In a recent speech1 before the Managed Funds Association, U.S. Securities & Exchange Commission (SEC) Chair Mary Jo White discussed what she called a “new era of transparency and openness” for the private funds industry, including hedge funds. Her address largely provided an overview of two significant pieces of legislation, namely, the Dodd-Frank Act, which among other things requires most hedge fund advisers to register with the SEC, and the JOBS Act, which lifted the longstanding ban on solicitation in connection with certain private securities offerings.
But more importantly, Chair White’s speech made it clear that the SEC is now scrutini sing the hedge fund industry and will not be shy about bringing enforcement actions. Accordingly, hedge fund advisers need to ensure that they understand their new reporting and disclosure obligations and that they are prepared to demonstrate their compliance with the new rules.
New registration requirements and compliance examinations for funds
Until Congress passed and President Obama signed the Dodd-Frank Act, many hedge fund and other private fund advisers were able to avoid registering as investment advisers with the SEC because of an exemption that applied to advisers with fewer than 15 ‘ clients’ and that treated each fund as one client, even if the advisers managed significant assets for many people or institutions through those funds.2 Although hedge funds avoided scrutiny in the past based in part on a view that hedge fund investors were sophisticated and therefore did not need as much SEC protection, in recent years hedge funds have not only grown in size and influence, they have also begun to attract a wider class of investors, including institutional investors who manage the assets of thousands more investors. This dramatic growth eventually caught the attention of legislators.
With Dodd-Frank, Congress addressed this issue by extending registration requirements to most hedge fund advisers. 3 As Chair White explained in her recent speech, since the legislation’s adoption, 1,500 previously unregistered fund advisers have registered.4 Dodd-Frank requires advisers to disclose specific information about the funds they manage, including information about business operations and conflicts of interest, which will then be publicly available via the SEC’s website. Moreover, advisers have to provide information regarding their funds’ risk profiles on a confidential basis to the SEC, so that it can use the information to monitor potential systemic risk in the industry.5
These developments of course pose new risks for many hedge fund advisers new to SEC registration and oversight because the law imposes new regulatory requirements with which funds must comply and they open funds up to greater scrutiny by the SEC. As pointed out in the speech, the new rules require compliance with business conduct rules and also subject advisers to compliance examinations, where SEC examiners review records to ensure compliance with SEC rules and regulations. “To foster a two-way street of transparency,” Chair White identified the following five areas that the SEC staff is focusing on in exams:
- Portfolio management;
- Conflicts of interest;
- Safety of client assets; and
Although Chair White stated that “[t]he goal of examinations is not to play ‘gotcha,’ ” she went on to warn advisers that “should we find fraud, we will pursue it.”7 This should be a very real concern for fund advisers, particularly those new to SEC compliance examinations. Examinations can, and often do, lead to enforcement actions.
The benefits and burdens of investor solicitation
Chair White also spoke briefly about the JOBS Act’s impact on advisers through the lifting of the ban on solicitation imposed on entities making private securities offerings pursuant to Rule 506 of Regulation D. She acknowledged the benefits of permitting hedge fund managers to communicate more directly with the public, but there was clearly a tone of caution in her speech about solicitation. According to Chair White, the SEC staff has already begun an effort to monitor how solicitation actually occurs in the market, which “includes assessing the impact of general solicitation on the market for private securities and — importantly — on identifying fraud if it is occurring.”8 She went on to mention that the SEC’s new ‘ bad actor’ rule, which was adopted at the same time the solicitation ban was lifted, will prohibit those who violate certain securities laws from participating in the streamlined private offering process.
It is thus clear that the SEC will be closely watching the hedge fund industry in light of these developments, and given its ability to conduct exams, the SEC will be far more able to monitor the industry. This of course raises the specter of increased SEC enforcement against hedge funds. Indeed, Chair White said as much, reporting that the SEC had recently been “quite active in bringing enforcement cases involving private funds,” including charges for “insider trading; false advertising and performance claims; overvaluing assets in order to charge excessive fees; benefitting favored investors at the expense of other investors; and using private fund assets for the personal benefit of the fund’s adviser.”9 These charges in many ways mirror the areas of examination noted above.
The new obligations imposed on hedge funds present new risks. For many fund advisers, they will be interacting with the SEC far more directly and far more often than in the past. And while the newfound ability to solicit new investors presents clear opportunities, it also creates potential issues. Hedge funds must take these new risks seriously because violations could lead to significant and potentially crippling penalties.
For better or worse, the SEC clearly has its sights set on hedge funds. Because many fund advisers have not had to engage with the SEC too often, some hedge funds at first might prove to be easy targets for an SEC hoping to burnish its enforcement reputation in the wake of the financial crisis. For all these reasons, it is critical that fund managers take steps to build and implement strong compliance programs.
Nicholas Lewis is an Associate in the Washington, DC office of McGuireWoods LLP. He focuses his practice on securities enforcement and white collar criminal defense, and has represented financial institutions, corporations and individuals under investigation by government entities, including the U.S. Securities & Exchange Commission and the U.S. Department of Justice.
McGuireWoods LLP is a full-service law firm with more than 900 lawyers in 19 offices worldwide. The firm’s top-ranked Government, Regulatory and Criminal Investigations (GRCI) practice draws on a team of lawyers devoted exclusively to these difficult, serious and high-stakes inquiries. For more information, please visit www.mcguirewoods.com
1 See Mary Jo White, Chair, U.S. Securities & Exchange Commission, “Hedge Funds – A New Era of Transparency and Openness,” Managed Funds Assoc. Outlook 2013 Conference (Oct. 18, 2013) [“Chair White Speech”]