More On Legal & Compliancefrom The Advisor's Professional Library
- Preventing and Dealing with Client Complaints Although the SEC has not provided specific guidance on how client complaints should be handled, a firms policies and procedures should provide clear direction how to do so, as neglecting complaints can exacerbate a bad situation.
- Do’s and Don’ts of Advisory Contracts In preparation for a compliance exam, securities regulators typically will ask to see copies of an RIAs advisory agreements. An RIA must be able to produce requested contracts and the contracts must comply with applicable SEC or state rules.
Bruce Karpati, head of the SEC’s Asset Management Unit, housed within the agency’s Enforcement Division, told compliance officers Tuesday that overseeing hedge funds’ compliance will continue to be a priority for the agency next year.
Speaking at the Regulatory Compliance Association’s conference in New York, Karpati said that from 2010 to present, the SEC's Enforcement Division has brought more than 100 cases against hedge fund managers, "a significant majority of which involved conflicts of interest, valuation, performance, and compliance and controls."
He told conference attendees that the Asset Management Unit is particularly concerned about four developments in the hedge fund space.
First, he said, the retailization of hedge funds, which has “made it easier for unsophisticated investors to invest directly in hedge funds.” Looking ahead, he said, the elimination of the prohibition on general solicitation and general advertising as a result of the JOBS Act “could have an immediate impact because, what were formerly private offerings, can now in some form be broadcast to a much wider audience.” While, he added, the SEC “understands that this may facilitate capital formation, one of our concerns is that these retail-oriented hedge funds may be offered to investors that may have the financial wherewithal to meet accredited investor standards but are otherwise financially unsophisticated.”
Second, Karpati said is the “emerging retail orientation” of hedge funds that increasingly exposes ordinary investors to such funds either directly or indirectly through pensions, endowments, foundations, and other retirement plans.
For instance, Karpati cited data that has found that private sector pension funds currently seek to allocate on average about 10% of their assets to hedge funds, and public sector pensions target an 8% allocation on average. “Adding in private equity and real estate, these numbers get even bigger,” he said. “According to these sources, larger pensions with more than $1 billion in assets have increased their stakes in alternative investments to almost 20%, nearly double the percentage from five years ago.”
The third area of concern, Karpati continued, is the fact that alternative investment vehicles “often involve complex, illiquid or opaque investments.” This lack of transparency into their investment strategies and operations, he said, “may occur for legitimate business reasons, but, at the same time, the potential for fraud is substantial. Even sophisticated investors can be defrauded through alternative investment vehicles, especially when their practices are not transparent to investors or regulators.”
Fourth, the Asset Management Unit is “particularly aware of the risks posed by private funds advised by unregistered advisers,” Karpati said. “Smaller private fund advisers, typically those with less than $150 million in assets under management, pose a risk because they may be exempt from SEC registration.”
Unregistered advisors, he said, “may not have effective compliance policies and procedures to prevent fraud and other violations, are not subject to inspection by exam staff, and need not comply with the commission’s advertising rules applicable to registered advisers.”
Said Karpati: “Knowing that a disproportionate amount of fraud occurs at smaller hedge fund advisers, the Asset Management Unit is concerned that unregistered advisers may engage in general solicitation without the proper policies in place to ensure that only accredited investors invest.”
Karpati also told compliance officers to be prepared for SEC exams. Not only is it important to be “cooperative with exam staff while an examination takes place,” he said, but firms must also “implement any necessary corrective steps if the SEC identifies violations or possible violations. Taking these steps will help the examination process to proceed more efficiently and reduce the likelihood of more formal inquiries” by enforcement or Asset Management Unit staff.
He noted that the three SEC units that specialized in hedge fund oversight–Market Abuse, Structured and New Products, as well as the Asset Management Unit–have each hired industry professionals such as hedge fund managers, private equity analysts, and due diligence professionals, who assist on investigations, consult on exams and assist in policymaking.
Said Karpati: “These industry professionals have already been successful in uncovering issues that we may not have identified otherwise. We like to say: “They know where the bodies are buried–and understand how they got there.”
Asset Management Unit staff, Karpati added, has also made it a priority to "develop an advanced understanding of the operating environment and incentives of asset managers in order to proactively monitor and combat fraud" in the hedge fund industry. For instance, he said, because hedge fund managers are compensated by both management fees and performance fees, "the manager has incentives to overprioritize compensation." The temptation to overvalue assets to boost compensation has "emerged repeatedly" in enforcement cases brought by the agency.
That's why the Asset Management Unit is focused on "detecting fraudulent or weak valuation practices–including lax valuation committees and the use of side pockets to conceal losing illiquid positions–and the failure to follow a fund’s stated valuation procedures."