As part of its National Exam Program, the SEC’s Office of Compliance and Examinations (“OCIE”) has just mailed a letter to senior executives and Chief Compliance Officers of newly-registered investment advisers apprising them of what practices they can expect to be examined.
While the letter primarily concerns risk-based exams of advisers to private funds that registered with the SEC after July 21, 2011, the significance the OCIE examination staff is attaching to certain adviser practices in these so-called “Presence Exams” should be weighed by all advisers regardless – whether they’re new or a private fund. As we have discussed these and other areas of exam focus in previous posts, OCIE’s hot areas referenced, and set for review, include:
- Marketing materials;
- Portfolio management;
- Conflicts of interest;
- Safety of Client Assets; and
- Valuation of Client holdings and assessment of fees based on valuations.
Through the SEC’s lens, each of these topics is being viewed in three phases: engagement; examination; and reporting.
Add a few recent SEC actions against hedge funds that include a hedge fund manager running a $37 million Ponzi scheme; a former director in a compensation scheme that netted hundreds of thousands of dollars in undisclosed income; co-founders of a Chicago-area investment firm misleading investors and supervisory failures resulting in penalties of more than $1 million; a private fund manager and his investment advisory firm taking more than $17 million in losses in a Ponzi-like scheme.
And now add to that two even more recent cases: a hedge fund manager over the course of several years invest the majority of a fund’s assets in a private business owned by the manager’s affiliated company; and a manager who used his hedge fund as a ruse to misappropriate over $550,000 from a retired schoolteacher, and you get the math of why SEC hedge fund oversight will continue to intensify. Given many of the enforcement actions in the past two years are the result of fairly egregous conduct, the SEC Office of Investor Education and Advocacy’s most recent Investor Bulletin is still instructive, not simply for investors, but also, for the hedge funds who serve them.
The bulletin warns investors about continued hedge fund-related misconduct in the markets while mentioning these cases as examples of why investors need to take precaution before making hedge fund investments. While there’s nothing surprising about precautions and recommendations that include
- a need for investors to understand a hedge fund’s investment strategy and its use of leverage and speculative techniques before making the investment;
- a need for investors to evaluate a hedge fund manager’s potential conflicts of interest and take other steps to research those managing the fund;
the bulletin highlights the need for registered advisers to hedge funds to pay particular attention to conflicts of interest when making investment decisions, particularly when determining how investment opportunities are allocated. Advisers also have to be wary about engaging in principal transactions when managing hedge funds — for example, engaging in rebalancing or other types of cross trades. Among others, they should concern themselves with the valuations assigned to particular securities, and calculations of all fees and other income sources.
For hedge fund advisers, these bulletins, whose primary aim is educating the investing public, are another way to take a deeper look for potential conflicts that may lead to violations and to understand the emphasis SEC examiners and regulators will place on such conflicts.