How to Handle an SEC Inspection

May 1, 2002 Advisory
Complinet


Every adviser will be examined at some point by the SEC's examination staff. That is a given. Sometimes the inspection will be preceded by a letter or telephone call from an SEC staff member notifying the adviser of the date for the scheduled inspection. Other times, an examiner will simply appear at the door unannounced. No one can be entirely prepared for a surprise inspection by a regulator. There are, however, a number of things that advisers can and should do now to ensure that an inspection is handled as efficiently as possible. With proper planning before the SEC arrives, advisers can minimize the disruption to their business and reduce or eliminate the possibility of regulatory sanctions. In so doing, advisers are encouraged to remember the age-old adage -- "An ounce of prevention is worth a pound of cure."

I. THINGS TO DO BEFORE AN INSPECTION IS EVEN ANNOUNCED

  • Inculcate a "culture of compliance" at your firm from the very outset. It is axiomatic that good compliance is good business.
  • Do your best to fix problems before the SEC arrives. Remember that first impressions are lasting, so get your house in order ahead of time.
  • Have books and records ready for inspection -- organized and up-to-date.

- See Rule 204-2 under IA Act; Rules 31a-1, 2 and 3 under IC Act

  • See SEC Inspection Manual (made public in 1984)
  • See SEC Standard Inspection Letter, "Investment Adviser Examination List of Books and Records Requested for Review" (made public in 1995)
  • Be sensitive to the SEC examination cycle. While an adviser can go for years between exams, the more time that has passed since your last exam, the more likely that you will be inspected shortly. As a rule of thumb, large fund complexes are inspected annually, while advisers are reviewed once every 2-3 years. Of course, exams can occur at any time, hence the need to be prepared. Advisers should also be alert for targeted "sweeps" which focus on specific industry practices and which have become popular in recent years. Trade publications often offer alerts on this score when they can.
  • Review your firm's compliance manual periodically to ensure that it is complete and up-to-date. The week between Christmas and New Year's Day is a good time to conduct an "annual check-up," but any time is really fine. Be sure that such seemingly simple things as the name of the current chief compliance officer is correct, as well as the firm's policies and procedures. This is also a good time to confirm that certifications of the receipt of and adherence to the firm's policies and procedures are signed, dated and in the file for all covered employees.
  • Consider conducting a mock exam or internal audit before the regulators arrive. Be sure, however, that the exam or audit is constructed in such a way to ensure the confidentiality of the findings. The only effective way to do this is in conjunction with legal counsel, whose involvement offers the protection of the attorney-client privilege. Be sure to discuss the scope and format of any mock exam with counsel in advance. Otherwise, you may be drafting a blueprint of internal problems for the next SEC examination team to follow.
  • Review the inspection or deficiency letters generated by the SEC in connection with their last few inspections of the firm. These letters frequently serve as a beginning point for a new examination of the adviser by the SEC, and nothing is worse than failing to correct a problem previously detected by the regulator. Be sure, also, that all promises or commitments made by the firm to the SEC in response to prior deficiency letters have been adequately implemented.
  • Designate in advance a "point person" and one or two alternates to head up any regulatory inspection that occurs -- whether announced or impromptu. Someone in the organization -- typically the chief compliance officer -- should be on "stand-by" in the event a regulator happens to drop in unannounced.
  • Determine in advance where in your offices you will station the SEC examiners when they arrive. They will arrive at some point.
  • Advise your receptionist(s) what to do in the event any regulator appears unannounced, and be certain to apprise your receptionist and appropriate staff in advance if an inspection has already been scheduled.
  • Respond diligently to the SEC's pre-inspection notification letter by preparing, copying and segregating the requested documents in the room where inspection will take place.
  • DON'T panic when your turn comes. Every firm will be inspected.
  • DON'T assume that everything will be fine without any prior preparation. Receptionists and others caught off guard may unwittingly do or say things they shouldn't.
  • DON'T try to stonewall the SEC. They are entitled to inspect and to request any unprivileged document you create or maintain.

II. WHAT TO DO DURING THE INSPECTION

  • Greet the SEC staff in a courteous, professional, and cooperative manner, but resist the temptation to volunteer information or speak "off the cuff".
  • Identify the point-person for the firm for the inspection and politely, but firmly, advise the SEC examiners that all requests for information or documents during the exam must come through the point person or a specific designee on staff. The point person (or his or her designee) must then be available throughout the inspection to respond to the examiners' requests in a timely fashion. Otherwise, you run the risk of delay and frustration setting in on the part of the SEC examiners, something that is never a good result.
  • Try to obtain the business cards, or at least the names, titles, and phone numbers of the SEC staff who appear at the inspection. (SEC staffers are usually happy to pass these out upon request.) Try also to determine who is the most senior member of the inspection team, if this can be done in a politic, unobtrusive way. Knowing who is in charge can provide a tactical advantage as the exam plays out. Remember that all regulators -- like all registrants -- do not see eye to eye on all matters. A frustrating encounter with a low-level staff person may be easily remedied if you know who's in charge of the examination.
  • Try to determine the nature and scope of the exam to the extent possible (i.e., is it "routine," "for cause," or part of a targeted sweep?). Also try to determine how long the inspection will take. While the SEC staff is not obligated to provide any of this information, there is no harm in asking and you may learn something valuable from your query.
  • Advise the SEC staff that you will do the copying of any records they need. In no way should you ever grant the SEC direct access to your photocopiers or your files. You or a designee must, however, remain on "stand-by" to accommodate their requests for files and copies as needed. A common approach is for the examiners to accumulate a certain amount of material for copying before asking for it to be reproduced. This approach limits the amount of rushing around that must take place in order to accommodate the examiners.
  • Provide the SEC staff with appropriate accommodations during the inspection. The best location is somewhere away from your operations staff, that includes a conference table and a door that closes. This limits the opportunity for the SEC examiners to overhear conversations they should not, and reduces the possibility of "chance encounters" between the SEC and a member of your staff. Remember that one of the keys to a successful exam is control.
  • Maintain a detailed log of all documents requested by, and produced to, the SEC staff during the course of the inspection and update the log with any post-examination requests by the staff. (See further below).
  • Request confidential treatment under the Freedom of Information Act ("FOIA") for all documents produced to the SEC staff. Ideally, this should be done in writing to the senior member of the inspection staff and the appropriate SEC FOIA officer.
  • Never lie to or mislead the SEC, and instruct your staff to conduct themselves the same way.
  • Do not refuse to produce documents requested by the SEC staff unless the requested documents are protected under the attorney-client privilege or some other applicable protection. In the event the SEC staff requests documents that are of a competitively sensitive or personal nature (e.g., your proprietary trading model or clients' tax returns), try to negotiate with the staff for limitations on their use. Many times the staff will agree to initially inspect a particular document, while reserving on the question of whether the document must be copied. Don't forget, however, that once privileged documents are shown to an examiner, they lose their protection. To the extent possible involve a lawyer in negotiating the SEC's access to these sensitive documents.
  • Try to conclude the inspection as quickly as possible. Remember that your goal is to have as uneventful an inspection as possible. The shorter the exam the happier everyone will be.
  • Request an "exit interview" with the staff. This type of briefing at the end of the inspection (but before a formal written report is prepared by the SEC staff) is voluntary on the part of both the SEC and the registrant. Nonetheless, it is an excellent opportunity to gauge the areas of greatest concern to the SEC staff and it allows the registrant to take pro-active steps in appropriate situations. It also provides a good opportunity for the firm to express to the SEC staff its own views of any matters in dispute, provided that this is done in a calm and factual manner.

III. POST-INSPECTION STEPS

  • Follow through (in writing) on any promises to the SEC staff to produce additional documents or information.
  • Apprise the relevant people in your organization orally about how the exam went. Avoid detailed written memorandum or e-mail to your staff or senior management, however, about the exam or likely next steps, as the documents you create will likely not be exempt from later inspection by the SEC (or third parties in the event that litigation ensues).
  • Identify those practices and procedures flagged during the exam which require improvement or modification, or which the SEC is likely to comment upon in a deficiency letter. The best time to formulate your likely responses to a written deficiency letter -- or to consider which documents are most supportive of your position -- is immediately after the exam. By organizing your thoughts and papers that relate to particular issues raised during the exam while they are still fresh in your mind, you will be in a far better position to respond formally in the event that a deficiency letter is actually sent by the SEC.
  • Start planning for the next SEC exam!