The SEC Discusses Private Fund Enforcement Priorities

December 19, 2012


Yesterday, Bruce Karpati, Chief of the Asset Management Unit (“AMU”) in the Securities and Exchange Commission’s Division of Enforcement (“Enforcement”) spoke about current enforcement priorities related to hedge funds and private equity funds.[1] In particular, Karpati described risks, priorities, best practices, and recent Enforcement actions and noted that Enforcement has brought over 100 cases against hedge fund advisers since just 2010, a majority of which relate to conflicts of interest, valuation, performance, and compliance and controls. Although focused primarily on hedge fund advisers, Karpati’s remarks are instructive to private equity fund advisers.

Private Equity Initiative: Enforcement’s AMU launched a Private Equity Initiative to identify private equity fund advisers that are at higher risk for certain specific types of fraudulent behavior. Karpati noted that this risk analytic initiative helps to identify private equity fund advisers that may be improperly failing to liquidate assets or misrepresenting the value of their holdings to investors.

Identified Risks and Priorities: Karpati identified risks, as well as problematic issues and trends related to hedge fund advisers, that Enforcement may begin to focus upon, including:

  • Proposed New Rule 506(c) Offerings. AMU believes the JOBS Act’s elimination of the prohibition on general solicitation and advertising could result in retail-oriented hedge funds offering interests to investors that meet accredited investor standards but are otherwise financially unsophisticated.
  • Unregistered Advisers. AMU has observed that a disproportionate amount of fraud occurs at smaller hedge fund advisers and is concerned that unregistered advisers may engage in general solicitation without the proper policies in place to ensure that only accredited investors invest.
  • Side Letters. Karpati highlighted the conflict of interest that arises when advisers have provided more favorable treatment to certain investors through preferential redemptions or side letters.
  • Valuation Weaknesses and Fraud. Karpati noted advisers’ compensation incentives may lead to fraudulent or weak valuation practices or failures to follow valuation procedures.
  • Falsifying Performance. AMU has observed that pressure to yield high returns can cause advisers to falsify performance metrics to make the fund attractive to new investors and keep current investors satisfied.
  • Insider Trading and Expert Networks. AMU has identified fund advisers seeking an informational edge in the market through illicit means, such as inside trading, at times involving expert networks.

Best Practices: Karpati suggested the following practices, among others, for hedge fund advisers to insure fulfillment of fiduciary duties and to reduce the likelihood of more formal inquiries by Enforcement’s AMU:

  • Adopt and implement a compliance program and controls tailored to the risks, business activities, and investment strategy of the adviser, test and verify valuation and compliance procedures, put controls into place to check and monitor traders, periodically review procedures and operations to identify gaps, and update procedures as necessary.
  • Prepare for examination inquiries, cooperate with examination staff during the examination process, and implement corrective action identified during the examination.

Recent Enforcement Actions Based on Alleged Hedge Fund Misconduct: A few noteworthy cases, among the ten highlighted by Karpati, include cases alleging:

  • Adviser made investments radically contrary to the disclosure in the fund’s offering documents and marketing materials and hid an investment made to a company for which the hedge fund adviser was the chairman.[2]
  • Adviser used a side pocket to conceal more than $12 million in profits owed to investors.[3]
  • Adviser made misrepresentations about whether its fund advisers had “skin in the game” or investments in their own hedge fund, advisory personnel misled investors about their due diligence process when they created after-the-fact investment memoranda, and inaccurately described key terms regarding certain related party loans.[4]

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O’Melveny & Myers is available to advise private fund advisers on the Investment Advisers Act and on the development, management and review of compliance programs. For questions, please contact Heather Traeger at (202) 383-5232, Kris Easter at (202) 383-5364, or Matthew Cohen at (202) 383-5179.

[1] A copy of Karpati’s speech can be found here.
[2] SEC v. Rooney, No. 11-cv-8264 (N.D. Ill. filed Nov. 17, 2011).
[3] SEC v. Juno Mother Earth Asset Management, No. 11-civ-1778 (S.D.N.Y. filed Mar. 15, 2011).
[4] In re Quantek Asset Mgmt., Adm. Proc. File No. 3-14893 (instituted May 29, 2012).

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Heather Traeger, an O'Melveny partner licensed to practice law in the District of Columbia and Texas, Kris Easter, an O'Melveny counsel licensed to practice law in Texas, and Matthew Cohen, an O'Melveny associate licensed to practice law in the District of Columbia and California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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