COMPLIANCE CORNER
What Managers Should Know About the SEC Staff’s Hedge Fund Sweep
By Benjamin J. Haskin, Richard D. Marshall and Gary J. Meer*
The Securities and Exchange Commission staff (“SEC Staff”) has engaged in a fact-finding inspection sweep of a group of registered
investment advisers who manage hedge funds, including interviews with hedge fund portfolio managers and counsel. The SEC also has
approved a formal order of investigation, which means that the SEC Staff has the power to compel the production of information
through the issuance of subpoenas. Although the SEC Staff has framed this sweep as a way to gather more information about the
industry, there is always the risk of SEC enforcement actions if violations are detected. The SEC Staff has expressed concern that the
minimal regulation of the hedge fund industry might encourage deficient compliance practices and even fraud against investors.
Several senior members of the SEC Staff have noted an increased number of fraud cases involving hedge funds.
The SEC has two principal bases to regulate the hedge fund industry. One is the regulation of the advisers to the funds. Larger
advisers generally are registered with the SEC. However, even unregistered advisers are subject to the anti-fraud rules of the
Investment Advisers Act of 1940 (“Advisers Act”). Second, hedge funds generally offer their interests, which are securities, under
exemptions from registration under Regulation D under the Securities Act of 1933 and the exemptions from investment company
registration under Sections 3(c)(1) or 3(c)(7) under the Investment Company Act of 1940 (“ICA”), as well as other regulatory exemptions.
These exemptions are predicated on the belief that the relying hedge fund is not engaged in a public offering of securities and that the
hedge fund is being offered solely to eligible investors. The SEC has the authority to enforce compliance with these exemptions. The
SEC Staff has indicated that it believes that the activities of some hedge funds and hedge fund managers are inconsistent with the
statutory and regulatory exemptions.
Distribution Issues. The SEC Staff has particularly focused on distribution issues involving hedge funds. The SEC Staff has expressed
interest in the propriety of marketing directly to investors who are unaccustomed to investing in hedge funds, the compliance with the
SEC Staff’s prior positions concerning the use of websites, and the accuracy of information posted on websites. One of the primary
concerns of the SEC Staff is determining whether hedge fund distribution practices comply with the limitations on public distribution
under Regulation D. If a hedge fund is marketed through advertising or unsolicited contacts, the fund may be engaged in a public
distribution of securities, which would mean that the hedge fund and the sale of its shares would be subject to registration under the
federal securities laws.
• Websites Many hedge funds are listed on certain passworded websites. While the SEC Staff permitted such passworded websites,
the SEC Staff is concerned that the activities of some of these websites may not be consistent with its prior pronouncements, and
that sales of hedge funds through these websites may be occurring to investors who are not “accredited investors,” as required.
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• Retail Investors Additionally, the SEC Staff is concerned that hedge funds have been marketed directly and indirectly to “retail”
investors. A related issue is whether appropriate suitability determinations are being made with respect to hedge fund investors.
Finally, the SEC Staff is concerned about sales of hedge fund shares other than through registered broker-dealers, and whether some
non-registered marketers of hedge fund shares should be required to register as broker-dealers.
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• Distribution Activities of Prime Brokers The SEC Staff has also expressed interest in the activities of prime brokers to hedge funds in
facilitating the distribution of hedge funds through arranging meetings between hedge fund managers and clients of the prime
brokers. In particular, the SEC Staff is interested in knowing whether the prime brokers are assisting hedge funds in marketing
activities that are not consistent with the private placement exemption. Finally, the SEC Staff has also questioned whether prime
brokers have any duties with respect to any performance information that they distribute to ascertain whether it is accurate. The
SEC Staff has specifically referenced an Institutional Investorarticle (July 2002) that described certain hedge fund sales practices by
prime brokers.
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• Accredited Investor Compliance Procedures The SEC Staff is additionally requesting information about the compliance procedures
for ascertaining whether an investor is accredited.
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Valuation of Assets. The SEC Staff is interested in the valuation of fund assets, particularly for harder to value or illiquid securities.
The SEC Staff has particularly expressed concern that some hedge fund managers may have incentives to misprice assets to realize
higher performance fees.
Performance Calculation. The SEC Staff is evaluating whether performance is appropriately calculated, both for marketing and for
performance fee purposes.
Conflicts of Interest. The SEC Staff is interested in potential conflicts of interest, such as trade allocation issues between hedge funds
and other advisory clients, particularly registered mutual funds, where the hedge fund is favored due to the higher fees it pays the
adviser, and the establishment of hedge funds to evade personal trading restrictions. (Hedge funds are often exempt from the
restrictions advisers impose on their employees to prevent abusive personal trading practices, even when the hedge fund is wholly
owned by the adviser’s personnel.) The SEC Staff has also expressed concern that the advisers that manage products both with
performance fees and without performance fees may devote more time and effort to the products with performance fees, in an apparent
violation of fiduciary duties.
Selection of Brokers. Another issue is the use of fund brokerage, including the use of brokerage arrangements to benefit the manager
at the expense of the hedge fund.
Compliance With Private Placement Offering Material. The SEC Staff is concerned that some managers may not be managing
hedge funds in compliance with the investment guidelines set forth in the offering materials provided to investors.
Howls the SEC Staff Undertaking its Hedge Fund Sweep?
The SEC Staff has sent inspection request letters to various SEC registered investment advisers who are hedge fund managers pursuant
to their examination powers under the Advisers Act. These requests have asked for detailed information regarding the funds, such as
their size, investment policies and objectives, fee structure, performance, disclosures to investors, service provider relationships and
distribution channels. Information has also been requested about the adviser’s management practices, such as valuation, custody, risk
management policies, conflicts of interest, brokerage and execution, marketing and insider trading. Sometimes, the SEC Staff has
followed up these requests with on-site examinations.
The SEC Staff’s second line of inquiry has been with prime brokers. These brokers typically provide not only brokerage, execution, and
custody services to hedge funds, but also marketing and distribution services. As the prime brokers are regulated entities, the SEC Staff
may send request letters to them pursuant to its examination powers under the Securities Exchange Act of 1934. While we are unaware
of any unregistered advisers contacted in the sweep, the SEC Staff does have authority to inquire of these entities and can always
obtain information through subpoenas.
WhatAre Some of the Possible Outcomes ofthe SEC Staff’s Sweep?
Although the sweep could result in nothing more than fact-finding and possibly a report, it is also possible that the SEC will take one or
more of the following actions, depending upon what they learn. (1) The SEC Staff can issue deficiency letters warning advisers that their
practices are violative and need to be corrected. (2) In the recent past, the SEC brought enforcement actions in cases involving hedge
fund fraud, and the SEC can take action against advisers involved in the sweep if it finds non-compliance with legal and regulatory
requirements.
Regulatory Changes
(1) Senior SEC Staff officials have discussed the possibility of changing the calculation rules for the number of clients, treating each
investor in a hedge fund as a separate client. The effect of this would be to require many more advisers to register with the SEC or the
state regulatory agencies. (2) The SEC could amend or interpret the exemption under Regulation D or the ICA in order to curtail
distribution practices. (3) The SEC Staff is considering whether additional regulation is necessary to require standards for the custody of
hedge fund assets.
Benjamin J. Haskin and Cary J. Meer are partners in the Washington D.C office, and Richard D. Marshallis a partner in the New York office, of
Kirkpatrick & Lockhart LLP The views expressed herein are not necessarily those ofKirkpatrick & Lockhart LLP This article provides general
information on the subject matterand should not be relied on for legal advice on any matter
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Reprinted with permission from the Investment Counsel Association of America
ICAA Newsletter
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flecerni,er 2002