BY JOHN HAGUE
Changes stemming from the Dodd-Frank Wall Street Reform and Consumer Protection Act and other fallout from the financial crisis mean that hedge and private equity funds face a higher degree of scrutiny from the SEC than ever before.
The SEC has added examiners and is performing significantly more exams ”” in fact, they are on pace to perform 4,000 exams at hedge and private equity funds for 2013. Funds that were not previously required to register with the SEC now must. And even funds that are not required to register are still open to regulatory attention from the SEC.
As a result of increased examination of hedge and private equity funds, the number of cases involving such funds that have been referred to the SEC”™s enforcement division has approximately doubled in recent years. In 2007, the enforcement division pursued 79 such cases, representing about 13 percent of its caseload. In 2012, the enforcement division pursued 147 of these cases, comprising nearly 25 percent of its caseload. That number is expected to continue to trend up.
Hedge and private equity funds should also note that the enforcement division has established a specialized asset management unit, which is solely focused on pursuing investigations of investment advisers. This unit is staffed largely with personnel hired from hedge and private equity funds, giving it the specialized experience necessary to pursue its investigations.
Also, the way in which the examination and enforcement divisions coordinate activities has changed. Previously, examiners would complete their investigation and then decide whether to refer a fund to the enforcement division. Now, examiners will often coordinate with the enforcement division during the exam. It is now more common for an attorney from the enforcement division to join an examination to help focus the examiners”™ efforts on those areas of most interest to the enforcement division.
Both the examination and enforcement divisions are focusing their attention on certain key areas, including:
Ӣ valuations, particularly of illiquid securities;
Ӣ the treatment of fees and expenses, including inappropriately charging management expenses to investment funds, failure to clearly and accurately disclose fees, or improper allocation of fees and expenses among accounts and clients (often to favor high-value clients over other clients);
Ӣ related party transactions and conflicts of interest;
Ӣ the adequacy of compliance policies and procedures, including the appointment of a knowledgeable compliance officer, and the conduct of annual compliance reviews; and
Ӣ various custody rule violations.
Not only is the SEC examining more funds, the way those exams are conducted has changed and the pace at which they proceed has accelerated. Previously, the SEC attempted to put all funds subject to exam on a recurring schedule, and would then subject each to the same exhaustive checklist-based approach. This made it easier for funds to anticipate whether, when and how they would be examined.
Now, under its new presence exam approach, the SEC is using a risk-based model both in targeting funds for examination and in determining how they will be examined. Using information from ADV filings and other public information, the SEC is targeting funds based on a wide variety of criteria ranging from their business model and performance returns compared to the market. In October of 2012, the SEC began sending letters to registrants about their new presence exam process that identified key areas on which examiners would focus. Those areas included:
Ӣ marketing materials and approaches used to solicit investors (including the use of placement agents). The SEC Staff will consider misstatements, important omitted facts and any misleading facts or statements to be a fraudulent or deceptive activity;
Ӣ portfolio management practices (especially allocation of investment opportunities among funds); and
Ӣ conflicts of interest (including transactions with related persons and fee and expense allocations) custody of client assets valuations.
Next week: Facing an SEC examination.
John Hague is a partner and financial services industry leader for Chicago-based McGladrey, which maintains an office in Stamford and which provides tax, assurance and consulting services. Lindsey Simon, founder, Simon Compliance L.L.C. in Chicago, contributed to the column.
