the time has come to reconsider the gutfreund standard

Transcription

Vol. 45 No. 15
September 12, 2012
THE TIME HAS COME TO RECONSIDER
THE GUTFREUND STANDARD
Under the Gutfreund standard, a legal or compliance professional can be held
responsible as a supervisor if he has the “responsibility, ability, or authority” to affect the
conduct of the employee at issue. This subjective standard, the author argues, has failed
in its fundamental purpose of providing legal clarity to the law of supervision. A better
reading of Gutfreund, he believes, would be to treat the standard as defining the
membership of the control group in collective decision-making and to use control as the
essence of supervision in future cases.
By John H. Walsh *
The Gutfreund standard has failed. More precisely, the
definition of a supervisor set out in the Gutfreund order
has worked in conventional settings, where almost any
reasonable definition would have sufficed, and failed in
those difficult settings, where an effective legal standard
was most needed. Efforts to apply the Gutfreund
standard to difficult facts have led to incoherent results,
creating uncertainty on the very question the standard
was intended to resolve: when is a legal or compliance
official a supervisor?
This article suggests that it is time to reconsider the
Gutfreund standard. Part I reviews the order of the
Securities and Exchange Commission that gave rise to
the standard: In re Gutfreund.1 Part II discusses how
————————————————————
1
In re Gutfreund, Exch. Act Rel. No. 34-31554, 51 SEC 93
(Dec. 3, 1992).
 JOHN H. WALSH is a partner in Sutherland Asbill & Brennan
LLP’s Financial Services Practice and a member of its Securities
Enforcement and Litigation Team in Washington, D.C. Mr.
Walsh was previously Acting Director and Associate Director
Chief Counsel in the Securities and Exchange Commission’s
Office of Compliance Inspections and Examinations. His e-mail
address is [email protected].
September 12, 2012
the definition of a supervisor set out in the order has
been applied, and its incoherence when applied to legal
and compliance professionals. Part III proposes a new
reading of Gutfreund and its standard. Finally, in Part
IV, the article concludes by recommending several
specific policy goals that could help move forward from
the confusion caused by the current standard.
I. IN THE MATTER OF JOHN H. GUTFREUND
In April 1991, three senior executives of a registered
broker-dealer, the Chairman and CEO (“CEO”), John H.
Gutfreund; the President; and the Vice Chairman in
charge of fixed income trading, were informed that the
head of the firm’s Government Trading Desk had
submitted a false bid in a U.S. Treasury auction.2 A few
————————————————————
2
Id. at 95.
IN THIS ISSUE
● THE TIME HAS COME TO RECONSIDER THE GUTFREUND
STANDARD
Page 177
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days after learning of the false bid, the executives met in
the CEO’s office. The Vice Chairman summarized the
situation, indicated that he believed the incident was an
aberration, and expressed his hope it did not end the
career of the head of the trading desk. The brokerdealer’s Chief Legal Officer – Donald M. Feuerstein -also attended the meeting, and told the group that
submission of the false bid was a criminal act, and, while
there was no duty to do so, they had no choice but to
report the matter to the government. The group then
discussed where and how to report the matter, and
concluded that the preferable approach would be to
report it to the Federal Reserve Bank of New York. The
meeting then ended.
At the conclusion of the meeting, each of the four
executives apparently believed that a decision had been
made that the CEO or President would report the false
bid to the government, although each had a different
understanding of how the report would be handled.3
However, there had been no discussion during the
meeting about investigating what the head of the trading
desk had done, disciplining him, or placing limits on his
activities. Each of the four executives placed the
responsibility for investigating and responding to the
conduct on one or more of the other participants in the
meeting. The matter was not reported to the government
and no limits were placed on the head of the trading desk
for some months. During that period of time, he
submitted additional unauthorized bids.
When the false bids came to the attention of the SEC,
it brought an enforcement action against the four
executives who had participated in the meeting.4 The
SEC noted that each of the three line executives – CEO,
President, and Vice Chairman – apparently believed that
someone else would take the supervisory action
necessary to respond to the conduct on the trading desk.
They did not discuss what action would be taken or who
would be responsible for it. Instead, each of the
supervisors assumed that another would act. As a result,
the SEC concluded, “although there may be varying
————————————————————
3
Id. at 99-100.
4
Id at 106-07. The SEC also brought enforcement actions against
the broker-dealer and its parent company. Id. at 107.
September 12, 2012
degrees of responsibility, each of the supervisors bears
some measure of responsibility for the collective failure
of the group to take action.”5 The SEC sanctioned all
three for failure to supervise.
The SEC included the firm’s Chief Legal Officer in
the proceeding, although, recognizing that he was not a
direct supervisor of the trader, it did so by way of a
report of investigation.6 The SEC’s order said:
Employees of brokerage firms who have
legal or compliance responsibilities do not
become “supervisors” … solely because
they occupy those positions.
Rather,
determining if a particular person is a
“supervisor” depends on whether, under the
facts and circumstances of a particular case,
that person has a requisite degree of
responsibility, ability, or authority to affect
the conduct of the employee whose behavior
is at issue.7
The SEC went on to say that given the Chief Legal
Officer’s “role and influence within the firm[,]” he
shared in the responsibility to take appropriate action.8
It was not sufficient to be a mere bystander to the events.
In other words, once involved in formulating
management’s response to the problem, the Chief Legal
Officer should have either discharged those supervisory
responsibilities himself or known that others were taking
appropriate action.
II. THE “RESPONSIBILITY, ABILITY, OR
AUTHORITY” STANDARD IN ACTION
The legal community immediately recognized that the
Gutfreund order was a major statement by the
————————————————————
5
Id. at 110.
6
Id. at 113. As a report of investigation, no disciplinary action
was taken against him.
7
Id.
8
Id.
Page 178
Commission on supervisory responsibilities.9
Nonetheless, as a settled order, it had questionable
precedential value, and litigants challenged its
application.10 In 2002, the SEC appears to have resolved
the status of the order when it upheld its precedential
value, even in regards to conduct that had predated its
issuance.11 An Administrative Law Judge12 later noted,
in 2010, that the case and its ‘responsibility, ability, or
authority’ standard had been referenced many times by
the Commission in litigated cases.13 Indeed, the SEC
has cited to its use of Gutfreund in at least one other
context, as standing for the proposition that the
Commission may use an opinion issued in connection
with a settlement to state views that it would apply in
other contexts.14
In most litigated cases, application of the standard
appears to have been relatively straightforward. The
definition of a supervisor set out in Gutfreund has been
used when analyzing: whether a broker-dealer branch
manager was a supervisor;15 the scope of a branch
manager’s supervisory authority;16 whether a regional
sales manager was a supervisor because of his
responsibility to implement certain special supervisory
procedures;17 and whether a metropolitan area manager
————————————————————
9
See, e.g., James R. Doty, Regulatory Expectations Regarding the
Conduct of Attorneys in the Enforcement of the Federal
Securities Laws: Recent Development and Lessons for the
Future, 48 BUS. LAW. 1543 (1993) (stating that the private bar
had a “lively concern” about what the decision “portends for
lawyers generally”).
10
See, e.g., In re Kolar, Exch. Act Rel. No. 34-46127, 77 SEC
Docket 2944 (June 26, 2002) (discussing challenge to authority
of Gutfreund as a settled decision).
11
Id. at 2949.
12
Litigated administrative proceedings before the SEC are
generally heard before Administrative Law Judges, with appeal
available to the Commission (meaning, in this context, the five
Commissioners), and ultimately, from the Commission to a
United States Court of Appeals.
13
In re Prime Capital Services, Initial Decision, 2010 WL
2546835, *43 n.40 (SEC Rel. No. 398) (ALJ June 25, 2010).
14
In re SIG Specialists, Exch. Act Rel. No. 34-51867, 85 SEC
Docket 2060 (June 17, 2005).
15
In re Pasztor, Exch. Act Rel. No. 34-42008, 70 SEC Docket
1979, 1983 n.27 (October 14, 1999).
16
In re Logay, Initial Decision, 2000 WL 95098, *13 (SEC Rel.
No. 159.) (ALJ January 28, 2000).
17
In re Muth, Exch. Act Rel. No. 33-8622, 86 SEC 972
(October 3, 2005).
September 12, 2012
was a supervisor of the personnel in branch offices over
which he had “direct supervisory authority.”18 The
Gutfreund standard has also been cited in several settled
cases. Many of these cases also appear relatively
straightforward. They included: a finding that a firm’s
director of Global Research and director of U.S. Equity
Research supervised one of the firm’s research
analysts;19 and a finding that a portfolio manager
supervised the person responsible for executing portfolio
trades.20
In all of these cases the formulation of the standard of
supervisory responsibility was probably not a significant
issue. One can easily imagine all of these cases being
resolved on the basis of a standard that two
Commissioners had articulated in a case, In re Huff,
decided the year before the Gutfreund order. 21 The two
commissioners had said: “In our view the most probative
factor that would indicate whether a person is
responsible for the actions of another is whether that
person has the power to control the other’s conduct. …
Control … is the essence of supervision.”22 Some cases
continued to articulate a control standard, even after
issuance of the Gutfreund order, in addition to the
Gutfreund standard,23 or as a statement of the meaning
of the Gutfreund standard.24 Indeed, then-Commissioner
Schapiro, who joined the concurring opinion in Huff and
was on the Commission when it issued the Gutfreund
order, said that she believed both cases: “display a
————————————————————
18
In re Kolar, Exch. Act Rel. No. 34-46127, 77 SEC Docket 2944
(June 26, 2002).
19
In re Hoffman, Exch. Act Rel. No. 34-51713, 85 SEC Docket
1243, Invest. Comp. Act Rel. No. 2386 (May 19, 2005).
20
In re Fanam Capital, Invest. Co. Act Rel. No. IA-2316, 84 SEC
Docket 228 (October 29, 2004).
21
In re Huff, Exch. Act Rel. No. 34-29017, 50 SEC 524, 530
(March 28, 1991) (Shapiro & Lochner, Comm’rs, concurring).
In this case a unanimous Commission dismissed the proceeding
against Huff, but two Commissioners did so on the basis that
Huff had supervised reasonably, and two (Commissioners
Schapiro and Lochner) on the basis that Huff was not a
supervisor. The latter portion of the opinion set out the
definition of a supervisor discussed in the text. Id.
22
Id. at 532.
23
In re Raymond James Financial, Initial Decision, 86 SEC 604
(SEC Rel. No. 296) (ALJ September 15, 2005 (citing Huff and
Gutfreund)), aff’d without appeal.
24
In re Dornfeld, Exch. Act Rel. No. 34-55209, 89 SEC 2792
(January 31, 2007).
Page 179
consistent emphasis on authority, responsibility, and
control, as the hallmarks of a ‘supervisor.’”25
In sum, the Gutfreund standard has generally been
used in conventional settings where a control standard
would probably have been equally effective. However,
these situations were not the purpose for which it was
articulated. As noted above, the standard was intended
to determine when legal and compliance personnel were
supervisors. Some cases have continued to describe the
Gutfreund standard in such specialized terms. For
example, one recent case opined that direct supervisors
are presumed to be supervisors, “while a compliance
officer must be shown to have the responsibility, ability,
and authority to affect the conduct of an employee” to be
considered his or her supervisor.26
This raises the question: how has the Gutfreund
standard functioned in this, its core mission? Some
insight can be gained from the ALJ’s analysis in a
recently litigated case, In re Theodore Urban.27 The staff
alleged that Urban, a broker-dealer’s General Counsel
and head of compliance, was a supervisor.28 While an
evenly divided Commission eventually dismissed the
proceeding on appeal,29 the ALJ’s analysis highlights
how the Gutfreund standard works in practice.30
The ALJ described the question: when are legal and
compliance officials supervisors even though they do not
————————————————————
have any of the traditional powers associated with
supervision?31 The ALJ’s analysis is worth quoting:
“As General Counsel, Urban’s opinions on legal and
compliance issues were viewed as authoritative and his
recommendations were generally followed by people in
[the firm’s] business units, but not by Retail Sales.”32
This last caveat was significant, because the offending
salesman worked in Retail Sales and the head of Retail
Sales declined to follow Urban’s recommendation to
terminate the salesman. This factual predicate – Urban’s
opinions were viewed as authoritative and his
recommendations were generally followed, but in this
case they were not – poses an interesting analytical
problem.
At the threshold, it is worth noting that the ALJ’s
focus on opinions and recommendations was consistent
with the Gutfreund standard. In the Gutfreund order, the
Commission had noted the Chief Legal Officer’s role
and influence within the firm. The authoritativeness of
Urban’s opinions would be indicative of his role and
influence. Similarly, the ALJ’s consideration of whether
Urban’s recommendations were generally followed was
also consistent with the Gutfreund standard. In the
Gutfreund order, the Commission had noted that the
Chief Legal Officer had made recommendations in the
past and management had relied upon him.33 Moreover,
another ALJ had taken a similar view earlier in 2010,
noting in his Initial Decision, In re Prime Capital
Services, that: “the record does not contain evidence
that any of [the Chief Compliance Officer’s]
recommendations were ignored or refused.”34 In short,
the ALJ’s reasoning in Urban is a fair test for the
Gutfreund standard. Let us take each element in turn.
25
Mary L. Schapiro, SEC Commissioner, Speech at SIA
Compliance and Legal Seminar, Broker-Dealer Failure to
Supervise: Determining Who is a Supervisor, SIA Compliance
and Legal Seminar (March 24, 1993) (transcript available at
www.sec.gov/news/speech/1993/032493schapiro.pdf).
26
2546835, *43 (SEC Rel. No. 398) (ALJ June 25, 2010).
27
In re Urban, Initial Decision, 99 SEC Docket 994 (SEC Release
No. 402) (ALJ September 8, 2010), proceeding dismissed by an
evenly divided Commission, Exch. Act Rel. No. 34-66259,
2012 WL 1024025 (ALJ January 26, 2012).
28
Id.
————————————————————
29
Id.
31
30
The author wishes to note that as a member of the staff of the
SEC at the time of the proceeding against Urban, he played a
small role in the staff’s case. The author also wishes to
emphasize that this article does not seek to revisit the
underlying issues presented in the case, such as whether Urban
should have been held liable. Rather, the purpose is to
highlight the analytical difficulties – for potential respondents
and regulators alike – created by the Gutfreund standard as it is
currently understood.
In re Urban, Initial Decision, 99 SEC Docket 994 (SEC Rel.
No. 402) (ALJ September 8, 2010), proceeding dismissed by an
evenly divided Commission, Exch. Act Rel. No. 34-66259,
2012 WL 1024025 (ALJ January 26, 2012).
32
Urban, 2012 WL 1024025 at *44 (2010).
33
In re Gutfreund, Exch. Act Rel. No. 34-31554, 51 SEC 93, 112
(Dec. 3, 1992).
34
2546835, *45 (SEC Rel. No. 398) (ALJ June 25, 2010).
September 12, 2012
The first element, how people viewed Urban’s
opinions, illustrates the essential nature of the
“authority” test under the Gutfreund standard, its
subjectivity. How someone views someone else’s
opinion is by its nature subjective. It also raises the
question: how does one prove these views in evidence?
Are some views more authoritative than others? What
happens when there is a conflict, with different people
Page 180
having different views? Most fundamentally, the idea
that a legal or compliance official becomes a supervisor
because of someone else’s subjective view, is difficult to
square with any common understanding of supervision.
The second element, whether Urban’s
recommendations were accepted, appears more
objective. Proof of recommendations and whether or not
they were followed can be introduced into evidence,
assessed, and tested. The ALJ in the Prime Capital
Services case, cited above, who was searching the record
for evidence of ignored or refused recommendations,
appears to have been working in this direction. Even so,
this does not free the Gutfreund standard from its
subjectivity. The idea that legal or compliance officials
become supervisors when their recommendations are
accepted leaves the decisive action within the other
persons’ subjective control: do they choose to follow?
Again, most fundamentally, the idea that a legal or
compliance official becomes a supervisor because of
someone else’s subjective decision to follow, is difficult
to square with any common understanding of
supervision.
While the ALJ in the Urban case stated these two
activities separately – viewing opinions and following
recommendations – as a practical matter, they mean
much the same thing. One’s recommendations are
followed because one’s opinions are viewed as
authoritative, and vice versa. Moreover, both of these
activities, viewing and following, arise from the same
subjective source: the perceptions and choices of others
at the firm. Following the reasoning to its logical
conclusion, the better one’s opinions, the more
authoritative one appears, and the more others choose to
follow, the more likely one will be a supervisor and
potentially liable. This is an odd reversal of the usual
understanding that a failure to supervise is a failure.
Indeed, in this case, the head of Retail Sales failed to
follow Urban’s recommendation.
This is the crux of the problem. If the standard is
based on people viewing opinions as authoritative and
following recommendations, what happens when they do
not? In the Urban case, the ALJ concluded that Urban
was a supervisor. Indeed, she said, “the language in
Gutfreund, taken literally, would result in [the person
who engaged in misconduct] having many supervisors
because many people at the [firm] acted to affect [his]
conduct in a variety of different ways.”35 This suggests
that legal and compliance professionals are supervisors
of anyone whose conduct they can affect in any way.
————————————————————
35
Urban, 2012 WL 1024025 at *44 (2010).
September 12, 2012
The limiting principle for this status is difficult to
discern. The ALJ in the Urban case gave a hint of its
open-ended scope when she asked what further action
Urban should have undertaken to fulfill his supervisory
responsibilities. The ALJ answered: nothing. The ALJ
found that approaching the CEO (to whom Urban was a
direct-report) or Board of Directors (of which Urban was
a member) would have been futile.36
This analysis leads to a state of extreme incoherence.
A legal and compliance official has authority and is a
supervisor because his opinions are authoritative and
recommendations are followed. Yet no further action
was required because additional recommendations
would have been futile, from which we can presume
they would not have been authoritative. In other words,
legal and compliance officials are supervisors when they
are authoritative, and even when they are not.
At the end of the day, application of the Gutfreund
standard leaves one at a loss as to what makes a legal or
compliance official a supervisor. In practice, application
of Gutfreund’s “authority” test appears to be based on a
subjective assessment of an individual’s general role and
influence within the firm. This subjectivity should
concern regulators as well as legal and compliance
officials. In the Urban case, the potential responsibility
of a senior executive of a regulated firm, who had been
deeply involved in addressing a serious compliance
problem and was a member of more than one
governance committee, was decided based on the ALJ’s
speculation about the likely authoritativeness of
recommendations that were not made. While this
opinion was later rendered moot, it demonstrates the
weakness of the Gutfreund standard’s subjective
approach. There must be a better way to make this
determination.
III. GUTFREUND RECONSIDERED
When we return to the Gutfreund order and ask if its
current incoherence was inherent in the original
decision, we make an interesting discovery. The
Gutfreund standard is actually quite reasonable when
applied to the facts of that case. This is because its facts
and circumstances have been largely forgotten. The
Gutfreund case was a matter of collective, not
individual, responsibility.
————————————————————
36
Again, please see note 30 supra, the author states no view on
the merits of the ALJ’s findings. Rather, taking the findings as
a given, the question is: does analysis pursuant to the
Gutfreund standard make sense?
Page 181
In the Gutfreund case, the four responsible executives
met; discussed the problem; failed to address critical
issues – such as investigating the conduct and preventing
a recurrence; adjourned; and then did nothing further,
each assuming that someone else would undertake the
appropriate actions. In its order, the SEC highlighted the
collective nature of this failure. It was, the Commission
said, a collective failure of the group, and, while there
were varying levels of responsibility for each of the
participants, all shared in that collective failure. When
we turn to the report of investigation involving the Chief
Legal Officer, we find that his failure was similar: once
he became part of management’s collective response to
the problem – i.e., once he was a member of the control
group – he shared in the collective responsibility to see
that appropriate action was taken.37
In light of these facts and circumstances, the
Gutfreund standard takes on a new meaning. It is not
based on a subjective assessment of an individual’s
general authoritativeness within the firm, regardless of
the present circumstances. Rather, it is based on a
specific collective or institutional setting. At its origin,
the Gutfreund standard applied to a defined group that
was meeting to address a defined question. The standard
articulated in the order addressed the question: who
among the participants shared in the group’s control over
the problem? This gives the definitional standard a
specific content. A junior official entering the meeting
to deliver a report or spreadsheet would not have the
necessary role or influence; while a senior executive
opining on the proper course of action for the firm very
well could. Viewed as a standard for defining who
belonged to the control group in a particular meeting
regarding a particular problem, the Gutfreund standard
makes sense.
IV. CONCLUSION
How do we move forward from the obvious
confusion caused by the current application of the
Gutfreund standard? Set out below are five policy goals
that should be considered.
First, we should recognize that the Gutfreund
standard as it is currently understood is a failure. The
Commission’s dismissal of the Urban proceeding does
not resolve the analytical problems it revealed. Most
importantly, the standard has failed in its fundamental
purpose: providing legal clarity to the affected
population so it can determine whether or not it is
subject to the law of supervision. Regulators, as well as
legal and compliance officials, should be concerned
about a subjective standard that leads to such incoherent
and speculative analyses.
Second, we should read the language of Gutfreund as
a specialized standard applicable only to group
responsibility. This resolves many of the analytical
concerns discussed above. It grounds the analysis in a
concrete institutional setting and asks a specific
question: who is a member of the identified control
group? In addition, the need for such an analytical tool
is growing. Collective decision-making has spread
across the financial sector, with compliance committees,
risk committees, valuation committees, and numerous
other institutionalized activities. In many cases, the
traditional view of supervision – one supervisor and one
supervisee – is obsolete. The Gutfreund standard,
properly understood, is a timely answer to this
development.
Third, having narrowed the Gutfreund standard to its
original facts and circumstances, we should resume our
search for an effective definition of when legal and
compliance officials become supervisors. Such a
definition already exists: the control standard set out in
the concurring opinion in Huff. In fact, but for the
intervening issuance of the Gutfreund order, the control
standard would probably be of general application today.
As the Commissioners who articulated the standard put
it: control is the essence of supervision. Legal and
compliance officials should be held to the same
standard. In some firms, they can break trades and
discipline employees for misconduct.38 Query: is that
control? Moreover, as the Gutfreund order – properly
understood demonstrates – legal and compliance
officials may exercise control indirectly, through
membership in defined control groups. But ultimately,
as a matter of policy, legal and compliance officials
should be treated the same as everyone else: they should
not be responsible for conduct they do not control.
Fourth, we should remember an important element of
the control standard that has been lost in the Gutfreundinspired search for generalized influence. That is the
need to put responsible parties on notice of their
responsibility. The concurring opinion in Huff stated it
thus: “it should have been clear to the individual in
question that he was responsible for the actions of
———————————————————— ————————————————————
37
Although, we should note, even in this setting, the standard
would have made more sense if the Commission had drafted it
as: “responsibility, ability, and authority.”
September 12, 2012
38
See e.g., In re Newbridge Securities Corp., Initial Decision, 96
SEC Docket 241 (SEC Rel. No. 380) (June 9, 2009) (discussing
authority of trading compliance officer).
Page 182
another and that he could take effective action to fulfill
that responsibility.”39 In other words, to state this as a
matter of policy: control is the essence of supervision,
and notice of responsibility is the essence of liability.
This suggestion is also timely. As collective decisionmaking institutions have spread across the financial
sector, many firms are establishing governance
structures for them. Careful planning in this regard
could work well within a properly understood Gutfreund
standard. That is, as firms define what their committees
will supervise and who will control the committees, they
can decide how to meet the collective responsibility test
set out in the Gutfreund standard. This would put
participants on notice of their responsibilities and the
matters for which they will be held accountable.
Fifth and finally, we should recognize that difficult
facts will not disappear. Some future adjudicator will
again address the supervisory responsibility of a
powerful individual who claims to have been giving only
advice. Framing the issue as control, not influence,
should help avoid the subjective considerations that have
troubled application of the Gutfreund standard. We can
only wonder what would have happened in the Urban
case, had the Commission, in some previous year,
adopted the control standard, instead the Gutfreund
standard. The next case, hopefully, will turn on
demonstrable evidence of control, or the lack thereof,
and not on speculation about influence.
In conclusion, properly understood, the Gutfreund
standard could have an important role to play in
addressing the recent growth of collective decisionmaking. This would be a positive turn of events from
the incoherence, speculation, and confusion it is causing
today.■
————————————————————
39
In re Huff, Exch. Act Rel. No. 34-29017, 50 SEC 524, 532
(March 28, 1991) (Shapiro & Lochner, Comm’rs, concurring).
September 12, 2012
Page 183
2012 Investment Management
Compliance Testing Survey
Lynne M. Carreiro, ACA Compliance Group
Kathy D. Ireland, Investment Adviser Association
June 14, 2012
Survey Focus Areas
 Overall Compliance Program
 Performance Advertising
 Pay to Play
 Special Trading Issues
 Best Execution Reviews
 Cross Trades
 Oversight of Third-Party Service Providers
 TREND UPDATE – Social Media
 TREND UPDATE – Whistleblowing
 TREND UPDATE – Gifts & Entertainment
 TREND UPDATE – Insider Trading
 TREND UPDATE - “Hot” Compliance Topics
© 2012 ACA Compliance Group, Investment Adviser Association, and Old Mutual Asset Management
2
Survey Demographics

The largest contingency responding were mid-size firms
with 39% of respondents between $1 billion and $10
billion in assets under management and 68% of
respondents reporting 50 employees or less.

Both small and large firms were well represented with
36% of respondents managing <$1 billion and 24% of
respondents managing >$10 billion.

Established firms (5-25 years in business) constituted
54% with long-timers (more than 25 years) making up
29% of respondents.

The services provided by our respondents span the full
range:
•
•
•
•
•
•
56% advise a private fund.
47% advise high net worth individuals (>$1mm).
39% advise ERISA assets and/or are pension
consultants.
36% advise a registered investment company.
18% advise retail individuals (<$1mm).
10% advise a family office.
3
Notable Findings
 37% of the firms responding have only
one person in a full time
legal/compliance role.
 7% of firms reported detecting material
compliance issues – and 22% reported
finding no compliance issues.
 67% of CCOs are wearing two or more
hats.
 54% of firms use automated/electronic
compliance systems.
 80% of firms have adopted formal
written policies concerning social
networking.
 Pay to play policies are on the
increase.
4
Compliance Program

94% of the firms responding have at least one employee dedicated full-time to the
legal/compliance role.

There are common threads in best practices regardless of the characteristics of the firm:
• 92% of firms provide a copy of the annual compliance review to senior
management.
• 83% of firms conduct at least annual employee compliance training.
• 77% of CCOs attend committee and other management meetings (e.g. valuation,
best execution, investment/portfolio management etc.).
• 75% of CCOs are mandated to immediately inform the CEO/President of any
material compliance issues.
• 75% of CCOs meet periodically with the CEO/President of the firm to discuss
compliance issues and initiatives.
5
Compliance Program

Firms reported increasing the amount
of testing in the following areas:
•
•
•
•

Pay to Play (48%)
Advertising/Marketing (43%)
Personal Trading (39%)
Social Media (38%)
When asked about areas of decreased
testing, 79% of firms indicated that they
have not decreased testing in any
area.
6
Automated/Electronic Compliance Systems

54% of firms use automated/electronic
compliance systems.

These systems are most frequently used
in the following areas:
•
•
•
•
•

Personal Trading (68%)
Client Guidelines (42%)
Gifts & Entertainment (33%)
Pay to Play (31%)
Portfolio Management (31%)
Only a few firms (2%) had discontinued
use of automated/electronic compliance
systems in any area.
7
Automated/Electronic Compliance Systems

Firms that do not use automated/electronic
compliance systems cited:
•
•
•

Cost (57%)
Lack of “fit” with business (48%)
Systems limitations (11%)
Comments:
“Not needed until we grow
bigger”
“Very small firm – easily
managed ‘manually’”
8
Performance Advertising
How do you test your performance calculations and
presentations?
 We confirm that disclosures required by the Investment Advisers Act and
relevant no action relief are included in appropriate font, location and
prominence (55%)
 We confirm that performance presentations are presented net of fees unless
in one-on-one presentations and then we confirm that the one-on-one
presentation is in compliance with relevant no action relief (55%)
 We confirm that required back-up documentation is retained (52%)
 We confirm that consistent periods and benchmarks are included in
marketing materials overtime to detect cherry picking (50%)
 We review compliance with our firm’s policies and procedures (e.g., GIPS
policies) (46%)
 We sample marketing materials periodically to confirm that accurate
performance figures are being used and that all necessary disclosures are
included (46%)
9
 Only 36% of firms test for performance dispersion among similarly managed
accounts – a valuable test to find potential conflicts of interest and violations of the
firm’s trade allocation policies AND one frequently performed by SEC examiners.
 31% of respondents who do not claim GIPS compliance indicated that they engage
a third party to verify their firm’s performance presentations, with 50% of those firms
receiving quarterly verifications and 33% receiving annual verifications.
“All promotional materials
containing performance
information must be reviewed
and certified in writing as to
their accuracy by relevant
management and control
personnel.”
10
Of the firms reporting that they have significantly increased testing of
performance advertising in the past year, most reported that it was due to
preparation for registration as an Investment Adviser as a result of the
Dodd-Frank Act.
Interestingly, despite the SEC’s increased focus on performance
advertising, 3% of firms indicated that they do not conduct any
testing of performance advertising.
11
GIPS Update
 Less than half of respondents claim compliance with GIPS (43%)
 Even though the CFA Institute determined not to mandate GIPS verifications, the
majority of GIPS compliant respondents engage a verifier (85%) and 67% also
obtain a performance review of certain composites.
 The majority (90%) of firms who engage a verifier receive quarterly updates
(47%) or annual updates (43%) despite the CFA Institute’s implication that biannual verifications (only done by 3.2% of respondents) is acceptable.
 Frequently cited under reasons for significant increases in performance testing
was the adoption of GIPS: “Obtained GIPS audit. Significantly increased
compliance to meet GIPS standards in addition to SEC standards.”
12
Pay to Play

Pay to play policies are on the increase.

15% of firms report that the rule is not applicable
to them (compared with 20% in 2011).

43% of firms reported that they have adopted
policies to address the rule as part of other
compliance policies.

38% of firms have adopted a stand alone policy to
address the rule.
 76% of firms apply their policy to all employees, as
compared with last year’s survey percentage of 68%. Only
12% limit their policy to Covered Associates.
 23% of firms apply their policy to the spouses, household
members and/or dependent children of Covered
Associates.
 13% of firms apply their policy to the spouses, household
members and/or dependent children of other
employees covered by the policy.
13
Pay to Play

7% of firms prohibit all political contributions.

60% of firms responding require pre-clearance of
political contributions by Covered Associates.
This is the most common approach, followed by
reporting (32%), prohibition above a de minimis
amount (21%), and pre-clearance above a de
minimis amount (14%).

De minimis amounts ranged from $100 to $350
and were defined by additional controls such as:
•
•
the eligibility of the employee to vote for the
candidate
whether it was a state or federal election.

60% of firms require periodic certifications by
employees as to their compliance with the policy.

35% of firms request a list of all contributions as
part of the employee hiring process.
14
Best Execution
 82% of firms conduct best execution reviews. Of those 82%,
•
•
•
•
29% are Advisers to private funds
26% are Advisers to High Net Worth Individuals
23% are Advisers to ERISA assets/pension consultant
21% are Adviser to RICs
 Surprisingly, given the issues which have arisen with regard to FX best
execution, only 17% of respondents include FX transactions in their
review.
 88% of firms indicated that they do not report the results of best
execution evaluations to their broker dealers.
 55% of firms report that they conduct reviews quarterly, while the rest
are split, with 20% reporting annual reviews, 15% reporting semi-annual
reviews, and only 10% conducting monthly reviews.
15
Best Execution
 87% of firms reported that
compliance personnel are
involved in the best execution
reviews, while only 71% of
firms reported that traders are
involved.
 In the “Other” category, firms
reported participation by
technology personnel, senior
management, legal staff,
operations staff, accounting
personnel.
 92% of firms reported including equity assets in their best execution
reviews, followed by fixed income assets (52%), and derivatives
(21%).
 Mutual Funds and ETFs dominated the “Other” category.
16
Best Execution
 Common Forensic Tests for best execution:
1. Review of trade errors (53%)
2. Review of best execution policies and procedures (53%)
3. Review of an approved broker-dealers list (52%)
4. Comparisons to benchmarks such as VWAP (45%)
5. Soft dollars and/or commission sharing arrangements (41%)
 Common Focus Areas for best execution reviews:
1. Timeliness of Execution and Settlement (76%)
2. Intermediary Compensation (69%)
3. Order Flow Sent to Brokers (60%)
4. Products and research services provided (52%)
5. Timeliness and accuracy of trade confirmations (52%)
17
Best Execution
 92% of firms maintain written documentation evidencing their
best execution reviews:
•
“Brokerage committee minutes, third party trade cost analyses,
internal analyses”
•
“Best execution memorandum, soft dollar reports, vwap analysis,
trade error reports approved broker list.”
•
•
•
“Meeting materials consisting of agenda, commission reports,
excerpts of policies and procedures, broker evaluations, trade
error documentation.”
“Best Execution Committee minutes and corresponding
memorandum, results of broker surveys, Compliance test plan
and corresponding exhibits (Bloomberg VWAP screens, trade
tickets).”
“Agenda, Trade Cost Analysis reports, gift and entertainment
logs, commission budget (includes soft dollar budget), broker
review matrix, approved broker list.”
18
Cross Trades
 Only 23% of firms reported that they engage in cross trading. Of those:
•
•
•
29% are Advisers to Private Funds.
23% are Advisers to a Registered Investment Company.
21% are Advisers to ERISA/pension assets.
 50% of firms engaged in cross trading conduct cross trades in the
market through non-affiliated broker-dealers, while 44% reported that
they cross trades internally.
 Most common testing of cross trades reported:
•
•
•
•
•
•
•
Review cross trades for compliance with firm policies.
Review each transaction for fiduciary principles. (i.e., mutually
beneficial to both clients.)
Review pricing process and results for cross trades.
Review participating client accounts to ensure eligibility to cross trade.
Review documented rationale for each transaction.
Review Form ADV and other disclosures regarding cross trades for
consistency with actual practices.
Review transactions in light of Investment Company Act regulations.
76%
72%
64%
58%
57%
56%
51%
19
Cross Trades
 95% of respondents indicated that they maintain documentation related
to the firm’s cross trading activities:
You indicated that your firm maintains documentation related to cross
trades. Which of the following best describes the type of documentation
maintained? (check all that apply)
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Trade ticket.
Chief
Compliance
Officer sign-off.
Daily trade
reports.
Cross trade
forms.
Other (please
specify):
20
Oversight of TSPs
 Unsurprisingly, 91% of respondents indicated that they engage a
third-party service provider:
1.
2.
3.
4.
5.
Attorneys (85%)
Email Archival Vendors (81%)
Auditors (75%)
Independent Qualified Custodians (71%)
Information Technology Companies (65%)
 Also mentioned frequently:
•
•
•
Proxy Voting Vendors
Sub-Advisers
Personal Trade Compliance Vendors
 Interestingly, in a post-Galleon world, only 22% of firms indicated
that they engage third-party Investment Research Consultants.
21
Oversight of TSPs
How does your firm conduct oversight of its third-party service providers?
• We conduct an initial due diligence.
• We oversee through regular interaction but do not conduct a focused
review.
• We designate employees responsible for managing each relationship.
• We conduct onsite visits on a periodic basis.
• We conduct periodic testing (e.g., business continuity, compliance with
contractual representations, etc.)
•
•
•
•
We conduct teleconferences on a periodic basis.
We review all contracts annually.
We require periodic reporting/questionnaires (please explain below).
We engage a third-party to conduct due diligence.
83%
51%
39%
34%
29%
25%
21%
19%
3%
“Not all of the items checked above apply to all service providers. Oversight is
determined based on the services - what is warranted by the services.”
“We ask for members of the office cleaning crew to sign in when they clean so we
may track them.”
“We request SAS-70 reports annually.”
“We conduct an annual review of all service providers.”
22
Oversight of TSPs
What types of information do you request from the third-party service
provider as part of your due diligence? (check all that apply)
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
Other (please
explain below).
Internal control
reports (e.g.,
SSAE 16).
Complaints.
Criminal history.
Regulatory
history.
Current Litigation.
Background
checks of
employees.
References from
other customers.
Company
Financials.
Exception
reporting (please
specify below).
Disaster recovery
plans.
Confidentiality
agreements.
Privacy policies.
0.0%
 Only 26% of respondents indicate that they require periodic certifications from service
providers.
 The most frequently reported certifications requested by respondents include
compliance certifications, data privacy and security, and disaster recovery planning.
23
TREND UPDATE: Social Media and Networking

80% of firms have adopted formal written
policies and procedures to govern the use
of social networking by employees, compared
to 64% in 2011. Another 10% have informal
policies.

54% prohibit the use of personal social
networking websites for business purposes.

54% test compliance with the firm’s social
media policy.

Social media testing is most commonly done
annually (31%), but 24% test quarterly.

52% report that the firm’s social media testing
has increased over the past year.
24
TREND UPDATE: Social Media and Networking
 Testing approaches:
•
Use Google alerts for firm, fund and employees’ names to detect
unauthorized social media use.
•
Subscribe to service that screens social media sites for key words and
reports results daily
•
Require employees to “friend”/connect with CCO
25
TREND UPDATE: Whistleblowing

The majority of respondents have some form of
whistleblowing policy (67%).

24% reported that they have or are implementing a
hotline for anonymous reporting.

33% reported that their whistleblowing policies have
changed since 2011.

Comments:
• “We indicate in our Code of Ethics that we
support the SEC Whistleblowing Policy
whereby all allegations are taken seriously and
no employee will be ostracized for reporting a
potential violation.”
• “A Reporting Procedure was added to our
Code of Ethics creating a responsibility to
every employee to report violations of the
Firm’s policies.”
26
TREND UPDATE: Gifts and Entertainment
 The vast majority of firms (over 95%) have a gifts and entertainment
policy.
 Testing has increased in less than 15% of firms, with common testing
approaches including:
•
•
•
•
Interviews
Review of corporate credit card charges
Email reviews
Use of tracking software summary of client policies
 Only 25% of those responding obtain and review gifts and entertainment
policies of clients, but over half of those conduct testing of compliance
with client policies.
27
TREND UPDATE: Insider Trading

98% of firms report that their testing in the
area of insider trading has increased or
remained the same since 2011.
Common tests used for the detection of insider
trading:
•
Reviewing trading patterns around news
stories for client trading
•
Reviewing news stories around personal
trading
•
Reviewing for unusually profitable trades
in client accounts and personal accounts
•
Email surveillance
28
TREND UPDATE: Hot Compliance Topics
Topics
2009
2010
2011
2012
Custody
26%
56%
35%
12%
Data Security/Privacy
22%
41%
33%
15%
Advertising/Marketing
27%
27%
29%
26%
Valuation
33%
20%
27%
25%
Fraud Prevention
22%
20%
20%
11%
Regulatory reporting
X
X
44%
31%
Insider Trading
X
X
42%
32%
Pay to Play
X
X
X
19%
Social Media
X
X
X
43%
29
Special Contact Information
Lynne M. Carreiro, Senior Principal Consultant
ACA Compliance Group
18 Tremont Street, Suite 520
Boston, MA 02108
(617) 589-0904
Kathy D. Ireland, Associate General Counsel
Investment Adviser Association
1050 17th Street, NW, Suite 725
Washington, DC 20036
(202) 293-4222
30
Ignites - Martin Currie: The Perils of Side-by-Side ManagementPrint Issue
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Martin Currie: The Perils of Side-by-Side
Management
By Beagan Wilcox Volz May 15, 2012
A recent SEC enforcement action against Martin Currie highlights what can go wrong when firms manage mutual
funds and hedge funds side by side.
The Securities and Exchange Commission and its U.K. counterpart, the Financial Services Authority, last week
fined the Scottish asset manager nearly $14 million for allegedly advising a U.S. closed-end fund to invest in the
bonds of a Hong Kong–listed printer cartridge company in order to prop up a hedge fund also run by Martin
Currie.
“The misconduct in this case strikes at the heart of the fiduciary relationship between an investment adviser and
its client,” said Robert Khuzami, head of the SEC’s Division of Enforcement, in a press release. “Advisers must
treat each client with undivided and disinterested loyalty, and must make full and fair disclosure of all material
conflicts of interest.”
The case suggests the importance of undertaking a vigorous analysis of potential conflicts of interest and using
that to determine tailored policies and procedures at firms that engage in side-by-side management of mutual
funds and hedge funds, industry attorneys say.
The SEC notes that Martin Currie’s closed-end fund, The China Fund, and its China Hedge Fund made similar
investments in China and were managed by two portfolio managers who headed the firm’s China operations from
Shanghai. One of the portfolio managers, referred to as “PM-1” in the SEC administrative proceeding, was
considered a star manager and struck a lucrative profit-sharing arrangement with Martin Currie in 2006. Under
this arrangement, PM-1 and the second portfolio manager formed their own company and entered into a joint
venture with Martin Currie. This meant they received a portion of the fee revenues on investments they managed.
PM-1 operated with “very little supervision,” despite the fact that he oversaw a third of the firm’s assets, the SEC
says.
In addition to these “structural flaws,” the firm had weak controls ensuring compliance with the securities laws,
the SEC says. In particular, Martin Currie was deficient in its “identification and management of conflicts of
interest.”
As an example of this deficiency, the SEC says that the investment mandates of the two funds, along with other
affiliated clients, allowed the portfolio managers to make direct investments in the debt and equity of unlisted or
micro-cap companies in China. As a result, multiple funds and separate accounts invested in different parts of the
capital structure of the same company, “presenting potential conflicts of interest.” Yet, the firm did not have
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Ignites - Martin Currie: The Perils of Side-by-Side ManagementPrint Issue
Page 2 of 5
sufficient policies and procedures to ensure it was meeting its fiduciary obligations to each client in these
situations.
In this particular case, Martin Currie’s hedge fund had purchased $10 million in unlisted illiquid bonds in 2007
from a Hong Kong–listed printer cartridge company called Jackin International. As the financial crisis worsened,
the hedge fund ran into liquidity issues partly due to a big increase in redemption requests. Jackin, however, was
short on capital to make debt payments to bondholders such as the hedge fund. Martin Currie decided to use the
mutual fund to buy $22.8 million in convertible bonds from a subsidiary of Jackin. The subsidiary in turn lent
$10 million to troubled Jackin, allowing it to redeem $10 million in bonds held by the hedge fund.
The SEC says that the firm’s officials were aware that the mutual fund’s involvement presented a direct conflict
of business and could have been unlawful to boot.
“In an attempt to cure that conflict, they sought and obtained approval from the China Fund’s board of directors.
However, they failed to disclose that proceeds of the fund’s investment would be used to redeem bonds held by
another client — the hedge fund,” the SEC says.
The case demonstrates the importance of a “rigorous analysis of conflicts of interest to guide the internal control
procedures,” says Paul Huey-Burns, partner at Bryan Cave. The regulators believe there was a clear conflict of
interest and yet the procedures weren’t attuned to that potential conflict, he adds. Huey-Burns says his firm
frequently advises clients to go through their business practices and to think hard about where there may be
conflicts of interest, and then to tailor their processes to address those potential conflicts.
The SEC order says the agency considered Martin Currie’s cooperation and remedial efforts as part of the
settlement. Those include the firm's compensating the closed-end fund for net losses stemming from the bond
transaction and refunding management fees incurred as a result of the deal. The firm also ended its ties to PM-1
and “terminated, replaced or disciplined certain other senior employees.” It made changes to its policies and
procedures governing compliance with the securities laws as well.
Despite this cooperation, the SEC’s $8.3 million fine is significant, says Mark Schonfeld, a litigation partner at
Gibson Dunn and former head of the SEC’s New York Regional Office. Indeed, one could question what benefit
the firm got for its cooperation with the SEC, Schonfeld says.
On the other hand, the FSA says that Martin Currie agreed to settle at an early stage of the regulator’s
investigation and “therefore qualified for a 30% (Stage 1) discount under the FSA’s executive settlement
procedures.”
One of the difficulties with the SEC’s efforts to incentivize cooperation is that there’s very little transparency into
the benefits a firm gets for cooperating, adds Schonfeld.
One industry attorney says that the SEC’s new requirement that certain private advisors to hedge funds register
could lead those firms to register mutual funds as well, raising the possibility of more enforcement actions
stemming from side-by-side management.
Mike Wolensky, partner at Schiff Hardin, cites the old saying, “In for a penny, in for a pound.” If hedge fund
advisors have to register, they may decide to go ahead and run “the full panoply” of investment vehicles, he says.
There are 1,277 private fund advisors that have registered with the SEC as of May 1, according to data on file
with the agency, which includes advisors to private equity and hedge funds.
Ignites is a copyrighted publication. Ignites has agreed to make available its content for the sole
use of the employees of the subscriber company. Accordingly, it is a violation of the copyright
law for anyone to duplicate the content of Ignites for the use of any person, other than the
employees of the subscriber company.
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Address at the Private Equity International Private Fund Compliance Forum (Carlo V. di ... Page 1 of 10
Home | Previous Page
Speech by SEC Staff:
Address at the Private Equity International Private Fund
Compliance Forum
by
Carlo V. di Florio
Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
New York, NY
May 2, 2012
Q1. Thanks for being with us Carlo. As everyone here is aware, the deadline
has now passed for advisers to large private equity firms to register with the
SEC. Can you discuss what the agency is doing to prepare for the nearly
4000 private fund advisers that are registered with the Commission?
Let me begin by thanking you for inviting me to speak to you today on
important topics of concern to private equity fund advisers, many of whom
are newly registered with the Commission as required under the Dodd-Frank
Act. We in the National Examination Program (“NEP”) have shared
objectives when it comes to protecting investors, market integrity and
capital formation. Many of you have been charged by your firms with
bolstering their compliance functions to prepare for registration with the
Commission. I salute you for the important work that you are undertaking
to promote good risk management, compliance and ethics in the private
equity fund sector. My door is always open and I welcome the dialogue and
collaboration as we work together to prevent fraud, improve compliance,
monitor risk and inform policy. As you know, the views that I express here
today are my own and do not necessarily reflect the views of the
Commission or of my colleagues on the staff of the Commission.
The Data Profile of New Registrants. This morning I can share with you
some new data, as of March 30, 2012, about changes to the population of
investment advisers registered with the Commission as a result of the
recent deadline for new private fund registrants under Dodd-Frank:
z
z
z
z
There are now close to 4000 IAs that manage one or more private
funds registered with the Commission, of which 34 per cent have
registered since the effective date of the Dodd-Frank Act.
32 per cent of all advisers that register with us report that they
adviser at least one private fund.
Of the roughly 4000 registered private fund advisers, 7 per cent are
domiciled in a foreign country (the UK is the most significant).
Registered private fund advisers report that they advise nearly 31,000
http://www.sec.gov/news/speech/2012/spch050212cvd.htm
5/15/2012
z
z
private funds with total assets of $8 trillion (16% of total assets
managed by all registered advisers).
Based on available information, of the 50 largest hedge fund advisers
in the world, 48 are now registered with the Commission. Fourteen of
these are new registrants.
Of the 50 largest private equity funds in the world, 37 are now
registered with the Commission. 18 of these are new registrants.
Examination Strategy. Regarding NEP staff preparations for new
registrants, we are identifying the unique risks presented by private equity
funds, as well as by hedge funds, based on a number of factors. These
include our past examination experience with these types of registrants and
staff expertise that we have been developing through hiring and training in
anticipation of our new responsibilities. We are also developing information
management systems to help us organize and evaluate the new information
we will be collecting on private equity firms on new Form PF as well as on
Form ADV, to help us identify where and how best to allocate our
examination resources across existing and new registrants. We are also
working to ensure the integrity of confidential information internally, while
also developing processes to ensure that examiners are given access to
information that will provide them with a better understanding of an entity
and allow for better scoping of exams.
Based on these factors, we have a three-fold strategy. First, we will have
an initial phase of industry outreach and education, sharing our
expectations and perceptions of the highest-risk areas. This will be followed
by coordinated examinations of a significant percentage of new registrants,
focusing on highest risk areas of their business, and helping us to risk-rate
the new registrants. Finally, we intend to culminate in publication of a
series of “after-action” reports on the broad issues, risks and themes
identified. All of this will be planned and executed in consideration of other
responsibilities of the exam program, fulfilling the NEP mission to improve
compliance, prevent fraud, inform policy and monitor industry-wide and
firm-specific risks.
Regulatory Expectations. An important part of NEP’s examination
strategy for private equity advisers is to be clear and transparent about our
expectations. Registration with the SEC imposes important obligations on
newly registered advisers. Upon registration, advisers to hedge funds must
comply with all of the applicable provisions of the Advisers Act and the rules
that have been adopted by the SEC. These provisions require, among other
things, adopting and implementing written policies and procedures,
designating a chief compliance officer, maintaining certain books and
records, filing annual updates of Form ADV, implementing a code of ethics
and ensuring that advertising and performance reporting complies with
regulatory rules. In addition, once registered, advisers become subject to
examinations by the SEC.
Some of the compliance obligations that I want to highlight for you include:
1. The “Compliance Rule” requires registered advisers, including hedge
fund advisers, to (a) adopt and implement written policies and
procedures reasonably designed to prevent violation of the Advisers
Act and rules that the Commission has adopted under the Advisers
Act; (b) conduct a review, no less than annually, of the adequacy of
5/15/2012
2.
3.
4.
5.
the policies and procedures; and, (c) designate a chief compliance
officer who is responsible for administering the policies and
procedures.1
The “Books and Records Rule” requires registered advisers, including
private equity advisers, to make and keep true, accurate and current
certain books and records relating to the firm’s investment advisory
business. Generally, most books and records must be kept for five
years from the end of the year created, in an easily accessible
location.2
Form ADV Updates—Rule 204-1 of the Advisers Act requires
registered advisers to complete and file an annual update of Parts 1A
and 2A of the Form ADV registration form through Investment
Advisers Registration Depository (IARD). Advisers must file an annual
updating amendment to Form ADV within 90 days after the end of the
firm’s fiscal year. In addition to annual filings, amendments must
promptly be filed whenever certain information contained in the Form
ADV becomes inaccurate.
The “Code of Ethics Rule” requires a registered adviser to adopt a
code of ethics which sets forth the standards of business conduct
expected of the adviser’s supervised persons and must address the
personal trading of their securities.3
The “Advertising Rule” prohibits advertisements by investment
advisers that are false or misleading advertising or contain any
untrue statements of material fact.4 Advertising, like all statements
made to clients or prospective clients, is subject to the general
prohibition on fraud under section 206 of the Advisers Act as well as
other anti-fraud provisions under the federal securities laws. In
addition to specific regulatory requirements, SEC staff has also
indicated its view that, if you advertise performance data, the firm
should disclose all material facts necessary to avoid any unwarranted
inferences.5
Another important dimension to your responsibilities is that investment
advisers are “fiduciaries” to their advisory clients – the funds. This means
that advisers have a fundamental obligation to act in the best interests of
their clients and to provide investment advice in their clients’ best interests.
Investment advisers owe their clients a duty of loyalty and good faith.
Advisers to private equity funds should consider some of the following
issues:
Fees/Expenses: As a fiduciary, it is important that private equity advisers
allocate their fees and expenses fairly. A firm should clearly disclose to
clients the fees that it is earning in connection with managing investments
as well as expense allocations between a firm and its client fund. Advisers
should ensure the timeliness, accuracy and completeness of such reporting.
A firm’s disclosure policies and procedures should address the allocation of
their fees and expenses. In cases where two funds managed by the same
investment adviser co-invest in the same investment vehicle, expenses
should be allocated fairly across both funds.
Conflicts of Interest: Private equity fund advisers should identify any
conflicts presented by the type and structure of investments their funds
typically make, and ensure that such conflicts are properly mitigated and
disclosed. Advisers of pooled investment vehicles also have a duty to
disclose material facts to investors and prospective investors and failure to
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do so may constitute fraud.6
As I discussed in my presentation at this conference last year, it is useful to
think about conflicts in the context of the lifecycle of a private equity fund:
The Fund-Raising Stage, the Investment Stage, the Management Stage,
and the Exit Stage. Without replicating what I said there, there are a
number of conflicts that arise at particular stages of that lifecycle.
For example, in the Fund-Raising Stage there are a number of potential
conflicts around the use of third-party consultants such as placement
agents, and potential conflicts between the private equity fund manager,
the fund or its investors, around preferential terms in side-letters for
example. There could also be conflicts over how the fund is marketed,
particularly where marketing materials make representations about returns
on previous investments.
In the Investment Stage, among other potential conflicts, there are
potential opportunities for insider trading. For example, even if the portfolio
company has been taken private, a fund manager serving on its board
could learn material nonpublic information about public companies that the
portfolio company does business with. There may also be opportunities for
insider trading when a private equity firm makes an equity investment in a
public company. Other examples of potential conflicts at the investment
stage include allocation of investment opportunities, and allocation of fees.
In the Management Stage some of the same conflicts described in the
investment stage can also arise . There is also the potential for misleading
reporting to current or prospective investors on PE fund performance by
selectively highlighting only the most successful portfolio companies while
ignoring or underweighting portfolio companies that underperform.
Finally, in the Exit Stage, which is typically set so that the fund has a 10year lifespan, with scope to extend for up to three 1-year periods (subject
to investor approval) there are several other potential conflicts. For
example, the manager could claim to need more time to divest the fund of
any remaining assets, but have an ulterior motive to accrue additional
management fees. Issues surrounding liquidity events also raise potential
conflicts, and valuation of portfolio assets is again an area of potential
concern.
Risk Management: The management of conflicts of interest is just one part
of good risk management. Private equity fund advisers should evaluate
their risk management structures and processes by asking themselves the
following types of questions. 1) Do the business units manage risks
effectively at the fund levels in accordance with the tolerances and
appetites set by the principals and by senior management of the
organization? 2) Are the key control, compliance and risk management
functions effectively integrated into the structure of the organization while
still having the necessary independence, standing and authority to
effectively identify, manage and mitigate risk? 3) Does the firm have an
independent assurance process, whether through an internal audit
department or a third party performing a comparable function by
independently verifying the effectiveness of the firm’s compliance, control
and risk management functions? 4) Do senior managers effectively exercise
oversight of enterprise risk management? 5) Does the organization have
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the proper staffing and structure to adequately set its risk parameters,
foster a culture of effective risk management, and oversee risk-based
compensations systems and the risk profiles of the firm?
Q2 You have spoken extensively about the SEC’s new strategy with regard
to other types of financial institutions of engaging senior management and
corporate boards. Can you explain what that means in regard to private
equity firms?
We at NEP have been seeking to strengthen channels of communications
with senior management across the entire range of entities that we
examine, including broker-dealers, fund complexes, clearing agencies, etc.
In the context of private equity firms, of course there often may not be the
same level or complexity of organization that we might find at, for example,
a major broker-dealer. Instead of meeting with senior officers and a board
of directors, we might instead meet with the principals, senior investment
professionals or general partners of the organization. In all instances, our
expectations of who we would want to engage are tailored to the structure
and nature of the particular entity. But the purposes and goals of this dialog
are largely the same regardless of the titles of the individuals. This helps us
to assess the corporate culture and tone being set at the top of
organizations. It also furthers our goal of improving compliance, by helping
us to determine if the CCO has the full support and engagement of senior
management and the principals (or board of directors, if applicable). In
addition, this enables us to understand the firm’s approach to enterprisewide risk management – e.g., from the perspective of the board of directors
(if one exists) or the principals of the firm, and then from senior
management. This engagement also gives us a strong overall context for
any examination of the firm. Finally, these types of communications help us
indentify risks across the industry or determine areas of focus not just at
the firm but similar registrants, to help us better allocate and leverage our
resources on the most significant risks.
I believe that this approach is good for us, good for CCOs, and good for the
entities that we examine. I hope that you will agree with me that good
ethics and risk management is vital to business success, in private equity
just as much as in any other are of financial services.
There is another reason why meeting with firms’ leadership is especially
important in connection with private equity firms. I have said in front of
other audiences that an effective risk governance framework includes three
critical lines of defense, which are in turn supported by senior management
and the board of directors or the principal owners of the firm.
1. The business is the first line of defense responsible for taking,
managing and supervising risk effectively and in accordance with
laws, regulations and the risk appetite set by the board and senior
management of the whole organization.
2. Key support functions, such as compliance and ethics or risk
management, are the second line of defense. They need to have
adequate resources, independence, standing and authority to
implement effective programs and objectively monitor and escalate
risk issues.
3. Internal Audit is the third line of defense and is responsible for
providing independent verification and assurance that controls are in
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place and operating effectively.
While I understand that some private equity firms have not traditionally
had internal audit functions, I am encouraged to see such functions start to
develop, and I hope to see further development of the internal audit
function. In the meantime, at firms that lack a robust internal audit function
the NEP will place even greater weight on assurance that senior
management and the firm’s principals are supporting each of the other two
levels by reinforcing the tone at the top, driving a culture of compliance and
ethics and ensuring effective implementation of risk management in key
business processes, including strategic planning, capital allocation,
performance management and compensation incentives.
Q3. You mentioned a National Exam Program that will take a more riskbased approach in how it exams registered advisers, can you elaborate on
how that will look in practice?
Let me divide this question into two parts: identifying risks to inform which
candidates to select for examination, and identifying the scope of individual
examinations.
Regarding candidate selection, over the past two years, OCIE has
undertaken a comprehensive set of improvement initiatives designed to
improve the exam process, break down silos, and promote teamwork and
collaboration across the SEC and with other regulatory partners. In
particular, OCIE has implemented a National Exam Program, based around
a risk-focused exam strategy. In 2011we created a centralized Risk
Assessment and Surveillance (“RAS”) Unit to enhance the ability of the
National Exam Program to perform more sophisticated data analytics to
identify the firms and practices that present the greatest risks to investors,
markets and capital formation.
This risk-based approach is partly a matter of wanting to use our resources
as effectively as possible, and partly a matter of necessity, given that the
exam program has only been able to cover a very small portion of the
individuals and entities that register with the Commission, even before new
registrants such as are represented in this audience came within our
purview as a result of the new requirements of the Dodd-Frank Act.
It is not possible for me to discuss very specifically all of the risks we are
currently monitoring, but I can give you an overview of how this process
works. Generally, we rely on four categories of inputs for risk identification.
The first is the National Exam Program itself, this includes the leadership in
each program area (the National Associates) and the observations from our
900 examiners across the nation our tips, complaints and referral system,
and our RAS Unit. The second is other parts of the Commission, particularly
the Division of Risk, Strategy and Financial Innovation, the Enforcement
Division’s Asset Management Unit, the Office of Market Intelligence, and the
Divisions of Trading and Markets and Investment Management. Third are
other regulators, such as sister federal financial regulators, SROs, state
regulators, and foreign regulators. Fourth are external sources such as
trade groups and news media reports.
This process of collecting and inventorying risks is a continual, real-time
process, and feeds into an annual strategic plan for the National Exam
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Program, as well as mid-year assessments of that plan. Based on the risks
identified, we then make a top-down assessment of which firms appear to
exhibit these risks. We also make a bottom-up assessment, based on the
data available for our registrants, as to which firms exhibit a higher risk
profile given their business activities and regulatory history. For example,
leveraging data and information provided in filings and reports made with
the Commission and the SROs, our staff can develop risk profiles of
Registrants, their personnel and their business activities.
This risk-screening process is particularly challenging for us with regard to
private equity funds due to the general lack of data in this area. However,
there are a number of risk characteristics that we are likely to consider, and
we expect that as we gain more experience with this sector of the capital
markets we will become more effective in identifying and assessing risks
related to private equity. Examples of some basic risk characteristics that
we would track include any information from our TCR system, any material
changes in business activities such as lines of business or investment
strategies, changes in key personnel, outside business activities of the firm
or its personnel, any regulatory history of the firm or its personnel,
anomalies in key metrics such as fees, performance, disclosures when
compared to peers or to previous periods, and possible financial stress or
weaknesses.
Regarding the application of risk-based analysis to examination execution,
we seek to conduct robust pre-exam work and due diligence, leveraging
data from the examination selection process so that we can have focused
document requests and interviews that hone in on higher risk areas. The
National Exam Program is also working with all areas of the Commission,
particularly the Divisions of Investment Management, Enforcement, and
Risk, Strategy and Financial Innovation – to use data and data analytics to
target specific risk areas.
In general, the fundamental questions that we are seeking to answer in
most examinations are these: Is the firm’s process for identifying and
assessing problems and conflicts of interest that may occur in its activities
effective? Is that process likely to identify new problems and conflicts that
may occur as the future unfolds? How effective and well-managed are the
firm’s policies and procedures, as well as its process for creating and
adapting those policies and procedures, in addressing potential problems
and conflicts?
Some of the risk areas regarding private equity that might be considered
during an examination include these:
a. What is the Fund strategy? Does the Fund control portfolio companies
or hold only minority positions? Is the strategy to invest with other
firms or alone? Does strategy make general sense? Are investments
in easily understandable companies?
b. How clear are investor disclosures around ancillary fees (particularly
those charged to portfolio companies), management fee offsets and
allocation of expenses? How robust are the processes to ensure
compliance with those disclosures?
c. Does the firm have a complicated set of diverse products? If so, how
are inter-product conflicts managed? These conflicts can arise, for
instance, from two products investing in different parts of a deal’s
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capital structure or products competing for deal allocation.
d. What risks are posed by the life cycle of the funds? For example, for
funds approaching the end of their life fund raising may be necessary,
in which case risks related to claims about the fund’s track record and
valuation should be in focus. Conversely, a “Zombie” adviser who is
unlikely to raise additional capital may be motivated to extract value
from its current holdings, in which case risks related to fees,
expenses and liquidity would come into focus. For a fund at the
beginning of its life cycle, deal allocations between investment
vehicles, or other types of favoritism might be a greater focus of
concern.
e. How sophisticated and reliable are the processes used by the Fund?
Is the valuation process robust, fair and transparent? Are there
strong processes for compliance with the fund’s agreements and
formation documents? Are compliance and other key risk
management and back office functions sufficiently staffed? What is
the quality of investor communications? What is the quality of
processes to ensure conflict resolution in disputes with or among
investors?
f. What is the overall attitude of management towards the examination
process, its compliance obligations, and towards risk management
generally, compared to its peers?
Finally, in our experience with examinations of private funds in the past, we
have found that private fund advisers were slightly more likely to have
significant findings, be cited for a deficiency, or have findings referred to
enforcement, than the non-private fund adviser population. Perhaps this
was attributable, at least in part, to the fact that many private fund
advisers then, like many of your firms now, were new registrants, and
might not have built the compliance systems and controls that other
advisers with longer experience as regulated entities had put in place.
Q4. I suspect conflicts of interest is also part of that risk assessment.
Coming back to your earlier comments on conflicts of interest, can you
elaborate further on what conflicts the agency sees and what firms should
do to address them?
Based on our experience with private equity firms to date, I would like to
mention two factors that seem to be important sources of conflicts of
interest for these firms. First, many conflicts of interest can arise when fund
professionals co-invest with their clients. Second, fund professionals taking
roles at portfolio companies also create a number of conflicts that we will
want to look at. Let me hasten to add that there is nothing inherently
wrong with either of these activities. In particular, fund professionals being
active in portfolio companies is a part of the PE business model. My point is
simply that these activities increase the risk of other conflicts that need to
be managed.
From the examinations of private equity firms that we have conducted to
date, there are a number of conflicts that we have identified that I can
share with you. These include:
a. The profitability of the management company is obviously an
important concern for private equity general partners and this creates
an incentive to maximize fees and minimize expenses. We have seen
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b.
c.
d.
e.
f.
instances where expenses that should have been paid by the
management company were pushed to the funds and have also seen
instances where questionable fees were charged to portfolio
companies. In addition, the same manager may be incentivized to be
opaque with fee disclosures for fear that fund investors may not see
extra fees as being in their best interest and to pursue larger deals
which can absorb more fees. While I have no opinion about the merits
of a management company choosing to offer equity shares to the
public, I would encourage such firms to consider, as part of their risk
management process, whether the short term earnings focus of the
public equity markets could exacerbate these conflicts.
The adviser negotiates more favorable discounts with vendors for
itself than it does for the fund;
The adviser favors side-by-side funds and preferred separate
accounts by shifting certain expenses to its less favored funds;
The adviser puts one or more of the funds that it manages into both
equity and debt of a company, which traditionally have conflicting
interests, especially during initial pricing and restructuring situations;
One or more of a private equity firm’s portfolio companies may hire a
related party to the adviser to perform consulting or investment
banking services. This type of conflict may be remediated through
strong disclosures, but we have seen instances where disclosures
were not very robust;
Conflicts between different business lines, where there may be the
potential for confidential information to be improperly shared. The
traditional means of remediating these types of conflicts is to
maintain effective information barriers, but here too we have seen
weaknesses in private funds’ practices. For example, we have
observed instances of weak or nonexistent controls where the public
and private sides of the adviser’s business hold meetings or telephone
conversations regarding an issuer about which the private side has
confidential information, or poor physical security during business
hours over the adviser’s office space such that employees of
unrelated financial firms that have offices in the same building could
gain access to the adviser’s offices.
Q5.I’m sure everyone here would love to be tested on their ability to
address those conflicts of interest, but for those who don’t, how does a firm
stay off your radar? Or if a firm is selected for an exam, how do they, for a
lack of better words, end the exam as quickly as possible?
The best way to avoid attracting our attention would be to be very
proactive and thoughtful about identifying conflicts, both the ones I have
mentioned as well as others that you are aware of, and remediating those
conflicts with strong policies, procedures and other risk controls, as well as
making sure that your firm has a strong ethical culture from top to bottom.
If your firm is selected for an examination, things are certain to go better if
you are prepared, know how to readily access data that our examiners are
likely to want to see, and have your policies and procedures ready to show
us. Having strong records to document your due diligence on transactions
and on valuations will also help you greatly. It will also be enormously
helpful to you and to us if you can show us that you have documented
ongoing monitoring and testing of the effectiveness of your policies and
procedures. Finally, it is important to be forthcoming about problems.
Nothing could be worse than for us to find a problem, through an
examination or through a tip, referral or complaint, that personnel in your
5/15/2012
Address at the Private Equity International Private Fund Compliance Forum (Carlo V. ... Page 10 of 10
organization knew about but tried to conceal.
1
Rule 206(4)-7. See also the adopting release, Compliance Programs of
Investment Companies and Investment Advisers, Advisers Act Release No.
2004, 68 Fed. Reg. 74,714 (Dec. 17, 2003), for a full discussion of the
“Compliance Rule.”
2
Rule 204-2.
3
Rule 204A-1.
4
Rule 206(4)-1.
5
Information for Newly-Registered Investment AdvisersInformation Sheet,
available at http://www.sec.gov/divisions/investment/advoverview.htm
6
Rule 206(4)-8.
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5/15/2012
Speech by SEC Staff: What SEC Registration Means for Hedge Fund Advisers
Page 1 of 8
Home | Previous Page
Speech by SEC Staff:
What SEC Registration Means for Hedge Fund Advisers
by
Norm Champ
Deputy Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
New York City Bar
May 11, 2012
Thank you for inviting me to speak to you today. I am very pleased to be
here. As you know, the views that I express here are my own and do not
necessarily reflect those of the Commission or my colleagues on the staff of
the Commission.
Today I will cover the following three topics: First, I will briefly discuss the
provisions of the Dodd-Frank Act that are applicable to private fund
advisers, specifically hedge fund advisers, and what the Commission staff
and the National Examination Program have been doing to prepare for
these new registrants.1 Second, I will highlight several key requirements
under the Advisers Act as well as briefly discuss some important
considerations for newly registered hedge fund advisers.2 Specifically, I will
focus on the following three areas: fees, conflicts of interest and risk
management. Third, I will cover certain areas for management at hedge
fund advisers to consider.
Dodd-Frank Requirements for Advisers and the National
Examination Program
Dodd-Frank Requirements
Registration. Title IV of the Dodd-Frank Act eliminated the private adviser
exemption.3 These private advisers, including advisers to hedge funds and
private equity funds, are subject to the same registration, regulatory
oversight and other requirements, such as examination, that apply to other
SEC regulated investment advisers. These new registrants were required to
register with the Commission by March 30, 2012.4
We at the NEP have been monitoring the Form ADV applications of new
advisers as they have been filed. As of early April, there were
approximately 4,000 investment advisers that manage one or more private
funds registered with the Commission, of which 34% (more than 1,350)
registered since the effective date of the Dodd-Frank Act, July 21, 2011.
We estimate that this represents a 52% increase in registered private fund
http://www.sec.gov/news/speech/2012/spch051112nc.htm
5/15/2012
Page 2 of 8
advisers; 32% of all advisers currently registered with the Commission
report that they advise at least one private fund. Of the registered private
fund advisers, approximately 7% (284) are domiciled in a foreign country;
most of these (136) are in the United Kingdom. Registered private fund
advisers report on Form ADV that they advise approximately 30,000 private
funds with total assets of $8 trillion, which is 16% of total assets managed
by all registered advisers.
Based on available information, we believe that 48 of the 50 largest hedge
fund advisers in the world are now registered with the Commission.
Fourteen of these largest hedge fund advisers are new registrants.
New Reporting Obligations. Pursuant to the Dodd-Frank Act, the SEC
also adopted a rule requiring registered investment advisers (including
advisers to hedge funds, private equity funds and liquidity funds) with at
least $150 million in private fund assets under management to periodically
file a new reporting form, Form PF.5 The information reported in Form PF
will be used by the Financial Stability Oversight Council (FSOC) to monitor
risks to the U.S. financial system and by the SEC to conduct risk
assessments of private fund advisers. The type of information that is
required to be disclosed on Form PF and the frequency of filing depends on
whether the investment adviser is an adviser to private equity funds, hedge
funds6 or liquidity funds and a “large private fund adviser,” which for a
hedge fund adviser is an adviser with at least $1.5 billion in hedge fund
assets under management.7
All investment advisers required to file a Form PF must provide basic
information in Sections 1a and 1b. Section 1a requires indentifying
information about the adviser and all related persons whose data is
included, the large trader identification number, if any, the regulatory
assets under management and net assets under management broken out
by types of funds advised, and any assumptions made in responses to any
question in Form PF. Section 1b requires information for each advised fund,
including identifying information, gross and net asset values, investor
concentration, borrowing and liquidity, and performance. There are also
questions regarding a fund’s investment in other private funds and parallel
managed accounts. Hedge fund advisers must disclose information about
investment strategies, identification of significant credit risk, and trading
and clearing practices in Section 1c.
Large private fund advisers must provide more detailed information than
smaller advisers. Section 2a of Form PF requires that large hedge fund
advisers disclose aggregate information regarding their hedge funds,
including information regarding exposures by asset class, geographical
concentration of investments held by funds and the monthly value of
portfolio turnover by asset class. Section 2b requires that registered
advisers that are large private fund advisers and advise at least one
“qualifying hedge fund,” a hedge fund with a net asset value of at least
$500 million, disclose information for each qualifying hedge fund relating to
fund exposures, portfolio liquidity, unencumbered cash holdings,
identification of the fund’s base currency, collateral practices with
significant counterparties, risk metrics, market risk, concentration of
positions, and trading and financing for each such hedge fund.8
Most hedge fund advisers must begin filing Form PF following the end of
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Page 3 of 8
their first fiscal year or fiscal quarter, as applicable, to end on or after
December 15, 2012. Hedge fund advisers, with at least $5 billion in assets
under management attributable to hedge funds, must begin filing Form PF
following the end of their first fiscal year or quarter, as applicable, to end
on or after June 15, 2012.
Smaller hedge fund advisers will be required to file only annually within 120
days of the end of their fiscal year. Large hedge fund advisers will be
required to file quarterly, within 60 days after the end of each fiscal
quarter.
National Examination Program’s Plan for New Registrants
We at the NEP have been evaluating the unique risks presented by hedge
funds and private equity funds based on a number of factors, including our
past examination experience with these types of registrants and staff
expertise. We are also looking to add staff with expertise in these areas.
We are evaluating the new information that we will be collecting on Form PF
to help us identify where and how best to allocate our examination
resources across existing and new registrants. We are also working to
ensure the integrity of the confidential information internally, while also
developing processes to ensure that examiners are given access to
information that will provide them with a better understanding of an entity
and allow for better scoping of exams.
Our strategy for these new registrants will include (i) an initial phase of
industry outreach and education like today (sharing our expectations and
perceptions of the highest risk areas), (ii) followed by a coordinated series
of examinations of a significant percentage of the new registrants that will
focus on the highest risk areas of their business and help us to risk rate the
new registrants, and (iii) culminating in the publication of a series of “after
action” reports, reporting to the industry on the broad issues, risks, and
themes identified during the course of the examinations.
All of this will be planned and executed in consideration of the substantial
existing responsibilities of the examination program with the goal, as
always, of ensuring that we are optimally allocating our resources to fulfill
the OCIE mission to improve compliance, prevent fraud, inform policy, and
monitor industry-wide and firm-specific risks.
Important Considerations for Registered Hedge Fund Advisers
Obligations under the Advisers Act
Registration with the SEC imposes important obligations on newly
registered advisers. Upon registration, advisers to hedge funds must
comply with all of the applicable provisions of the Advisers Act and the rules
that have been adopted by the SEC. These provisions require, among other
things, adopting and implementing written policies and procedures,
designating a chief compliance officer, maintaining certain books and
records, filing annual updates of Form ADV, implementing a code of ethics
and ensuring that advertising and performance reporting complies with
regulatory rules. In addition, once registered, advisers become subject to
examinations by the SEC.
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Page 4 of 8
Some of the compliance obligations include:
1. The “Compliance Rule” requires registered advisers, including hedge
fund advisers, to (a) adopt and implement written policies and
procedures reasonably designed to prevent violation of the Advisers
Act and rules that the Commission has adopted under the Advisers
Act; (b) conduct a review, no less than annually, of the adequacy of
the policies and procedures; and, (c) designate a chief compliance
officer who is responsible for administering the policies and
procedures.9
2. The “Books and Records Rule” requires registered advisers, including
hedge fund advisers, to make and keep true, accurate and current
certain books and records relating to the firm’s investment advisory
business. Generally, most books and records must be kept for five
years from the end of the year created, in an easily accessible
location.10
3. Form ADV Updates—Rule 204-1 of the Advisers Act requires
registered advisers to complete and file an annual update of Part 1A
and 2A of the Form ADV registration form through Investment
Advisers Registration Depository (IARD). Advisers must file an annual
updating amendment to Form ADV within 90 days after the end of the
firm’s fiscal year. In addition to annual filings, amendments must
promptly be filed whenever certain information contained in the Form
ADV becomes inaccurate.
4. The “Code of Ethics Rule” requires a registered adviser to adopt a
code of ethics which sets forth the standards of business conduct
expected of the adviser’s supervised persons and must address the
personal trading of their securities.11
5. The “Advertising Rule” prohibits advertisements by registered
advisers that are false or misleading or contain any untrue
statements of material fact.12 Advertising, like all statements made to
clients or prospective clients, is subject to the general prohibition on
fraud under section 206 of the Advisers Act as well as other antifraud provisions under the federal securities laws. In addition to
specific regulatory requirements, SEC Staff also has indicated its view
that, if you advertise performance data, the firm should disclose all
material facts necessary to avoid any unwarranted inferences.13
These are just some of the obligations for registered advisers under the
Advisers Act and rules thereunder.
Special Considerations for Hedge Fund Advisers
It is important to note that investment advisers are “fiduciaries” to their
advisory clients—the funds. This means that advisers have a fundamental
obligation to act in the best interests of their clients and to provide
investment advice in their clients’ best interests. Investment advisers owe
their clients a duty of loyalty and good faith. Advisers to hedge funds
should consider some of the following issues:
Fees/Expenses: As a fiduciary, it is important that hedge fund advisers
allocate their fees and expenses fairly. A firm should clearly disclose to
clientss the fees that it is earning in connection with managing investments
as well as expense allocations between a firm and its client funds. Advisers
should ensure the timeliness, accuracy and completeness of such reporting.
5/15/2012
Page 5 of 8
A firm’s disclosure policies and procedures should address the allocation of
their fees and expenses. Particular caution should be exercised when deals
are undertaken among funds under common management and affiliated
entities. In cases where two funds managed by the same investment
adviser co-invest in the same investment vehicle, expenses should be
allocated fairly across both funds.
Conflicts of Interest: Hedge fund advisers should identify any conflicts
presented by the type and structure of investments their funds typically
make, and ensure that such conflicts are properly mitigated and disclosed.
Advisers of pooled investment vehicles also have a duty to disclose material
facts to investors and prospective investors and failure to do so may
constitute fraud.14 Examples of such conflicts are an adviser who failed to
tell clients that it would receive additional commissions if they switched
from one series of a fund to another15 and an adviser who failed to disclose
to clients its investment of client funds in entities in which the advisers’
principals had interests.16 Fee structures can also lead to conflicts of
interest. For example, conflicts of interest may arise when an adviser has
the incentive to allocate trades to the hedge fund at the expense of
affiliated mutual funds because of the opportunity for the investment
adviser to earn greater profits from its management of hedge funds.
Risk Management: The management of conflicts of interest is just one
part of good risk management. Hedge fund advisers should evaluate their
risk management structures and processes by asking themselves the
following types of questions. 1) Do the business units manage risks
effectively at the product and asset class levels in accordance with the
tolerances and appetites set by the board and senior management of the
organization? 2) Are the key control, compliance and risk management
functions effectively integrated into the structure of the organization while
still having the necessary independence, standing and authority to
effectively identify, manage and mitigate risk? 3) Does the firm’s internal
audit processes independently verify the effectiveness of the firm’s
compliance, control and risk management functions? 4) Do senior
managers effectively exercise oversight of enterprise risk management? 5)
Does the organization have the proper staffing and structure to adequately
set its risk parameters, foster a culture of effective risk management, and
oversee risk-based compensations systems and the risk profiles of the firm?
My Ten Suggested Takeaways for Registered Advisers to Hedge
Funds
1. Review your control and compliance policies and procedures
annually. As a new registrant, you should undertake a
comprehensive review of your operations to identify any gaps to your
control and compliance policies and procedures. Make sure that they
work for your organization. Update them if you have changes in your
firm’s activities or products. Assign responsibility to specific
persons/positions for maintaining the procedures. In addition to
reviewing policies and procedures annually, which is required under
Rule 206(4)-7, you should periodically test and verify procedures. For
example, test and verify your valuation procedures and make sure
your firm is consistent and following its procedures, especially for
complex or illiquid securities.
2. Assess and prepare for Form PF requirements. Form PF may
5/15/2012
3.
4.
5.
6.
7.
8.
9.
10.
Page 6 of 8
require voluminous data. Hedge fund advisers may find that they do
not maintain or collect all of the information that is required. Much of
the information may be located in various places throughout the firm
and some effort may be required to collect and report the
information. Therefore, you need to begin now to identify the sources
within the business where the data resides, determine how to best
capture such data, collect and compile the data, and assure its
accuracy.
Identify risks. You should identify risk. Brainstorm any factors that
create risk exposure for your clients and your firm.
Enhance your expertise. Make sure your employees are
knowledgeable about their work and that you have enough expertise
to oversee what goes on. Continue to update and train your
employees about new rules and procedures applicable to your firm
and its products.
Verify client assets. Be aware that examiners may verify some or
all of your assets and the possibility that the examination staff will
reach out to third parties and possibly clients in this process. Make
sure your organization has done adequate due diligence in connection
with third parties, including consultants and service providers.
Get rid of any silos, identify conflicts. Get rid of silos and open
communication among divisions and offices where appropriate and
legally possible. I realize that in some situations barriers between
certain areas of a firm are required legally. In particular, identify any
situations where your interests may conflict with those of your clients.
Make sure you manage those conflicts and disclose them to your
clients.
Provide clear, complete, and accurate disclosure in
performance and advertising. Make sure you’ve made complete
and accurate disclosure about performance, arrangements, fees,
affiliates and affiliated transactions. Review marketing documents,
client communications and questionnaire responses to ensure
information is truthful, accurate and not misleading now that the
JOBS Act permits general solicitation. Verify that fees are calculated
correctly and accurately disclosed. Make sure you can trust the
information, both external and internal, upon which you rely.
Verify portfolio management compliance. Review client account
holdings for appropriateness. Review trades for unusual performance
relative to peers and markets. Compare trades to restricted lists and
determine if trades were made ahead of publicly available news or
research reports.
Address your complaints. For complaints, make sure your
procedures provide adequate instructions on handling them, and
follow up to make sure they have been resolved.
Check your IT security. Check your IT security to ensure that
clients’ assets and information are not at risk.
1
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No.
111-203, 124 Stat. 1376 (2010).
2
Unless otherwise noted, when we refer to the Advisers Act, or any
paragraph of the Advisers Act, we are referring to 15 U.S.C. § 80b of the
United States Code, at which the Advisers Act is codified, and when we
refer to rule 203-1, rule 204(b)-1, rule 204-2, rule 204A-1, rule 204-4, rule
5/15/2012
Page 7 of 8
206, rule 206(4)-1, or rule 206(4)-7, or any paragraph of these rules, we
are referring to 17 C.F.R. § 275.203-1, 17 C.F.R. § 275.204(b)-1, 17 C.F.R.
§ 275.204-2, 17 C.F.R. § 275.204A-1, 17 C.F.R. § 275.206, 17 C.F.R. §
275.206(4)-1, or 17 C.F.R. § 275.206(4)-7, respectively, of the Code of
Federal Regulations (“C.F.R.”), in which these rules are published.
3
Section 403 of the Dodd-Frank Act. Title IV repealed the “private adviser
exemption” contained in section 203(b)(3) of the Advisers Act on which
many advisers, including those to many hedge funds, private equity funds
and venture capital funds, relied in order to avoid registration under the
Advisers Act. The adopting release, Rules Implementing Amendments to
the Investment Advisers Act of 1940, Release No. IA-3221 (Jun. 22, 2011),
76 Fed. Reg. 42950 (Jul. 19, 2011) is available at:
http://www.sec.gov/rules/final/2011/ia-3221.pdf.
4
Rule 203-1(e).
5
Rule 204(b)-1. The adopting release, Reporting by Investment Advisers to
Private Funds and Certain Commodity Pool Operators and Commodity
Trading Advisors on Form PF, Release No. IA-3308 (Oct. 31, 2011), 76 Fed.
Reg. 71128 (Nov. 16, 2011), is available at:
http://www.sec.gov/rules/final/2011/ia-3308.pdf.
6
Form PF defines a “hedge fund” generally as any private fund (other than
a securitized asset fund) that (a) pays a performance fee or allocation
calculated by taking into account unrealized gains (other than a fee or
allocation the calculation of which may take into account unrealized gains
solely for the purpose of reducing such fee or allocation to reflect net
unrealized losses); (b) may borrow an amount in excess of one-half of its
net asset value (including any committed capital) or may have gross
notional exposure in excess of twice its net assets value (including any
committed capital); or (c) may sell securities or other assets short or enter
into similar transactions (other than for the purpose of hedging currency
exposure or managing duration). Form PF: Glossary of Terms, at 4,
available at http://www.sec.gov/rules/final/2011/ia-3308-formpf.pdf.
7
Form PF defines a “large hedge fund adviser” generally as an adviser and
its related persons who collectively, have at least $1.5 billion in hedge fund
assets under management as of the last day of any month in the adviser’s
fiscal quarter immediately preceding its most recently completed fiscal
quarter. Id. at 5.
8
Form PF defines a “qualifying hedge fund” as one that has a net asset
value (individually or in combination with any feeder funds, parallel funds
and/or dependent parallel managed accounts) of at least $500 million as of
the last day of any month in the fiscal quarter immediately preceding the
adviser’s most recently completed fiscal quarter. Id. at 8.
9
Rule 206(4)-7. The adopting release, Compliance Programs of Investment
Companies and Investment Advisers, Release No. IA-2004, 68 Fed. Reg.
74,714 (Dec. 17, 2003)(“Compliance Programs Release”), is available at
http://www.sec.gov/rules/final/ia-2204.htm
10
Rule 204-2.
5/15/2012
11
Rule 204A-1.
12
Rule 206(4)-1.
Page 8 of 8
13
Information for Newly-Registered Investment Advisers Information
Sheet, available at
http://www.sec.gov/divisions/investment/advoverview.htm
14
Rule 206(4)-8.
15
In re Valentine Capital Asset Mgmt., Release No. IA - 3090, 2010 WL
3791924 (Sept. 29, 2010) (settled administrative proceeding).
16
In re Sierra Fin. Advisors, LLC, Release No. IA - 3087, 2010 WL 3725370
(Sept. 23, 2010) (settled administrative proceeding).
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the time has come to reconsider the gutfreund standard

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