SEC Stepping Up Fund Enforcement Actions

SEC Stepping Up Fund Enforcement Actions

Some interesting news today out of the SEC about new enforcement actions by the SEC against hedge funds - specifically, against three separate advisory firms and six individuals for alleged violations initially uncovered through the results of SEC proprietary data analysis.  That final point may be the most interesting since, evidently, the SEC is not simply waiting for whistleblowers under the SEC's Dodd-Frank whistleblower program, which financially compensates those who ring the alarm bells about fraud and wrongdoing at their companies.  Instead, it appears to be proactively investigating hedge funds, using its proprietary data analysis. These internal investigatory efforts may signal a new front in the SEC's efforts to police hedge funds and probably other types of funds as well.

Read more after the jump, courtesy of Deborah MeshulamPerrie WeinerNicolas Morgan and Joshua Briones:

The SEC's proprietary "Risk Analytics"

In addition to tips and complaints becoming the basis for an SEC investigation, the SEC has also quietly embarked on an extensive internal effort to generate investigative leads through what it is calling Risk Analytics.  

The agency is now relying on extensive data analysis - the same kind of quantitative analysis that fund advisers may use to evaluate potential investments.  The SEC's "Aberrational Performance Inquiry," conducted by the SEC's Enforcement Division's Asset Management Unit, uses proprietary techniques to evaluate hedge fund returns.  Performance that appears inconsistent with a fund's investment strategy or other benchmarks forms a basis for further scrutiny.  In other words, the SEC is looking for returns that appear too good to be true, and then it is investigating.

Fraud allegations began with Aberrational Performance Inquiries

The enforcement actions announced by the SEC on December 1, 2011 against three separate advisory firms and six individuals were uncovered through Aberrational Performance Inquiry analysis.1

The alleged misconduct includes:

  • overvaluing the returns and assets of a hedge fund, which at one point reported US$844 million under management.  The SEC claims that by allegedly inflating the numbers, the defendants made millions in fees and were able to raise additional money from investors.  The case has also prompted criminal charges
  • allegedly inflating the returns, size and other aspects of two hedge funds, which oversaw about US$520 million in 2008
  • allegedly making investments contrary to those permitted by the fund's offering documents and marketing materials
  • allegedly concealing from investors past regulatory infractions, conflicts of interest and investment liquidity

In discussing these recent enforcement actions, Robert Kaplan and Bruce Karpati, Co-Chiefs of the SEC Enforcement Division's Asset Management Unit, explained, "[t]he extraordinary returns reported by these advisors and portfolio managers were, in most cases, too good to be true.  In other cases, outlier returns were a telltale sign that something else was amiss.  We are applying analytics across the investment advisor space-beyond performance and beyond hedge funds."

Not coincidentally, just days before the SEC's announcement concerning its Risk Analytics enforcement actions, the Asset Management Unit announced three unrelated actions against investment advisers for violations of Rule 206(4)-7 of the Investment Advisers Act, which requires registered investment advisers to adopt and implement written policies and procedures that are reasonably designed to prevent, detect and correct securities law violations.  (See the SEC's press release.)

Compliance procedures and documentation will minimize risk

All these cases emphasize the need for all fund advisers, whether registered or not, to adopt and follow compliance policies and procedures, especially with regard to critical areas such as asset valuation, performance reporting and communication with and disclosures to fund investors. 

Equally important, all fund advisors should thoroughly document compliance efforts and the basis by which assets are valued and returns are calculated.  Such documentation can serve to rebut the findings of risk analytics that may initially suggest to the SEC that something is amiss.

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