SEC Enforcement Examinations?

Securities and Exchange Commission (“SEC”) staff has suggested greater involvement and concern by Division of Enforcement staff with respect to examinations of registered investment advisers, including private fund and private equity managers. In a speech before the Regulatory Compliance Association on December 18, 2012, Bruce Karpati, Chief of the Enforcement Division’s Asset Management Unit, indicated that the SEC has established areas within the Division of Enforcement to “work with staff outside the Units on investigations and exams.”

These recently-established units include the Market Abuse Unit, Structure and New Products Unit and the Asset Management Unit. In addition, the Division of Investment Management has hired its own set of examiners separate from those in the Office of Compliance Inspections and Examinations (“OCIE”). Indications are that these Investment Management examiners will be visiting hedge fund and private equity investment advisers either separate from or with OCIE staff. This suggests that the Division of Enforcement and the Division of Investment Management are taking a greater interest in and will be participating in examinations prior to referral of matters to Enforcement and that there is more coordination and harmonization of objectives among the various offices and divisions of the SEC that oversee the asset management field. We explore the implications that this coordination has on investment advisers and the SEC staff’s role during examinations.

Mr. Karpati indicated that “these Units work to generate expertise for the Division of Enforcement” and that “they consult on exams; they lead our initiatives; they conduct training for staff; and they assist on policymaking.” These quotes suggest an emphasis on gathering and imparting intelligence regarding the asset management industry and its constituents, specifically hedge fund and private equity managers. As has been the case with other offices and divisions of the SEC, the Division of Enforcement has, according to Mr. Karpati, “hired industry professionals such as hedge fund managers, private equity analysts, and due diligence professionals.” Presumably, the Investment Management examiners would also be gathering intelligence that would inform rule making.

Mr. Karpati described the reasons these units have been created and where they are focusing their attention with regard to hedge fund and private equity firms. Among the notable reasons for establishing these units are the increasing indirect investments in hedge funds by the general public through participation in pension and retirement plans that invest in hedge funds and other alternative investments and the upcoming “elimination of the prohibition on general solicitation and general advertising as a result of the JOBS Act” which would allow hedge funds to reach a “wider audience”. This exposure to a larger group of investors is of concern to the SEC staff in that these investors may be financially unsophisticated and may not understand the products they are being offered. Further, these units seek to understand hedge fund managers in order to be proactive in detecting and combating fraud which suggests involvement by Enforcement staff at an earlier stage in the process than was previously typical. Formerly, Enforcement staff would typically become involved after a matter had been referred to them by another division or office of the SEC. Based on Mr. Karpati’s speech, it appears that Enforcement desires information regarding motivations, incentives and opportunities at hedge fund advisers that are in potential conflict with advisers’ fiduciary duty and that it will take action at an early stage in the examination process.

Among the focus areas for the Asset Management Unit are:

  • Overvaluation of assets to boost performance and management fees, including concealing losing illiquid positions in side pockets;
  • Fraudulent or weak valuation practices (note that this a stated major focus area for OCIE as well);
  • Insider trading, including the use of expert networks;
  • Related-party transactions and misappropriation of assets or concealment of losses through such transactions;
  • Favoring of certain investors through the use of side letters and preferential redemptions; and,
  • The susceptibility of hedge funds to conflicts of interest and other fraudulent practices as a result of lack of independent governance.

It is of note that many of these focus areas are congruent with those of the OCIE’s “presence exams” about which we wrote earlier and which target newly-registered private fund advisers. This further indicates a harmonization between the goals of OCIE and the Division of Enforcement. The interest of the Enforcement Division is not limited to hedge fund managers. Mr. Karpati noted that the Asset Management Unit has also undertaken a Private Equity Initiative to identify private equity advisers at higher risk for fraud. This effort is undertaken in conjunction with OCIE and the Division of Investment Management.

In an echo of what officials at OCIE have said (again a sign of harmonization of goals and efforts), Mr. Karpati recommended that hedge fund and private equity advisers:

  • Maintain and update compliance policies and procedures tailored to the particular risks and strategies of a firm;
  • Set a tone at the top and have a culture of compliance;
  • Implement a supervision and monitoring program with respect to firm employees;
  • Establish internal controls;
  • Ensure that checks and balances are in place where firm employees have overlapping or conflicts positions or duties;
  • Review operations, identify gaps and test compliance procedures;
  • Prepare for SEC examination inquiries (It is notable that an Enforcement official expressed this and that Enforcement staff may be on examinations along with OCIE); and,
  • Correct violations and deficiencies identified by SEC staff.

Moreover, unregistered private fund advisers should also be aware that they are subject to the anti-fraud provisions of the Investment Advisers Act of 1940 and, as such, could still be targeted by Enforcement staff. According to Mr. Karpati, unregistered advisers are a segment of the industry that pose risk of and improper solicitation of non-accredited investors. We also echo the above recommendations which we have been making to our clients for years. We have found, as Mr. Karpati noted, that large institutional investors seek private fund and private equity advisers with robust compliance programs. Therefore, compliance makes senses not only from a regulatory perspective, but also as it affects a firm’s bottom line.

Firms should not be surprised to find Enforcement or Investment Management officials accompanying OCIE examiners. While in the past an Enforcement staff member onsite usually meant that a firm was under investigation or suspected of serious wrongdoing, it may now be indicative of the SEC’s efforts at gathering intelligence. Always ask SEC staff members who are at your firm for their business cards. This may give you an idea of their role. The walls between the offices and divisions of the SEC may be falling or, at least, getting lower, and communication and interaction at the SEC may lead to information about your firm being shared with Enforcement staff at an early stage. This makes it all the more imperative to have a robust compliance and oversight program and culture of compliance at a firm. The consequences for firms that lack these elements could be evident more quickly and, ultimately, lead to severe impairment or dissolution of a firm as we have seen in various cases in the recent past.


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