At Johnson & Company, we continually strive to provide our clients, constituents and other participants in the hedge fund eco-system with information, insight and intelligence we feel addresses critical issues in the successful operation of new, early-stage and sub-institutional hedge funds. To that end, I direct you to the following important piece, just released:

ENFORCEMENT CONTINUES TO PURSUE HEDGE FUND ADVISERS

The SEC continues to pursue enforcement actions against hedge fund managers for alleged self-dealing, undisclosed conflicts of interest and valuation issues. The SEC has stepped up its review and enforcement of private fund managers following Dodd-Frank, which required most investment advisers to private funds to register with the SEC, which in turn subjected them to increased regulatory oversight.

The SEC has publicly put hedge funds on notice that its Office of Compliance Inspections and Examination (OCIE) is ramping up examinations of advisers and would focus particularly on certain issues it has identified within the private fund industry, such as marketing practices, portfolio management, conflicts of interest, safety of client assets and valuation:

  • In early September, the SEC announced it settled an action with an investment adviser and its CEO, accused by the SEC of inflating the value of fund portfolio assets to generate unearned management fees. Among other issues, the CEO allegedly falsely claimed the fund owned an asset, when in reality, it owned a different asset worth substantially less. The SEC obtained over $1 million in combined disgorgement, interest and penalties, and the CEO agreed to be barred from the industry.
  • In the same press release, the SEC announced it had settled an administrative proceeding with the fund’s outside auditors. The SEC alleged that the auditors did not adhere to generally accepted auditing standards and performed a deficient audit, wherein they failed to obtain sufficient appropriate audit evidence regarding whether certain fund assets existed. The auditors have been suspended for three years from practicing as accountants on behalf of any publicly traded company or SEC-regulated entity.
  • And just last week, the SEC charged a registered investment adviser and its owner with securities fraud (and with violating, or aiding and abetting violations of, other SEC rules) related to its management of affiliated hedge funds and clients of those funds. As explained in the SEC’s press release announcing the charges, the SEC alleged that the adviser (and its owner) engaged in self-dealing and failed to disclose conflicts of interest or material facts about use of investor funds and investment risk. For example, the adviser allegedly caused affiliated hedge funds to invest in companies without disclosing its financial interests in those companies. This case reflects yet another example of the SEC Enforcement Division pursuing the same potential problems − such as conflicts of interest and portfolio management − that have been publicly identified as priority issues by OCIE and the National Examination Program.

This is not a trend but a directive that will continue. As more hedge funds are inspected, the odds are high that the SEC will identify additional problems and pursue more enforcement actions related to valuation issues, conflicts of interest, and other focal issues of OCIE examinations. Therefore, hedge funds need to ensure they have robust compliance programs tailored to the particulars of their individual business and that they review and update them often. Otherwise, it might not be just OCIE that comes knocking.

I strongly suggest that all funds engage experienced external compliance and operational professionals to help create, instill and demonstrate that a culture of compliance exist as reflected by implementation and consistent execution of best practices on an enterprise-wide basis.

In the instance, you are seeking professionals in these areas, we maintain a short list of experienced and highly qualified firms that stand ready to assist you. Just contact me for an introduction.

I hope you find this helpful and informative.

Bryan Johnson, Managing Partner
Direct: 512-786-1569
bkj@johnsn.com