The SEC continues its enforcement efforts relating to hedge funds and private equity funds. In recent remarks, Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit (AMU), indicated that the number of cases involving private equity will increase. Karpati stated that areas of focus include (1) misrepresentations concerning the value of assets, (2) insider trading and (3) other fraudulent practices. Recent SEC enforcement actions against private funds and their managers demonstrate that enforcement in these areas is robust and likely to continue throughout 2013.
Continued Enforcement Regarding Fund Valuation
As discussed in Kaye Scholer’s Summer 2012 Investment Funds Newsletter, the SEC is aggressively policing asset valuation issues—a trend that has continued into 2013 and that is anticipated to continue. In his recent remarks, Karpati stated, “the temptation to overvalue assets to boost compensation has emerged repeatedly in enforcement cases. The AMU is focused on detecting fraudulent or weak valuation practices—including lax valuation committees ... and the failure to follow a fund’s stated valuation procedure.” Karpati further stated, “[f]unds need to show performance metrics that will make the fund attractive to new investors and keep current investors satisfied.” The AMU division has demonstrated a willingness to take on cases with complex and technical issues, specifically ones involving illiquid asset valuations.
Allegations regarding whether the valuation is “accurate” or even “fair” are difficult to prove. As a result, the SEC has favored allegations about adherence to internal policies or other representations regarding valuation practices. For example, on March 11, 2013, the SEC announced a $2.8 million settlement with a fund it alleged disseminated misleading information about its valuation methods. In SEC v. Oppenheimer Asset Mgmt., Inc., the SEC alleged that, while the fund’s marketing materials represented that the funds were valued “based on the underlying managers’ estimated values,” in reality, the portfolio manager actually valued the fund’s largest investment at a significant markup to the underlying managers’ estimated value.
This change made the fund’s performance appear significantly better as measured by its internal rate of return. Regarding this settlement, Acting Enforcement Director George Canellos stated, “Honest disclosure about how investments are valued and how performance is measured is vital to private equity investors.” While the SEC noted that the assets were valued incorrectly, the crux of the allegation was that the fund did not adhere to its stated policies, and therefore misled investors about its valuation practices.
On March 22, 2013, the SEC announced charges against two hedge fund managers and the investment adviser and broker-dealer they ran, alleging, among several other things, that the fund inflated the valuations of its fund’s assets. In In the Matter of John Thomas Capital Mgmt. Group LLC, the fund manager allegedly recorded arbitrary valuations that lacked any reasonable basis for certain of the fund’s largest holdings. This, the SEC alleged, ran contrary to numerous representations made to investors, including representations in the investment adviser’s financial statements claiming that investments were recorded at “fair value” and that the respondents had adopted Financial Accounting Standard 157.
The SEC also brought an aggressive case alleging lax oversight by outside directors. In December 2012, the SEC announced charges against eight former members of the boards of directors of five funds for violating their asset pricing oversight responsibilities under the federal securities laws. In its order instituting ceaseand- desist proceedings in In the Matter of Alderman, the SEC alleged the funds fraudulently overstated the value of their securities at the onset of the financial crisis in 2007. The SEC further alleged that the eight charged directors (1) improperly delegated their fair valuation responsibility to a valuation committee without providing meaningful guidance on how fair valuation determinations should be made; (2) made no meaningful effort to learn how fair values were being determined; (3) received limited information about the factors involved with the funds’ fair value determinations; and (4) obtained almost no information explaining why particular fair values were assigned to portfolio securities. Robert Khuzami, then Director of the SEC’s Enforcement Division, stated, “had the board not abdicated its responsibilities, investors may have stood a better chance of preserving their hard-earned assets.” This matter is presently being litigated.
Additionally, in SEC v. Yorkville Advisers LLC, the SEC charged an investment adviser, its president and CFO with overvaluing assets under management and exaggerating the reported returns of the funds in order to hide losses and justify fees. The SEC alleged that respondents valued certain investments at face value while representing to investors that those investments were valued at fair value.
Continued Enforcement Regarding Insider Trading
Since October 2009, the SEC has filed more than 170 insider trading actions charging more than 410 individuals and entities, a number of which were hedge funds or their employees. This is the largest number of actions in the agency’s history for any three-year period. In remarks made in November 2012, former Enforcement Director Khuzami warned, “my message to tomorrow’s insider traders is that it’s a dangerous world for those who trade on insider information. And it’s getting more dangerous.” Karpati similarly pointed out that in the context of investment funds, “[d]ue in part to investment strategy, hedge funds may be desperate to get an information edge on the market.”
On March 21, 2013, the SEC charged Rengan Rajaratnam with insider trading related to his involvement in the Galleon Management insider trading scheme run by his brother, Raj. Rengan Rajaratam allegedly made several profitable trades on the basis of inside information that he received from his brother. The allegations are similar to those made against Raj Rajaratnam, with the exception that Rengan allegedly received his tips from Raj. Rengan was also charged criminally.
In SEC v. CR Intrinsic Investors, LLC, the SEC alleged that a hedge fund, its former portfolio manager and a medical consultant were involved in a $276 million insider trading scheme related to a clinical trial for an Alzheimer’s drug. Criminal charges were also brought against the portfolio manager. CR Intrinsic Investors recently settled with the SEC for over $600 million (approximately $275 million in disgorgement, $50 million in pre-judgment interest and $275 in penalties). This is the largest insider trading settlement ever. Regarding this settlement, Acting Enforcement Director George Canellos said, “The historic monetary sanctions against CR Intrinsic and its affiliates are a sharp warning that the SEC will hold hedge fund advisory firms and their funds accountable when employees break the law to benefit the firm.”
Additionally, in SEC v. Massoud, the SEC settled charges that an executive at an investment advisory firm engaged in insider trading using nonpublic information contained in an online data room to which he obtained access pursuant to a confidentiality agreement. In violation of the confidentiality agreement’s prohibition on trading, the executive allegedly purchased the stock of the company being sold on multiple occasions. Massoud agreed to a fine, an injunction against future violations, and to be effectively barred from the securities industry.
Increased Enforcement Regarding Other Fraudulent Practices
Since the beginning of 2010, the SEC has filed more than 100 cases alleging misconduct at hedge funds ranging from misusing investor assets to misrepresenting investment strategy or performance, charging excessive fees, or hiding conflicts of interest. In his recent remarks, Karpati indicated that the AMU examines fraud through the lens of fiduciary duties funds and their managers owe fund clients.
In November 2012, the SEC charged a hedge fund and its manager with defrauding investors by hiding millions in losses. In SEC v. Commonwealth Advisers, Inc., the SEC alleged that the investment adviser and its manager directed employees to conduct over 150 cross trades between hedge funds they advised and a collateralized debt obligation (CDO) whose collateral they managed, the purpose of which was to conceal losses. The basis of this charge was that an investment adviser owed a duty to each of the funds and CDOs managed, and that one fund’s interests may not be subordinated to another’s. Thus, as a practical matter, when a fund manager sells a non-performing asset from a troubled fund to a healthier fund, the burden will be on the fund manager to demonstrate that the sale was in the purchasing fund’s best interests.
Trade allocation issues have also drawn SEC scrutiny. In SEC v. Aletheia Research & Mgmt., Inc., the SEC charged a hedge fund manager and his investment advisory firm with engaging in a “cherry-picking” scheme in violation of their fiduciary duties. Specifically, the SEC alleged that the fund disproportionately allocated winning trades to its proprietary trading accounts and those of select clients, which resulted in monetary loss for most fund investors. The SEC further alleged that the fund failed to implement policies or a code of ethics aimed at preventing this type of misconduct.
In SEC v. Alleca, the SEC charged a fund manager and investment adviser with defrauding investors by misrepresenting the nature of the funds and their strategy, and by concealing trading losses. According to the SEC, the defendants falsely told investors they operated a “fund of funds” when, in fact, they engaged in active securities trading. When that trading incurred substantial losses, the SEC further alleged, the fund managers attempted to make the original fund whole by starting two new funds, all while concealing the losses with false account statements.
Additionally, the SEC recently announced a settlement with an investment adviser for allegedly fraudulent marketing practices. In In the Matter of Aladdin Capital Mgmt., the fund marketed itself as being “better” because it “co-invests alongside ... investors in every program. Putting meaningful ‘skin in the game’ as we do means our financial interests are aligned with those of our ... investors.” Despite the assertions in the marketing materials, the SEC alleged that the fund did not co-invest.
Enforcement trends relating to valuation issues, insider trading and other fraudulent practices are likely to continue this year, especially in light of the recent statements made by SEC leadership.
In this environment of heightened enforcement, strong training and compliance policies are the first line of defense. In several actions, the SEC has noted the absence of meaningful policies or, where such policies exist, the respondents’ deliberate disregard of those policies. Particularly in light of the SEC’s focus on valuation, funds should focus on contemporaneous documentation of their valuations and the use of consistent valuation methodologies. Karpati suggested that firms should “test and verify [their] valuation procedures.” Specifically regarding the compliance structure in private equity funds, Karpati pointed out, “Private equity COOs and CFOs are absolutely critical in making sure that clients’ interests are placed ahead of the interests of the management company and its principals ... Private equity firms should integrate compliance risk into their overall risk management process and should ensure that COOs, CFOs, CCOs and other risk managers are able to proactively spot and correct situations where [issues] may arise.”
Although there is no magic formula that can guarantee freedom from SEC inquiries, regulators generally view strong policies favorably in conducting their investigations. Should an SEC examination occur, Karpati advised, “It is important to be cooperative with exam staff while an examination takes place. It is also important to implement any necessary corrective steps if the SEC staff identifies deficiencies or possible violations. Taking these steps will help the examination process to proceed more efficiently and reduce the likelihood of more formal inquiries by the Enforcement Division or AMU staff.”