Part 2 of the SEC is getting serious

A question was asked "what is important to the SEC while preparing and conducting an exam of a private fund".  The answer was very succinct.  A good compliance and internal control program, a good valuation program and a good program to monitor conflict of interests.

Compliance Program and internal Controls

When the SEC is preparing for an exam, they will request the compliance manual from the Chief Compliance Officer (“CCO”).  The SEC will also request from the hedge fund or obtain through the web, things like client letters or disclosure documents. James Capezzuto, Associate Director, SEC stated “All is fair game in the pre-exam work” Once in the field the SEC will ensure that the CCO is informed and conversant in these materials.   

Bruce Karpati, Co-chief, Asset Management Unit, SEC Enforcement Division stated that compliance programs and internal controls “are very important to us and will be more important in upcoming exams”.  The exam method will include a top down approach starting with the CCO.  The SEC would like to see that the CCO and compliance function has support from the highest level(s) within the firm. 


The SEC will want to know that the CCO is knowledgeable of the rules and that the CCO “is engaged in the business” James Capezzuto further stated the they will be looking to see that the CCO “knows what the risks are in the business and that they effectively communicate those risks to upper management” The SEC also indicated that the stronger the compliance program the better feeling they will have about the firm.  However, they will not only rely on discussions with the CCO and the business lines, but will conduct testing surrounding the compliance program.

Good Faith points

The SEC indicated that a good faith effort to follow these programs goes a long way.  Bruce Karpati stated that if charges are brought against a firm and they firm had made a good faith attempt to deal with those issues both in a procedures manual and in practice (monitoring and testing) that the SEC will give the firm some credit for that.

It is clear that the SEC is saying that they want the firms to be knowledgeable and to have support from the top. Look at your procedures look at your business model and make sure they line up.

Outsourcing the Compliance Function

The SEC recognizes that some firms because of their size or lack of resources might outsource its compliance function.  This is allowed, but the SEC will review the compliance program and procedures manual just the same.  If the Firm outsources its compliance function they still need to ensure that it is germane to the business model and asset classes of the hedge fund.   If you outsource compliance and the program is off the shelf and does not have anything to do with the business the SEC will have concerns.  Further it was stated that if the compliance provider is far (not in geographical terms but from understanding the business model and related issues) the SEC will have concerns.  These outsourcing professionals need to know your business and need to ensure that there is good communication to all levels of the firm.

Tomorrow I will discuss the SEC's view on conflict of interest and valuation models.