SEC’s Co-Chief of Enforcement (Asset Management Unit) Describes Enforcement Priorities for the Year

The Co-Chief of the Securities and Exchange Commission’s Asset Management Unit (the “AMU”) recently provided a revealing and important glimpse into the SEC’s priorities in bringing enforcement actions in the investment fund community. Julie M. Riewe gave an overview of the AMU’s capabilities and accomplishments in the five years since it was formed, and provided a detailed summary of the AMU’s enforcement initiatives in the coming year at last month’s IA Watch 17th Annual IA Compliance Conference.

Ms. Riewe’s key note address makes it clear that the SEC’s Asset Management Unit is armed with significant new capabilities. Given the resources now being devoted to the AMU and the AMU’s close coordination with other arms of the SEC, its 2015 enforcement initiatives must be taken very seriously. Funds which fall under the AMU’s purview are advised to review their policies regarding conflicts of interest closely and to be mindful of the many issues which are now prominently on the SEC’s radar.

2015 Priorities

According to Ms. Riewe, the AMU has greatly expanded its roster to 75 professionals who are now housed in all 12 SEC offices. The AMU also is cooperating closely with other divisions of the SEC, specifically the Office of Compliance Inspections and Examinations (“OCIE”), the Division of Investment Management, and the Division of Economic and Risk Analysis. Ms. Riewe was forthcoming about the AMU’s priorities for 2015 enforcement actions against three separate classes of investment vehicles: registered investment companies, private funds (both hedge funds and private equity funds), and other accounts (e.g., separately managed accounts/retail accounts).

With respect to registered investment companies, Ms. Riewe stated that the AMU’s enforcement priorities would include “valuation and performance and the advertising of that performance; funds deviating from their investment guidelines or pursuing undisclosed strategies; fund governance, which includes boards’ and advisers’ discharging of their obligations under Section 15(c) of the Investment Company Act of 1940 […] when they evaluate advisory and other types of fee arrangements; and fund distribution[.]” Ms. Riewe mentioned that fund distribution was of particular concern given the conflicts of interest that it presents (more on this subject below).

With respect to hedge funds and private equity funds, Ms. Riewe stated that the AMU’s 2015 priorities included “conflicts of interest, valuation, and compliance and controls.” Specifically as to hedge funds, Ms. Riewe anticipated enforcement actions involving undisclosed fees, undisclosed conflicts (including related-party transactions), and valuation issues, including the use of friendly broker marks. Ms. Riewe referenced the Aberrational Performance Inquiry, an effort to use proprietary risk analytics to identify hedge funds with suspicious returns, and mentioned that the AMU had recently brought its eighth case generated by this initiative. Specifically with respect to private equity, Ms. Riewe noted that the AMU continues to work closely with the OCIE and that she expects to see more misallocated fee and expense cases brought in 2015.

With respect to other client accounts, Ms. Riewe stated that the AMU’s enforcement priorities in 2015 would include “conflicts of interest, fee arrangements, and compliance.” On the compliance front, Ms. Riewe discussed the efforts of the AMU in bringing cases as part of its Compliance Program Initiative, a joint effort with OCIE to identify advisory firms that lack effective compliance programs. She noted that eleven cases had been brought under this initiative, which “targets firms that have been previously warned by SEC examiners about compliance deficiencies but failed to effectively act upon those warnings, or firms that have wide-ranging compliance failures.”

Conflicts of Interest

The running theme of the address, and one given special attention by Ms. Riewe, was conflicts of interest. Ms. Riewe prefaced this portion of her speech by noting that all of the AMU’s ongoing matters involve an examination of whether the adviser in question has discharged its fiduciary obligation to identify its conflicts of interest and either (1) eliminated them, or (2) mitigated them and disclosed their existence to boards or investors. Ms. Riewe emphatically noted that [“a]n adviser’s failure to disclose conflicts of interest to clients subjects it to possible enforcement action.”

The AMU’s 2015 enforcement actions will potentially include a variety of matters, including “matters involving best execution failures in the share class context, undisclosed outside business activities, related-party transactions, fee and expense misallocation issues in the private fund context, and undisclosed bias toward proprietary products and investments,” according to Ms. Riewe. She also stated that the AMU anticipates enforcement action from the “Distribution in Guise Initiative” under which the AMU is examining “conflicts presented by registered fund advisers using the fund’s assets to grow the fund and, consequently, the adviser’s own fee.”

Speaking directly to investment managers regarding their efforts to identify and address conflicts of interest, Ms. Riewe had much to say about best practices. Her remarks are best excerpted in their entirety:

Take a step back and rigorously and objectively evaluate your firm, its personnel, its business, its various fee structures, and its affiliates. Is the firm a dually registered investment adviser and broker-dealer, or does the adviser have an affiliated broker-dealer? If so, the firm will have inherent conflicts risks if it engages in principal transactions or trades through its brokerage arm or an affiliated broker-dealer. Does the firm manage clients side-by-side? If so, and if the firm’s clients are funds, do they engage in inter-fund lending or investing? Does the firm receive compensation from any third parties for recommending investments or using certain service providers? Does it engage in proprietary trading or investing? If so, has the firm disclosed its potential biases and that its investment advice could be tainted by compensation received from any third parties or from proprietary investing?

For each conflict identified, as a threshold matter, can the conflict be eliminated? If not, why not? If the adviser cannot, or chooses not to, eliminate the conflict, has the firm mitigated the conflict and disclosed it? Is there someone – a person, a few individuals, a committee – at the firm responsible for evaluating and deciding how to address conflicts? Is that person or individuals or committee sufficiently objective? Is the process used to evaluate and address conflicts designed to be objective and consistent? Does the firm have policies and procedures in place to identify new conflicts and monitor and continually re-evaluate ongoing conflicts? As to mitigation, are the firm’s policies and procedures reasonably designed to address the conflicts the firm has identified, and are they properly implemented?

As to written disclosure, has the firm reviewed all of the relevant disclosure documents – among others, Forms ADV, private placement memoranda, limited partnership agreements, client agreements, prospectuses – to ensure that all conflicts are disclosed, and disclosed in a manner that allows clients or investors to understand the conflict, its magnitude, and the particular risk it presents? Does the firm review those documents regularly to ensure that new or emerging conflicts are disclosed in a timely way? Further to disclosure, is the adviser keeping the chief compliance officer and boards of directors (if any) informed about conflicts of interests, particularly the adviser’s analysis and decisions on whether to eliminate or mitigate a conflict?

The Takeaways

Ms. Riewe’s key note address provides a very helpful look into the new capabilities of the AMU, its close cooperation with other arms of the SEC, and its enforcement initiatives for the coming year. As noted above, funds falling under the AMU’s purview are advised to review their policies regarding conflicts of interest closely, and to be mindful of the many issues which are likely areas of interest to the AMU.