The most frequent quip I hear from owners and executives of investment advisers relating to compliance is that what keeps them up at night is they “don’t know what they don’t know.” I sympathize with them about the unknown and try and help insure that they are positioned to be compliant with federal and state securities laws. Rule 206(4)-7 requires each registered adviser to review its policies and procedures annually to determine their adequacy and the effectiveness. This rule serves as an annual reminder of the knowledge gap that owners and executives face without a trusted legal and compliance partner. This post is intended to provide a high level overview for owners and executives of things they ought to consider as part of this annual review process.
- The annual review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the firm’s policies or procedures. A firm would be prudent to review recent enforcement action and examination trends.
- The firm’s policies and procedures should be reviewed taking into consideration the nature of the firm’s operations. The policies and procedures should be designed to prevent violations from occurring, detect violations that have occurred, and correct promptly any violations that have occurred.
- The firm should take time to identify conflicts and other compliance factors creating risk exposure for the firm and its clients in light of the firm’s particular operations, and then ensure that the firm’s policies and procedures address those risks.
- The firm should confirm that the CCO is competent and knowledgeable regarding the Advisers Act and empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm.
- The firm should consider the following sources for performing the annual review: a) interviews, b) testing, and c) review of exceptions from the prior year.
- Review prior year’s review and recent deficiency letters from regulators.
- At a minimum, the firm’s policies and procedures should address the following issues to the extent that they are relevant:
- Review the firm’s portfolio management and trading processes. This should include:
- A review of how the firm allocates investment opportunities among clients,
- How it aggregates block trades,
- A review of the consistency of portfolios with similar investment objectives,
- Disclosures by the adviser regarding portfolio management processes,
- Review of any client-imposed and regulatory restrictions,
- Review of soft dollar arrangements and allocation of mixed usage, and
- Review of best execution (while I disagree with the SEC Staff that this concept extends to mutual fund purchases, adviser’s should consider whether their purchases and sales of funds and share classes through a specific broker-dealer or custodian are appropriate).
- Review trading by the firm and its personnel.
- Review the accuracy of disclosures made to investors, clients, and regulators, including account statements and marketing material.
- Review the safeguarding of client assets from conversion or inappropriate use by personnel.
- Review for the accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction.
- Review the firm’s marketing material and services, including the use of solicitors.
- Review how the firm values client holdings and charges fees based on those valuations. Review disclosures and agreements to insure that they are all in agreement.
- Review of the firm’s safeguards for the protection of confidential client information.
- Review the firm’s business continuity and succession plans.
It is always a good practice to have an independent party to provide a second set of eyes on the firm’s policies and procedures and their annual review. If you have concerns whether your firm has any gaps in its compliance program or whether it is properly documenting its review properly, do not hesitate reaching out.