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News July 23, 2012 Issue

Karpati Talks Shop on Specialized Enforcement Initiatives

Bruce Karpati, chief of the SEC Division of Enforcement’s specialized Asset Management Unit (AMU), spoke on July 20 at the ALI CLE Mutual Funds conference in Washington, DC. He offered some insight on the AMU’s operation and priorities, highlighting a number of enforcement cases that underscore those priorities.

Karpati spoke on a panel that included ProFunds general counsel Amy Doberman, Morgan Lewis partner Christian Mixter, and the panel’s moderator, Bingham partner Tom Harman. The three offered practical tips and takeaways to help firms avoid catching a regulator’s eye.

Karpati lead off the discussion.

Three of the five specialized units in Enforcement focus on asset management activities – the AMU, of course, and the Market Abuse and Structured Products Units, he said. It is the specific mandate of the AMU, however, to review the activities of advisers, investment companies, and private funds.

With the establishment of the specialized units, there really has been a sea change in how Enforcement does its job, said Karpati.

It’s not just tips, complaints, and referrals anymore, it’s more about identifying risks, and proactively uncovering them.

What makes the AMU tick?

The AMU has 75 staff across ten SEC offices. Denver is the newest addition. The AMU has fourteen assistant directors, and five specific industry experts with a depth of experience in hedge funds, portfolio management, private equity, and mutual funds. These staff are experienced in a wide variety of areas from complex trade execution, to due diligence, to fund-of-funds matters. The AMU expects to add two more positions with senior specialized expertise in the near future.

Experts play a big role in what the AMU does, and helps to focus energy on the AMU’s priorities:

  • Conflicts of interest;
  • Valuation;
  • Fee arrangements; and
  • Oversight controls and compliance.

Expert input is one of the ways the AMU tweaks its priorities to really get at risk areas.

"We also have an unprecedented level of coordination with the exam staff," said Karpati.

It is very important to coordinate and leverage off information from the exam staff – they really are the eyes and ears of the Commission, he said.

The AMU holds monthly meetings, and over the course of the year, close to 25 additional specialized sessions focusing on issues such as outsourced compliance, money market funds, traded REITs, and wrap fee maintenance.

The AMU also conducts risk analytics with data resources from the Division of Risk, Strategy and Financial Innovation to inform its priorities.

The Division of Enforcement has done these things in the past, said Karpati, but now conducts them in methodical, routine ways.

Specialization among the units informs investigation priorities. Not only unit by unit, but also with respect to the Division’s personnel. "For example, my career has been really focused on hedge funds," said Karpati. The regulated fund space has a different set of priorities. We have expertise on staff with a depth of registered fund experience, including fund distribution and the Section 15(c) advisory contract review process.

2011 in review.

In 2011, Enforcement brought fifty hedge fund cases, said Karpati. Those cases were focused on:

  • Incentive fee arrangements – with respect to both performance and valuation;
  • Marketing, performance advertising, and abberational performance;
  • Dominant managers with control over non-transparent investment vehicles; and
  • Conflicts of interest.

The recent "zombie fund" initiative, where the SEC has been investigating money managers that continue to take fees from essentially inactive funds, directly results from AMU work.

Even though the registered investment company space is tightly regulated, issues remain, such as:

  • Fee arrangements;
  • Valuation; and
  • Side-by-side arrangements.

Adviser actions over the past year have been fairly evenly split, said Karpati. Roughly, one third of the actions involved registered investment companies, including ETFs and closed-end funds; one third involved private funds; and one third involved separately managed accounts.

The current environment is ultra-competitive. It is low fee, low interest, low yield, and challenging to raise revenue.

In such an environment, certain risks are exposed.

For example, in the consolidation/merger context – is there a sufficient infrastructure to deal with taking on a larger advisory component? Are the controls and resources there?

The AMU also reviews mutual fund fees and the 15(c) process.

Why would we look at a process that is so well documented? he asked.

Small to medium advisers have had problems. Larger advisers aren’t immune either. Look at the recent Morgan Stanley case. "We have seen a lack of oversight and a willingness to cut corners to enhance revenues," said Karpati. Morgan Stanley represented they were providing services that they actually were not.

The AMU conducts initiative-based reviews on issues such as:

  • Abberational performance; and
  • Mutual fund fee arrangements.

The AMU also conducts theme-based reviews on issues such as:

  • Side pockets;
  • Quantitative managers and the controls around errors; and
  • Side-by-side management of hedge funds and mutual funds.

The AMU also conducted Operation ADV – a due diligence review of the educational and business backgrounds of advisory principals. Problems here are often indicators of bigger problems at those advisers, he said.

Scrutiny of the Gartenberg process.

In general, a fund board’s contract review under the Gartenberg standard is a well-documented, well-lawyered process. Why would we scrutinize it? Our inquiries are motivated by investor protection concerns. For the integrity of the 15(c) process we have to look at it to make sure it works.

The staff routinely reviews the actions of a fund’s board compared with how the adviser meets its obligations to disclose arrangements appropriately for the Board’s evaluation.

It is an unprecedented time, we’re looking at many advisers, said Karpati.

"I view my role as evaluating what the business is trying to accomplish and where the risks are," said Doberman. There are two types of violations – preventable and unpreventable.

In the Morgan Stanley case, the adviser had a well-documented Gartenberg process, but failed to corroborate information. The issue there and in other situations is that you must ensure a process is in place to document everything – portfolio management, valuation, the board review process – to ensure you know the facts and get people to sign off on it.

Question the expected.

Consider this, said Mixter: People are accustomed to look for what’s different. What has just changed? What is different? That’s how we’re wired. The issue in Morgan Stanley was that it was the same, year after year. Nothing changed.

What had changed underneath? Were the services being rendered or not? The real challenge for in-house professionals is to come up with ways to detect change happening underneath constants.

Valuation can present similar challenges, said Doberman. It is easy to look past that process instead of asking the tough questions. One way to do it is through the audit process. Take a deep dive in a particular area (15(c) for example).

Fee arrangements.

Another area worth diving into is fees, specifically other arrangements beyond the advisory fees, said Karpati. Look at the circumstances where the fund pays fees versus the adviser is paying fees. Are the fees disguised distribution fees?

The Smith Barney transfer agency case a few years back is a good example. An in-house transfer agent was hired at a significantly reduced cost, but those savings were not passed on.

This case is also important because it highlights that informing the board is one of your best defenses, said Doberman. "I have seen it again and again, you really have to be up front with the board."

Conflicts of interest.

The recent Martin Currie case is a good conflicts of interest example of not being forthcoming with the board, said Karpati. A mutual fund made an investment in a company to allow a hedge fund to reduce its exposure. The SEC has produced a long line of conflicts enforcement cases. "Conflicts of interest is an area that we will always give attention," he said. Look at the disclosures to the Board as well as disclosures to investors.

Be skeptical, and ask questions, said Doberman. Confirm information and follow your instincts. Be vigilant about checking facts in high-risk areas and document your checks.

Preferential treatment.

We’re going to look across vehicles for opportunities to preferentially treat one over the other, said Karpati.

The recent Harbinger Capital Partners/Philip Falcone action is a preferential treatment case in the hedge fund area. Taking a loan from their own fund was also a conflict of interest. This situation was unique because there were a fair amount of lawyers involved in the process, he said.

Preferential redemptions were offered to influential investors in exchange for their vote to restrict redemption rights of other investors.

We hear a lot that hedge fund investors are sophisticated and they can fend for themselves, said Karpati. In alternative investment vehicles though, there is a lack of transparency.

The Quantek Asset Management case just several weeks before that is another example where hedge fund investors were misled. The adviser falsely represented that its executives had "skin in the game" with their own fund investments. Loans to affiliates were not well documented, and investment memos were backdated.

Disclosure and compliance program issues.

These seem like obvious areas, but post-financial crisis and in the electronic trading environment have given rise to problems, he said.

The AXA Rosenberg case is a good example of this, where the adviser concealed a material error in a quantitative model. A senior official gave directions to keep the error quiet. For us, it was a great case to send the message that while you must disclose the actual risk, you also need an error correction process.

The quant world’s secretive culture is a risk and firms need to figure out how to manage that risk.

If you cannot identify and correct issues within a reasonable amount of time, it invites problems with the regulators, said Harman. The reactions to AXA were swift, too. Clients took their accounts away because the assessment was – ‘we can’t keep them, they’re too risky,’ he observed.

The AXA Rosenberg action was also notable because it was featured as the first case where credit for cooperation given, said Mixter. The individual who came forward was not charged.

Yes, the cooperation program was established at the same time as the specialized units, said Karpati. Getting people inside the organization to report problems is not just great, it is essential.

The recent OppenheimerFunds case illustrated the complexities associated with commercial mortgage-backed securities. OppenheimerFunds used total return swaps to make investments for a fund, which then suffered material losses during the financial crisis. The adviser understated losses to investors, describing them essentially as "paper" losses, and mislead investors as to the fund’s prospects for recovery.

The AMU focuses on derivatives as well as leverage, this case has both components.

In the high yield registered investment company space we are scrutinizing the use of leverage and the outliers – how can you get a result when others don’t? This is one area where we use analytics for risk assessment and during examinations.


Two cases offer good examples of issues related to valuation:

The Morgan Keegan case is another outgrowth of the financial crisis case. This case had many red flags of manipulation – arbitrary price adjustments and manipulated brokerage quotes.

A valuation committee left the process to lower level employees, who input adjustments without documentation. The valuation process also gave excessive authority to the portfolio manager to assign value. The fund’s board was without the necessary information it should have gotten.

This case underscores the need for hard internal controls, said Doberman. Focus on accountability for valuation determinations, preferably at higher levels, from senior managers without the same motivations as the portfolio manager.

The UBS Global Asset Management case is another valuation case, this time where the fund was carrying inflated values contrary to written procedures. In both cases – exam staff was in on uncovering the misconduct, said Karpati.

These are things that really stood out and never should have happened in the first place, said Harman. Think about the market environment, you can’t look at things the way you’ve always looked at them. Make some calls, do some quick "on the ground" due diligence.

Doberman agreed. If you have funds that are impacted by an event, or if you see something going on, follow up. For example: "covered bonds," what are they? They are issued by European banks. Pick up the phone and find out if you don’t know. Understand the instruments and be proactive based on what’s going on in the markets. Ask questions.

Don’t be fooled into thinking there’s no downside in being a little conservative, either, said Harman. Conservative valuations for mutual funds, for example, can result in processing out shareholders at too low a price. That can cause trouble, too.

Compliance and Controls.

The AMU is looking at circumstances where advisers don’t put in place policies and procedures appropriate to the risks, said Karpati.

The cases brought related to compliance programs and controls generally have represented extreme situations, he observed. Circumstances where the staff specifically pointed out deficiencies during an examination, for example, and on return visits a few years later see that the same problems persist. Also, circumstances where documents are fabricated or altered during the course of an examination.

A firm can be exposed to insider trading risks where firms don’t have policies and procedures geared to investment strategies. The expert network cases are good examples of that.

Remember, 80 percent of the staff is not in the specialized units, said Karpati.

The general Enforcement staff brought the OppenheimerFunds and Morgan Keegan cases. We work hard to share expertise outside the Unit, he said. Within the Units though, you can really look with a risk-based approach and focus in on specific issues.