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How to Ace an SEC Exam: 07 Priorities


NEW YORK-Soft dollars stay at the top of the "to do" list for examiners at the Securities and Exchange Commission in 2007, said Gene A. Gohlke, associate director of the SEC's Office of Compliance Inspections and Examinations.

The fund police will also be patrolling the use of non-public information, conflicts of interest in service provider agreements, best execution and securities lending.

"The main area of focus is the compliance program the fund group has established," said Gohlke, addressing attorneys at the Practising Law Institute's "Investment Management Institute 2007."

This year, companies will get between one and three weeks' notice before a sweep exam, rather than days. If inspectors turn up unannounced, it's not a sweep; it's probably a problem, Gohlke said.

The SEC's policy surrounding e-mails has also changed. Whereas it used to ask for all e-mails from a particular person, the agency found itself bombarded. Now the requests will be more pointed, he said.

During an exam, it's critical that chief compliance officers interface with examiners, said Stephanie Monaco, a partner with Mayer, Brown, Rowe & Maw in Washington.

Gohlke agreed that talking to examiners throughout the process will help fund companies understand what the examiners are looking for, and inspectors to see what policies the company has in action.

But there's no need to wait for a notice to prepare.

If examiners are conducting a sweep of the use of non-public information in making investment decisions, they will likely ask for the 10 most profitable investment decisions over the span of six months or a year. Extremely profitable trades might be signs of front running, driving examiners to delve deeper. The SEC will also scour the firm's proprietary accounts and even personal accounts of key personnel.

Of particular concern are trades involving distressed debt, or other styles that might give a firm access to non-public information.

The test, Gohlke said, is relatively simple, and smart companies will conduct it themselves. Accounts involving styles that might be more prone to such malfeasance might be tested more frequently, he suggested.

Sounds easy, but it's not, Monaco argued.

"What about the bad, evil people who can trade in non-transparent, unreported accounts?" she prodded. Furthermore, pre-empting every nefarious scheme proves daunting. It also does little to mend the cultural divide between compliance and other fund company staff, she said. "It makes the CCO think the worst of all employees," she said.

Gohlke painted a silver lining on her Hobbseian portrayal. The task is for firms to think about their environment holistically, he said, including the networks that managers and clients may have through old co-workers or friends that could pose a threat to security. News stories about other firms can help CCOs think of ways someone at their firm might do the same, or how to test controls already in place, Gohlke said.

This year, SEC examiners will also be looking into whether the arrangements between fund companies and their service providers are proper and adequately disclosed to investors. CCOs should look at contractual agreements that funds have, and ensure they are in line with the industry norm. They should also carefully consider whether any arrangements with subsidiaries of their own company pose a conflict of interest.

Simply because they are not named service providers, relationships with custodians should not escape scrutiny, said Phil Kirstein, senior vice president and compliance officer at Alliance- Bernstein in New York.

Custodial banks are not under SEC jurisdiction, Gohlke noted, so unlike other service providers, they are not subject to separate inspection.

That means fund companies must be especially vigilant in dealings with banks, Kirstein said. AllianceBernstein conducts quarterly calls with its custodians to review procedures and the terms of their agreements with any service providers they might use in conducting business on behalf of the funds, such as pricing services, or lending agents.

Soft dollars remain a hard issue for fund companies to manage, so the SEC will continue looking into them in 2007, along with best trade execution. To protect themselves, firms should document the reasons they trade with certain brokers, especially if those brokers charge above-average rates-say four cents when the going rate is a penny-or if the broker is an affiliate of the fund company.

There are some cases where it might not be the best execution from the shareholder's short-term perspective, but it is good business strategy, Kirstein said.

Gohlke conceded that while paying more per trade once in a while might be the only way to maintain a relationship with a bulge trader, or guarantee access to liquidity, the reasons should be disclosed.

Side-by-side managers, or those who manage different products simultaneously, can expect extra attention, Gohlke added. Compliance officers should consider running forensic tests to ensure such managers treat all their products fairly.

Securities lending marks the fifth and final examination field Gohlke outlined. Examiners will check whether loaned shares are recalled for proxy votes. If shares are not recalled, the SEC wants to know why and see that shareholders are alerted to the procedure, he said.

A successful sweep ends with an exit interview. "If we don't do an exit interview, you probably have something you should be concerned about," Gohlke said.

Just because the exam is over doesn't mean the dialogue should stop, Monaco said. Firms that receive comment letters should review them carefully, and challenge any claims that don't seem to make sense, she said.

Although the SEC will never rescind a letter once it's written, a strong rebuttal can end the issue altogether, she said. "You really want that back and forth with the [SEC] staff."

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