Bruce Karpati, the Chief of the SEC Enforcement Division’s Asset Management Unit, held a Q&A session entitled “Private Equity Enforcement Concerns” at the Private Equity International Conference held in New York on January 23, 2013. He addressed private equity firm activities of concern, how the SEC is tracking those activities, and ways firms can avoid getting into trouble. [Read more...]
SEC Enforcement Division’s Asset Management Unit’s Chief Anticipates Increase in Private Equity Enforcement
February 14, 2013 By Leave a Comment
SEC Enforcement Division’s Asset Management Unit Chief Reveals New Priorities in Regulation of Private Funds
January 9, 2013 By Leave a Comment
Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit, gave a speech entitled “Enforcement Priorities in the Alternative Space” on December 18, 2012. The recently established 75-member Asset Management Unit (AMU) is dedicated to investigating investment advisers, investment companies, hedge funds, mutual funds, and private equity funds making up the “alternative space” referred to in the speech’s title. Karpati addressed current enforcement priorities, touching upon, among other topics, the AMU’s enhanced expertise, investor risks, and how the hedge fund operating model incentivizes misconduct. As outlined in Karpati’s speech, the AMU’s current priorities indicate that, while traditionally hedge funds and private equity funds were lightly regulated, this will likely no longer be the case.
The loose regulation of private funds is the result of the assumed sophistication of the investors involved, the burgeoning market, increased industry specialization, and regulatory changes mean that unsophisticated investors are increasingly investing in private funds and even sophisticated investors are often unable to evaluate the risks involved in their investment. Unsophisticated investors are increasingly exposed to hedge funds indirectly through pensions, endowments, foundations, and other retirement plans. The increasing retail nature of hedge funds has encouraged wealthy but unsophisticated investors to invest directly, and the upcoming elimination of the prohibition on general solicitation and advertising will expose a much broader pool of investors to what previously would have been private offerings. In addition, alternative investment vehicles often involve complicated investments that create significant opportunity for fraud, even when investors are relatively sophisticated. Finally, smaller hedge fund advisers — where most hedge fund fraud occurs — are exempt from registration under federal securities laws. As a result, they may not have effective compliance policies, are not subject to inspection by the SEC, and are not required to comply with SEC advertising rules for investment advisers. Karpati highlighted the AMU’s concern that unregistered advisers may fail to limit offerings to accredited investors or fail to abide by other restrictions placed on registered advisers.
Karpati went on to discuss how the hedge fund operating model itself gives rise to conflicts of interest and incentives to commit fraud. First, hedge fund managers are compensated by both management fees and performance fees, so they often have an incentive to overvalue assets or engage in riskier strategies. Hedge fund managers also face considerable pressures to yield high returns. Finally, it is easy for fund advisers to engage in related party transactions or give favored treatment to certain investors through preferential redemptions or side letters.
While the SEC previously focused on enforcement of the various rules and regulations governing investment advisers, such as violations of registration and disclosure requirements and failure to adopt and enforce compliance procedures, the AMU’s new priorities, as outlined by Karpati, cover the more amorphous area of an adviser’s ethical obligations to investors and clients. There are many ways that federal securities laws govern such ethical obligations, but two of the most significant are: (i) the Investment Advisers Act of 1940 places a fiduciary duty on investment advisers to their clients and (ii) the anti-fraud provisions of Investment Advisers Act and other securities laws places a duty of disclosure of conflicts of interest to investors. Karpati stated that fund managers must guard against all incentives — even unconscious — that might cause them to provide advice that is not disinterested. It is possible to commit a violation of these laws even if the breach does not actually intend to injure a client. In addition, an adviser can violate the law even if a client does not suffer actual injury.
To effectively carry out enforcement against these kinds of violations, the personnel conducting an SEC examination will need to operate on a more sophisticated level than merely trying to check off a list of requirements that the adviser was required to meet. Karpati revealed that the AMU has hired former industry professionals such as hedge fund managers, private equity analysts, and due diligence professionals. These experts have implemented certain risk-based analytic initiatives utilizing data analysis and designated risk criteria to identify individuals or firms that could be engaged in specific types of misconduct. One such initiative is the “Aberrational Performance Inquiry,” which targets hedge fund performance returns that seem too good to be true. Together with the Division of Risk, Strategy, and Financial Innovation and the Office of Compliance Inspections and Examinations (OCIE), the AMU’s experts analyze performance data of thousands of hedge fund advisers and identify possible misconduct. This initiative has so far yielded seven enforcement actions against hedge fund advisory firms and managers for improper use of fund assets, fraudulent valuations, misrepresenting fund returns, failure to disclose related party transactions, and other misconduct. Another risk analytic initiative is the “Private Equity Initiative,” which seeks to uncover private equity fund advisers that pose a higher risk for certain misconduct, such as improperly failing to liquidate assets or misrepresenting the value of holdings to investors.
Just as enforcing standards of fiduciary duty and the duty to disclose conflicts of interest requires SEC enforcement personnel to think on a more sophisticated level, complying with these requirements will also require investment advisers and fund managers to consider their compliance practices on a more sophisticated level. Merely following bright line rules many no longer be enough.
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© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Unlikely Coalition Comes Together in Opposition to the Creation of an SRO for Investment Advisers
August 6, 2012 By Leave a Comment
As part of the Dodd-Frank Act, Congress directed the SEC to review whether a so-called “self-regulatory organization” (or “SRO”) should be created to regulate investment advisers. Doing so would make investment adviser regulation more akin to the way broker-dealers are regulated.
Under securities laws, broker-dealers must register with the SEC by filing Form BD. But Form BD is a relatively minor step in the process of registering a broker-dealer, because broker-dealers are also required to become a member of the Financial Industry Regulatory Authority (“FINRA”). The membership application for FINRA is the most time-consuming step in creating a new broker-dealer. After a broker-dealer is registered, FINRA also takes the primary role in regulating the activities of the broker-dealer.
After the SEC issued its report on an SRO for investment advisers, House Financial Services Committee Chairman Spencer Bachus (R-LA) and Rep. Carolyn McCarthy (D-NY) introduced the Investment Adviser Oversight Act of 2012. The bill is an amendment to the Investment Advisers Act of 1940 which requires investment advisers to join a new SRO that would be funded by membership fees. Though not explicitly set forth in the bill, FINRA (or another organization affiliated with FINRA) would be expected to be that SRO.
However, the North American Securities Administrators Association (“NASAA”), which is the association that represents the state securities regulators, has taken the position that an SRO is neither necessary nor a good idea because they believe that the state securities regulators and the SEC can collectively regulate the investment adviser industry in a more efficient manner than an SRO. In its opposition to an SRO, NASAA has argued that an SRO would not be an effective regulator because an SRO, being a membership based organization, is beholden to the same members it is required to regulate. In addition, the Investment Advisers Association (“IAA”), a lobbying group for investment advisers, opposes the creation of an SRO for investment advisers as a heavy, unnecessary burden for the investment advisory industry.
In June, after the Government Accountability Office issued a report which criticized the SEC’s oversight of FINRA, Rep. Maxine Waters (D-CA) introduced the Investment Advisor Examination Improvement Act of 2012, which keeps oversight of investment advisors with the SEC, and pays for the SEC’s review with user fees charged to investment advisers. This user fee model is supported by both the NASAA and industry groups, like the IAA, which have argued that not only is it cheaper to fund SEC oversight (rather than create a new SRO), but that the SEC will be more effective at protecting the public from investment advisors than FINRA.
Momentum seems to be moving away from the creation of an SRO for investment advisers. It isn’t very often that you will see the NASAA (which generally lobbies for the most restrictive securities regulation) on the same side as the securities industry itself. In addition, Rep. Waters is not exactly known as a particularly pro-business congresswoman, so it’s difficult to argue that she is beholden to industry. While you’d think that industry would prefer to be regulated by the private sector, the reality is that broker-dealers’ experience with FINRA has led industry players to believe that a government regulator may actually be more preferable than the ones at FINRA, which charges expensive membership fees and issues extensive regulation which broker-dealers must follow in addition to SEC rules. The result has made for some strange bedfellows.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Maryland Securities Commissioner Issues New Order Adopting a Private Fund Exemption Based on Model NASAA Rule
June 22, 2012 By 2 Comments
On June 15, 2012, the Maryland Securities Commissioner issued an order adopting the NASAA model rule exemption for investment advisers to private funds.
Like the model rule, the new order issued by the Maryland Securities Commissioner, provides for an exemption from registration for “private fund advisers”, which is any investment adviser who provides advice solely to one or more private funds (i.e. a 3(c)(1) fund or a 3(c)(7) fund). A private fund adviser must not be subject to disqualification from prior bad acts such as fraud or other securities law violations. The private fund adviser must also make the same Form ADV filings as an exempt reporting adviser would.
Any private fund adviser that advises one or more 3(c)(1) funds (other than venture capital funds, as defined under federal regulations) must also comply with additional restrictions. All investors in these funds must be “qualified clients.” [1] The fund manager must also disclose in writing all services that are provided to individual owners (if any), all duties owed to individual owners (if any), and any other material information affecting the rights or responsibilities of owners. Finally, the fund manager must provide audited financial statements to each investor.
Fund managers registered with the SEC will be required to make applicable notice filings to the Maryland Securities Commissioner even if they would otherwise qualify for the private fund adviser exemption.
The new rule also provides grandfathering provisions for fund managers of 3(c)(1) funds that existed before June 15, 2012 but cease accepting non-qualified clients after the date, as long as the fund manager does comply with the disclosure and audit requirements of the new exemption.
This order continues the trend of an increasing number of states adopting the NASAA model rule, or something substantially similar. So far California, Indiana, Maine, Virginia, Massachusetts, Michigan, Wisconsin, Missouri, Rhode Island (proposed but not yet adopted), and Maryland have adopted some form of the NASAA model rule.
Footnotes
[1] A “qualified client” is defined as an individual or company that has at least $1 Million under the management with the investment adviser or has a net worth (together with assets held jointly with a spouse) of more than $2 Million, not counting an individual’s primary residence.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Missouri Commissioner of Securities Proposes New Private Fund Exemption Based on Model NASAA Rule
May 9, 2012 By Leave a Comment
On April 26, 2012, the Missouri Commissioner of Securities proposed revised regulations exempting certain private fund managers from investment adviser registration with the State of Missouri.
Background
Prior to the repeal of the federal 15-client exemption, Missouri had an exemption for fund managers who were exempt under the old federal 15-client exemption and who managed investments solely for private funds with at least $5 million under management. After the repeal of the federal 15-client exemption, fund managers have relied on a No-Action Determination by the Missouri Commissioner of Securities dated July 20, 2011, which allowed private fund managers in Missouri to continue to rely on Missouri’s old exemption, until the earlier of June 28, 2012 or the promulgation of a new exemption, notwithstanding the repeal of the federal 15-client exemption. Now, it appears that the Missouri Commissioner of Securities is ready to adopt that new exemption.
The New Proposed Regulations
The new proposed regulations are based upon the NASAA model rule exemption for investment advisers to private funds. They provide for an exemption from registration for “private fund advisers.” A private fund adviser is any investment adviser who provides advice solely to one or more private funds (i.e. a 3(c)(1) fund or a 3(c)(7) fund).[1] A private fund adviser must not be subject to disqualification from prior bad acts such as fraud or other securities law violations. The private fund adviser must also make the same Form ADV filings as an exempt reporting adviser would.
Any private fund adviser that advises one or more 3(c)(1) funds (other than venture capital funds, as defined under federal regulations) must also comply with additional restrictions. All investors in these funds must be (i) an accredited investor, as defined in Regulation D or (ii) a qualified client, as defined in federal regulations. [2] However, the exemption does not allow private fund managers that advise a 3(c)(1) fund to accept accredited investors who are individuals that qualify solely by the income test.[3] The inclusion of certain categories of accredited investors within 3(c)(1) funds is a significant departure from the model NASAA rule, which requires that all investors in a 3(c)(1) fund at least be a qualified client (at least for the fund manager to be exempt from registration). The fund manager must also disclose in writing all services that are provided to individual owners (if any), all duties owed to individual owners (if any), and any other material information affecting the rights or responsibilities of owners. Finally, the fund manager must provide financial statements to each investor. This is also a departure from the NASAA model rule, which requires that such financial statements be audited.
The new rule also provides grandfathering provisions for fund managers of 3(c)(1) funds that existed before the effective date of the new regulations but cease accepting, after the effective date, accredited investors that are individuals that meet the income test but don’t meet the net worth test, as long as the fund manager does comply with the disclosure and audit requirements of the new exemption.
The Commissioner of Securities did not state in their announcement when they expect the new exemption to take effect, but we can expect that to occur on or prior to June 28, 2012.
Footnotes
[1] A 3(c)(1) fund is a fund which has not more than 100 investors. A 3(c)(7) fund is a fund which is limited to qualified purchasers, which are defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.
[2] A “qualified client” is defined as an individual or company that has at least $1 Million under the management with the investment adviser or has a net worth (together with assets held jointly with a spouse, but not including the value of the individual’s primary residence) of more than $2 Million.
[3] Rule 501 of Regulation D allows an investor to qualify as an accredited investor if such investor has income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
