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Big Broom: SEC Sweep Letters Land at Hedge Funds

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CHICAGO (–It turns out the Securities and Exchange Commission’s big push to require hedge fund managers to register as investment advisers was more than just a show.

Recently the commission has been proactive, seeking written information and documents from registered advisers in advance of scheduling inspection visits to those advisers’ offices. Anecdotal evidence suggests that since the Feb. 1 registration deadline, the SEC has initiated examinations of least a dozen, perhaps more, hedge fund managers, figures an SEC spokesman declined to verify.

Using its list of newly registered managers, the SEC recently sent out a 17-page “sweep” letter to some hedge fund managers asking for volumes of specific information pertaining to compliance programs, business and operations, portfolio management, ethics and personal trading, brokerage arrangements and trade execution, trade allocation, performance advertising and marketing, information disclosure, safety of client funds and assets, portfolio pricing, and individual fund information.

The period covered by the request spans 26 months, from Jan. 1, 2004 through March 31 of this year.

One hedge fund attorney, who was granted anonymity out of concern his on-the-record comments could harm clients who might be subject to the sweep, said he was struck by the scope of the SEC’s inquiry and added that producing some of the information and preparing for the inspection would be time consuming for advisers. “This letter is extremely comprehensive,” the attorney said. “The thing is, it’s everything. Everything possible is in here. It’s going to be a massive undertaking for the chief compliance officer and the principals of the fund from the time they receive the request to the time the SEC sets foot in the door.”

The attorney said he understood that at least a dozen hedge fund advisers had received letters, all similar in scope and tone, and that the SEC was using the process to refine its hedge fund examination and inspection program.

John Nester, director of public affairs at the SEC, said the letters are sent as a way to initiate the examination process for registered investment advisers. Previously, the SEC did not have the authority to conduct such examinations of many hedge funds because they were not required to be registered with the commission. But new rules that passed in 2004 and took effect Feb. 1 required most hedge fund managers to register with the SEC as investment advisers. That opened the door to conducting examinations.

Mr. Nester said the information the letters ask for is based on previous familiarity with hedge funds, but the queries are always evolving in response to the SEC’s risk analysis and are tailored to specific entities. “We’ve done extensive training over the past year and will continue to do so,” Mr. Nester said of the SEC’s hedge fund inspections.

Last year, the SEC sent out a six-page mini-sweep letter with a 22-item checklist of information the commission wanted to collect. This latest letter is three times as long.

Reading through the letter, hedge fund managers could be forgiven if they feel as if the SEC is challenging them to prove they aren’t doing anything wrong.

Among the areas in which the SEC appears to want to collect more information on effective compliance controls is side letters, or agreements with favored investors granting those investors better terms than other investors–for instance, allowing them to redeem more often than spelled out in the prospectus. Specifically, the SEC wants information about side agreements that were rejected, along with the reasons for the rejection and the names of those involved.

In its letter, the SEC asks for “?? 1/2 a written summary of any business transaction, investment opportunity, deal, side deal, arrangement, or similar matter that Registrant was asked to consider but rejected because the proposal was deemed inadvisable, inappropriate, unethical or possibly illegal. The summary should include a detailed description of the matter, the name and contact information of all involved firms and persons, and the reason(s) for the proposal being rejected. Copies of any pertinent letters or electronic communications should also be provided.”

Under “General Information,” the SEC wants from advisers lists of officers or directors who resigned or were fired during the period, and lists of employees who were fired, both with explanations for their departures.

The SEC also wants lists of wrap fee programs in which the advisers participate, including the names of the programs and types of investment strategies; client names, account numbers and current balances; the names of representatives responsible for the accounts; names of the custodian, sponsor and/or prime broker; the total fee percentage charged by the sponsor; terms of the adviser’s compensation; and the total value of client assets in the program as of Dec. 31, 2005.

The attorney was surprised to see a request for such detailed information about wrap fee programs in the sweep letter, and said typically the SEC tends to ask about such things during examinations, not in advance of them.

The letter, which asks for much more information than is discussed here, also specifies in what format the SEC wants information–printed or electronic–and even details which electronic formats it prefers for certain bits of information.

There’s an entire section on performance advertising and marketing that asks for things like quarterly returns during the period for each investment strategy and for each client account; a list of parties to whom cash referral fees were paid during 2004 and 2005, as well as copies of agreements and total cash compensation amounts; a copy of the most recent request for proposals completed during the inspection period; and copies of all advertisements or promotional materials.

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Contact Bob Keane with questions or comments at [email protected].


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