By Lawrence Delevingne
| Bruce Karpati: Some portfolio managers may be incentivized to overvalue portfolios |
The new-look Securities and Exchange Commission—belatedly overhauled following the financial crisis and Bernie Madoff scandal—is making headlines for its policing of hedge funds. The investigation of Galleon Group founder Raj Rajaratnam and a slew of insider-trading-related charges, in conjunction with the U.S. Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation, have shown the SEC’s aggressive new oversight of the industry.
“We are pleased with the jury’s verdict,” said SEC Enforcement Division director Rob Khuzami about the showpiece Rajaratnam criminal conviction (civil charges are pending). “It is a stark reminder of the serious consequences of engaging in insider trading.”
Other serious reminders sent by the SEC to hedge funds in 2011 alone include charges for alleged fraud in the sale of promissory notes and undisclosed change in trading strategy (Gualario & Co.); the alleged misappropriation of hedge fund assets and misrepresentation of skin in the game (Juno Mother Earth Asset Management); misuse of side-pocketed assets by a hedge fund adviser for a real estate venture, a record company and personal expenses (Baystar Capital Management); and a manager allegedly diverting millions of dollars for a vacation home and business and personal expenses (SJK Investment Management). Those aren’t brand names, of course, but the focus is clear.
Central to policing poorly behaving hedge funds is the SEC’s Division of Enforcement and the largest of its five new specialized groups, the Asset Management Unit. The unit’s team of 65 attorneys, experts and paralegals is led by co-chiefs Robert Kaplan, in Washington, D.C., and Bruce Karpati in New York. Besides hedge funds, the unit focuses on investigations involving investment advisers, investment companies and mutual and private equity funds.
Co-chief Karpati is one of the SEC officials most knowledgeable about hedge funds. A former associate at elite law firm Dechert, he founded the SEC’s Hedge Fund Working Group (now absorbed by the unit) and has worked on investment adviser investigations and cases involving valuation, performance, insider trading, conflicts of interest, derivatives, manipulation and disclosure, among others.
Every bit of that expertise will be needed to effectively police hedge funds. The industry’s assets under management have raced back past $2 trillion, according to HedgeFund Intelligence, and could surpass their 2007 precrisis peak of $2.6 trillion. And the Dodd-Frank Act’s new registration and reporting rules will likely lead to an increase in enforcement referrals from the SEC’s inspectors, given the deluge of new industry data. Khuzami recently told the New York Times he already faces a “significant backlog” of tips and referrals. Despite all that, some in Congress, particularly Republicans, are calling for cuts to the SEC’s $1.18 billion budget, already more than $200 million less than requested by the Obama administration for the 2012 fiscal year.
AR staff writer Lawrence Delevingne recently spoke with Karpati about his unit and hedge fund regulation.
AR: Will the focus on insider trading continue?
Bruce Karpati: Yes. It has always been our objective in Enforcement to pursue insider trading, and that is going to continue. One of the priorities for the unit is to look at registered advisers in the private fund space to ensure that they have the appropriate policies and procedures and controls to prevent insider trading. Not only is that required under the Investment Advisers Act, but as seen by the spate of insider trading cases, proper procedures and controls are needed to avert insider trading and ensure there’s a level playing field for all investors.
AR: Does the hedge fund industry generally have adequate insider trading controls?
Bruce Karpati: I do not want to generalize, but we have legitimate concerns about whether hedge fund managers are instituting proper controls around insider trading. The lifeblood of investment advisers is getting better information than competitors, so ensuring that you have those proper controls is essential. There are plenty of investment advisers who take seriously these responsibilities. What bothers us is when there’s a lack of policies and procedures and where the incentives of the advisers are aligned with getting information at any cost—they’ll take significant risk to get as much information as they can, even when it means crossing the line.
AR: Can you give an example of the types of controls you expect hedge funds to have in place? What should people be doing if they don’t have the proper controls?
Bruce Karpati: The proper controls around insider trading depend on the facts and circumstances of each case, but typical controls would include procedures tailored to the risks of the particular firm. A typical long/short firm might institute certain controls, such as employee acknowledgment of the firm’s insider trading policies, review of and in certain cases prohibitions on personal trading by significant employees and managers, surveillance of significant and outlier trades, and documenting the rationale behind such significant trades.
AR: Another area you’ve been looking at is the valuation of illiquid assets, especially in side pockets. Describe your efforts there and some of the common issues you’re encountering.
Bruce Karpati: Coming out of the credit crisis, we’ve had a focus on overvaluation of portfolios. When you look at the compensation structures at private fund investment advisers, particularly hedge funds, there may be motivations to exaggerate valuations. The compensation structure, the ability to attract investors, performance and the ability to market the fund—they all can drive valuation. In large part due to the credit crisis, we’ve had a real focus on the valuation process and procedures and representations to investors about the process that’s in place for valuing securities. A significant part of our investigative caseload is dedicated to looking at valuation issues, and valuation will continue to be a concern because it is inextricably linked to performance. Since the business models of private funds are predicated on performance—both for adviser compensation and to attract capital—the incentives to improperly value portfolio securities can be considerable. We want to ensure that people are taking the right approach in terms of disclosing to investors what they are doing on valuation and ensuring that investors get adequate and accurate representations about valuations and the valuation process. Besides disclosures, we have concerns that certain managers may be effecting transactions with affiliates or other market participants with the intention to inform their own valuations.
AR: Any specifics on how hedge funds may not be valuing their portfolios correctly?
Bruce Karpati: When you look down deep at hedge funds and their operating process, there’s often plenty of disclosure around valuation and what they’re engaged in with respect to valuation, including implementation of valuation committees, use of independent valuation agents and the due diligence process, and the other checks and balances that go with having accurate valuations. When we see people not complying with what they’ve told investors they’re going to do, that’s problematic. The Asset Management Unit has brought a couple of side pocket cases that demonstrate lack of transparency when it comes to valuation and how side pockets could be used to the advantage of fund managers and to the detriment of investors. We have a number of valuation investigations that are looking at precisely these issues.
AR: What is the status of those side pocket investigations?
Bruce Karpati: In the last several months, we brought cases against two portfolio managers who misrepresented their valuation process with respect to side-pocketed assets: SEC v. Palisades, as well as a fund manager who profited off a side-pocketed investment at the expense of hedge fund investors, SEC v. Goldfarb. These cases are representative of the types of issues we see in our valuation inquiries—misstatements about the valuation process and the diligence that went into the process, especially as it concerns illiquid and hard-to-value portfolios.
AR: Does the SEC think it’s appropriate for managers to charge management fees on side-pocketed investments, given the difficulty of estimating the real value of some of these assets?
Bruce Karpati: We don’t advise or opine on the appropriateness of fee arrangements. However, when valuations or performance based off valuations are exaggerated or manipulated, or when fees are pocketed through misapplication of the valuation process, we will inquire further and scrutinize the transactions or valuations at issue. When misrepresentations or omissions do occur, we’ll pursue the fees, either management or performance fees generated from the fraudulent conduct. We are also concerned when an adviser continues to charge fees on assets that have been side-pocketed for lengthy periods of time, require no active management by the adviser, and for which the adviser lacks a sufficient basis for maintaining the side pocket.
AR: Another area of focus is aberrational performance. Rob Khuzami recently testified before Congress that the SEC was looking at hedge funds beating the markets by 3% or more consistently. Can you elaborate? Wouldn’t that be a huge universe of funds?
Bruce Karpati: I’m not going to speak directly to the testimony, but we’ve talked about aberrational performance—of that being an indicator or red flag as to potential problems when it comes to valuation or deliberate manipulation of performance. Aberrational performance is used as another indicator of possible wrongdoing. When we discuss risk analytics, we’re talking about a sophisticated methodology in partnership with other offices and divisions: RiskFin [Division of Risk, Strategy, and Financial Innovation], OCIE [Office of Compliance Inspections and Examinations], and IM [Division of Investment Management]. We’re all coming together to use risk analytics in ways that we haven’t before. One method we use is looking at suspicious returns—whether it’s smooth reporting, whether it’s outsize gains, analytics like that are very important to us. We don’t just say, ‘There’s one threshold and we’ll look at that threshold.’ Our analytics are at a sophisticated level.
AR: What are some of the other red flags on misconduct?
Bruce Karpati: None of these are entirely conclusive, but just a few are unsophisticated investment staff or operations, lack of transparency into the operations, misrepresentations of business or educational background, lack of cooperation with Examination or Enforcement staff, undisclosed affiliated or related party transactions, and manipulative-type trading.
AR: Expert networks have also been an area of focus. Some of the proposals to regulate hedge funds’ use of them seem impractical, like monitoring every e-mail. Can you comment on what needs to be done?
Bruce Karpati: When we talk about compliance controls and procedures, they need to be geared to the specific risks of the particular firm that’s at issue. So depending on the investment strategy of the firm—if it’s a long/short fund and they have a business model that’s very dependent on getting certain types of information, of course they’re going to need to be more focused on what policies and procedures and controls they have around expert networks. The way we like to address this is through making sure there are effective policies and procedures when it comes to the risk of that particular investment strategy. A quant fund, for example, presents somewhat different issues. And so on the insider trading front, a long/short fund in particular may have more risk when it comes to insider trading and the use of expert networks. In that scenario there needs to be a real focus on the controls so that material nonpublic information is not being passed from insiders at public companies or the experts to managers or analysts at the fund.
Firms using expert networks need to ensure that the information they obtain is legitimate, and managers can do so by enabling a robust compliance program that has the backing of senior management. The procedures and controls around expert networks need to establish clear parameters about what constitutes legitimate information. Appropriate procedures may utilize proactive surveillance techniques, such as chaperoned conversations, where compliance staff monitor conversations. Other compliance steps might include prohibitions on experts being employed by public companies and due diligence on the expert network firm’s own compliance mechanisms.
AR: What are some other areas of enforcement focus?
Bruce Karpati: One is portfolio management contrary to disclosures—when you look at what portfolio managers are telling their investors in terms of what their strategy is and what they’re actually doing on the ground. This is of particular concern with private funds where there may be a lack of information flowing to investors about what in fact the hedge fund is engaged in. Style drift is an aspect of that.
On conflicts of interest, that is one that has been a focus of the unit. When you look at private funds, we need to be focused on the self-interested motivations of fund managers, especially when they fail to disclose that they are treating themselves better than their funds or their investors. As we discussed, some portfolio managers may be incentivized to overvalue portfolios in order to attract investors, in order to generate performance, and of course in order to line their pockets in terms of compensation.
Other conflicts include relationships they have with affiliated broker/dealers, the relationships they have with their own funds, especially when it comes to their own interest in those funds and transactions between their own funds, as well as loans or other transactions that materially benefit the manager at the expense of investors.
Preferential treatment of the managers or principals of a fund without appropriate disclosure to investors is a practice the unit has concerns with, especially where prior to a write-down in the value of the portfolio, the manager or affiliated parties withdraw capital, while other investors are left holding less liquid securities.
A common thread across these issues is the role of compliance and the implementation of a practical and functional compliance program. As many legal practitioners know, the compliance rule (rule 206(4)-7 under the Investment Advisers Act) requires that an adviser adopt policies and procedures that are reasonably designed to prevent violations by both the adviser and its supervised persons. When we see problems along any of these fronts, we are finding that they are not necessarily the result of a lack of policies per se, but how those policies are designed to interact with the businesses. This doesn’t mean just having a compliance manual—it means implementing an effective one.
AR: How does the Dodd-Frank Act enhance hedge fund regulation ability? What tools did you get?
Bruce Karpati: I can’t speak to Dodd-Frank, as it’s being implemented as we speak. However, regarding some of the principal benefits of regulation: First, registration. Allowing us to inspect funds is important, as it means being on the ground and seeing what’s happening at firms as well as getting access to information. Second, the reporting of data: Risk analytics is a component of what we do, and we need to get as much data as possible that is driven both by public disclosures and form ADV. Both data reporting and registration are significant components that will assist the enforcement division, examination staff, and of course, the unit. With inspection, you get earlier opportunities to find misconduct, while with more data we can look for abnormal or inconsistent information to better assess risk—performance, leverage and portfolio valuations are all data points that will assist regulators in doing their jobs.
AR: Speaking of Dodd-Frank, the act pushed for more SEC funding, but Republicans have been targeting the commission for cuts. Do you have the funding you need now?
Bruce Karpati: Funding is not my bailiwick, but what I can speak to is that you can always use more resources when it comes to the complex and ever-growing capital markets. The complexities of the private fund arena and the fact that on the examination side we’re getting more private fund registrants necessitates more allocation of resources to look at their operations. You always need more resources.
When it comes to what we’ve implemented in the Enforcement Division, the vision we have is an Enforcement Division focused on protecting investors to the largest degree possible, and that necessitates expending resources and maintaining expertise. When it comes to the specialized units, including the Asset Management Unit, over the past year we’ve brought in expertise. We have a former hedge fund portfolio manager, a former private equity analyst and a former execution trader. They’ve all brought expertise to the division, to the unit and to the Examination staff in ways we haven’t had before. It’s important to note we’re getting more expertise, but as the markets evolve we need to keep up with that expertise.
It’s also important to know that the Asset Management Unit...was not intended to supplant the great work of the Enforcement Division. The Enforcement Division is approximately 1,000 enforcement lawyers, 80% of whom are not specialized, and a large proportion of their work is asset management related.
