Regulator roadmap: Could new SEC rule force advisors to give too much away?

An SEC commissioner is warning a new rule requiring advisors to write down findings — embarrassing and otherwise — from their internal compliance reviews could give regulators a "roadmap" for unearthing violations.

Hester Peirce, one of two commissioners to vote against a 660–page rule mainly meant for advisors to hedge funds and other funds, said a mandate for firms to document any findings from internal compliance audits could backfire: Rather than conduct painstaking searches for any shortcomings, advisors might simply back off from thorough reviews.

"You could be deterring firms from doing comprehensive reviews because they're perceived as a roadmap for exams and enforcement," Peirce said, "because the first thing exams and enforcement is going to do is come in and ask for that review."

Despite her objections, the Securities and Exchange Commission voted 3-2 in a virtual meeting Wednesday in favor of the documentation rule for compliance reviews, alongside a slew of changes to the rules governing advisors to hedge and private-equity funds. The new requirement for documenting internal audit findings will now take effect 60 days after appearing in the Federal Register.

Before the vote, SEC investment management director William Birdthistle noted that — whether required to or not — many advisory firms now write down findings from their annual internal compliance audits. Birdthistle said he's seen no evidence to suggest that those who already do this believe they're tipping their hand to regulators.

"So we generally think, overall, that having written documentation is certainly helpful and will create more robust reviews," Birdthistle said. "But we do not see the problem that you've identified so far."

Adam Kanter, a partner in the investment management group in the Washington, D.C. office of Mayer Brown, said most of the advisors his firm works with already write down findings from their internal reviews. Yes, he said, the documentation can help guide regulators when they come knocking.

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"They may want to know: What did you change? And what was inadequate?" Kanter said. "And then they'll wonder: Should we turn over those same rocks that you did and see if there are more problems?" 

The bulk of the changes approved on Wednesday apply to advisors to so-called private funds, which manage more than $25 trillion for retirement plans, universities and the rich. Private funds are often viewed as providing sophisticated investors a means of tapping returns they might not be able to obtain in the public markets.

But SEC Chairman Gary Gensler and others have long worried that the funds are attracting more and more regular savers and retirees. Investors in private funds, he said, include "municipal workers, teachers, firefighters, professors, students, and more."

Looking at firms' Form ADVs filed in the year leading up to Sept. 30, 2022, the SEC estimated that 5,157 registered investment advisors had private funds as clients. Of those, 2,554 provided advice to securitized-asset funds — funds dealing with mortgage-backed securities and similar instruments — which are largely excluded from the SEC's new rules.

Firms that fall under the new rule for working with private funds may find themselves paying substantially more to meet the annual auditing requirement. Any auditors they hire to review private funds must come from the Public Company Accounting Oversight Board, a nonprofit organization created by Congress to oversee audits of public companies and broker-dealers.

The rule adopted Wednesday is in large part meant to force private funds to be more forthcoming about their investment holdings and any deals that they might have struck exclusively with large investors. Private funds will now have to provide quarterly financial statements and undergo annual audits. They'll also be banned from offering special terms to certain investors — such as a greater ability to withdraw their money — unless they disclose those deals to all other investors.

Not all of the new requirements are scheduled to take effect at the same time. Certain provisions will hit large firms first.

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The rule on disclosing special deals to all investors, for instance, will take effect within a year of its publication in the Federal Register for advisors with $1.5 billion or more in private fund assets. Advisors with less under management will get 18 months.

Gail Bernstein, general counsel at the Investment Adviser Association — an industry group for independent advisors — said the staggered deadlines were something that the IAA and its allies fought for.

"The IAA is increasingly concerned about the disproportionate and rapidly increasing challenges smaller advisers are facing from the sheer scale, scope, and speed of the SEC's current rulemaking agenda," she said in an emailed statement. "The challenges are substantial in isolation and potentially overwhelming on a cumulative basis."