The SEC Previews 2013 Enforcement Priorities in the Alternative Space
V&E's Securities Litigation and Enforcement Update E-communication, January 10, 2013
Private fund managers should take note of a recent speech by Bruce Karpati, Chief of the SEC Enforcement Division's Asset Management Unit (AMU), in which Karpati described the SEC's enforcement priorities for 2013 and provided guidance for managers of private equity funds and hedge funds.
In his December 18, 2012 speech before the Regulatory Compliance Association, Karpati discussed the SEC’s past enforcement activity concerning alternative investments and made clear that the AMU will continue to scrutinize hedge funds and private equity funds. Karpati also reviewed the SEC’s past three years of enforcement activity against hedge fund managers, highlighting that the SEC has brought more than 100 enforcement actions against fund managers, many of which involved conflicts of interest, valuation, and compliance issues. Although he recognized that the majority of advisers to hedge and private equity funds take their fiduciary obligations seriously, Karpati expressed a continuing belief that the private fund operating model includes a certain degree of inherent tension — which may lead to a “misalignment of incentives” between an adviser and its investors — and that the AMU’s imperative has been to develop an advanced understanding of this operating environment to proactively monitor and combat fraud.
Overall, while the speech did not provide much in the way of new information, it provided concrete examples of how the SEC is stepping up regulation of the alternative investments industry which, up until recently, flew mostly under the radar. Notably, Karpati announced the launch of a series of risk-based investigative initiatives that are targeted at detecting and preventing fraudulent conduct. His speech highlighted two of these initiatives:
- The Private Equity Initiative (PEI) seeks to identify private equity fund advisers that are at higher risk for certain specific fraudulent behavior through the use of “certain data sources.” Karpati mentioned two examples of the types of managers on which PEI is focused: (i) managers of so-called “zombie” funds delaying liquidating holdings because the manager’s only source of revenue is the income derived from these assets, and (ii) advisers misrepresenting the value of their holdings to investors.
- The Aberrational Performance Inquiry seeks to identify hedge fund managers who post suspicious or improbable returns by analyzing performance data of thousands of hedge fund advisers. Managers identified through this analysis are referred for further examination or investigation. According to Karpati, this initiative has resulted in seven enforcement actions against hedge fund advisory firms for various types of misconduct, including improper use of fund assets, fraudulent valuations, misrepresenting fund terms, and failure to disclose related-party transactions.
These risk-based enforcement initiatives represent another step in the SEC’s efforts to enhance its overall expertise and ability to protect investors in increasingly complex securities markets and products. They come on the heels of the SEC’s hiring of industry professionals such as private equity analysts, hedge fund managers, and due diligence professionals to assist with uncovering misconduct, consulting on exams, and conducting training for the SEC’s staff.
Fund advisers should be prepared to encounter examiners with greater industry experience and an ability to discuss sophisticated technical issues. Karpati urged fund managers to be “alert and prepared” for exam inquiries, to be cooperative with the SEC’s staff during an examination, and to implement any necessary corrective steps if the SEC identifies violations or possible violations.
Finally, Karpati emphasized that managers of hedge funds and private equity funds should create a culture of compliance by ensuring that firms have robust internal controls and consistent supervision of employees. Fund advisers ought to carefully review their funds’ policies and procedures regarding valuation and liquidation of holdings. More detailed reviews of funds’ compliance programs should be conducted at least annually.
For more information about this topic, please contact Vinson & Elkins lawyers Ari Berman or Mark Proctor. Visit our website to learn more about V&E's Private Equity and Securities Litigation and Enforcement practices.