In an interesting speech before the Regulatory Compliance Association yesterday, Bruce Karpati, Chief of the SEC Enforcement Division's Asset Management Unit, explained that his specialized unit allows the SEC to focus on the specific vulnerabilities to fraud that hedge funds may face due to their operating model. Karpati said that developing an advanced understanding of the operating environment and incentives of asset managers helps the SEC proactively monitor and combat fraud in the industry.  

Karpati pointed to certain motivations and realities inherent in the hedge fund model that have led hedge fund managers to engage in fraud or misconduct, and how the SEC tries to use its knowledge in this area to guide its enforcement effort. These include:

Compensation tied to both management fees and performance fees. This formula, Karpati said, has led numerous hedge fund managers to overvalue fund assets to boost their compensation. As such, the AMU looks closely for fraudulent or weak valuation practices at hedge funds. 

 

Pressure to demonstrate and market consistently positive performance.  Strong performance is constantly needed to make the fund attractive to new investors and keep current investors satisfied. This may leave hedge funds desperate to get an informational edge in the market, Karpati said, and lead to efforts at insider trading such as in the recent expert networks cases.

 

Ability to control every aspect of their business. Such control can provide fund managers with severe conflict of interest situations in which they have the opportunity to put their personal interests ahead of investors.  The SEC looks closely at possible related-party transactions where the manager can misappropriate money by engaging in self-serving transactions or hide losses.

 

Wide latitude on how to invest. Managers may be presented with the opportunity to favor certain investors through preferential redemptions or side letters. The SEC is alert to these situations, and other conflicts of interest such as "commonly managed accounts, allocation practices, affiliated broker dealers, undisclosed compensation arrangements, soft-dollars, and best execution. "

 

Lack of independent governance. Because their loose governance structure makes hedge funds more susceptible to the sorts of misconduct discussed above, the AMU focuses on whether registered advisers have proper compliance procedures and controls in place.

Given what he labeled the "misaligned incentives" in the hedge fund operating model, Karpati offered three steps that hedge fund managers should take to insure that they meet their fiduciary duties:

1. Set the "tone at the top" and create a culture of compliance within the firm, including robust supervision of employees and adequate internal controls;

2. Adopt and implement a compliance program and controls geared to the risks and investment strategy of the firm, including controls to check and monitor traders and to test and verify valuation procedures; and 

3. Be alert and prepared for exam inquiries, and implement any necessary corrective steps if the SEC identifies violations or possible violations.