Publications

7 Dec 2011

The SEC's Risk Analytics program signals new front in hedge fund regulatory scrutiny

Securities Enforcement Alert

Joshua Briones
Deborah R. Meshulam
Perrie Michael Weiner
Nicolas Morgan

The SEC has announced enforcement actions against three separate advisory firms and six individuals for alleged violations initially uncovered through the results of SEC proprietary data analysis.

For the past year, all eyes have been on the SEC’s Dodd-Frank whistleblower program, which financially compensates those who ring the alarm bells about fraud and wrongdoing at their companies. 

But while the SEC’s role in the Dodd-Frank whistleblower program is, by definition, passive – i.e., the whistleblower must bring tips about potential fraud to the SEC – the SEC is not simply waiting for whistleblowers.  Rather, it is proactively investigating hedge funds, using proprietary data analysis. These internal investigatory efforts signal a new front in the SEC’s efforts to police hedge funds.

The SEC’s proprietary “Risk Analytics”

In addition to tips and complaints becoming the basis for an SEC investigation, the SEC has also quietly embarked on an extensive internal effort to generate investigative leads through what it is calling Risk Analytics.  

The agency is now relying on extensive data analysis – the same kind of quantitative analysis that fund advisers may use to evaluate potential investments.  The SEC’s “Aberrational Performance Inquiry,” conducted by the SEC’s Enforcement Division’s Asset Management Unit, uses proprietary techniques to evaluate hedge fund returns.  Performance that appears inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further scrutiny.  In other words, the SEC is looking for returns that appear too good to be true, and then it is investigating.

Fraud allegations began with Aberrational Performance Inquiries

The enforcement actions announced by the SEC on December 1, 2011 against three separate advisory firms and six individuals were uncovered through Aberrational Performance Inquiry analysis.¹

The alleged misconduct includes:

• overvaluing the returns and assets of a hedge fund, which at one point reported US$844 million under management.  The SEC claims that by allegedly inflating the numbers, the defendants made millions in fees and were able to raise additional money from investors.  The case has also prompted criminal charges
• allegedly inflating the returns, size and other aspects of two hedge funds, which oversaw about US$520 million in 2008
• allegedly making investments contrary to those permitted by the fund’s offering documents and marketing materials
• allegedly concealing from investors past regulatory infractions, conflicts of interest and investment liquidity

In discussing these recent enforcement actions, Robert Kaplan and Bruce Karpati, Co-Chiefs of the SEC Enforcement Division’s Asset Management Unit, explained, “[t]he extraordinary returns reported by these advisors and portfolio managers were, in most cases, too good to be true.  In other cases, outlier returns were a telltale sign that something else was amiss.  We are applying analytics across the investment advisor space—beyond performance and beyond hedge funds.”

Not coincidentally, just days before the SEC’s announcement concerning its Risk Analytics enforcement actions, the Asset Management Unit announced three unrelated actions against investment advisers for violations of Rule 206(4)-7 of the Investment Advisers Act, which requires registered investment advisers to adopt and implement written policies and procedures that are reasonably designed to prevent, detect and correct securities law violations.  (See the SEC’s press release.)

Compliance procedures and documentation will minimize risk

All these cases emphasize the need for all fund advisers, whether registered or not, to adopt and follow compliance policies and procedures, especially with regard to critical areas such as asset valuation, performance reporting and communication with and disclosures to fund investors. 

Equally important, all fund advisors should thoroughly document compliance efforts and the basis by which assets are valued and returns are calculated.  Such documentation can serve to rebut the findings of risk analytics that may initially suggest to the SEC that something is amiss.

For more information about these cases and about the SEC’s Risk Analytics program, please contact:

Deborah Meshulam

Perrie Weiner

Nicolas Morgan

Joshua Briones

 
You may also be interested in our earlier Alerts about Dodd-Frank’s whistleblower provisions, “SEC's whistleblower report reveals surprising volume of tips from foreign countries”  and “Responding to the SEC's final whistleblower bounty rules.”