Top Tips Every Trader Should Know to Prepare for an SEC Exam, from Lori Hoch, Cortina Asset Management

An SEC exam can be an intimidating thing to face, but many trading firms will have to deal with one some day. The problem is that you may not have any idea when it’s coming, and when it does, you are going to have to be prepared with a great deal of information at the ready.

At TradeTech USA, Lori Hoch, Principal, COO, Cortina Asset Management, keyed in on some top strategies that firms need to implement in order to prepare themselves for such an exam. “You always hear people talking about Dodd-Frank at these conferences and you don’t learn how to do anything differently,” she said. “I want to talk about practical things that will impact you.”

First off, you’ll know that your firm is going to have to undergo an examination when the SEC sends an exam letter. Once that’s happened, they will want to send someone on site to do more investigating, and that person will be on site for at least a week – typically longer. They then send a sweep letter and a “Chicago” letter which is a two-page request for documents that you have to mail back within 10 days. Hoch stressed that internal compliance will expect you to know what to keep, for how long, and assume that you can produce documents quickly.

The top three things that every trader should know about the SEC examination process is that:

1. SEC examiners are lawyers and accountants. They are NOT traders or portfolio managers, so they will not understand your business. This isn’t always easy to deal with.

2. The SEC will interview your traders and expect them to be able to answer questions clearly and definitively.

3. Compliance expects that you know the rules and have the documents to back up your statements.

Traders should understand what the focus areas will be for the SEC’s exam:

- Conflicts of interest

- Portfolio management

- Outsourcing services

- Valuation of client assets

-  Safeguarding client assets

- Performance claims

There are four common requests that will come out of an SEC exam letter:

1. Soft dollar budget that describes the products and services the adviser obtains using clients’ brokerage commissions.

2. All IPO’s or secondaries and information on allocation including trade date, security, symbol, total number of shares and participating accounts. For IPO’s, indicate whether shares were traded at premium when secondary market began trading.

3. Order memorandum showing terms and conditions of order, person who recommended the transaction, person who placed the order, the account, date of entry, bank or broker who executed order and whether entered pursuant to discretion. This will all have to be on ONE page.

4. Any documents created in the evaluation of brokerage arrangements and best execution (broker vote, directed brokerage)

With regards to conflicts of interest in trading, here are some considerations the SEC might want to examine:

- Soft dollars: traders placing orders for clients’ accounts to generate sell dollar credits rather than seeking best execution

- Adviser manages seconds with competing investment strategies (long only vs. short)

- Traders perform multiple functions

- Account restrictions – do traders enter, have ability to override, monitor, report on, etc?

- Traders receive performance-based bonuses

According to Hoch, the SEC has said that traders need to take responsibility for things that may be out of their control.

There are also some new considerations that must be taken into account when preparing for an SEC exam. For instance, the Department of Labor recently decided that companies must disclose all the people that trade firms pay – they want to know every broker you’ve paid and how much, said Hoch. It’s important to keep that in mind as you are paying out whoever is servicing your business. Another hot topic is social media – and that has implications for SEC examination because of the way that firms can be portrayed on the worldwide web through social media. The SEC’s social networking sweep letter basically states that the only thing individuals employed in financial institutions can write about on any social media platform is the name of the company they work for and their title there. Anything else might be seen as a form of advertising and therefore isn’t allowed.

There’s also the topic of political contributions by investment advisers. The SEC’s form ADV Part II – effective March 31, 2011 for most firms, according to Hoch – states that if you’ve donated more than $350 to a candidate you are able to vote for and you take business from that person you cannot get paid on it. Sure, you can take as much business as you like, but in order to stay within legal stipulations, you’ll have to do it pro-bono.

But as intimidating as this all might sounds, what really matters is that you are keeping track of your business responsibly and in an organized fashion. As long as you have a process, that’s all the SEC really cares about,” said Hoch.

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