Legal and regulatory
“It is difficult to overstate how much the regulatory landscape for hedge fund managers has changed over the past four years.”1 So said Norm Champ, director of the Securities and Exchange Commission’s Division of Investment Management, in a recent speech wherein he outlined how the SEC has built on its newfound authority to regulate private fund advisers, including by taking advantage of its increased access to information and new analytical tools.2 As we’ve previously discussed in this newsletter, since Dodd-Frank, most investment advisers to private funds, such as hedge funds, now have to register with the SEC, thus subjecting them to SEC oversight and regulatory requirements.3
In recent months, the SEC has actively engaged with the industry through speeches, guidance updates, and examinations to counsel advisers on their newfound obligations and to gain a better understanding of the industry. Director Champ’s speech is one of the latest examples of this outreach. But, as we’ve discussed here previously, the SEC also has clearly conveyed that its increased scrutiny of private funds likely will lead to an increasing number of enforcement investigations and actions.4 Champ’s speech and other recent events confirm this trend.
Advisers must provide significant data to the SEC
Advisers to most private funds must not only register with the SEC, but also provide significant information to the SEC, including through a new Form PF, which seeks information on an adviser’s investment strategy. As the staff of the Investment Management Division recently reported to Congress, Form PF, which must be completed by advisers to funds with greater than US$150 million in regulatory assets under management, requires advisers (depending on the size of the funds they manage) to provide information such as the types of funds advised (e.g., hedge funds, private equity funds), the funds’ size, the use of leverage, the types of investors, liquidity, performance, fund strategy, counterparty credit risk, and the use of trading and clearing mechanisms.5 Advisers to large funds must provide more details and must do so more often.6
The SEC actively uses this data in connection with examinations and enforcement actions
Dodd-Frank requires the SEC to treat this information confidentially, and the staff of the Investment Management Division has confirmed that the SEC has designed and implemented controls for handling Form PF data.7 Yet, while the SEC must treat Form PF data confidentially, fund advisers should take heed that the SEC and other regulators, such as the Commodity Futures Trading Commission, are actively using this information in their examination and enforcement duties.
As the staff of the Investment Management Division confirmed in a recent report to Congress, although Form PF’s ‘primary aim’ is to compile data on private funds to help the Financial Stability Oversight Council (FSOC) assess systemic risk in the economy,8 the SEC also is “using the information to support its own regulatory programs, including examinations, investigations and investor protection efforts relating to private fund advisers.”9 Likewise, Director Champ explained in his speech that the SEC’s Office of Compliance Inspections and Examinations (OCIE) not only reviews Form PF data before examining an adviser to better understand the adviser’s business, it also “reviews information contained in the Form PF filing for inconsistencies with an adviser’s publicly available documents, the investment strategies disclosed to investors, and other information obtained during an examination.”10 Even more importantly, he confirmed that the SEC’s Enforcement Division reviews Form PF filings during investigations, and that the SEC uses the data in connection with its “Aberrational Performance Inquiry, which seeks to identify hedge fund advisers that report aberrational returns relative to certain benchmarks for further investigation, and has resulted in the identification of fraudulent or improper conduct.”11 The SEC previously confirmed that the Aberrational Performance Inquiry has led to numerous enforcement actions against hedge fund advisers.12
In sum, advisers to private funds must ensure accuracy in their Form PF submittals and consistency between the Form PF and information disclosed in other public and private documents, such as the Form ADV, marketing brochures and the adviser’s website. Failure to do so may lead to examination deficiency letters and quite possibly an enforcement action.
Increased examination and enforcement
The SEC also is continuing to pursue its initiatives to examine a significant proportion of newly registered advisers. In his recent speech, Director Champ again confirmed that OCIE’s National Examination Program (NEP) has pledged to visit 20 percent of advisers who have been registered for three or more years but who have not yet been examined.13 Such a visit may involve a ‘risk assessment’ to better understand the adviser’s firm, but it also may entail a more ‘focused’ review involving “comprehensive, risk-based examinations of one or more higher-risk areas, which could include, among others, the compliance program, portfolio management, or safety of client assets.”14
Meanwhile, since 2012 the NEP has pursued an initiative to conduct ‘presence’ examinations of 25 percent of private fund advisers who registered following Dodd-Frank’s expansion of registration requirements.15 In these examinations, the NEP is focusing on marketing, portfolio management, conflicts of interest, safety of client assets, and valuation.16 SEC Chair Mary Jo White advised Congress earlier this year that the NEP was on track to complete its goal of conducting presence exams of 25 percent of advisers by the end of 2014.17 Finally, as Champ mentioned in a speech last June,18 and as confirmed by recent reporting,19 OCIE has launched a sweep examination of fund complexes that offer ‘alternative mutual funds’, which are described by Champ as funds whose primary strategy focuses on non-traditional asset classes (e.g., currencies), non-traditional strategies (e.g., long/short equity positions), and/or illiquid assets (e.g., private debt).20
Predictably, the SEC’s increased scrutiny of hedge fund and private fund advisers has led to new enforcement actions. For example, the SEC has advised the private fund industry repeatedly over the past few years that it is paying close attention to potential conflicts of interest between fund advisers and their fund clients. In discussing these concerns yet again, Champ cited the SEC’s recent settled enforcement action against an adviser to a hedge fund wherein the SEC charged the adviser and its owner with failing to provide effective written disclosure regarding transactions between its hedge fund client and a firm-affiliated broker-dealer.21 While the firm established a conflicts committee to review the transactions, the SEC found that the members of that committee were themselves conflicted. This matter was also notable as the SEC’s first action against an entity for retaliating against a whistleblower for exposing the issue to the SEC. The firm and its owner agreed to pay US$1.7 million in disgorgement, prejudgment interest of over US$180,000 and a penalty of US$300,000.22
In a more recent matter postdating Director Champ’s speech, the SEC settled an enforcement action with an adviser to two private equity funds regarding charges of breach of a fiduciary duty and failure to adopt and implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act.23 The SEC alleged that the adviser misallocated expenses between the two portfolio companies it managed. Although the firm integrated the companies to capitalise on synergies between the two, the firm charged certain expenses to one company despite the fact that those expenses applied to the other company or benefitted both companies.24 The SEC order noted that, when the adviser registered on March 28, 2012, it became subject to the Advisers Act requirements to adopt and implement adequate policies and procedures, and concluded that the adviser violated the Act by failing to adopt and implement such procedures.25 The adviser agreed to pay US$1.5 million in disgorgement, over US$350,000 in prejudgment interest and a US$450,000 penalty.26
As these examples demonstrate, the SEC is not only scrutinising whether fund advisers are implementing effective policies and sufficiently disclosing information to their fund clients, but also actively pursuing enforcement actions for failures to comply. With the proliferation of newly registered private fund advisers, the dramatic increase in data those advisers are required to report, and the SEC’s goal of promptly examining a significant number of newly registered advisers, it is almost certain that we will continue to see increasing numbers of enforcement actions. Therefore, it is imperative that advisers to private funds ensure that they have adequate compliance programs (which they review and update often), and that all disclosures, public and private, are consistent and accurate. Sooner or later, the SEC will visit. Advisers must be prepared.
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 20 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 Norm Champ, Director, Division of Investment Management, U.S. Securities & Exchange Commission, “Remarks to the Practising Law Institute, Hedge Fund Management Seminar 2014,” (Sept. 11, 2014), available at: http://www.sec.gov/News/Speech/Detail/Speech/1370542916156. [“September 2014 Champ Speech”].
2 See id.
3 See Nicholas Lewis, “A New Era of Openness, or Open Season on Hedge Funds?”, Eurekahedge, November 2013.
4 See id.
5 See Staff of the Division of Investment Management, U.S. Securities & Exchange Commission, “Annual Staff Report Relating to the Use of Data Collected from Private Fund Systemic Risk Reports,” pp. 2-3 (Aug. 15, 2014).
7 Id. at 3.
8 Id. at 1, 4.
9 Id. at 4.
10 See September 2014 Champ Speech.
12 See U.S. Securities & Exchange Commission, Release 2011-252, “SEC Charges Multiple Hedge Fund Managers with Fraud in Inquiry Targeting Suspicious Investment Returns,” (Dec. 1, 2011), available at: http://www.sec.gov/news/press/2011/2011-252.htm.
13 See September 2014 Champ Speech.
14 See id.
15 See id.
17 See Mary Jo White, Chair, U.S. Securities & Exchange Commission, Before the Committee on Financial Services, U.S. House of Representatives, “Testimony on ‘Oversight of the SEC’s Agenda, Operations and FY 2015 Budget Request,’” (Apr. 29, 2014), available at: http://www.sec.gov/News/Testimony/Detail/Testimony/1370541674457.
18 See Norm Champ, Director, Division of Investment Management, U.S. Securities & Exchange Commission, “Remarks to the Practising Law Institute, Private Equity Forum,” (June 30, 2014) [“June 2014 Champ Speech”].
19 See Ed Beeson, “SEC Launches Sweep Examination of Alternative Mutual Funds,” Law 360, Aug. 13, 2014, available at: http://www.law360.com/articles/566905/sec-launches-sweep-examination-of-alternative-mutual-funds.
20 See June 2014 Champ Speech.
21 See September 2014 Champ Speech (citing In the Matter of Paradigm Capital Management, Inc. and Candace King Weir, Investment Advisers Act Release No. 3857 (June 16, 2014)); see also U.S. Securities & Exchange Commission, Press Release 2014-118, “SEC Charges Hedge Fund Adviser with Conducting Conflicted Transactions and Retaliating Against Whistleblower,” June 16, 2014, available at: https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542096307.
22 See In the Matter of Paradigm Capital Management, Inc. and Candace King Weir, Investment Advisers Act Release No. 3857 (June 16, 2014).
23 See In the Matter of Lincolnshire Management, Inc., Investment Advisors Act Release No. 3297 (Sept. 22, 2014); see also U.S. Securities & Exchange Commission, Press Release 2014-205, “SEC Charges New York-Based Private Equity Fund Adviser with Misallocation of Portfolio Company Expenses,” (Sept. 22, 2014), available at: https://www.sec.gov/News/PressRelease/Detail/PressRelease/1370543006673.
24 In the Matter of Lincolnshire Management, Inc., Investment Advisors Act Release No. 3297 (Sept. 22, 2014), at 5-6.
25 Id. at 6.
26 Id. at 7.