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Enforcement Priorities in the Alternative Space

Bruce Karpati

Chief, SEC Enforcement Division's Asset Management Unit
U.S. Securities and Exchange Commission

Before the Regulatory Compliance Association, New York, N.Y.

Dec. 18, 2012

Thank you to the Regulatory Compliance Association for having me here today.  I am grateful for the opportunity to speak about current hedge fund enforcement priorities.   Let me start by saying that my comments here today are mine and mine alone, and do not represent the views of the SEC, the Commissioners, or the staff.1

Today, I plan to speak about the Enforcement Division’s and in particular the Asset Management Unit’s priorities in the hedge fund space.  I’ll discuss the importance of specialization and expertise to this effort; the risks for investors; how these risks are informed   by the hedge fund operating model; and how a hedge fund manager’s business may be at odds with the manager’s fiduciary duty to the fund.  I’ll also discuss the types of misconduct we’ve seen crossing our desks in the Asset Management Unit, and I’ll conclude with certain best practices to avoid the specter of an enforcement referral or inquiry.

Asset Management Unit: The Unit and Specialization

In today’s increasingly complex and competitive marketplace, industry specialization has become the norm rather than the exception.  So, to more effectively investigate certain types of fraud in the financial markets, the Enforcement Division established Units dedicated to several specialized and complex areas.  The focus on a specific business, practice or product category gives each Unit the ability to focus on the risks that the business, practice or product poses to investors.  The specialized Units also help provide the additional structure, resources, and expertise needed for enforcement staff to keep pace with the ever-changing markets and to tackle the more sophisticated issues that arise in our capital markets.

Among the Units, there are three that touch heavily on the hedge fund industry.  The Market Abuse Unit focuses on investigations involving large-scale market abuses and intricate manipulation schemes by institutional traders, market professionals, and others and on highly sophisticated market structure issues.  The Structured and New Products Unit focuses on complex derivatives and financial products including credit default swaps, collateralized debt obligations, and securitized products. The Asset Management Unit, comprised of 75 staff across 11 offices, focuses its investigations on investment advisers, investment companies, hedge funds, mutual funds and private equity funds.  All of these Units work to generate expertise for the Division of Enforcement, and work with staff outside the Units on investigations and exams.

Each Unit utilizes enhanced training and expertise to adopt proactive approaches to identifying misconduct and practices ripe for investigation and to conduct those investigations efficiently and effectively.  In particular, each Unit has hired industry professionals such as hedge fund managers, private equity analysts, and due diligence professionals.  They assist on investigations; they consult on exams; they lead our initiatives; they conduct training for staff; and they assist on policymaking.  Significantly, these industry professionals have already been successful in uncovering issues that we may not have identified otherwise.  We like to say: “they know where the bodies are buried – and understand how they got there.”

The Risks to Hedge Fund Investors

The Asset Management Unit or AMU specializes in investigating securities law violations in the asset management industry. Over the last decade, as the asset management industry has grown to encompass a huge percentage of wealth, it has also grown more sophisticated. This growth and complexity coupled with the market events of the last couple of years have highlighted the need to closely monitor the full spectrum of investment advisers and investment companies.  Therefore, the AMU looks at all investment advisers including sophisticated financial institutions, mutual and private fund advisers, and retail advisers.  Just the creation of the Unit has sent the deterrent message to advisers that “SEC Enforcement is on the scene.”

One of the AMU’s central focuses is on investment advisers to alternative investments and private funds, and more specifically, hedge fund advisers.  Over the past two decades the industry has seen tremendous growth in the number of funds operating, expanding from a few hundred in 1990 to tens of thousands of individual funds today.  Collectively, these funds have trillions of dollars under management.  The Asset Management Unit was created in part to better understand the workings of the hedge fund industry generally, and, more specifically, the diversity of their investment strategies.  Within the Enforcement Division, the AMU is generating the training, focus, and expertise to be able to handle the challenges that come with detecting and combating fraud and other violations in this ever-evolving and sophisticated industry.

Before I turn to the risks of hedge fund investments, it is important to note that we recognize that the majority of funds take their obligations as investment advisers seriously.  Additionally, we understand the importance of alternative investment vehicles as the industry’s capital grows, and likewise recognize that hedge funds’ trading adds depth and liquidity to the markets in which they invest. 

Over the course of the last couple of years, it is clear that even the sophisticated class of investors who invest in hedge funds are by themselves unable to effectively monitor the industry.  We firmly believe that in order to protect investors, the industry needs vigilant enforcement oversight, and over the last few years, we have observed certain behavior by private funds that highlights the need for such oversight. 

First, alternative investment vehicles often involve complex, illiquid or opaque investments.  The lack of transparency into their investment strategies and operations may occur for legitimate business reasons, but, at the same time, the potential for fraud is substantial.  Even sophisticated investors can be defrauded through alternative investment vehicles, especially when their practices are not transparent to investors or regulators.

Second, there is an emerging retail orientation of hedge funds that increasingly exposes ordinary investors to such funds either directly or indirectly through pensions, endowments, foundations, and other retirement plans. For example, according to certain sources, private sector pension funds currently seek to allocate on average about 10% of their assets to hedge funds, and public sector pensions target an 8% allocation on average.  Adding in private equity and real estate, these numbers get even bigger. According to these sources, larger pensions with more than $1 billion in assets have increased their stakes in alternative investments to almost 20 percent, nearly double the percentage from 5 years ago. 

Third, besides indirect investment, the retailization of hedge funds has made it easier for unsophisticated investors to invest directly in hedge funds.  Looking ahead, the elimination of the prohibition on general solicitation and general advertising as a result of the JOBS Act could have an immediate impact because, what were formerly private offerings, can now in some form be broadcast to a much wider audience.  We understand that this may facilitate capital formation, but one of our concerns is that these retail-oriented hedge funds may be offered to investors that may have the financial wherewithal to meet accredited investor standards but are otherwise financially unsophisticated.

Fourth, the AMU is particularly aware of the risks posed by private funds advised by unregistered advisers.   Smaller private fund advisers, typically those with less than $150 million in assets under management, pose a risk because they may be exempt from SEC registration.  Unregistered advisers may not have effective compliance policies and procedures to prevent fraud and other violations, are not subject to inspection by exam staff, and need not comply with the Commission’s advertising rules applicable to registered advisers.  Knowing that a disproportionate amount of fraud occurs at smaller hedge fund advisers, the AMU is concerned that unregistered advisers may engage in general solicitation without the proper policies in place to ensure that only accredited investors invest.

Finally, just recently, in coordination with the filing of several enforcement actions, the staff issued an investor bulletin detailing the information investors should evaluate to better understand the risks of hedge fund investing.  The bulletin highlights examples where both purportedly sophisticated and unsophisticated investors were victims of various forms of fraud, including managers lying about their background, their fee structure, and their investment strategy.  Particularly worrisome is the extent to which retail investors are exposed to these types of frauds.2

The Operating Model of Alternative Investment Vehicles

Having discussed some of the risks, I want to turn to some of the vulnerabilities to fraud hedge funds may face due to particular aspects of their operating model.  Because of the rapid growth in the industry and many hedge funds’ opaque operating models, misalignment of incentives can occur between the adviser and its investors.  It has been imperative for us in the AMU to develop an advanced understanding of the operating environment and incentives of asset managers in order to proactively monitor and combat fraud in this industry.  Understanding the varying business motivations behind investment advisers’ actions and decisions helps us identify problematic issues and trends within the asset management industry.  For example:

  • Because hedge fund managers are compensated by both management fees and performance fees, the manager has incentives to over-prioritize compensation.  For example, the temptation to overvalue assets to boost compensation has emerged repeatedly in enforcement cases.  The AMU is focused on detecting fraudulent or weak valuation practices – including lax valuation committees and the use of side pockets to conceal losing illiquid positions – and the failure to follow a fund’s stated valuation procedures.
  • The hedge fund business model and industry growth put a great deal of pressure on the manager to demonstrate and market consistently positive performance.  Since the hedge fund industry has grown dramatically, it has become harder for individual funds to yield the high returns that hedge fund investors have come to expect.  Funds need to show performance metrics that will make the fund attractive to new investors and keep current investors satisfied.
  • Due in part to the particular investment strategy, hedge funds may be desperate to get an informational edge in the market.  Some fund managers seek this information through illicit means such as insider trading.  Recent cases involving serial insider trading by hedge fund managers, including managers using expert networks, are dramatic examples of such misconduct.
  • Because some hedge fund managers may control every aspect of their business, severe conflicts of interest can arise.  The fund manager may have the opportunity and incentive to put his or her personal interests ahead of investors.  Related-party transactions, through which the manager can misappropriate money by engaging in self-serving transactions or to hide losses, are examples of these types of conflicts.
  • The adviser may have the opportunity and incentive to give favored treatment to certain investors through preferential redemptions or side letters. Though the hedge fund structure leaves advisers with wide latitude on how to invest, advisers must be sure to avoid conflicts of interest in areas such as commonly managed accounts, allocation practices, affiliated broker dealers, undisclosed compensation arrangements, soft-dollars, and best execution.
  • Finally, the lack of independent governance (or sometimes governance in name only) for many hedge funds makes them more susceptible to conflicts of interest, insider trading and other fraudulent practices.  Therefore, the AMU has been focusing on making sure registered advisers have proper compliance procedures and controls in place.

Hedge Fund Managers As Fiduciaries

The incentives and opportunities provided by the hedge fund operating model may be in tension with a manager’s role as a fiduciary.  As you know, the Investment Advisers Act of 1940 imposes on investment advisers a broad fiduciary duty to act in the best interest of their clients. This means that investment advisers have “an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’... clients.”3  As a fiduciary, a hedge fund manager must guard against conscious and unconscious incentives that might cause him or her to provide less than disinterested advice since an investment adviser may be faulted even when he or she does not intend to injure a client or even if a client does not suffer a monetary loss.4  The fiduciary duty is the lens through which the AMU looks at many of the issues it investigates, and the anti-fraud provisions of the Investment Advisers Act (including Sections 206(1) and (2) and Rule 206(4)-8)) enable the AMU to pursue breaches of fiduciary duty and other forms of misconduct. 

Types of Hedge Fund Misconduct

Over the last couple years as an area of emphasis, the Enforcement Division has brought numerous actions against hedge fund managers that have breached their fiduciary duties to their clients or engaged in other types of fraudulent conduct.  In fact, from 2010 to the present, the Division of Enforcement has brought over 100 cases against hedge fund managers, a significant majority of which involved conflicts of interest, valuation, performance, and compliance and controls.  Below are ten cases representative of the various types of hedge fund misconduct where it’s been alleged that managers failed to uphold their obligations to their funds and their investors:

  • In October 2012, the SEC charged Yorkville, a former $1 billion hedge fund advisory firm, along with two executives, with scheming to overvalue assets under management and exaggerate the reported returns of the hedge funds they managed.  The SEC alleged that Yorkville and the two executives enticed pension funds and other investors to invest in their hedge funds by falsely portraying Yorkville as a firm that, among other things, employed a robust valuation procedure.5 
  • In June, the SEC filed wide ranging fraud charges against New York-based hedge fund manager Philip Falcone and his advisory firm, Harbinger Capital Partners, for alleged illicit conduct that included misappropriation of client assets, market manipulation, and preferential treatment of certain clients.  In particular the SEC alleged that Falcone fraudulently obtained a $113 million loan from a hedge fund that he advised, and that Falcone secretly granted favorable redemption and liquidity rights to certain strategically important investors at the expense of other investors.6 
  • In May, the SEC charged hedge fund adviser Quantek Asset Management LLC with making misrepresentations about whether its fund managers had “skin in the game” or investments in their own hedge fund, Quantek Opportunity Fund.  In fact, the managers had never personally invested any of their money in the fund.  The SEC also alleged that Quantek employees misled investors about their due diligence process when they created after-the-fact investment memoranda, and inaccurately described key terms regarding certain related party loans.7  
  • SEC v. Balboa: Hedge fund manager allegedly schemed with brokers to inflate the fund’s reported returns and net asset value by manipulating its supposedly independent valuation process.8
  • SEC v. Rooney: Hedge fund manager allegedly made investments contrary to the disclosure in the fund’s offering documents and marketing materials.  In addition to alleging a radical change in the investment strategy, the complaint alleges the manager hid an investment made to a company for which the hedge fund manager was the Chairman.9
  • SEC v. Kapur: Hedge fund manager allegedly engaged in pattern of deceptive conduct to bolster his performance track record, size, and credentials.10
  • In re Pegasus Inv. Mgmt.:  Managers allegedly received undisclosed cash payments from a proprietary trading firm in exchange for enabling the fund’s order flow to be bundled with the prop firm’s trading to obtain reduced commission rates from an executing broker.11
  • SEC v. Juno Mother Earth Asset Mgmt.: Managers allegedly misrepresented the partners’ “skin in the game,” misappropriated client assets, inflated assets under management, and filed false information with the SEC.12
  • SEC v. Goldfarb: Manager allegedly concealed more than $12 million in investment proceeds that he owed fund investors by using a side pocket to hide the profits.13
  • SEC v. Mannion: A hedge fund manager allegedly overvalued illiquid assets in a side pocket and extracted excessive management fees based on the asset values in the side pocket.14

The Enforcement Division and AMU are intent on holding hedge fund managers accountable for their actions, particularly where they may breach their fiduciary duties to their funds or otherwise failed to live up to the obligations owed to their investors.

Risk-Analytic Initiatives

The Enforcement Division, and in particular the AMU, was able to bring many of these cases because of the enhanced expertise developed by the Unit’s staff and experts.  With the enhanced expertise, the Asset Management Unit has developed risk-based investigative approaches through which the Unit can detect and prevent fraudulent conduct.  Each initiative utilizes data analysis and appropriate risk criteria to identify individuals or entities that may be engaged in specific types of misconduct. 

For example, the Aberrational Performance Inquiry focuses on suspicious or improbable performance returns posted by hedge fund advisers.  The Unit works with the Division of Risk, Strategy, and Financial Innovation (RiskFin) and the Office of Compliance Inspections and Examinations (OCIE) to analyze performance data of thousands of hedge fund advisers and refer suspicious candidates for examination or investigation.  This initiative has resulted in seven enforcement actions against hedge fund advisory firms and managers for various types of misconduct including improper use of fund assets, fraudulent valuations, misrepresenting fund returns, and failure to disclose related party transactions.  The inquiry is now focused on a subset of hedge fund strategies that have a high incidence of suspicious returns.

The AMU has also launched a Private Equity Initiative, in coordination with RiskFin, the Division of Investment Management, and OCIE to identify private equity fund advisers that are at higher risk for certain specific fraudulent behavior.  For example, there has been concern, widely cited in the industry, that managers of what are called “zombie” funds are delaying the liquidation of their holdings because the income derived from these assets is their only source of revenue.  Using certain data sources, this risk analytic initiative seeks to identify those private equity fund advisers that may be improperly failing to liquidate assets, or have been misrepresenting the value of their holdings to investors.  This initiative has brought attention to a practice that went undetected for many years.

Intersection with Regulation

The initiatives have also given the AMU the ability to use information the Commission receives through filings and the examination process to hone in on hedge fund misconduct. As you know, the Dodd-Frank Act repealed the private adviser exemption.  This means that private fund advisers generally are now subject to regulatory oversight and other requirements such as SEC examination.  Currently there are over 4,000 registered private fund advisers, and approximately 2,300 of those manage hedge funds.  Of those 4,000 advisers, more than 1,500 have registered with the SEC since the effective date of the Dodd-Frank Act.  Now that more private fund advisers are registering – particularly hedge fund advisers – the AMU has more information about more advisers than ever before to mine for use in its risk analytic initiatives.  

Registration is also important because registered advisers are subject to examination by SEC staff.  The SEC can conduct on-site exams based on targeted risk assessment.  This means that the SEC’s ability to collect and analyze information to identify certain risk groups, practices, or specific funds is now coupled with the ability to go out and knock on doors to examine the funds first hand.  In a new initiative, OCIE is conducting focused, risk-based examinations of investment advisers to private funds, so-called “presence exams,” in which staff will review one or more higher-risk areas of their operations, including marketing, conflicts of interests, and valuation.  Together, data analysis and examinations are making the Commission and AMU more effective at our job of protecting the investing public from hedge fund fraud.

Conclusion — Best Practices

As I mentioned before, most hedge fund managers take their fiduciary duties seriously. However, the hedge fund operating model can create misaligned incentives.  In my view, there are various steps managers can take to insure that they fulfill their fiduciary duties.

First, I believe hedge fund managers should set the tone at the top and create a culture of compliance within the firm.  Hedge fund managers should make sure that there is robust supervision of employees and that internal controls exist to foster a culture of compliance.  For example, managers should ensure that appropriate checks and balances are present where employees have overlapping, and potentially conflicting positions, such as a trader calculating the fund’s P&L, or a portfolio manager valuing the fund’s assets.  Advisers have a responsibility to create and maintain a culture of compliance.  While the demands of managing and marketing a fund can take up a great deal of the manager’s time and focus, he or she needs to make sure that compliance is given adequate time and resources.

Second, I believe an adviser should adopt and implement a compliance program and controls geared to the risks and investment strategy of the firm.  Controls should be put in place to check and monitor traders.  Although the size of the fund may impact the level of compliance and controls, all registered advisers should periodically undertake a comprehensive review of their operations to identify any gaps in their compliance policies and procedures, make sure that their policies are tailored to the organization, and update them if there have been changes in the firm’s activities or products.  A firm also has to assign responsibility to specific persons for, among other things, maintaining and periodically testing the compliance procedures.  For example, a firm should test and verify its valuation procedures.  This is especially true for complex or illiquid securities. Implementing an oversight and compliance program will ensure that the manager’s fiduciary responsibilities are properly addressed.  In addition, a robust compliance program will help attract and retain sophisticated, institutional investors.

Finally, I think all investment advisers need to be alert and prepared for exam inquiries.  It is important to be cooperative with exam staff while an examination takes place.  It is also important to implement any necessary corrective steps if the SEC identifies violations or possible violations.  Taking these steps will help the examination process to proceed more efficiently and reduce the likelihood of more formal inquiries by Enforcement or AMU staff.

Thank you again for this opportunity.

1    The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.

2    See SEC Investor Bulletin: Hedge Funds (Oct. 2012).

3    SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (citation omitted).

4    Id. at 191-192. 

5    SEC v. Yorkville Advisors, No. 12 Civ. 7728 (S.D.N.Y. filed Oct. 17, 2012).

6    SEC v. Falcone, No. 12 Civ. 5027 (S.D.N.Y. filed June 28, 2012); SEC. v. Harbinger Capital Partners, No. 12 Civ. 5028 (S.D.N.Y. filed June 28, 2012).

7    In re Quantek Asset Mgmt., Adm. Proc. File No. 3-14893 (instituted May 29, 2012).

8    SEC v. Balboa, No. 11-civ-8731 (S.D.N.Y. filed Dec. 1, 2011).

9    SEC v. Rooney, No. 11-cv-8264 (N.D. Ill. filed Nov. 17, 2011).

10 SEC v. Kapur, No. 11-civ-8094 (S.D.N.Y. filed Nov. 10, 2011).

11 In re Pegasus Inv. Mgmt., Adm. Proc. File No. 3-14425 (instituted June 15, 2011).

12 SEC v. Juno Mother Earth Asset Management, No. 11-civ-1778 (S.D.N.Y. filed Mar. 15, 2011).

13 SEC v. Goldfarb, No. CV-11-0938 (N.D. Cal. filed Mar. 1, 2011).

14 SEC v. Mannion, No. 10-cv-3374 (N.D. Ga. filed Oct. 19, 2010).

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