A
BNA, INC.
SECURITIES!
REGULATION & LAW
REPORT
Reproduced with permission from Securities Regulation & Law Report, 42 SRLR 2284, 12/06/2010. Copyright 姝 2010 by The Bureau of National Affairs, Inc.
(800-372-1033) http://www.bna.com
SEC ENFORCEMENT
New SEC Enforcement Unit Focuses on Funds and Advisers
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
BY STEPHEN J. CRIMMINS
or 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.
F
The author is a partner at K&L Gates LLP in
Washington and New York. He was a senior
officer of the SEC Enforcement Division and
co-managed its Trial Unit.
COPYRIGHT 姝 2010 BY THE BUREAU OF NATIONAL AFFAIRS, INC.
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
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.
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2
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 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 is3
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.
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sues, 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 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 exten4
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.
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sively 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 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
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.
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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
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 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
7
130 S.Ct. 1418, 1426 (2010).
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.
11
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.
8
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4
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
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 filings, as discussed below, we see some key themes likely to recur in asset
management cases ahead.14
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 brokerdealer, who ultimately tipped the adviser’s managing
director.15
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 Commission investigation and related enforcement
action.’’17
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
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 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
13
Testimony of Robert S. Khuzami before the U.S. Senate
Judiciary Committee, Sept. 22, 2010, available at sec.gov.
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).
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).
22
Mtr. of Morgan Asset Management, SEC Press Rel.
2010-53(4/7/10).
23
SEC v. Mack, SEC Lit. Rel. 21731 (Nov. 4, 2010).
24
SEC v. Brewer, SEC Lit. Rel. 21715 (Oct. 29, 2010).
25
Mtr. of Greenberg, SEC Press Rel. 2010-165 (Sept. 7,
2010).
C. Recent Areas of Prosecutorial Interest
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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 ceaseand-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-and-desist order.28 On September 23, 2010, the
SEC charged an adviser and its principles 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-anddesist order.29
Books and Records / Form ADV Issues. On November
17, 2010, the SEC charged that an adviser, its brokerdealer 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 be26
Mtr. of New Castle Funds LLC, I.A. Rel. 3114 (Nov. 22,
2010).
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 Sierra Financial Advisors, LLC, I.A. Rel. 3087
(Sept. 23, 2010).
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fore 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 settled
with revocation of the adviser’s registration, a ninemonth suspension of its CEO, and a cease-and-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-anddesist 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 winwin formula for the SEC, the fund industry and their investors.
30
Mtr. of Buckingham Research Group, Inc., SEC Press
Rel. 2010-223 (Nov. 17, 2010).
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).
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