Sep. 2, 2021

Five Lessons Hedge Fund Managers Can Learn From SEC Enforcement Actions

Hedge fund managers must comply with numerous requirements under the securities laws, as well as related rules and regulations. In many cases, the laws simply state that managers must do – or not do – certain things without specifying the exact steps they should take, policies they should implement, etc. The SEC may provide additional guidance, such as risk alerts, that fleshes out those requirements, but it does not always do so. There is another valuable source of compliance insights available, however: the SEC’s enforcement actions. The cases that the Enforcement Division brings against private fund managers and others are essentially cautionary tales, illustrating what not to do and the consequences of making those mistakes. By reviewing enforcement actions, managers can learn important lessons that they can then apply to their own compliance programs. In light of the upcoming Labor Day holiday in the U.S., the Hedge Fund Law Report is highlighting five articles from its archives on SEC enforcement actions that provide valuable lessons for hedge fund managers. These actions focus on hot-button areas in which managers continually face heightened scrutiny, including compliance policies and procedures; disclosure; fees and expenses; conflicts of interest; and valuation. Next week (the week starting September 6, 2021), the HFLR will resume its normal weekly publication.

Lesson #1: Tailor Policies and Procedures to Manager’s Risks and Operations

Rule 206(4)‑7 under the Investment Advisers Act of 1940 (Advisers Act) – the so‑called “compliance rule” – requires investment advisers to, among other things, adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the SEC’s rules. In other words, fund managers must have compliance programs. Moreover, the SEC has made it very clear that it expects those compliance programs to be specifically tailored to a manager’s business, including its strategy, structure and specific practices. Failing to customize the compliance program, such as by simply adopting an off-the-shelf program, can result in enforcement actions. For example, the SEC initiated enforcement actions against several hedge fund managers for failing to maintain policies and procedures tailored to the risks of their respective operations. Although the areas of deficiency in question vary widely, the respondents all found themselves in trouble for allegedly failing to maintain and enforce “reasonably designed” and appropriately tailored policies and procedures. To help readers adopt best practices and insulate themselves against similar enforcement actions, the HFLR interviewed legal professionals with expertise in regulatory enforcement matters. This article presents the insights from those interviews, along with former SEC Chair Jay Clayton’s thoughts on the matter. See our three-part series on tailoring a compliance program: “Why Fund Managers Should Customize” (Jul. 16, 2020); “What Fund Managers Should Consider” (Jul. 23, 2020); and “When Fund Managers Should Review and Update” (Jul. 30, 2020).

Lesson #2: Self‑Reporting, Remediation and Cooperation Can Help Minimize or Avoid Penalties

Despite a fund manager’s best efforts, violations of the securities laws may still occur. How the manager responds when it discovers those violations, however, can have a profound impact on the consequences it may face. For example, if the manager voluntarily reports the violations to the SEC; takes appropriate remedial steps to correct the violations and prevent future infractions; and cooperates with the SEC staff, it may avoid a harsh penalty – or even any penalty at all. For instance, the SEC’s settlement order (Order) against an investment adviser alleged that the adviser failed to disclose its right to recapture certain fees that it waived or expenses that it reimbursed to four funds it advised and the fact that fee and expense recaptures caused those funds to exceed certain expense caps. Notably, the adviser escaped a penalty by self-reporting, taking remedial action and cooperating with the SEC. This article discusses the adviser’s alleged misconduct and the other relevant provisions of the Order. For more on the benefits and risks of self-reporting, see our two-part series “Why, When and How Fund Managers Should Self-Report Violations to the SEC”: Part One (Jan. 10, 2019); and Part Two (Jan. 17, 2019).

Lesson #3: Strictly Adhere to Disclosed Fee and Expense Calculation Methodologies

Fees and expenses is a perennial area of focus for the SEC, including adequate disclosure, proper calculation and appropriate allocation of fees and expenses. For example, an SEC enforcement action against an investment adviser and its principal is a critical reminder to fund managers of the importance of, among other things, ensuring that fees and expenses are calculated precisely in accordance with the methodologies disclosed to investors. The SEC entered a settlement order against the adviser and its principal for their failures to properly calculate fees and expense reimbursements as disclosed in their fund documents and SEC filings, and to make adequate disclosure regarding related-party-transaction conflicts of interest. Without admitting or denying the SEC’s allegations, the respondents agreed to be censured; to cease and desist from future violations; and to pay roughly $2.2 million in fines, disgorgement and interest. This article summarizes the SEC’s findings and the terms of the settlement order. For coverage of another SEC enforcement action involving fees and expenses, see “SEC Fines Fund Manager for Failing to Equitably Allocate Fees and Expenses to Its Affiliate Funds and Co‑Investors” (Jun. 6, 2019). See also our three-part series on fee and expense allocation practices: “Practices Fund Managers Should Avoid” (Aug. 25, 2016); “Flawed Disclosures to Avoid” (Sep. 8, 2016); and “Preventing and Remedying Improper Allocations” (Sep. 15, 2016).

Lesson #4: Properly Disclose Conflicts of Interest

Another topic that is always top-of-mind for the SEC is conflicts of interest – especially proper disclosure of those conflicts. In fact, a substantial portion of the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers focuses on the appropriate identification and disclosure of conflicts of interest in accordance with an adviser’s fiduciary duty. See our three-part series on navigating the interpretation: “What It Means to Be a Fiduciary” (Oct. 17, 2019); “Six Tools to Systematically Identify Conflicts of Interest” (Oct. 24, 2019); and “Three Tools to Systematically Monitor Conflicts of Interest” (Nov. 7, 2019). For example, in a settled SEC enforcement proceeding, the SEC claimed that an investment adviser used clients’ soft dollars to purchase investment software from a company controlled by the firm’s chief investment officer without disclosing that conflict of interest to its clients. This article analyzes the SEC settlement order. For other enforcement actions involving undisclosed conflicts of interest, see “SEC Sanctions Adviser for Undisclosed Conflicts and Misleading Form ADV” (Jun. 3, 2021); “Advisers Must Disclose Conflicts of Interest and Heed the Terms of Client Agreements, or Risk Stiff SEC Sanctions” (Jun. 28, 2018); “Failure to Disclose Fees Received From Third-Party Broker-Dealers May Result in Significant Penalties for Investment Advisers” (Apr. 13, 2017); and “Advisers Investing Client Assets in Affiliated Funds Could Face SEC Scrutiny for Conflicts of Interest” (Oct. 13, 2016).

Lesson #5: Do Not Ignore Red Flags Indicating Misconduct

A fund manager’s policies and procedures should provide for remedial steps if red flags reveal violations or misconduct, as well as the consequences for the employees involved, such as warnings, retraining, disgorgement of any profits or termination. If a manager becomes aware of red flags and does nothing, the misconduct will continue – and the manager may find itself subject to an enforcement action. For example, the SEC issued settlement orders against an investment adviser and its chief financial officer (CFO) in connection with alleged insider trading and fraudulent valuation practices by several of the adviser’s former portfolio managers. The SEC charged that, by virtue of the portfolio managers’ misconduct, the adviser violated the antifraud and compliance provisions of the federal securities laws. In addition, the CFO allegedly failed to supervise the portfolio managers, including by missing or ignoring three red flags regarding the valuation of the fund’s assets. This article analyzes the terms of the settlements. For more on the importance of responding to red flags, see “How to Avoid Five Common Duty to Supervise Traps: Respond to Red Flags; Implement Reasonable Policies and Procedures; and Conduct Adequate Training (Part Three of Three)” (Sep. 20, 2018).