Vol. 19, No. 5 • May 2012
The SEC’s Aggressive New Approach to Exams
and Investigations of Investment Advisers and
Investment Companies
by Luke T. Cadigan
T
he US Securities and Exchange Commission (SEC) is focused on investment
advisers and investment companies and bringing record numbers of enforcement
actions against them. From 2009 to 2011, the number of enforcement actions
brought against investment advisers and investment companies rose more than 92
percent, from 76 in FY 2009 to a record 146 in FY 2011. By comparison, during the same period,
the number of overall enforcement actions increased only 14 percent from 644 to 735.1
This focus on investment management is
only likely to continue. As of March 30, 2012,
most private hedge fund and private equity
Luke T. Cadigan (Luke.Cadigan@KLGates.com)
is a former Assistant Director in the Securities
and Exchange Commission’s Enforcement Division,
serving that role in both the Boston Regional Office
and in the Foreign Corrupt Practices Act Unit.
Mr. Cadigan is now a partner in the Government
Enforcement Practice Group in the Boston office
of K&L Gates. This article is for informational purposes and does not contain or convey legal advice.
The information in this article should not be used
or relied upon in regard to any particular facts or
circumstances without first consulting a lawyer.
advisers with more than $150 million in assets
under management are required to register
with the SEC. Many of the new registrants
have never before been subject to an SEC
examination. In addition, under various new
rules, hedge funds and private equity advisers will be required to make more disclosures
and provide the SEC with more information
than they have ever had to before. The SEC
has new tools to make the most of the new
information. Among other things, with the
aid of computer risk-based analytic tools, the
Asset Management Unit in the SEC’s Division
of Enforcement is taking the data provided by
investment advisers and scrutinizing it for signs
provided the SEC with original information
about a possible violation of the federal securities laws that led to an SEC enforcement or
related action with sanctions over $1 million.
To coordinate the program, the SEC set up
an Office of the Whistleblower, which claims
to be receiving an average of seven whistleblower tips each day.3
The SEC also enhanced and centralized
its system for receiving and processing tips,
complaints, and referrals (TCRs) and created
an Office of Market Intelligence to oversee
and administer the system. While the whistleblower program has received far more attention, the revamped TCR system has arguably
had a greater influence on the number and
quality of Enforcement investigations, while
also informing the examination process.
Perhaps the most significant aspect of the
restructuring of the Enforcement Division
was the creation of five specialized units: the
Foreign Corrupt Practices Act (FCPA) Unit,
focused on bribery of foreign officials in violation of the FCPA; the Municipal Securities and
Pension Funds Unit, which examines violations
in this huge (nearly $3 trillion in outstanding
municipal bonds, $2 billion in public pensions),
but thinly-regulated market; the Structured and
New Products Unit, which has been dealing
primarily with violations arising in connection
with the recent financial crisis, many of which
involved credit default obligations (CDOs); the
Market Abuse Unit, which examines large-scale
insider trading networks and market manipulation; and the Asset Management Unit, which
is focused on investigations of hedge funds and
investment advisers. While each of the units
has been investigating conduct, if not bringing
actions, based on the conduct of investment
advisers,4 the units that have been targeting
investment advisers most prominently have
been the Asset Management Unit and the
Market Abuse Unit.
of potential securities violations. In addition,
the SEC’s Office of Compliance Inspections
and Examinations (OCIE) is using similar data
analyses to identify the highest risk entities for
examination. The SEC is also seeking a significant increase in budget to enable it to hire more
people to conduct exams and investigations.
This article will examine the recent changes
in, and initiatives and actions announced by
the SEC’s Division of Enforcement, particularly its Asset Management Unit, which have
impacted and will continue to impact investment advisers and investment companies. The
article will then discuss similar changes in and
areas of focus identified by OCIE, and suggest
ways to avoid having examinations escalate
into Enforcement investigations.
The Division of Enforcement
In the wake of the SEC’s failure to detect the
$17.3 billion Ponzi scheme by Bernie Madoff,
the SEC undertook a massive overhaul of its
Enforcement Division. Among other things,
the SEC delegated authority to initiate formal
investigations to the SEC Staff, thereby allowing the Staff to promptly issue subpoenas
in appropriate circumstances, a process that
previously took weeks because the Staff first
had to secure approval of the SEC itself. The
Enforcement Division also eliminated a level
of supervisors (that is, Branch Chiefs). This
move was intended to increase efficiency by
eliminating a level of bureaucracy. The consequence is that frontline Staff Attorneys now
have more autonomy, but also less supervision
in their conduct of investigations.
With considerable fanfare, in January 2012,
the Enforcement Division unveiled a cooperation program to reward and incentivize individuals and companies to fully and truthfully
cooperate and assist with SEC investigations
and enforcement actions. This program borrowed liberally from cooperation tools used by
criminal prosecutors. Since then, the SEC has
entered into 37 cooperation agreements with
individuals, three deferred prosecution agreements, and one non-prosecution agreement.2
In May 2011, the SEC also announced a
whistleblower program, pursuant to which
the SEC would pay 10-30 percent of any
recovery to an eligible whistleblower who
THE INVESTMENT LAWYER
The Asset Management Unit
The Asset Management Unit, led by
Co-Chiefs Bruce Karpati and Robert Kaplan,
is the largest of the specialized units with
approximately 65 attorneys. The DC and New
York offices have almost 20 unit members
each, Chicago has another six and Atlanta,
2
and using analytics to identify hedge funds
with returns too good to be true. In certain
cases, these firms that the unit is looking at
are far surpassing their rival hedge funds.
In others, they are quietly producing modest results without suffering a down month.7
After the Madoff scandal broke, the SEC
began developing a system to help it examine
performance data and identify red flags that
might signal possible fraud. This tool now
analyzes monthly returns from thousands of
hedge funds.8 The SEC has said little about
the specific analytics being used. Although
Robert Khuzami, Director of the Enforcement
Division, stated in congressional testimony in
March 2011 that the Asset Management Unit
was looking at hedge funds that claimed to
outperform market indexes by three percent
or more on a regular basis, the SEC has since
disavowed any such threshold.9
Pursuant to the aberrational performance
initiative, on December 1, 2011, the SEC
announced that it had brought actions against
three separate hedge funds and six individuals, charging them with, among other things,
fraudulent valuation of portfolio holdings,
improper use of fund assets, and misrepresentations to investors about such things
as performance, assets, liquidity, investment
strategy, valuation procedures and conflicts
of interest.10 In the case of ThinkStrategy
Capital Management, for example, the firm
reported a 4.6 percent return in 2008, the sixth
year in a row that it had a positive year. By
contrast, the average hedge fund reported a
loss of approximately 19 percent that year.
The SEC alleged that the firm actually had a
90 percent loss and that it also continued to
report positive returns even after it had been
liquidated and had stopped trading.
The Asset Management Unit is also using
the analytic tools used in this initiative to
identify performance inconsistent with a
fund’s investment strategy. More specifically,
it is scrutinizing algorithmic traders and quant
funds that rely primarily on computer models
to execute investment strategies in order to
ensure that they are forthcoming about the
execution and risks of their strategies.11
Encouraged by the results of this initiative, the SEC will be expanding its scrutiny
to mutual funds and private equity funds.
Boston, Ft. Worth, Los Angeles, Miami and
San Francisco have three to four attorneys
each.
The Asset Management Unit works closely
with the Division of Investment Management
(IM). The coordination is designed to ensure
that the Asset Management Unit has access to
expertise within IM but also to create greater
uniformity with respect to the manner in which
each SEC office deals with investment adviser
investigations and actions. The unit also coordinates with the OCIE. Indeed, Kaplan has
stated that 20-30 percent of the unit’s caseload
comes from exam referrals.5 The unit works
closely with the Division of Risk, Strategy and
Financial Innovation (RiskFin), with input from
OCIE and IM, to come up with risk analytics to
help it identify potential securities violations.
In general, the Asset Management Unit has
indicated a focus on violations arising in the
following areas: (1) valuation issues; (2) conflicts of interest; (3) compliance controls and
governance; and (4) propriety of products sold
to investors. In addition, the unit has signaled
an interest in smaller advisers, particularly
those that do not have compliance programs
in place and those that raise concerns of possible Ponzi schemes.
Since its inception, the Asset Management
Unit has also announced a number of initiatives.6 These include initiatives targeting:
• Aberrational performance by hedge
funds;
• Compliance programs;
• Mutual fund fees;
• Problem advisers;
• Preferential redemptions;
• Valuation of bond funds; and
• Private equity firms.
Hedge Fund Aberrational
Performance Initiative
Working with RiskFin, OCIE and IM, the
Asset Management Unit has been developing
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Vol. 19, No. 5 • May 2011
clients. Additionally, the firm agreed to hire an
independent consultant to review its compliance operations annually for two years, provide a copy of the SEC’s order to past, present
and future clients, and prominently post a
summary of the order on its Web site.
With both, the SEC is looking for outlier
performance and with the private equity funds,
the SEC is focusing on excessive valuations of
funds’ holdings.12
Compliance Program Initiative
Mutual Fund Fee Initiative
The Asset Management Unit’s compliance
program initiative is designed to ensure that
each investment adviser has a viable compliance program in place. In connection with this
initiative, on November 28, 2011, in separate
administrative proceedings, the SEC charged
three investment advisers (Asset Advisors,
LLC, (Asset Advisors), Feltl & Company, Inc.,
(Feltl) and OMNI Investment Advisors Inc.
(OMNI)) for failing to put in place compliance
procedures designed to prevent securities law
violations.13 In two of the cases—OMNI and
Asset Advisors—SEC Exam Staff had previously warned the firms about their compliance
deficiencies.
In the case against OMNI, the firm had no
compliance program and its advisory representatives were completely unsupervised for
nearly three years.14 Similarly in the case
against Asset Advisors, the firm had failed to
adopt and implement a compliance program.
When the SEC Staff brought the matter to
the firm’s attention, Asset Advisors adopted
policies and procedures but never fully implemented them. It also adopted a code of ethics but then failed to adequately abide by it.
Under its settlement, Asset Advisors agreed
to pay a $20,000 penalty, cease operations, deregister with the SEC, and, with clients’ consent, move advisory accounts to a firm with an
established compliance program.
Finally, the SEC charged that Feltl had
likewise failed to adopt and implement written compliance policies and procedures for
its growing advisory business. It had also
neglected to adopt a code of ethics. As a
result of its compliance failures, the SEC
claimed, Feltl engaged in hundreds of principal transactions with its advisory clients’
accounts without informing them or obtaining their consent as required by law. Feltl also
improperly charged undisclosed commissions
on certain transactions. Under its settlement,
Feltl agreed to pay a penalty of $50,000 and
return more than $142,000 to certain advisory
THE INVESTMENT LAWYER
The Asset Management Unit has been
developing analytics for inquiries into whether
the fees mutual fund advisors charge retail
investors are excessive. In a December 1, 2011
speech, Mr. Khuzami explained that the Asset
Management Unit is seeking to identify mutual
funds that exhibit poor performance but have
relatively high fee arrangements and subadvisers, signs to the SEC of possible excessive fees.15
As Mr. Khuzami has stated, “These analytics
are expected to result in examinations and
investigations of investment advisors and their
boards of directors concerning duties under
the Investment Company Act.”16 According
to Mr. Kaplan, the Asset Management Unit is
looking for situations in which parties do not
fulfill their obligations, where directors do not
request and review all necessary information,
and where advisers do not provide it.17
The Asset Management Unit is focused
particularly on the investment advisory contract renewal process. Mr. Kaplan has indicated that the SEC is looking both at the information about fees that investment advisors are
presenting to the boards and boards’ processes
for reviewing those fees.18 Given that most
boards have robust processes already in place
for reviewing fees, it remains unclear whether
there can be much activity under this initiative
except in extreme circumstances.
The Asset Management Unit’s decision to
focus on advisory fees may appear to many
to be a curious one particularly given the
Supreme Court’s 2010 decision in Jones v.
Harris Associates. In that case, the Court reinforced the latitude that investment advisors
have with respect to the fees they charge, holding that in order for an adviser to be held liable
for breach of fiduciary duty under Section
36(b)(1) of the Investment Company Act of
1940 (the Investment Company Act),19 “an
investment adviser must charge a fee that is so
disproportionately large it bears no reasonable
4
and that the hedge fund held more than $1.2
billion in assets.25
relationship to the services rendered and could
not have been the product of arm’s length bargaining.”20
Interestingly, Jones likely spurred the Asset
Management Unit’s interest in this area. More
specifically, during oral arguments in the case,
Justices Ruth Bader Ginsburg and Antonin
Scalia both asked Curtis Gannon, Assistant to
the Solicitor General, arguing on behalf of the
United States for Jones, whether the SEC had
brought any excessive-fee cases. Mr. Gannon
responded that the SEC had not used Section
36(b) of the Investment Company Act to bring
such a claim since 1980.21
The SEC brought its first case under this initiative on November 16, 2011, charging Morgan
Stanley Investment Management with violating
the Investment Advisers Act of 1940 when it
failed to tell a fund’s board and its investors that
a subadviser had been paid fees for advisory services that it had not provided.22 The firm settled
the matter agreeing to pay the $1.845 million for
the subadviser’s fees and a $1.5 million penalty.
In addition to looking at fees charged by
investment advisers, the Asset Management
Unit is also scrutinizing transfer agent, custodian and other service provider fees. It is
examining the role of placement agents and
distribution agents to see if their roles and fees
have been fully disclosed.23
Preferential Redemption Initiative
The Asset Management Unit has also
expressed an interest in preferential redemption cases, cases in which (a) certain investors
were permitted to redeem their investments on
preferential terms or (b) individuals redeemed
shares, or tipped others to do so, while in
possession of material, nonpublic information. Citing the Marquardt and Baldt cases,
Kaplan has stated that the Asset Management
Unit will be looking closely at situations in
which trades are conducted in circumstances
in which there is a disparity of information.26
The basic question that the unit is asking is:
Are investors being treated the same?
In SEC v. Marquardt, the SEC brought a
settled insider trading action against a senior
vice president of an investment adviser.27 The
defendant had learned that a mutual fund for
which his firm served as the investment adviser
might be closed. The SEC alleged that he then
promptly redeemed all of the fund shares he
owned and caused a member of his family to
do the same. In David W. Baldt, an administrative law judge similarly found that a portfolio
manager for a municipal bond fund engaged
in insider trading when he tipped his family
members to redeem their shares in a fund he
managed while he possessed material, nonpublic information about the fund.28
Going forward, Bruce Karpati, Co-Chief of
the Asset Management Unit has stated that the
SEC will likely bring more preferential redemption cases against hedge funds, where the firm’s
principals or selected investors are allowed to
liquidate their investments before other investors.29 As an example of such a case, the unit has
reportedly indicated that it is considering charges
against the hedge fund Harbinger Capital
Partners LLC and its manager Phillip Falcone
for, among other things, allegedly allowing some
investors to withdraw their investments while
prohibiting others from doing the same.30
Problem Adviser Initiative
According to Mr. Khuzami, the problem
adviser initiative is “a risk-based approach
to detecting problem investment advisors
through on-going due diligence reviews of
advisers’ representations to investors related
to their education, experience and past performance.”24 The Asset Management Unit
is scrutinizing ADV and other disclosures
to find flagrant misrepresentations in the
hopes of getting those advisers out of the
business before they become a problem for
other investors. For example, on October 26,
2011, the Asset Management Unit brought an
action against a purported quant hedge fund
manager, alleging that he had raised $1.7 million from investors by, among other things,
falsely claiming that he had undergraduate
and graduate degrees from Harvard, that he
had previously worked at Barclays Capital,
Bond Fund Initiative
This initiative focuses on disclosure and valuation issues in mutual fund bond portfolios.
5
Vol. 19, No. 5 • May 2011
regulators.”35
In addition, on October 26, 2011, the SEC
adopted a new rule requiring certain advisers
to hedge funds and other private funds to
report information for use by the Financial
Stability Oversight Council in monitoring
risks to the US financial system.36 The rule
requires registered investment advisers with at
least $150 million in private fund assets under
management to file a new reporting form
(Form PF).
Large hedge fund advisers (that is, those
with at least $1.5 billion AUM attributable to
hedge funds) must report each fiscal quarter
on an aggregated basis providing information
regarding exposures by asset class, geographical concentration and turnover by asset class.
In addition, for each managed hedge fund having a net asset value of at least $500 million,
these advisers are required to report certain
information relating to that fund’s exposures,
leverage, risk profile and liquidity.
Large private equity fund advisers (that is,
those with at least $2 billion AUM attributable to private equity funds) must file Form
PF annually, providing information focusing
primarily on the extent of leverage incurred
by their funds’ portfolio companies, the use of
bridge financing, and their funds’ investments
in financial institutions.37
Smaller private fund advisers must provide
information regarding size, leverage, investor types and concentration, liquidity and
fund performance. Smaller advisers managing hedge funds must also report information
about fund strategy, counterparty credit risk,
and use of trading and clearing mechanisms.
To help it make the most of all the data it
has and will have available to it, the SEC is
seeking to invest $100 million in information
technology in FY 2013. It is also seeking to
add 191 new positions in Enforcement, 222
new positions in OCIE, and 110 new positions
in RiskFin, IM and the Division of Trading
and Markets.38
Triggered by practices identified in an exam of
a large bond fund complex, the initiative seeks
to use risk analytics to identify red flags, such
as misrepresentations of leverage, outlier performance and problematic valuations.31
Private Equity Initiative
In connection with its most recently
announced initiative, the Asset Management
Unit is examining private equity firms to determine whether they are valuing assets appropriately, handling conflicts of interest properly,
charging and allocating fees and expenses as
they should, and making accurate claims of
performance. The unit is also concerned with
identifying so-called “zombie funds,” funds for
which the manager has no reasonable prospect
of a return to investors and yet the manager
perpetuates the fund solely in order to generate its management fee.32 As part of this
initiative, the SEC sent letters late last year to
several private equity firms asking for details
on fund investments, valuation of assets and
representations to clients.33
More Information for Data Analysis
The recent activity by the Asset Management
Unit reflects that it is actively using the data
available to it and conducting risk analytics
to identify firms to investigate. In the coming
months, the Unit will not only have a better
grasp of its analytic tools but it will also have
far more information from more firms, many
of which may not be prepared for such scrutiny.
On June 22, 2011, the SEC adopted rules
that require certain advisers to hedge funds
and other private funds to register with the
SEC.34 More specifically, under the rules,
most private hedge fund and private equity
advisers with more than $150 million in assets
under management (AUM) are required to
register with the SEC. Those newly required
to register had until March 30, 2012 to do so.
In announcing the rules, SEC Chairman Mary
L. Schapiro emphasized that “our proposal
will give the [SEC], and the public, insight
into hedge fund and other private fund managers who previously conducted their work
under the radar and outside the vision of
THE INVESTMENT LAWYER
The Market Abuse Unit
The main focus of the Market Abuse Unit
is investigating systematic insider trading and
manipulation schemes as well as high-frequency trading and algorithmic trading, large
6
inherent difficulties with proving these cases
at trial, prosecutors have been employing and
will continue to employ aggressive investigative techniques such as wiretaps.44
In addition, the SEC is attempting to
establish a consolidated audit (CAT) system
that would enable it to track information
related to trading orders received and executed
across the securities markets. Just as the Asset
Management Unit will have the benefit of
more information to conduct its analyses, the
Market Abuse Unit would be a primary beneficiary if the CAT system is established.
volume trading, and data feed latency issues.
Working in conjunction with criminal prosecutors, however, the Market Abuse Unit has
been particularly busy investigating insider
trading at hedge funds.
Much of the focus on insider trading at
hedge funds is the result of the conduct
that the SEC and US Attorney’s Office for
the Southern District of New York (USAOSDNY) uncovered in investigating and prosecuting insider trading at Galleon Management
Co. (Galleon), as well as a result of the success the SEC and USAO-SDNY has had in
prosecuting that conduct. On May 11, 2011,
a jury found Raj Rajaratnam, the former
head of Galleon, guilty of insider trading
and he was subsequently ordered to pay $10
million in criminal penalties and to forfeit
another $53.8 million in ill-gotten gains. On
November 8, 2011, in a separate SEC proceeding, the Honorable Jed Rakoff ordered
Rajaratnam to pay $92.8 million in penalties,
a record sanction against an individual in an
SEC insider trading case.39 Overall, the insider
trading probe into Galleon has resulted in civil
charges against a total of 30 individuals and
entities including hedge fund advisers, Wall
Street professionals and corporate insiders.
Working with criminal prosecutors, the Asset
Management Unit has turned its attention from
Galleon to other hedge funds. In connection
with its investigation of Expert Network cases,
for example, the SEC has charged 22 defendants, including several hedge fund managers
and traders.40 Indeed, since late 2009, criminal prosecutors have charged 66 individuals at
hedge funds and other entities with insider trading, winning 57 convictions or guilty pleas.41
Further, the government has announced that
it is currently investigating approximately 240
individuals, including hedge fund traders and
company insiders, on suspicion of insider trading.42 Of these, 120 have been classified as targets, meaning that the government already has
what it believes to be substantial evidence that
they have engaged in insider trading.43
Historically, insider trading prosecutions
rested on circumstantial evidence involving
anomalous trading activity. Insider trading
can be harder to detect and prove at hedge
funds where funds engage in hundreds or
thousands of trades each day. To overcome the
The Office of Compliance Inspections
and Examinations (OCIE)
The SEC’s OCIE administers the SEC’s
nationwide examination and inspection program. OCIE has examiners in Washington,
DC and in the SEC’s 11 regional offices. Like
the Enforcement Division, OCIE, in the wake
of the Madoff scandal, has undertaken a
broad self-assessment of its strategy, structure,
people, processes and technology, and it has
initiated significant reforms. As part of these
reforms, OCIE is implementing a National
Exam Program, which includes a national
governance model and enhanced risk-focused
exam strategy.45 OCIE also created a centralized Risk Assessment and Surveillance Unit
to enhance the ability of the National Exam
Program to perform more sophisticated data
analytics to identify the firms and practices
that present the greatest risks to investors,
markets and capital formation.46 In addition, OCIE is engaged in greater coordination
with the Divisions of Enforcement, IM, and
RiskFin to help it monitor areas of concern
within firms. OCIE is also utilizing the TCR
system, discussed above, to help inform its
selection of firms for examinations and the
scope of such exams.47
OCIE has also formed new Specialization
Working Groups to help it identify, understand, and proactively examine new and complex industry developments. The initial specialized groups are focused on the following areas:
new and structured products, valuation, equity
market structure and trading practices, fixed
income and municipal securities, microcap
fraud, and marketing and sales practices.48
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Vol. 19, No. 5 • May 2011
with the addition of new registrants, the SEC
estimates that it will still oversee approximately
10,000 investment advisers with $44 trillion
under management.54 As a result, IM has
stated that without added resources, it believes
“the [SEC] likely will not have sufficient capacity in the near or long term to conduct effective examinations of registered investment
advisers with adequate frequency.”55
To ease the burden, the SEC is requesting a budget of $1.566 billion for FY 2013,
an increase of $245 million over its FY 2012
appropriation.56 With the added budget, the
SEC plans to hire 222 new Staff to its exam
program.57
With such limited resources, OCIE has
abandoned routine or cycle examinations.
Instead, it now uses a risk-based process to
identify and allow it to focus on firms and
activities posing enhanced risks to investors.
To make this assessment, OCIE generally relies
on information contained in regulatory filings,
assessments made during past examinations,
and available information, including media
coverage, Staff knowledge of the adviser, and
tips, complaints and referrals. The SEC has
described the approach of OCIE as follows:
To assist it, OCIE has also hired several Senior Specialized Examiners, practiced
industry professionals with specialized experience in trading, portfolio management, valuation, complex products, sales, compliance and
forensic accounting. In addition, OCIE is providing its examiners more regular and relevant
training. For example, more than 300 became
certified fraud examiners last year.
OCIE is also in the process of finalizing its
first National Examination Manual, aimed at
nationalizing the exam program and creating
greater consistency across regional offices.
Modeled on the SEC’s Enforcement Manual,
it will set forth OCIE’s key examination policies and standards and include guidance on
what to expect during SEC’s examinations.
This project will include the use of an automated National Examination Workbook,
which is designed to promote consistency,
effectiveness, efficiency and accountability in
the exam process nationwide. The first draft
of the National Examination Manual was distributed to examiners in January 2012 and will
be made available to the public later this year
after months of field testing and revision.49
As OCIE Director Carlo di Florio has
noted, this new risk-based approach is driven
in part by the fact that OCIE’s current examination resources can only cover an ever
smaller portion of the registrants that it is
responsible for examining.50 In 2011, OCIE’s
Investment Management Exam Program was
responsible for oversight of approximately
11,540 investment advisers with total assets
of approximately $43.8 trillion dollars.51
However, OCIE has only approximately 450
Staff members conducting exams of investment advisers and investment companies,
meaning that for every Exam Staff member
there were almost 26 registered investment
advisers to examine.52 With so few examiners, OCIE has the resources to inspect all
investment advisers only once every 9-11
years on average. During FY 2011, only eight
percent of registered advisers were examined.
Further, 38 percent of advisers registered with
the SEC have never been examined.53
With the changes brought about by the
Dodd-Frank Wall Street Reform and
Consumer Protection Act, smaller investment
advisers will transition to state oversight, but
THE INVESTMENT LAWYER
OCIE uses risk-based methodologies
to focus resources on firms and activities that could pose the greatest risk to
investors and the integrity of the markets. Higher risk firms are those that
appear to engage in activities associated with emerging or resurgent risks
or that simply manage or handle such
large amounts of investor assets that
if something should go wrong there
could be significant harm to both investors and investor confidence. Higher risk activities include those where
there are significant conflicts of interest coupled with weak or non-existent
compliance policies and procedures to
mitigate and manage those conflicts.58
The SEC Staff has estimated that hedge
funds are nearly three times more likely to be
considered higher-risk advisers.59 For those
investment advisers that it identifies to be
high-risk, the SEC has stated that it will seek
to inspect these entities every three years.60
8
profit centers, products, business plans), affiliations and conflicts of interest, and control
environment.”62
While investment advisers should be cognizant of all of OCIE’s areas of focus discussed
above, they should pay particular attention
to their compliance controls. One of the first
things that Exam Staff will look at in assessing a firm is the compliance program. If
controls are weak or non-existent, examiners
will devote more resources to the exam. OCIE
will be focusing on hedge funds in particular
with weak compliance systems and due to
lack of resources, will rely on the stronger
firms to police themselves. New York Regional
Director George Canellos has stated that if a
firm’s compliance program is adequate, “we
probably won’t take a very deep dive. We’ll
rely on them to self police [and] . . . devote our
resources elsewhere.”63
In the past, OCIE Staff was likely to interact primarily with CCOs and meet with top
executives only if there was a specific reason
to do so.64 In a departure from past practices,
and as part of this focus on compliance and
risk controls, OCIE Staff is now interviewing
senior executives, as well as chief risk officers,
during exams to get a better sense of the firm’s
commitment to compliance and the level of
support given compliance and risk officers.65
The top substantive areas of focus for
OCIE include:
• New hedge fund and private equity registrants;
• Verification and confirmation of assets;
• Disclosure issues, especially those relating to conflicts of interest, valuation,
risk, and expenses;
• Performance claims, with particular focus on quantitative models;
• Sales of new and complex products;
• Risk management;
• The firm’s control environment, that is,
whether internal controls are in place to
prevent fraud and other violations;
• Staff resources, particularly whether a
firm has adequate compliance and internal audit staff, including designation of
a chief compliance officer and an internal auditor;
• Fund governance, including oversight
of risk at the board and senior management levels;
Referrals to Enforcement
• The firm’s portfolio management, with
an eye towards whether a firm’s strategy
and investment follow the representations made to investors; and
In FY 2011, 82 percent of investment
adviser exams and 72 percent of investment
company exams resulted in a deficiency letter.
In a deficiency letter, the Staff describes any
deficiencies and requests that the entity implement appropriate corrective action and then
respond with a letter describing those actions.
In addition, in approximately 10 percent of
investment adviser exams and seven percent
of investment company exams, OCIE made a
referral to Enforcement. In making a referral,
OCIE Staff is notifying the Enforcement Staff
of circumstances suggesting a possible securities violation worthy of investigation. Given
the risk-based selected process that OCIE is
now using, the new aggressive approaches
taken by OCIE and Enforcement, and the
many new registrants, the percentage of
exams resulting in referrals is likely to increase
• Indicia of fraud.61
In connection with mutual funds, OCIE is
also interested in examining the role of boards
in reviewing advisory fees and valuation determinations. Other areas of focus may depend
upon the firm’s activities. For example, given
a firm’s activities, the Exam Staff may have
heightened concerns about insider trading
or FCPA issues. As Mr. di Florio has stated,
OCIE will tailor the scope of its examinations “based on identified risks through our
understanding of, for example, the registrant’s
business model (for example, revenue streams,
9
Vol. 19, No. 5 • May 2011
cess can seem heavy-handed and burdensome,
a distraction to the business. However, there
may be no surer way to prolong an exam (if
not ensure a referral to Enforcement) than to
vent on the Staff by being rude or uncooperative. Other things that can have the effect of
prolonging the process are failing to provide
documents in a timely manner (if at all) or
making misleading statements to the Staff.
Such things would be taken as red flags that
the adviser may be hiding something. At a
minimum, they would suggest that the adviser
does not fully appreciate or respect the role of
its regulator and perhaps that it does not take
its compliance function or regulatory obligations seriously. These impressions would linger
with the Exam Staff when conferring with
their supervisors and contemplating whether
a deficiency letter or referral to Enforcement
is appropriate.
In general, an entity subject to an examination needs to be cognizant of the impression that
it is giving the Staff. Misimpressions or miscommunications with the Staff can unnecessarily
turn examinations into Enforcement referrals,
and investigations into Enforcement actions.
One cannot overestimate the importance of
dealing appropriately with the Staff during the
examination process. Accordingly, simple as
the following tips may seem, they should not be
overlooked by any entity wanting to ensure as
painless an examination as possible:
significantly in the coming years.
As a practical matter, once a matter is
referred from OCIE to Enforcement, it becomes
difficult to close before Enforcement has conducted a serious investigation of the matter.
The Exam and Enforcement Staffs share the
same physical office space in the SEC regional
offices and have considerable interaction daily
on substantive and non-substantive matters.
The Regional Director of each regional office
supervises both the Enforcement Staff and
the OCIE Staff within his or her given region,
ensuring the coordination of and interaction
between the respective Staffs. Further, the
Enforcement Division was recently criticized
in a recent report by the Office of the Inspector
General for not attributing sufficient significance to OCIE referrals.66 The Enforcement
Division and the Asset Management Unit in
particular, is also now doing more to encourage OCIE to make appropriate referrals. Given
these considerations, Enforcement Staff would
not want to risk insulting the OCIE Staff by
closing an investigation into a referred matter
without first conducting a thorough investigation.
Dealing with an Examination
The Exam Staff is under a lot of pressure
to conduct its exams as quickly and efficiently
as it can. It has deadlines to meet and more
exams to get through than it has people to
conduct them. At the same time, given the
criticism it has received for failing to catch
Madoff, the Staff is under even more pressure
not to miss something. The reality (one not
lost on the Staff) is that the Staff will rarely if
ever be publicly criticized for being too aggressive during an exam or imposing too great a
burden on an investment adviser; however, it
will be criticized if it is not thorough enough
in its review.
When the Exam Staff conducts a review,
the investment adviser will get relatively little
if any advance notice. Further, the Staff has
a list of documents and other information
(much of which is standard for all investment
advisers) that it will request for review and/or
production. From the viewpoint of an investment adviser, particularly one that has not had
many, if any, dealings with the Staff, the pro-
THE INVESTMENT LAWYER
• Be prepared.
• Be courteous and appropriately cooperative.
• Have compliance and other documents
ready for review and production.
• Review past deficiency letters and ensure all deficiencies have been addressed.
• Designate a person to act as the contact
for the Exam Staff.
• Prepare employees, including senior
management, for Staff interviews.
• Correct
potential
promptly.
10
misimpressions
• Provide context where appropriate for
issues/documents that may raise issues.
5. Robert Kaplan, Co-Chief, Asset Management Unit,
Remarks at Panel: “Understanding the SEC’s Changing
Role in Mutual Fund Regulation,” sponsored by K&L
Gates, Fund Director Intelligence, DC Bar Committee
on Broker-Dealer Regulation and SEC Enforcement, and
Federal Bar Association Securities Law Section (Nov. 1,
2011) (Kaplan 11/1/11 Remarks).
• Do not alter historical documents that
raise issues.67
• Maintain a log of documents requested
and provided.
6. Robert Khuzami, Director, Enforcement Division,
Testimony before the US Senate Committee on the
Judiciary, Sept. 22, 2010 (Khuzami 9/22/10 Testimony),
available at http://www.sec.gov/news/testimony/2010/
ts092210rk.htm; Kaplan 1/11/11 Remarks.
• Provide documents and information
responses to Staff requests in a timely
manner.
7. Jean Eaglesham and Steve Eder, “SEC Ups Game to
Find Rogue Firms”, Wall St. J., Dec. 27, 2011, at C1, available at http://online.wsj.com/article/SB10001424052970203
686204577116752943871934.html.
• Segregate privileged information.68
8. Id.
Conclusion
9. Id.
Given the new risk-based approaches of
the SEC, the new tools and information it
has available, and the new resources it hopes
to get, investment advisers, particularly those
newly registered, need to be prepared for the
enhanced scrutiny that the SEC will be giving
them in the months and years to come. An
appreciation of this enhanced scrutiny, along
with an understanding of the SEC’s areas of
focus and a recognition of the importance of
interacting effectively with the Staff, will help
investment advisers avoid unnecessary pain
and pitfalls in their dealings with the SEC.
10. “SEC Charges Multiple Hedge Fund managers
with Fraud in Inquiry Targeting Suspicious Investment
Returns,” SEC Press Release (Dec. 1, 2011), available at
http://www.sec.gov/news/press/2011/2011-252.htm.
11. Joshua Gallu, “SEC Scrutinizes Algorithmic Traders,”
Bloomberg, Oct. 3, 2011, available at http://www.bloom
berg.com/news/2011-10-03/algorithmic-traders-under
-scrutiny-from-sec-s-hedge-fund-police.html.
12. Eaglesham and Eder, supra n.7.
13. “SEC Penalizes Investment Advisers for Compliance
Failures,” SEC Press Release (Nov. 28, 2011), available at
http://www.sec.gov/news/press/2011/2011-248.htm.
14. Aggravating the matter, the firm’s chief compliance
officer (CCO), who was also charged, had assumed the
CCO responsibilities while living abroad. The SEC alleged
that OMNI had produced to the Staff certain client advisory agreements with the CCO’s signature evidencing his
supervisory approval when, in fact, the CCO had never
reviewed the agreements. The CCO had backdated his signature on those agreements one day before the documents
were produced to the SEC.
Notes
1. “SEC Enforcement Division Produces Record Results
in Safeguarding Investors and Markets,” SEC Press
Release (Nov. 9, 2011), available at http://www.sec.gov
/news/press/2011/2011-234.htm; Select SEC and Market
Data, Fiscal 2011, at p.3, available at http://www.sec.gov
/about/secstats2011.pdf; Select SEC and Market Data,
Fiscal 2009, at p.3, available at http://www.sec.gov/about
/secstats2009.pdf.
15. Robert Khuzami, Director, Enforcement Division,
Remarks before the Consumer Federation of America’s
Financial Services Conference (Dec. 1, 2011), available at
http://www.sec.gov/news/speech/2011/spch120111rk.htm.
2. David Bergers, Regional Director, Boston Regional
Office, Remarks at The SEC Speaks in 2012 (Feb. 24,
2012).
16. Khuzami 9/22/10 Testimony.
3. Sean McKessy, Chief, Office of the Whistleblower,
Remarks at The SEC Speaks in 2012 (Feb. 24, 2012).
17. Kaplan 11/1/11 Remarks.
4. For example, as has been widely reported, the FCPA
unit has an on-going inquiry into dealings by investment
advisers and banks with sovereign wealth funds. In addition, many of the CDO cases brought by the Structured
and New Products Unit and a number of the actions
brought by the Municipal Securities and Pension Funds
Unit have been against investment advisers.
19. Section 36(b)(1) of the Investment Company Act
imposes a “fiduciary duty [on investment advisers] with
respect to the receipt of compensation for services.” 15
U.S.C. § 80a-35(b).
18. Id.
20. Jones v. Harris Assocs. L.P., 130 S. Ct. 1418, 1425-26
(2010).
11
Vol. 19, No. 5 • May 2011
37. Large liquidity fund advisers (i.e., those with at least $1
billion in AUM attributable to liquidity funds and registered
money market funds) must each quarter file Form PF to update
information regarding the liquidity funds they manage. These
advisers must provide information on, among other things, the
types of assets in each of their liquidity fund’s portfolios and
certain information relevant to the risk profile of the fund.
21 Transcript of Oral Argument, Jones v. Harris Assocs.
L.P., No. 08-586 (Nov. 2, 2009), at 20-21, available at
http://www.supremecourt.gov/oral_arguments/argument
_transcripts/08-586.pdf.
22. “SEC Charges Morgan Stanley Investment
Management for Improper Fee Arrangement” SEC Press
Release, (Nov. 16, 2011), available at http://sec.gov/news
/press/2011/2011-244.htm.
38. Testimony of Mary L. Schapiro, Chairman, SEC,
before the Subcommittee on Financial Services and general Government Committee on Appropriations, US House
of Representatives (March 6, 2012), available at http://www
.sec.gov/news/testimony/2012/ts030612mls.htm (Schapiro
3/6/12 Testimony).
23. Kevin Kelcourse, Assistant Director, Asset
Management Unit, Remarks at “The SEC Enforcement
Division’s Asset Management Unit: Priorities and Recent
Developments,” Boston Bar Association (Dec. 14, 2011)
(Kelcourse 12/14/11 Remark”).
39. “SEC Obtains Record $92.8 Million Penalty against
Raj Rajaratnam,” SEC Press Release (Nov. 8, 2011), available at http://www.sec.gov/news/press/2011/2011-233.htm.
24. Khuzami 9/22/10 Testimony.
25. “SEC Halts Fraud by Purported Quant Hedge Fund
Manager,” SEC Press Release (Oct. 26, 2011), available at
http://www.sec.gov/news/press/2011/2011-225.htm.
40. See, e.g., “SEC Charges Oregon-Based Expert
Consulting Firm and Owner with Insider Trading in
Technology Sector,” SEC Press Release (Feb. 17, 2012),
available at http://www.sec.gov/news/press/2012/2012-30.htm.
26. Kaplan 11/1/11 Remarks.
27. Civil Action No. 1;10-cv-10073 (D. Mass.).
41. Jenny Strasberg and Reed Albergotti, “Insider Targets
Expanding,” Wall St. J., Feb. 28, 2012, at A1, available at
http://online.wsj.com/article/SB10001424052970203833004
577249710504638728.html.
28. Admin Pro. File No. 3-13887 (April 21, 2011) (Initial
Decision).
29. Gallu, supra n.11.
42. Id.
30. Steve Eder, “SEC Puts Falcone, Harbinger in Its
Sights,” Wall St. J., Dec. 10, 2011, available at http://online
.wsj.com/article/SB100014240529702034133045770884402
83592970.html.
43. Id.
44. See Stephen Joyce, “Official Says DOJ to Continue
Pursuit of Insider Cases at Hedge Funds,” BNA Securities
Regulation & Law Report, 43 SRLR 2468, Dec. 13, 2011.
31. Khuzami 9/22/10 Testimony.
32. See Bruce Karpati, Co-Chief, Asset Management
Unit, Remarks at The SEC Speaks in 2012 (Feb. 24, 2012).
45. Carlo di Florio, Director, OCIE, “Management and
Structural Reforms at the SEC: A Progress Report,”
Testimony before the Subcommittee on Securities,
Insurance, and Investment, United States Senate
Committee on Banking, Housing and Urban Affairs
(Nov. 16, 2011), available at http://www.sec.gov/news
/testimony/2011 /ts111611rk.htm (Di Florio 11/16/11
Testimony); Carlo di Florio, Director, OCIE, Remarks
at the Compliance Outreach Program, Jan. 31, 2012 (Di
Florio 1/31/12 Remarks).
33. Joshua Gallu and Cristina Alesci, “SEC Review of
Private Equity Said to Focus on Smaller Firms,” Bloomberg
(Feb. 13, 2012), available at http://www.bloomberg.com/
news/2012-02-13/sec-said-to-look-at-smaller-firms-in
-review-of-private-equity-valuations.html.
34. The rules also establish new exemptions from SEC
registration and reporting requirements for certain advisers and reallocate regulatory responsibility for advisers
between the SEC and states.
46. Di Florio 1/31/12 Remarks.
47. Id.
35. “SEC Adopts Dodd-Frank Act Amendments to
Investment Advisers Act,” SEC Press Release (June 22,
2011), available at http://www.sec.gov/news/press/2011/2011
-133.htm. While the Dodd-Frank Act gives the SEC much
greater exposure to the largest hedge funds, it does not give
it exposure to the category of those hedge funds that have
been the subject of most of its cases over the past three years.
Indeed, 90 percent of cases brought against hedge funds
during that period have involved firms with less than $150
million in assets under management. Kelcourse 12/14/11
Remarks.
48. Carlo di Florio, Director, OCIE, Remarks at the
CCOutreach National Seminar (Feb. 8, 2011), available
at http://www.sec.gov/news/speech/2011/spch020811cvd.htm
(Di Florio 2/8/11 Remarks).
49. Di Florio 1/31/12 Remarks.
50. Di Florio 11/16/11 Testimony.
51. See “Office of Compliance Inspections and
Examinations: Offices,” available at http://www.sec.gov
/about/offices/ocie/ocie_offices.shtml.
36. “SEC Approves Confidential Private Fund Risk
Reporting,” SEC Press Release (Oct. 26, 2011), available at
http://www.sec.gov/news/press/2011/2011-226.htm.
THE INVESTMENT LAWYER
52. Di Florio 1/31/12 Remarks; 2011 Evolution
Report by the Investment Adviser Association (IAA)
12
and National Regulatory Services (NRS), available
at
http://www.nrs-inc.com/Global/White%20Papers
/NRSEvolutionRevolution_2011_WhitePaper_Screen
_final.pdf.
53. Di Florio 11/16/11 Testimony.
54. Mary L. Schapiro, Chairman, SEC, Testimony before
the Subcommittee on Financial Services and general
Government Committee on Appropriations, US House of
Representatives (March 6, 2012), available at http://www
.sec.gov/news/testimony/2012/ts030612mls.htm (Schapiro
3/6/12 Testimony).
55. Id. at pp.3-4; SEC Staff Study on Enhancing
Investment Adviser Examinations (Jan. 19, 2011), available at http://www.sec.gov/news/studies/2011/914studyfinal.
pdf, at 3-4.
56. Schapiro 3/6/12 Testimony.
57. As noted above, the SEC is also seeking to add over
300 positions in Enforcement, IM, RiskFin, Trading
and Markets and to invest $100 million in Information
Technology. Schapiro 3/6/12 Testimony. These developments would have a direct impact on the examination and
investigation of investment advisers.
58. “Office of Compliance Inspections and Examinations:
Highlights,” SEC Web site, available at http://www.sec.gov
/about/offices/ocie/ocie_highlights.shtml.
59 “Staff Study on Enhancing Investment Adviser
Examinations” (Jan. 19, 2011), available at http://www
.sec.gov/news/studies/2011/914studyfinal.pdf;seealsoCommissioner
Elisse B. Walter, Statement on Study Enhancing Investment
Adviser Examinations (Required by Section 914 of Title IX of
the Dodd-Frank Wall Street Reform and Consumer Protection
Act) (Jan. 2010), available at http://www.sec.gov/news/speech/2011
/spch011911ebw.pdf.
60. SEC’s FY 2011 Performance and Accountability Report,
at p.59, available at http://www.scribd.com/doc/72912216
/SEC-FY-2011-Performance-and-Accountability-Report.
61. See, e.g., Di Florio 2/8/11 Remarks; Di Florio 11/16/11
Testimony.
62. Di Florio 11/16/11 Testimony.
63. “SEC Will Rely More on Hedge Funds to Self-Police,
Official Says,” Bloomberg Securities Law, vol.5, no.48,
(Nov. 28, 2011), at p.17.
64. Peter Ortiz, “SEC Grills Top Execs about Firms’s
Compliance Culture,” Ignites (Oct. 21, 2011), available at
http://www.ignites.com/c/264721/31681.
65. See Di Florio 1/31/12 Remarks.
66. “OCIE Regional Offices’ Referrals to Enforcement,”
SEC Office of the Inspector General, Office of Audits
Report No. 493 (March 30, 2011), available at www.sec-oig
.gov/Reports/AuditsInspections/2011/493.pdf.
67. From time to time, employees at an entity may
make the mistake of trying to hide a deficiency by
altering documents or giving misleading information
to the Staff. An example might be rewriting or hiding
a troublesome description of an incident in a CCO’s
annual report. Such actions are usually perceived by the
Staff to be far worse than the deficiency the employees
are trying to hide.
68. In preparation for an examination, many investment
advisers hire a law firm or third party to conduct a mock
exam or an independent review of compliance policies
or procedures. Hiring a law firm to conduct the exam or
review (either itself or by engaging a consultant) will help
ensure the results remain privileged.
Copyright © 2012 CCH Incorporated. All Rights Reserved
Reprinted from The Investment Lawyer May 2012, Volume 19, Number 5, pages 3-15,
with permission from Aspen Publishers, Wolters Kluwer Law & Business, New York, NY,
1-800-638-8437, www.aspenpublishers.com