SEC and Registered Hedge Fund Investment Advisors: Report by the GAO

This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds.  The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

There are many important items in the except below.  While many hedge fund investment advisors are no longer registered with the SEC because the hedge fund registration rule was vacated by a circuit court judge, many hedge fund managers are registered.  As I have done with certain previous articles (see SEC Emphasizes IA Compliance for Hedge Funds), I believe that the following excerpt should be required reading for all investment advisor chief compliance officers (CCOs). The article discusses, the areas which the SEC examiners are likely to emphasize during an examination.  Such areas include: soft dollars, prime brokerage, calculation of the performance fee, valuation of hedge fund assets, and custody of hedge fund assets.

The report also notes that almost 92% of hedge funds receive a deficiency letter after an examination.  Tho central areas where hedge funds were deficient are stated in the report:

According to SEC officials, the 321 hedge fund advisers’ examinations found that these advisers had the greatest deficiencies in the following areas: (1) information disclosures, reporting, and filing–e.g., private placement memorandum was outdated; (2) personal trading–e.g., quarterly reports were not filed or filed late for personal trading accounts; and (3) compliance rule–e.g., policies and procedures were inadequate to address compliance risks. Examiners also cited concerns with performance advertising and marketing of portfolio management, brokerage arrangement and execution, information processing and protection, safety of clients’ funds and assets, pricing of clients’ portfolios, trade allocations, and anti- money laundering.

Accordingly, registered hedge fund investment advisors and their CCOs will need to be particularly aware of these area when they prepare for a SEC examination.

****

SEC Examinations of Hedge Fund Advisers Identified Areas of Concern:

In fiscal year 2006, SEC took additional steps to oversee hedge fund advisers by creating an examination module specifically for hedge fund advisers and providing training for examiners in hedge fund-related topics. The new examination module outlines how the examination of a hedge fund adviser generally begins with an analysis of the adviser’s compliance program and the work of its chief compliance officer and uses a control scorecard as a guide. As part of this review of compliance programs, examiners inspect the typical activities of advisers and are expected to obtain a clear understanding of all activities of affiliates and how these activities may affect or conflict with those of the hedge fund adviser being examined. Examiners are to focus primarily on the following activities during their examinations of hedge fund advisers:

  • portfolio management;
  • brokerage arrangements and trading;
  • personal trading by access persons;
  • valuation of positions and calculations of net asset value;
  • leverage;
  • safety of clients’ and funds’ assets;
  • performance calculations;
  • fund investors and capital introduction;
  • violations of domestic or foreign laws that may directly harm fund investors or other market participants, or cause harm to prime brokers;
  • books and records, fund financial statements, and investor reporting;
  • chief compliance officer, compliance culture, and program; and:
  • boards of directors for offshore funds (fiduciary duties to shareholders of the hedge funds and consistent disclosure to its investors).

In preparation for the registration of hedge fund advisers and because SEC does not have a dedicated group of examiners that focus on hedge funds, SEC and hedge fund industry officials noted the need for more experience and ongoing training of examiners on hedge funds’ investment strategies and complex financial instruments. SEC developed a specialized training program to better familiarize its examiners with the operation of hedge funds to improve effectiveness of examinations of hedge fund advisers. In that regard, from October 2005 through October 2006, SEC held about 20 examiner training sessions on hedge fund-related topics. Industry participants were instructors in many of these sessions. These sessions covered topics such as hedge fund structure, hedge fund investment vehicles, identification and examination of conflicts of interests at hedge fund advisers, risk management, prime brokerage, valuation, current and future regulation, examination issues, and investment risk. SEC continues to offer hedge fund training to examiners and other staff on an ongoing voluntary basis.

SEC uses a risk-based examination approach to select investment advisers for inspections. Under this approach, higher-risk investment advisers are examined every 3 years.* One of the variables in determining risk level is the amount of assets under management. SEC officials told us that most hedge funds, even the larger ones, do not meet the dollar threshold to be automatically considered higher-risk. As part of the overall risk-based approach for conducting oversight of investment advisers, SEC uses a database application called Risk Assessment Database for Analysis and Reporting (RADAR), to identify the highest-risk areas designated by examiners and to develop and recommend regulatory responses to address these higher-risk areas. In fiscal year 2006, RADAR identified a number of hedge fund-related risk areas, which although not exclusive to hedge funds require additional regulatory attention, including the following:

  • soft dollars (e.g., paying for a hedge fund’s office space without disclosing it);
  • market manipulation (e.g., the dissemination of false information to inflate the price of a stock);
  • hedge fund custody and misappropriation (e.g., theft of hedge fund assets by its advisers);
  • complexity of hedge fund products and suitability (e.g., inadequacy of policies and procedures to assess the complexity of financial instruments and the suitability of products for investors);
  • prime brokerage relationships (e.g., potential conflicts of interest where prime brokers give hedge fund clients–who often pay large dollar amounts of commissions–priority over non-hedge fund clients regarding access to information/research);
  • performance fees (e.g., incorrect calculation of performance fees);
  • hedge fund valuation (e.g., inadequate policies and procedures to ensure that asset valuations are accurate);
  • fund of funds’ conflicts of interest (e.g., conflicts of interest between fund of funds advisers and their recommendation to a fund of hedge fund to invest in certain hedge funds);
  • insider trading (e.g., trading on nonpublic information); and:
  • hedge fund suitability (e.g., inadequate policies and procedures to ensure the financial qualification of investors).

According to SEC officials, they plan to address these risks by primarily focusing on these areas during subsequent examinations.

As part of its fiscal year 2006 routine inspection program, SEC conducted examinations of 1,346 registered investment advisers, of which 321 were believed to have involved hedge fund advisers. SEC used its new hedge fund module, along with other modules as appropriate, to conduct the 321 examinations, which included 5 of the largest 78 U.S. hedge funds.** According to SEC officials, the 321 hedge fund advisers’ examinations found that these advisers had the greatest deficiencies in the following areas: (1) information disclosures, reporting, and filing–e.g., private placement memorandum was outdated; (2) personal trading–e.g., quarterly reports were not filed or filed late for personal trading accounts; and (3) compliance rule–e.g., policies and procedures were inadequate to address compliance risks. Examiners also cited concerns with performance advertising and marketing of portfolio management, brokerage arrangement and execution, information processing and protection, safety of clients’ funds and assets, pricing of clients’ portfolios, trade allocations, and anti- money laundering.

In our review of 9 of the 321 examinations of hedge fund advisers, we found that examiners cited deficiencies in 8 of these examinations. Deficiencies found included all of the above mentioned categories except for trade allocations. For example, examiners identified concerns in 5 of the examinations regarding disclosures and in one of the examinations, for instance, the hedge fund adviser’s marketing package did not disclose any material conditions, objectives, or investment strategies used to obtain the performance result portrayed. [HFLB note, please see Requirements for Hedge Fund Performance Reporting.]  In another examination, the hedge fund adviser failed to adequately disclose to investors that a conflict of interest may be present when the hedge fund adviser places transactions through broker-dealers who have invested in the hedge fund.

According to SEC officials, 294 (or approximately 92 percent) of the 321 hedge fund advisers examined received deficiency letters.*** Some 292 of them provided satisfactory responses to SEC that they had taken or would take appropriate corrective actions. Such actions can include advisers implementing policies and procedures to address deficiencies. Those hedge fund advisers that do not take or propose to take corrective actions for a material deficiency may be referred to SEC’s Division of Enforcement (Enforcement) for enforcement actions. According to SEC, 23 of the 321 examinations resulted in enforcement referrals, and most of these referrals regarded situations in which the adviser appeared to have engaged in fraud that harmed its clients.

* See GAO, Securities and Exchange Commission: Steps Being Taken to Make Examination Program More Risk-Based and Transparent, GAO-07-1053 (Washington, D.C.: Aug. 14, 2007).

** SEC did not identify the largest U.S. hedge funds cited in industry reports prior to conducting these hedge fund adviser examinations. Twenty-seven of the largest hedge fund advisers were examined by SEC from fiscal years 2005 to 2007.

*** For non-hedge fund investment advisers, the percentage that received a deficiency letter is 84 percent.

Other HFLB articles include:

1 thought on “SEC and Registered Hedge Fund Investment Advisors: Report by the GAO

  1. Pingback: GAO Report Provides Insight into Potential Future Hedge Fund Regulation | Hedge Fund Law Blog

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.