manual or whether there are additional measures records will likely be penalized. While conducting that should be taken. If there are frequent your audit, it is a good idea to review your books occurrences of non-compliance with a particular and records policy and test your employees’ ability procedure, it is a strong indication that the to produce various documents in a 24 hour period. procedure needs revision and/or the employee In addition, you should review all material requires additional training or supervision. In produced to ensure that all files are complete. addition, you may want to request that certain supervisors demonstrate that they are Best Execution and Soft Dollars. appropriately supervising their employees’ work. Advisers have a duty, in executing client For example, if your compliance manual requires securities transactions, to seek to obtain the best that the portfolio managers supervise the firm’s net price reasonably available under the traders and their brokerage choices for the circumstances. The SEC expects firms to pay purposes of best execution, you should inquire as to special attention to best execution when they are how they are doing so. Do they review every trade? utilizing soft dollar arrangements and are expected Do they hold quarterly best execution meetings? to demonstrate to examiners why they are Ensure that they can demonstrate that the receiving quality trade execution, given the other procedures they are following are consistent with products and services they are also getting. During those set forth in the compliance manual. your examination it is important to review your best execution policy and ensure that you are Accurate Disclosure. following the procedures set forth therein. If you Pursuant to the Advisers Act, an adviser has an are required to have best execution meetings or affirmative duty to disclose all material facts to its reviews, ensure that such meetings or reviews have clients in a written disclosure document, usually been held, documented and that such Form ADV, Parts 1 and 2. During your inspection, documentation can be easily produced. In you should distribute copies of your Form ADV to addition, you may want to perform certain surprise all relevant personal for their review, to ensure that best execution checks, by choosing a few random your disclosure therein is still accurate and does trades and request that traders explain their not omit any material information. brokerage choices.

G Personal Securities Transactions. must be met if an investment adviser pays a cash fee for client referrals or solicitations. The adviser The staff reviews personal trading practices of also must maintain certain records related to its investment advisers closely during compliance referral arrangements, such as the written examinations because of the potential for abuse. It agreements between the adviser and the referring is important to maintain adequate records of party and the referring party’s written disclosure personal securities transactions as required documents. During your examination it is pursuant to your compliance manual. During your important to ensure that all solicitors used by your examination it is important to ensure that the firm meet the requirements of the Advisers Act required information is being collected from all and that all required documentation has been relevant personnel and that the Chief Compliance obtained. Officer or other designated person reviews such documentation consistently and can demonstrate Recidivism. that he has done so. In addition, you should The examination staff closely reviews the review any employee trading requests and ensure actions that advisers have taken to remedy the that any required restricted securities list is deficiencies cited during past examinations. appropriately maintained and distributed. During your examination it is important that you Compliance with Advisory Agreements. review any past deficiencies cited by the SEC staff following an examination and ensure that any A review of investment advisory agreements is a such deficiencies have been corrected. standard component of compliance examinations because these agreements play an important role in Demonstrating A Culture of Compliance. defining the adviser’s relationships with its clients. The SEC staff have stated that they are now During an examination, the staff will look to see “refining and formalizing their approach to whether the adviser is complying with its own identify, and examine more frequently, those firms representations and with the expectations of its that present the potential for greater harm to the clients as set forth in the advisory contract. investing public. An adviser with a strong However, very often an adviser and its client will compliance program, generally, will present a maintain a course of conduct that is mutually lessened risk to clients; while an adviser with few satisfactory, but may be contrary to the procedures or ineffective compliance controls presents a much contained in the advisory agreement governing higher risk.” While conducting your audit, it is the relationship. During your examination it is important to document all the areas reviewed and important to review your advisory agreements and any remedial action taken. It is also important ensure that any representations therein are that your employees can demonstrate that they are accurate and that all of your obligations are being following firm procedure. For example, if your fulfilled. policies require that the Chief Compliance Officer Referral Arrangements. review all records of employee personal trading quarterly, you may request that the Chief The Advisers Act establishes requirements that