Best Practices for Addressing and Mitigating Problems Outlined in Deficiency Letters

December 08, 2016

A vast majority of the SEC’s hedge fund manager examinations result in the issuance of a deficiency letter, reports Hedge Fund Legal & Compliance Digest ("Best Practices for Addressing and Mitigating Problems Outlined in Deficiency Letters," December 8, 2016). Dorothy Mehta discussed how managers can address and mitigate issues outlined in those letters.

Dorothy Mehta, a partner at Cadwalader, Wickersham & Taft, observed that “It is not uncommon to receive a deficiency letter upon an SEC examination. It is important for a hedge fund manager to not be surprised or overwhelmed when receiving a deficiency letter, and it is more important to take the deficiency letter seriously and respond appropriately. Understand the issue or issues raised in the deficiency letter and tailor the response to those issues.”

On assessment and internal review: “Managers need to take an introspective look into themselves to see how to handle a particular issue and what is reasonable when handling the issue. People at the firm who will be affected by any changes need to be notified of the changes, because you need total buy-in from your firm, or it won’t matter what changes you put in place because you could still have an issue.”

On written responses concerning disagreements: “When responding or considering a response to the regulator upon receipt of a deficiency letter, there should be a clear line of communication with one voice from the manager. If there is a deficiency that the manager disagrees with, it may be appropriate to open that dialogue with the regulator and let them know you disagree and why. For example, if there is a suggested change or a particular deficiency outlined in the letter that relates more to a best practice rather than a regulatory requirement, the manager can let the regulators know why things are done differently and why the way things are done makes sense for them. Best practices are not a one size fits all. Best practices for a large institutional manager are not the same for a small startup manager.”

On regulators’ “best practice” suggestions: “The issue could be that what regulators think is a best practice with respect to a certain policy or procedure simply does not make sense for the manager’s business model,” Mehta added. “Anything that the manager is not legally required to do, that is more of a best practice, needs to fit into the manager’s business model.”

On meeting implementation deadlines: “The deadline of remediation depends on the level of changes that need to be done. Whatever the deficiency is, you want to match that timeline and match that response accordingly.”

On addressing deficiencies: “If, in communications with the regulator, the response is that the issue will be rectified or that remediation is in place, then it must be implemented. More likely than not there will be follow up, and any misstatement not only lends itself to a loss of credibility but could even proceed to sanction or enforcement.”

On disclosing deficiencies to invertors: “In terms of disclosure, one area to consider is negotiated terms with investors, whether in operative documents, side letters or managed account agreements. Certain investors may want notice of any deficiency letter, even if not material, and may request notification within a certain time frame.”