Investment Management Legal Insight
December 2010
Author:
Stephen J. Crimmins
stephen.crimmins@klgates.com
+1.202.778.9440
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New SEC Enforcement Unit Focuses on
Funds and Advisers
For decades, the Securities and Exchange Commission’s Enforcement Division
allocated few of its limited resources to the world of funds and advisers. The ’40 Act
was left to the regulatory lawyers while, apart from the combined state-federal
campaign against market timing and late trading a few years ago, the enforcement
lawyers directed their investigations and litigation elsewhere.
This largely hands-off approach changed dramatically when the SEC’s new
Enforcement Director Robert Khuzami announced that his restructuring efforts
would include the creation of a new “Asset Management Unit” within the Division to
focus squarely on investigating and bringing enforcement cases against investment
advisers, investment companies, hedge funds and private equity funds.1 This article
discusses the Asset Management Unit’s formation and structure, its recently
announced initiatives impacting funds and advisers, and prosecutorial interests
discernable from the cases it has announced so far.2
A. Introducing the Asset Management Unit
Getting Started. Khuzami jump-started the Asset Management Unit by appointing
two experienced SEC veterans as the Unit’s new Co-Chiefs – Robert Kaplan, based
in Washington, and Bruce Karpati, based in New York. Karpati joined the
Enforcement program after litigating with a private firm, and went on to establish
and lead the Enforcement Division’s Hedge Fund Working Group. Kaplan also
litigated in private practice before joining the SEC, and later tried securities cases in
federal court as a member of the Division’s Trial Unit before becoming an Assistant
Director managing investigations, including matters related to the SEC’s recent
charges against Galleon Management LP.
The degree to which advisers and funds are now a high enforcement priority is
obvious from the fact that the Asset Management Unit is one of only five new
specialized units established during the Division’s recent reorganization, and from
the fact that it is the largest of the five units.3 Kaplan and Karpati spent the first
1
Remarks of Robert S. Khuzami, SEC Enforcement Director, Jan. 13, 2010, available at sec.gov.
2
Information on the Asset Management Unit in this article is drawn in part from the remarks of the
Unit’s Co-Chiefs Robert Kaplan and Bruce Karpati at “The SEC’s New Asset Management Unit –
Fresh Focus on Funds and Advisers,” a joint panel of the District of Columbia Bar and the Association
of the Bar of the City of New York, Nov. 23, 2010, which the author organized and moderated.
3
The others are (i) the Structured and New Products Unit, focusing on collateralized debt obligations,
credit default swaps, securitized instruments, other structured products, and other “newly-developing
products”; (ii) the Market Abuse Unit, focusing on “large-scale market abuses and complex
manipulation schemes” by institutional traders, market professionals and others; (iii) the Foreign
Corrupt Practices Unit; and (iv) the Municipal Securities and Public Pensions Unit, focusing on
offering and disclosure issues, tax and arbitrage driven activity, and pay-to-play schemes. SEC
Press Rel. 2010-5 (Jan. 13, 2010), available at sec.gov.
Investment Management Legal Insight
several months building their unit into a team of 65
professionals. The unit’s staff includes five industry
experts, reflecting the SEC’s ongoing efforts to
recruit “qualified industry professionals” from
outside the agency. The balance of the Unit is
comprised of 60 attorneys, of whom 13 are Assistant
Directors and the remainder staff attorneys and
senior counsel. The recruiting and organizational
process is now complete, and the Unit is actively
pursuing investigations and bringing cases.
Plan of Attack. The Asset Management Unit will
plan and coordinate all of the Enforcement
Division’s efforts relating to funds and advisers. It
will set priorities in investigating and bringing cases
and monitor the progress of filed cases. Unit
leadership – the Co-Chiefs and the Assistant
Directors – use regularly scheduled conference calls
to discuss and focus the Division’s efforts in the
asset management space.
The Unit operates nationwide, as a network of
specialists based both at SEC headquarters and at
eight of the SEC’s eleven regional offices around the
country. In this respect, it is part of the SEC’s recent
efforts to break down geographic silos and
encourage free exchange of information and ideas
across its programs. Particular cases will be staffed
with Unit personnel from different offices in what it
terms a “horizontal” staffing model. Case teams
may also include staff from outside the Unit, as
needed. The Unit will stress rigorous and
continuous training – both general and case specific
– from in-house and outside experts as a means to
develop its staff as a sophisticated team of asset
management specialists with a law enforcement
focus.
Unit staff will themselves handle a significant
portion of the Division’s cases against funds and
advisers, but staff outside the Unit will also continue
to do asset management cases. The Unit will liaise
with and support staff outside the Unit when they
pursue cases within the Unit’s mandate. Defense
counsel seeking meetings with top management on a
matter will approach Kaplan or Karpati on Unit
cases, and approach the senior officer at the top of
the supervisory chain for non-Unit cases.
Partnering. As the Unit continues to develop new
initiatives and cases, it will partner closely with the
SEC’s Investment Management Division on all
technical issues, and with the SEC’s Office of
Compliance Inspections and Examinations
(“OCIE”) for real-time industry intelligence from
the SEC’s “eyes and ears” in the field. The Unit
will look to OCIE as a significant source of case
referrals and will work with OCIE staff on
investigations. The Unit will also pursue
individuals it feels have misled OCIE examiners.
Additionally, the Unit will have at its disposal the
SEC’s new Division of Risk, Strategy, and
Financial Innovation (known as “RiskFin”), which
is already consulting with Unit staff on cases and
providing training. The SEC created RiskFin in
September 2009 to provide “sophisticated analysis”
in the areas of “risk and economic analysis, strategic
research, and financial innovation.” RiskFin has
recruited senior in-house talent in a variety of
technical areas, including experts on risk
management and the regulation of derivatives,
swaps and other financial innovations; a hedge fund
manager and risk management consultant; a head of
risk management at multiple Wall Street firms; a
structured finance expert; and a corporate finance
expert, among others.4
B. The New Unit’s Priorities and
Initiatives
Overall, the Asset Management Unit is focusing its
priorities by type of investment vehicle. For mutual
funds, the Unit’s leadership has indicated that key
areas of interest will include: (i) adequate
disclosures relating to strategies, performance,
valuation and risk; (ii) boards’ discharge of their
responsibilities, particularly as to valuation and
fees; (iii) director independence issues; and
(iv) personal trading, including redemptions before
material disclosures.
For hedge funds, the Unit’s focus will include,
among other things: (i) investigation of aberrational
4
In addition, the SEC last year implemented its “Industry and
Markets Fellows Program,” designed to attract “seasoned
industry professionals” to help the SEC “oversee complex
industry practices and products.” For background on these
efforts to attract outside professionals, see SEC Press Rel.
2009-98 (Apr. 30, 2009); Press Rel. 2009-199 (Sept. 16,
2009); Press Rel. 2009-205 (Sept. 24, 2009); and Press Rel.
2009-238 (Nov. 5, 2009), available at sec.gov.
December 2010
2
Investment Management Legal Insight
performance indicators; (ii) valuation processes and
use of side pockets; (iii) registration of advisers;
(iv) conflicts, including relationships among funds
under common management and among affiliated
entities; (v) compliance programs and internal
controls; and (vi) attention to private offering
requirements.
Beyond such general priorities, the Unit has already
identified several formal “initiatives” where it will
focus attention and resources. As described below,
these include the Hedge Fund Suspicious
Performance Initiative, the Mutual Fund Fee
Initiative, the Bond Fund Valuation Initiative, and
the Problem Adviser Initiative.
Hedge Fund Suspicious Performance Initiative.
Shortly after creating the Asset Management Unit,
Enforcement Director Khuzami gave a speech laying
out his concerns about hedge funds, which he termed
“particularly challenging.” Noting that they had
“undergone explosive growth,” he commented that
hedge funds are “not subject to the same rules as
mutual funds with respect to liquidity, redemptions,
conflict rules, pricing, disclosure, use of leverage,
short sales – among other areas.” He continued that
hedge funds “trade extensively in less transparent
markets, such as in credit and derivatives”; “utilize
high-tech trading systems and techniques”; “have
close prime brokerage, cap intro and other
relationships with investment banks, who
themselves are sources of a great deal of private-side
information that would be highly valuable to any
trading entity”; and “can have different fee
arrangements across multiple structures and
affiliates, which can create conflicts and incentives
for improper activity.”5
With such concerns front and center for the
Enforcement Director, it comes as no surprise that
the Asset Management Unit initiative that is said to
be the farthest along in development is what it terms
its “Hedge Fund Suspicious Performance Initiative,”
which will focus on several of Khuzami’s hedge
fund target areas. The Unit has worked with
RiskFin to develop methodologies to identify funds
with “outlier” returns or other suspicious
performance. When Unit staff identify such returns,
the funds and their advisers are then subjected to
further investigation and evaluation, which may in
turn lead to enforcement action if warranted.
Mutual Fund Fee Initiative. Khuzami told
Congress several weeks ago that the Asset
Management Unit is pressing a “Mutual Fund Fee
Initiative” that will “develop analytics ... for
inquiries into the extent to which mutual fund
advisers charge retail investors excessive fees.”
According to Khuzami, “these analytics are
expected to result in examinations and
investigations of investment advisers and their
boards of directors concerning duties under the
Investment Company Act.”6 Following decades of
little SEC involvement in the fee approval process,
this initiative may augur a big change for funds and
advisers.
According to the Unit’s leaders, this initiative will
involve sifting through data to determine whether
grounds exist for further investigation. In so doing,
the staff will ask two questions. First, whether fund
boards, particularly independent directors, are
appropriately vetting fee arrangements. Second,
whether advisers are appropriately disclosing
information needed for the board’s determinations.
The staff will want to be sure that both boards and
advisers are carrying out their responsibilities and
that, notwithstanding binders showing support and
legal advice, directors have actually asked the right
questions in making their determinations.
The Unit has developed its fee analytics with
assistance from other SEC divisions and offices,
including Investment Management, OCIE and
RiskFin. The Unit’s leaders have declined to
provide specifics as to its analytics, and they will
intentionally keep its surveillance parameters
confidential in order to prevent engineering around
the Unit’s monitoring. The Unit has said it will be
“continually refining” its analytics based on
experience.
Director Khuzami’s announcement of this initiative
immediately raised eyebrows across the fund
5
Remarks of Robert S. Khuzami before the Society of
American Business Editors and Writers, Phoenix, Arizona,
March 19, 2010, available at sec.gov.
6
Testimony of Robert S. Khuzami before the U.S. Senate
Judiciary Committee, Sept. 22, 2010, available at sec.gov.
December 2010
3
Investment Management Legal Insight
industry, with many concerned that the use of fee
“analytics” across groups of funds could be
inconsistent with the Supreme Court’s decision on
fees earlier this year in Jones v Harris Associates
L.P.7 In Jones, the Court essentially adhered to the
Second Circuit’s so-called Gartenberg standard that
had been followed for decades by lower courts.8
Under Jones and Gartenberg, to violate Section
36(b) of the Investment Company Act, an adviser’s
fee must be “so disproportionately large that it bears
no reasonable relationship to the services rendered
and could not have been the product of arm's length
bargaining.” The essence of this more flexible
standard is whether “under all the circumstances” it
appears to be an arm’s length bargain.”9
In so ruling, the Supreme Court explicitly rejected a
market-based approach to evaluate advisers’ fees
that had been proposed by the Seventh Circuit in the
decision that led to the appeal, and warned against
“inapt comparisons” in evaluating fee
determinations. The Supreme Court observed,
among other things, that there may be “significant
differences between the services provided by an
investment adviser to a mutual fund and those it
provides to a pension fund.” These can be
“attributable to the greater frequency of shareholder
redemptions in a mutual fund, the higher turnover of
mutual fund assets, the more burdensome regulatory
and legal obligations, and the higher marketing
costs.” And even as between mutual funds, the
Court warned against placing too much emphasis on
a comparison of one fund’s advisory fees against
fees charged to other mutual funds by other
advisers.10
and circumstances of a board’s approval of fees.”
Karpati added that “[o]ur analytics do not employ
any single fee threshold to determine appropriate
candidates for further review.”11
Bond Fund Valuation Initiative. Khuzami also
told Congress that his new Asset Management Unit
will mount a “Bond Fund Valuation Initiative” to
“focus on disclosure and valuation issues in mutual
fund bond portfolios.” He said that this initiative
arose from the Unit’s consideration of “practices
identified in an examination of a significant bond
fund complex,” which neither he nor the Unit’s
leadership have identified. As with its other
initiatives, the Unit has collaborated with other SEC
divisions and offices “to develop risk analytics that
identify red flags for further investigation.” These
red flags include “misrepresentations of leverage,
outlier performance, and problematic valuations.”12
Problem Adviser Initiative. Finally, Khuzami
identified an Asset Management Unit initiative to
deal with what he called “problem” advisers. He
told Congress that the Unit had worked with the
SEC’s examination staff to develop “a risk-based
approach to detecting problem investment advisers.”
The effort will involve “on-going due diligence
reviews of advisers’ representations to investors
related to their education, experience, and past
performance.”13
C. Recent Areas of Prosecutorial
Interest
The Co-Chiefs of the Asset Management Unit
responded quickly to these concerns. Kaplan told a
reporter that Unit staff “read Jones v. Harris very
carefully and recognize that in evaluating the fee
process there are a number of considerations. We
are aware of the admonition of not engaging in inapt
comparisons ... and we are looking at the total facts
A quick tour of very recent asset management cases
appearing in the Litigation Releases section of the
SEC’s website shows that the new Enforcement
Division focus on funds and advisers is moving
forward quickly. Not only is the number of recent
cases noteworthy, but also the fact that a number of
these cases are being litigated, which may indicate
that the cases are more aggressive than what we
have seen before. Looking at certain of these case
7
11
130 S.Ct. 1418, 1426 (2010).
8
Gartenberg v Merrill Lynch Asset Management, Inc., 694
F.2d 923 (2d Cir. 1982).
9
Jones v Harris Associates L.P., 130 S.Ct. at 1426
10
Id. at 1428-29.
Comments of Robert Kaplan and Bruce Karpati, reported in
Ignites, Oct. 21, 2010.
12
Testimony of Robert S. Khuzami before the U.S. Senate
Judiciary Committee, Sept. 22, 2010, available at sec.gov.
13
Testimony of Robert S. Khuzami before the U.S. Senate
Judiciary Committee, Sept. 22, 2010, available at sec.gov.
December 2010
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Investment Management Legal Insight
filings, as discussed below, we see some key themes
likely to recur in asset management cases ahead.14
Commission investigation and related enforcement
action.”17
Hedge Fund Insider Trading. On November 12,
2010, the SEC charged an adviser and its managing
director with insider trading on behalf of a hedge
fund based on information about a corporate
acquisition. In its complaint – personally signed by
Asset Management Unit Co-Chief Kaplan – the SEC
alleged that the adviser’s managing director was a
fourth-level tippee of two major law firm attorneys
who had misappropriated client information and
then tipped an unrelated attorney, who tipped a
proprietary trader at a broker-dealer, who tipped
another proprietary trader at the same broker-dealer,
who ultimately tipped the adviser’s managing
director.15
Valuation Issues. On October 25, 2010, the SEC
charged a hedge fund manager and his investment
advisory businesses with allegedly overvaluing his
funds’ largest position by misstating the acquisition
price and then continuing to value the investment at
the acquisition price. The SEC additionally charged
that the manager raised money for new funds with
the representation that the funds would be invested
in free-trading shares or cash, when they were
instead being invested largely in relatively illiquid
securities.18
The same day, the SEC filed a second complaint
against the same managing director of the
investment adviser that charged him separately with
insider trading on behalf of a hedge fund based on
information about two other acquisitions and an
earnings announcement. The second complaint
related to the SEC’s case against Galleon
Management LP, and the SEC took the opportunity
to recap that it has so far charged 22 defendants in
that matter with “repeated insider trading at
numerous hedge funds” in the securities of 14
issuers.16
On September 16, 2010, the SEC settled charges that
a hedge fund portfolio manager traded on behalf of
an investment adviser and for his own account based
on insider information about a large financial
services provider’s upcoming analyst
recommendations. The settlement included a bar of
the portfolio manager, as well as an injunction and
disgorgement of profits, but the SEC did not impose
a penalty “based upon his cooperation in a
14
Where cases discussed below have been resolved on
consent, the defendants have all settled without admitting or
denying liability and without any adjudication of fact or law,
consistent with the usual SEC practice. Where cases are
being litigated, the defendants obviously have denied the
SEC’s factual allegations and legal theories.
15
SEC v. Lanexa Management LLC, SEC Lit. Rel. 21741
(Nov. 15, 2010).
16
SEC v. Hardin, SEC Lit. Rel. 21740 (Nov. 15, 2010).
On October 19, 2010, the SEC charged two hedge
fund portfolio managers and their investment
advisory businesses with allegedly overvaluing
illiquid fund assets that had been placed in a “side”
pocket. A side pocket is an account that hedge
funds appropriately use to separate illiquid
investments from the remainder of a fund. The
SEC’s release on this case announced that the
“Asset Management Unit has been probing whether
funds have overvalued assets in side pockets.”19
Risk Disclosure / Subprime. On September 30,
2010, the SEC charged a chief investment officer
and a product engineer with failing to adequately
disclose risks and concentration in subprime
bonds.20 The matter related to a settled case filed
earlier this year involving their former employer.21
Interest in subprime-related matters has, of course,
been high over the last year. On April 7, 2010, the
17
Mtr. of Slaine, I.A. Rel. 3084 (Sept. 16, 2010), and SEC v.
Slaine, Lit. Rel. 21653 (Sept. 16, 2010). Early this year, the
SEC Enforcement Division announced a new “cooperation”
policy. In exchange for information that provides “material
assistance” to its law enforcement efforts, the Division will
consider lesser sanctions in appropriate cases. See
“Cooperation Policy Tops Changes in SEC Enforcement
Manual,” Securities Regulation and Law Report (BNA), Vol.
42, No. 4 (Jan. 25, 2010).
18
SEC v Southridge Capital Management, Lit. Rel 21709
(Oct. 25, 2010).
19
SEC v Mannion, Lit. Rel. 21699 (Oct. 19, 2010).
20
Mtr. of Flannery, SEC Press Rel. 2010-177 (Sept. 30,
2010).
21
Mtr. of State Street Bank and Trust Company, SEC Press
Rel. 2010-21 (Feb. 4, 2010).
December 2010
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Investment Management Legal Insight
SEC charged an adviser and two employees with
allegedly overstating the value of securities backed
by subprime mortgages. The SEC complained of an
alleged failure to employ reasonable procedures to
internally price the portfolio securities, with
resulting impact on the calculation of net asset
values for the funds in question, including through
price adjustments that allegedly ignored lower
values for the securities quoted by various dealers as
part of the pricing validation process.22
Performance / Strategies. On November 4, 2010,
the SEC charged two hedge fund managers and their
entities with allegedly making fraudulent
misrepresentations to investors concerning past
performance and anticipated future returns, as well
as concerning use of investor funds and investment
strategies.23 On October 28, 2010, the SEC charged
an investment adviser and its affiliates with
allegedly participating in fraudulent offerings that
lied to investors about use of proceeds and
investment risk.24 On October 7, 2010, the SEC
charged a portfolio manager and CEO of an adviser
with allegedly misrepresenting risk, diversification
and liquidity of the funds he offered, and with
making unsuitable recommendations to elderly
investors.25
Offering Requirements. On November 22, 2010,
the SEC charged an adviser with Reg M violations
for purchasing securities from an offering after
having sold short the same securities; the case
settled with a censure, disgorgement of $183,084 in
gains and avoided losses, a $100,000 fine and a
cease-and-desist order.26 On September 23, 2010,
the SEC charged a hedge fund adviser with Reg M
violations for purchasing securities from multiple
public offerings after having sold short the same
securities, including one instance where the portfolio
managers who sold short and bought in the offering
were different individuals; the case settled with a
censure, disgorgement of approximately $2.3
million in gains and avoided losses, a $260,000 fine
and a cease-and-desist order, and the adviser
undertook remedial measures, including enhanced
policies and procedures and installation of an
automated system to help prevent future Reg M
violations.27
Conflicts. On September 29, 2010, the SEC
charged an adviser with failing to tell clients that it
would receive additional commissions if they
switched from one series of a fund to another; the
case settled with a censure, disgorgement of
approximately $395,000 in commissions, a $60,000
fine for the adviser’s president, and a cease-anddesist order.28 On September 23, 2010, the SEC
charged an adviser and its principals with failing to
disclose conflicts, contrary to statements in the
adviser’s Form ADV, arising from their investment
of client funds in entities in which the adviser’s
principals had interests; the case settled with
revocation of the adviser’s registration, a bar of its
principals, and a cease-and-desist order.29
Books and Records / Form ADV Issues. On
November 17, 2010, the SEC charged that an
adviser, its broker-dealer parent, and their former
chief compliance officer failed to have adequate
policies and procedures to prevent misuse of
nonpublic information, and that the adviser
allegedly supplemented and altered its records
before producing them to the SEC’s examination
staff; the case settled with a censure, a $75,000 fine
for the adviser and a $35,000 fine for the former
officer, and a cease-and-desist order.30 On
November 16, 2010, the SEC charged that an
adviser failed to supply books and records to
examiners until it received an Enforcement Division
subpoena, and that it made misrepresentations in its
Form ADV concerning its ownership structure and
percentage of high net worth investors; the case
22
Mtr. of Morgan Asset Management, SEC Press Rel. 201053(4/7/10).
23
24
SEC v. Mack, SEC Lit. Rel. 21731 (Nov. 4, 2010).
SEC v. Brewer, SEC Lit. Rel. 21715 (Oct. 29, 2010).
25
27
Mtr of Carlson Capital LP, I.A. Rel. 3086 (Sept. 23, 2010).
28
Mtr. of Valentine Capital Asset Management, I.A. Rel. 3090
(Sept. 29, 2010).
29
Mtr. of Greenberg, SEC Press Rel. 2010-165 (Sept. 7,
2010).
Mtr. of Sierra Financial Advisors, LLC, I.A. Rel. 3087 (Sept.
23, 2010).
26
30
Mtr. of New Castle Funds LLC, I.A. Rel. 3114 (Nov. 22,
2010).
Mtr. of Buckingham Research Group, Inc., SEC Press Rel.
2010-223 (Nov. 17, 2010).
December 2010
6
Investment Management Legal Insight
settled with revocation of the adviser’s registration,
a nine-month suspension of its CEO, and a ceaseand-desist order.31 On October 22, 2010, the SEC
charged an adviser with failing to keep required
records, custody rule deficiencies, and Form ADV
deficiencies; the case settled with a censure, a
$60,000 fine and a cease-and-desist order.32
D. Conclusion
The Enforcement Division’s heightened interest in
investment management issues obviously means that
we have entered a period requiring increased
attentiveness. As always, the best approach to
dealing with stronger enforcement will be recruiting,
supporting and retaining competent compliance
personnel; establishing and maintaining quality
policies and procedures tailored to each entity’s
business and operations; and continuing to send a
clear message from senior management that
compliance is an organizational priority.
Where the new vigor in fund and adviser
enforcement at the SEC does turn up matters
warranting further attention, the focus and
sophistication that the Asset Management Unit
promises may do much to facilitate a reasoned and
fair resolution of complex problems. Counsel will
engage with staff possessing both practical industry
knowledge and a comprehensive mandate allowing
them to achieve consistent treatment across their
program. This will hopefully be a win-win formula
for the SEC, the fund industry and their investors.
Reproduced with permission from BNA's Securities
Regulation & Law Report, 42 SRLR 2284, 12/6/10.
Copyright 2010 by The Bureau of National Affairs,
Inc. (800-372-1033) http://www.bna.com.
31
Mtr. of Thrasher Capital Management LLC, I.A. Rel. 3108
(Nov. 16, 2010).
32
Mtr. of Sands Brothers Asset Management, I.A. Rel. 3099
(Oct. 22, 2010).
December 2010
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Investment Management Legal Insight
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December 2010
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