What To Expect from an SEC Audit

"If you want a place in the sun, you've got to put up with a few blisters."

Abigail Van Buren, b.1918, writer and journalist

Hedge fund managers that trade Asia's markets should be aware that an SEC audit may be coming your way and very soon. Talk in the markets suggests that they have already started this process targeting funds that are Asia and Japan-focused.

So what are the main surprises that you as a single hedge fund manager should be aware of? In no particular order here are a few tips to be aware of:

1) Third Party Marketing Contracts. Officers of the SEC will almost certainly be interested to see the written contracts to understand how this potential conflict of interest is formalized and who benefits from it?

2) Trades. The SEC will almost certainly be interested to see the actual trading tickets over a period of time to follow the trail of what the manager is doing, and in his/her process to assess internal processes and operational procedures on trade reconciliation.

3) The Handling of Cross-Trades. So-called end-of-month "window dressing" by which outstanding positions might be closed out only to be opened the following day (and month) are a particular area of interest. Too many times such activity may be conducted to benefit the manager (perhaps in terms of P&L calculations) and/or its prime broker which sees more commission generated flow. So, the SEC will probably ask questions to see if the activity is justified and whether the end-investor is paying unduly for this kind of activity - which might be a wash over the long term - but might nonetheless benefit constituencies other than the investors.

4) Trading Commissions. The SEC has developed pretty good baseline models as to how much a manager should be paying in trading flows to its brokers by strategy and geography. Do not be surprised if your fund is compared to this baseline with questions geared to how and why you paid so much in brokerage commissions? Have answers and in particular have a clear idea how this arrangement currently impacts your investors.

5) Treatment of Hot Issues. The SEC is also interested in the internal workings of IPOs as they relate to the hedge fund firm and its various funds. In the case of Japan this can be a significant P&L contributor as it was in 2004/05 for many funds. Why the interest? Again, it boils down to "fair treatment" of investors. They want to see and test how a manager distributes potentially favorable IPOs among various funds according to some criteria like the size of the fund/AUM. Clearly, the SEC might frown on a manager that had a class of funds for himself and family that took up an unusually large allocation from an IPO. Watch out!

6) Documentation and More Documentation. The SEC will want to see all paperwork to and from prime brokers and administrators to the investment advisors. Before they arrive at your office for the one to two week audit make sure you have all copies made and ready for inspection. It will save time and a lot of stress.

7) Compliance Documentation. It is always a good idea to have these all copied and prepared in advance, if possible in electronic form so that the SEC officers can take it away. Find out in advance of the visit what they will want to see and have it available for them.

8) No Excuses. Whatever happens in your life, do not expect the SEC to postpone their visit to accommodate the changes. If and when they say they will come and conduct the audit they will come. This is not like an U.S. jury duty summons - it is a lot more definite just like death and taxes.

As ever, we suggest that you get proper legal advice and as the old boy scout motto goes: "Be Prepared." Mahalo and Happy Thanksgiving to all.