SEC Preview Top Hedge Fund Enforcement Trends for 2013

By Perrie Michael Weiner, Patrick Hunnius and Stephanie Smith of DLA Piper


In a recent speech* before the Regulatory Compliance Association, Bruce Karpati, Chief of the Securities and Exchange Commission’s Enforcement Division’s Asset Management Unit, suggested where the SEC may be heading regarding hedge fund oversight in the months to come.

Mr. Karpati both highlighted the SEC’s past enforcement activity concerning hedge funds (including several cases where the SEC alleged funds fraudulently overvalued their holdings) and signaled that the SEC’s emphasis on such activity will continue.


The growing role of specialized units within the Enforcement Division


At the outset of his remarks, Mr. Karpati reviewed the Enforcement Division’s decision to create “specialized units” to provide the expertise and resources that will ideally provide better oversight of particular aspects of the financial markets.

Mr. Karpati heads the Asset Management Unit, or AMU, whose central focus is on hedge funds and investment advisers to alternative investments and private funds.  The AMU was created in part to better understand the workings of the hedge fund industry and the diversity of hedge funds’ investment strategies, in order to handle the challenges in detecting and combating possible fraud.

Notably, the AMU has hired “industry professionals such as hedge fund managers” and private equity analysts who now assist on investigations and exams, conduct training and “assist on policymaking.”  According to Mr. Karpati,  “these industry professionals have already been successful in uncovering issues that we may not have identified otherwise.  We like to say: ‘they know where the bodies are buried – and understand how they got there.’”


Recent hedge fund enforcement actions


In the past three years alone the SEC has brought more than 100 enforcement actions against hedge fund managers.  For example, in 2012 the SEC brought actions alleging that:

  • a fund and its advisers committed fraud by falsely portraying a robust valuation procedure
  • a hedge fund manager obtained a loan from another hedge fund he advised and gave liquidity rights to certain important investors (at the expense of other investors)
  • fund managers have misrepresented to investors that they had “skin in the game”
  • managers misstated investor returns and net asset values and
  • managers made investments contrary to their funds’ offering documents and marketing materials

According to Mr. Karpati, a “significant majority” of the 100+ cases “involved conflicts of interest, valuation, performance, and compliance and controls.”

He attributed seven of the hedge-fund related enforcement actions to the SEC’s previously announced “Aberrational Performance Inquiry,” whereby the “Division of Risk, Strategy, and Financial Innovation (RiskFin) and the Office of Compliance Inspections and Examinations (OCIE) … analyze performance data of thousands of hedge fund advisers and refer suspicious candidates for examination or investigation.”  Significantly, Mr. Karpati stated that the inquiry is continuing:  “The inquiry is now focused on a subset of hedge fund strategies that have a high incidence of suspicious returns.”


Hedge funds can anticipate these SEC investigations in 2013


In addition to alluding to the current focus of the Aberrational Performance Inquiry, Mr. Karpati also sent some clear signals (and some possible hints) regarding the types of enforcement actions that hedge funds and other participants in the “alternative space,” such as private equity funds, can expect the SEC to bring or pursue in 2013.

  • Mr. Karpati’s speech emphasized a current AMU program – the “Private Equity Initiative” – that aims to identify private equity fund advisers that are at higher risk for certain specific fraudulent behavior.
  • He identified one area that is likely to be targeted as part of the Private Equity Initiative:  so-called zombie funds that are allegedly delaying liquidity of their holdings or that are misrepresenting the value of assets because income from those assets is their only source of revenue.
  • The SEC will clearly maintain its recent focus on (and its willingness to second-guess) funds’ valuation of “complex, illiquid or opaque investments.”
  • Judging by Mr. Karpati’s focus on “an emerging retail orientation of hedge funds,” the SEC may prioritize inquiries of funds that either “expose[] investors to [hedge funds] directly or indirectly.”
  • Mr. Karpati’s speech seems to presage a particular focus on smaller, unregistered advisers (i.e., “those with less than $150 million in assets under management”), given his observation that such advisers “pose a risk.”
  • The SEC’s recent insider trading enforcement activity, including actions against and involving hedge fund managers, service providers and others, will continue.
  • Finally, Mr. Karpati suggested that hedge funds can expect to see an increase in on-site exams in light of the Dodd-Frank Act, which subjects more private fund advisers to regulatory oversight.  In particular, funds can expect to see an increase in risk-based “presence exams,” in which SEC staff will review one or more higher risk areas of a hedge fund’s operation.

Karpati recommends several steps


In closing, Mr. Karpati recommended several steps managers could take to “insure that they fulfill their fiduciary duties” and “reduce the likelihood of more formal inquiries by Enforcement or AMU staff.”

First, he recommended that hedge funds create a culture of compliance by making sure there is robust supervision of employees and satisfactory internal controls within the firm.

Mr. Karpati stressed that despite the demands on hedge fund managers, compliance must be given adequate time and resources.  This includes carrying out periodic comprehensive reviews of the funds’ operations – including testing the funds’ valuation methodologies — to identify gaps in compliance programs or to assess if changes are needed in light of new activities or products offered by the fund.

Finally, Mr. Karpati highlighted the need for hedge funds to be prepared for SEC exam inquiries.




*The official version of the speech is available at