HedgeOp would like to take the opportunity to highlight recent enforcement actions brought by the SEC Enforcement Division’s Asset Management Unit and remind all about the importance of  implementing a thorough compliance program and of maintaining a robust culture of compliance.

These recent actions evidence the SEC’s continued and increasing scrutiny of investment advisers and their compliance programs and of the SEC’s new focus on hedge funds and other pooled investment vehicles that appear to have abnormal investment performance. Advisers are urged to perform a critical review of their compliance programs on a periodic basis (no less frequently than annually).  This review should include confirming that they have remedied any deficiencies previously cited by SEC examiners.  In addition, advisers should carefully and continually review their funds’ valuation procedures, performance numbers and disclosure to confirm accuracy and consistency.

Late last month, the SEC charged three advisers for “failing to put in place compliance procedures to prevent securities law violations.” Earlier this month, the SEC announced enforcement actions against three separate advisory firms and six individuals charging them with misconduct, including improper use of fund assets, fraudulent valuations, and misrepresenting fund returns. This month’s enforcement actions are part of the SEC Aberrational Performance initiative to fight fraud at hedge funds and other private pooled investment vehicles, by using proprietary risk analytics to evaluate fund returns and focus on funds whose performance seems inconsistent with their investment strategies or other benchmarks. In the compliance program enforcement actions, the SEC specifically acknowledged the cooperation of their colleagues in the SEC’s Office of Compliance Inspections and Examinations (OCIE) National Exam Program.  The SEC’s Division of Risk, Strategy, and Financial Innovation; OCIE; and the Office of International Affairs have assisted the Asset Management Unit in the Aberrational Performance inquiries.

Representatives of  OCIE and of the Enforcement Division’s Asset Management Unit made a number of cautionary statements in their announcements of these actions. OCIE Director Carlo di Florio warned advisers that “[w]hen SEC examiners identify compliance deficiencies, firms are expected to remediate them…[and that the] Commission will take enforcement action against registrants that fail to do so.” The Asset Management Unit’s co-chair Robert Kaplan put advisers on notice, saying “there are additional [aberrational performance] cases in the pipeline,” including ones using data analysis against private equity and mutual fund advisers. The Asset Management Unit co-chairs announced that the SEC is “applying analytics across the investment adviser space — beyond performance and beyond hedge funds.”

Compliance Program Cases.  In two of the compliance program cases, SEC examiners previously had warned the firms about their compliance deficiencies, and the firms had failed to correct those deficiencies.

The following were among the deficiencies cited in the actions:

• Absence of any compliance program at all
• Adopting, but never fully implementing, policies and procedures
• Adopting, but never abiding by, a code of ethics
• Failure to supervise advisory representatives
• A chief compliance officer who was living abroad for a period of time
• Failure to collect required securities disclosure reports from employees
• Engaging in hundreds of principal transactions without informing advisory clients or obtaining their consent
• Improperly charging undisclosed commissions

Financial penalties and corrective actions imposed in the settlement of these actions included:

• payment by a CCO of a $50,000 penalty and permanent barring of that CCO from “acting within the securities industry in any compliance or supervisory capacity and from associating with any investment company”
• payments by two different advisers of  $50,000 and $20,000 penalties, respectively
• the return of money to certain clients
• one firm must provide a copy of the proceeding to anyone who was a client at any time during the three year period when there was no compliance program
• one firm must hire an independent consultant for an annual compliance program review for two years, provide a copy of the SEC’s order to past, present and future clients and post a summary of the order prominently on the adviser’s website
• one firm must cease operations, de-register with the SEC, and, with its clients’ consent, move advisory accounts to a firm with an established compliance program

Aberrational Performance Inquiry Actions.  The SEC described the returns of the advisers and portfolio managers charged in the Aberrational Performance inquiry actions as “extraordinary,” and as either “too good to be true” or as outlier returns that signaled a problem.

The firms and managers were charged with some or all of the following:

• fraudulent valuation of portfolio holdings
• misuse of fund assets
• misrepresentation of the adviser’s operating history, the number of management team members and the backgrounds of those people
• misrepresentation or failure to disclose material information to investors on matters such as one general partner’s negative regulatory history, compensation received by the general partners in connection with the fund’s investments and the conflicts of interest resulting from a general partner’s ownership interest in and control of some of the companies in which the fund invested.
• misrepresentations to investors about numerous other matters, including performance, assets, liquidity, investment strategy, valuation procedures, and conflicts of interest

Among the penalties imposed thus far:

• financial penalties to be paid by a firm and its managing director
• disgorging by the firm and the managing director of amounts to be determined
• permanent injunctions against the firm and the managing director from violating the securities laws’ anti-fraud provisions
• barring of the managing director from “association with any investment adviser, broker, dealer, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization”

HedgeOp will continue to monitor enforcement actions in these areas and update our blog accordingly.