Co-authored by Jason F. Clouser.
Bruce Karpati, Chief of the Securities Exchange Commission Enforcement Division’s Asset Management Unit (AMU), spoke before the Regulatory Compliance Association earlier this week to address the AMU’s current enforcement priorities. By way of background, the AMU is a specialized unit established by the Enforcement Division to focus on investment advisers, investment companies, hedge funds, mutual funds and private equity funds. The AMU employs industry professionals and experts (including fund managers, private equity analysts and due diligence professionals) to help identify and investigate emerging issues.
According to Mr. Karpati, “it is clear that even the sophisticated class of investors who invest in hedge funds are themselves unable to effectively monitor the industry.” This difficulty exists because, Mr. Karpati argued, the basic hedge fund business model creates incentives for potential abuse and misconduct, including that: (i) payment of both management and performance fees may cause managers to “overprioritize” compensation; (ii) managers are under pressure to show consistent or improving performance metrics; (iii) managers may seek to gain an informational edge that may result in improper insider trading; (iv) by controlling all aspects of the business, managers may be subject to conflicts of interest; and (v) competitive pressure may cause managers to give “favored treatment” to preferred investors.
Mr. Karpati emphasized his view that the hedge fund operating model may be in tension with the manager’s role as a fiduciary. He noted that “[a]s a fiduciary, a hedge fund manager must guard against conscious and unconscious incentives that might cause him or her to provide less than disinterested advice since an investment adviser may be faulted even when he or she does not intend to injure a client or even if a client does not suffer a monetary loss.” Mr. Karpati concluded that the anti-fraud provisions of the Investment Advisers Act enable the AMU to pursue “breaches of fiduciary duty and other forms of misconduct.”
In surveying recent cases, Mr. Karpati observed that, since 2010, the Enforcement Division has pursued over 100 cases against hedge fund managers, “a significant majority of which involved conflicts of interest, valuation, performance, and compliance and controls.” To identify potential cases, Mr. Karpati emphasized that the AMU is relying in part on new risk-analytic initiatives and data analyses, including the “Aberrational Performance Inquiry,” which looks for funds with suspicious or improbable performance returns. In addition, Mr. Karpati noted that the AMU is using its new methods with an eye toward “zombie funds,” which may be improperly delaying the liquidation of their holdings because the income from those assets is the manager’s only revenue source.
Mr. Karpati concluded his presentation by identifying “best practices” that fund managers might engage in to help fulfill their fiduciary obligations. According to Mr. Karpati, fund managers should: (i) set the “tone at the top and create a culture of compliance;” (ii) establish internal controls and checks and balances where employees have overlapping and potentially conflicting positions (e.g., a portfolio manager valuing the fund’s assets); (iii) check and monitor traders; (iv) periodically review and test compliance procedures; and (v) cooperate with exam staff and promptly implement any remedial measures identified during an examination.
Mr. Karpati’s speech is available here.