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SEC names Director of Division of Investment Management

The Securities and Exchange Commission today announced that Eileen Rominger has been named its Director of Investment Management. She will begin her work at the agency in February.

The Division of Investment Management protects investors and promotes capital formation through oversight and regulation of the nation’s multi-trillion dollar investment management industry. Ms. Rominger comes to the SEC from the asset management industry, where she worked for the past 11 years at Goldman Sachs Asset Management and most recently served as the firm’s global chief investment officer. She previously worked for 18 years at Oppenheimer Capital, where she was a portfolio manager, managing director, and a member of the Executive Committee.

Ms. Rominger is replacing Andrew J. “Buddy” Donohue, who left the agency in November.

“Eileen brings the agency a lifetime of experience in the asset management industry and a record of strong leadership,” said SEC Chairman Mary L. Schapiro. “She understands the importance of the nation’s investment management industry to the well-being of investors everywhere.”

Ms. Rominger’s experience spans nearly 30 years as a portfolio manager serving investors and accountable to mutual fund boards of directors, and as a leader of portfolio management teams.

“The investor protection mission of the SEC has never been more important,” said Ms. Rominger. “Retirement and other important financial needs loom large for millions of Americans, even as investment choices increase in number and complexity. I’m honored to have the opportunity to lead the Investment Management Division and its talented staff as they drive their critical agenda of transparency and integrity in the industry.”

Working within Goldman Sachs’s asset management unit, Ms. Rominger served as chief investment officer overseeing portfolio management teams in eight countries including fixed income, fundamental equity, and quantitative investment strategies. She also was a portfolio manager for fundamental equity portfolios. Ms. Rominger served as head of the investment committee for the Goldman Sachs Foundation, and was a member of the management committee and risk committee of the firm’s Investment Management Division.

At Oppenheimer Capital, Ms. Rominger managed equity portfolios and was a member of the firm’s management team.

Ms. Rominger, 56, received a BA in English from Fairfield University and an MBA in Finance from the Wharton School of Business at the University of Pennsylvania.

SEC creates unit to focus on funds and advisors

For decades, the Securities and Exchange Commission’s Enforcement Division allocated few of its limited resources to the world of funds and advisers. The ’40 Act was left to the regulatory lawyers while, apart from the combined state-federal campaign against market timing and late trading a few years ago, the enforcement lawyers directed their investigations and litigation elsewhere.

This largely hands-off approach changed dramatically when the SEC’s new Enforcement Director Robert Khuzami announced that his restructuring efforts would include the creation of a new “Asset Management Unit” within the Division to focus squarely on investigating and bringing enforcement cases against investment advisers, investment companies, hedge funds and private equity funds.[1] This article discusses the Asset Management Unit’s formation and structure, its recently announced initiatives impacting funds and advisers, and prosecutorial interests discernable from the cases it has announced so far. [2]

A. Introducing the Asset Management Unit

Getting Started

Khuzami jump-started the Asset Management Unit by appointing two experienced SEC veterans as the Unit’s new Co-Chiefs – Robert Kaplan, based in Washington, and Bruce Karpati, based in New York. Karpati joined the Enforcement program after litigating with a private firm, and went on to establish and lead the Enforcement Division’s Hedge Fund Working Group. Kaplan also litigated in private practice before joining the SEC, and later tried securities cases in federal court as a member of the Division’s Trial Unit before becoming an Assistant Director managing investigations, including matters related to the SEC’s recent charges against Galleon Management LP.

The degree to which advisers and funds are now a high enforcement priority is obvious from the fact that the Asset Management Unit is one of only five new specialized units established during the Division’s recent reorganization, and from the fact that it is the largest of the five units.[3] Kaplan and Karpati spent the first several months building their unit into a team of 65 professionals. The unit’s staff includes five industry experts, reflecting the SEC’s ongoing efforts to recruit “qualified industry professionals” from outside the agency. The balance of the Unit is comprised of 60 attorneys, of whom 13 are Assistant Directors and the remainder staff attorneys and senior counsel. The recruiting and organizational process is now complete, and the Unit is actively pursuing investigations and bringing cases.

Plan of Attack

The Asset Management Unit will plan and coordinate all of the Enforcement Division’s efforts relating to funds and advisers. It will set priorities in investigating and bringing cases and monitor the progress of filed cases. Unit leadership – the Co-Chiefs and the Assistant Directors – use regularly scheduled conference calls to discuss and focus the Division’s efforts in the asset management space.

The Unit operates nationwide, as a network of specialists based both at SEC headquarters and at eight of the SEC’s eleven regional offices around the country. In this respect, it is part of the SEC’s recent efforts to break down geographic silos and encourage free exchange of information and ideas across its programs. Particular cases will be staffed with Unit personnel from different offices in what it terms a “horizontal” staffing model. Case teams may also include staff from outside the Unit, as needed. The Unit will stress rigorous and continuous training – both general and case specific – from in-house and outside experts as a means to develop its staff as a sophisticated team of asset management specialists with a law enforcement focus.

Unit staff will themselves handle a significant portion of the Division’s cases against funds and advisers, but staff outside the Unit will also continue to do asset management cases. The Unit will liaise with and support staff outside the Unit when they pursue cases within the Unit’s mandate. Defense counsel seeking meetings with top management on a matter will approach Kaplan or Karpati on Unit cases, and approach the senior officer at the top of the supervisory chain for non-Unit cases.

Partnering

As the Unit continues to develop new initiatives and cases, it will partner closely with the SEC’s Investment Management Division on all technical issues, and with the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) for real-time industry intelligence from the SEC’s “eyes and ears” in the field. The Unit will look to OCIE as a significant source of case referrals and will work with OCIE staff on investigations. The Unit will also pursue individuals it feels have misled OCIE examiners.

Additionally, the Unit will have at its disposal the SEC’s new Division of Risk, Strategy, and Financial Innovation (known as “RiskFin”), which is already consulting with Unit staff on cases and providing training. The SEC created RiskFin in September 2009 to provide “sophisticated analysis” in the areas of “risk and economic analysis, strategic research, and financial innovation.” RiskFin has recruited senior in-house talent in a variety of technical areas, including experts on risk management and the regulation of derivatives, swaps and other financial innovations; a hedge fund manager and risk management consultant; a head of risk management at multiple Wall Street firms; a structured finance expert; and a corporate finance expert, among others.[4]

B. The New Unit’s Priorities and Initiatives

Overall, the Asset Management Unit is focusing its priorities by type of investment vehicle. For mutual funds, the Unit’s leadership has indicated that key areas of interest will include: (i) adequate disclosures relating to strategies, performance, valuation and risk; (ii) boards’ discharge of their responsibilities, particularly as to valuation and fees; (iii) director independence issues; and (iv) personal trading, including redemptions before material disclosures.

For hedge funds, the Unit’s focus will include, among other things:

  1. investigation of aberrational performance indicators;
  2. valuation processes and use of side pockets;
  3. registration of advisers;
  4. conflicts, including relationships among funds under common management and among affiliated entities;
  5. compliance programs and internal controls; and
  6. attention to private offering requirements.

Beyond such general priorities, the Unit has already identified several formal “initiatives” where it will focus attention and resources. As described below, these include the Hedge Fund Suspicious Performance Initiative, the Mutual Fund Fee Initiative, the Bond Fund Valuation Initiative, and the Problem Adviser Initiative.

Hedge Fund Suspicious Performance Initiative

Shortly after creating the Asset Management Unit, Enforcement Director Khuzami gave a speech laying out his concerns about hedge funds, which he termed “particularly challenging.” Noting that they had “undergone explosive growth,” he commented that hedge funds are “not subject to the same rules as mutual funds with respect to liquidity, redemptions, conflict rules, pricing, disclosure, use of leverage, short sales – among other areas.” He continued that hedge funds “trade extensively in less transparent markets, such as in credit and derivatives”; “utilize high-tech trading systems and techniques”; “have close prime brokerage, cap intro and other relationships with investment banks, who themselves are sources of a great deal of private-side information that would be highly valuable to any trading entity”; and “can have different fee arrangements across multiple structures and affiliates, which can create conflicts and incentives for improper activity.”[5]

With such concerns front and center for the Enforcement Director, it comes as no surprise that the Asset Management Unit initiative that is said to be the farthest along in development is what it terms its “Hedge Fund Suspicious Performance Initiative,” which will focus on several of Khuzami’s hedge fund target areas. The Unit has worked with RiskFin to develop methodologies to identify funds with “outlier” returns or other suspicious performance. When Unit staff identify such returns, the funds and their advisers are then subjected to further investigation and evaluation, which may in turn lead to enforcement action if warranted.

Mutual Fund Fee Initiative

Khuzami told Congress several weeks ago that the Asset Management Unit is pressing a “Mutual Fund Fee Initiative” that will “develop analytics ... for inquiries into the extent to which mutual fund advisers charge retail investors excessive fees.” According to Khuzami, “these analytics are expected to result in examinations and investigations of investment advisers and their boards of directors concerning duties under the Investment Company Act.”[6] Following decades of little SEC involvement in the fee approval process, this initiative may augur a big change for funds and advisers.

According to the Unit’s leaders, this initiative will involve sifting through data to determine whether grounds exist for further investigation. In so doing, the staff will ask two questions. First, whether fund boards, particularly independent directors, are appropriately vetting fee arrangements. Second, whether advisers are appropriately disclosing information needed for the board’s determinations. The staff will want to be sure that both boards and advisers are carrying out their responsibilities and that, notwithstanding binders showing support and legal advice, directors have actually asked the right questions in making their determinations.

The Unit has developed its fee analytics with assistance from other SEC divisions and offices, including Investment Management, OCIE and RiskFin. The Unit’s leaders have declined to provide specifics as to its analytics, and they will intentionally keep its surveillance parameters confidential in order to prevent engineering around the Unit’s monitoring. The Unit has said it will be “continually refining” its analytics based on experience.

Director Khuzami’s announcement of this initiative immediately raised eyebrows across the fund industry, with many concerned that the use of fee “analytics” across groups of funds could be inconsistent with the Supreme Court’s decision on fees earlier this year in Jones v Harris Associates L.P.[7] In Jones, the Court essentially adhered to the Second Circuit’s so-called Gartenberg standard that had been followed for decades by lower courts.[8] Under Jones and Gartenberg, to violate Section 36(b) of the Investment Company Act, an adviser’s fee must be “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining.” The essence of this more flexible standard is whether “under all the circumstances” it appears to be an arm’s length bargain.”[9]

In so ruling, the Supreme Court explicitly rejected a market-based approach to evaluate advisers’ fees that had been proposed by the Seventh Circuit in the decision that led to the appeal, and warned against “inapt comparisons” in evaluating fee determinations. The Supreme Court observed, among other things, that there may be “significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund.” These can be “attributable to the greater frequency of shareholder redemptions in a mutual fund, the higher turnover of mutual fund assets, the more burdensome regulatory and legal obligations, and the higher marketing costs.” And even as between mutual funds, the Court warned against placing too much emphasis on a comparison of one fund’s advisory fees against fees charged to other mutual funds by other advisers.[10]

The Co-Chiefs of the Asset Management Unit responded quickly to these concerns. Kaplan told a reporter that Unit staff “read Jones v. Harris very carefully and recognize that in evaluating the fee process there are a number of considerations. We are aware of the admonition of not engaging in inapt comparisons ... and we are looking at the total facts and circumstances of a board’s approval of fees.” Karpati added that “[o]ur analytics do not employ any single fee threshold to determine appropriate candidates for further review.”[11]

Bond Fund Valuation Initiative

Khuzami also told Congress that his new Asset Management Unit will mount a “Bond Fund Valuation Initiative” to “focus on disclosure and valuation issues in mutual fund bond portfolios.” He said that this initiative arose from the Unit’s consideration of “practices identified in an examination of a significant bond fund complex,” which neither he nor the Unit’s leadership have identified. As with its other initiatives, the Unit has collaborated with other SEC divisions and offices “to develop risk analytics that identify red flags for further investigation.” These red flags include “misrepresentations of leverage, outlier performance, and problematic valuations.”[12]

Problem Adviser Initiative

Finally, Khuzami identified an Asset Management Unit initiative to deal with what he called “problem” advisers. He told Congress that the Unit had worked with the SEC’s examination staff to develop “a risk-based approach to detecting problem investment advisers.” The effort will involve “on-going due diligence reviews of advisers’ representations to investors related to their education, experience, and past performance.”[13]

C. Recent Areas of Prosecutorial Interest

A quick tour of very recent asset management cases appearing in the Litigation Releases section of the SEC’s website shows that the new Enforcement Division focus on funds and advisers is moving forward quickly. Not only is the number of recent cases noteworthy, but also the fact that a number of these cases are being litigated, which may indicate that the cases are more aggressive than what we have seen before. Looking at certain of these case filings, as discussed below, we see some key themes likely to recur in asset management cases ahead.[14]

Hedge Fund Insider Trading

On November 12, 2010, the SEC charged an adviser and its managing director with insider trading on behalf of a hedge fund based on information about a corporate acquisition. In its complaint – personally signed by Asset Management Unit Co-Chief Kaplan – the SEC alleged that the adviser’s managing director was a fourth-level tippee of two major law firm attorneys who had misappropriated client information and then tipped an unrelated attorney, who tipped a proprietary trader at a broker-dealer, who tipped another proprietary trader at the same broker-dealer, who ultimately tipped the adviser’s managing director.[15]

The same day, the SEC filed a second complaint against the same managing director of the investment adviser that charged him separately with insider trading on behalf of a hedge fund based on information about two other acquisitions and an earnings announcement. The second complaint related to the SEC’s case against Galleon Management LP, and the SEC took the opportunity to recap that it has so far charged 22 defendants in that matter with “repeated insider trading at numerous hedge funds” in the securities of 14 issuers.[16]

On September 16, 2010, the SEC settled charges that a hedge fund portfolio manager traded on behalf of an investment adviser and for his own account based on insider information about a large financial services provider’s upcoming analyst recommendations. The settlement included a bar of the portfolio manager, as well as an injunction and disgorgement of profits, but the SEC did not impose a penalty “based upon his cooperation in a Commission investigation and related enforcement action.”[17]

Valuation Issues

On October 25, 2010, the SEC charged a hedge fund manager and his investment advisory businesses with allegedly overvaluing his funds’ largest position by misstating the acquisition price and then continuing to value the investment at the acquisition price. The SEC additionally charged that the manager raised money for new funds with the representation that the funds would be invested in free-trading shares or cash, when they were instead being invested largely in relatively illiquid securities.[18]

On October 19, 2010, the SEC charged two hedge fund portfolio managers and their investment advisory businesses with allegedly overvaluing illiquid fund assets that had been placed in a “side” pocket. A side pocket is an account that hedge funds appropriately use to separate illiquid investments from the remainder of a fund. The SEC’s release on this case announced that the “Asset Management Unit has been probing whether funds have overvalued assets in side pockets.”[19]

Risk Disclosure / Subprime

On September 30, 2010, the SEC charged a chief investment officer and a product engineer with failing to adequately disclose risks and concentration in subprime bonds.[20] The matter related to a settled case filed earlier this year involving their former employer.[21] Interest in subprime-related matters has, of course, been high over the last year. On April 7, 2010, the SEC charged an adviser and two employees with allegedly overstating the value of securities backed by subprime mortgages. The SEC complained of an alleged failure to employ reasonable procedures to internally price the portfolio securities, with resulting impact on the calculation of net asset values for the funds in question, including through price adjustments that allegedly ignored lower values for the securities quoted by various dealers as part of the pricing validation process.[22]

Performance / Strategies

On November 4, 2010, the SEC charged two hedge fund managers and their entities with allegedly making fraudulent misrepresentations to investors concerning past performance and anticipated future returns, as well as concerning use of investor funds and investment strategies.[23] On October 28, 2010, the SEC charged an investment adviser and its affiliates with allegedly participating in fraudulent offerings that lied to investors about use of proceeds and investment risk.[24] On October 7, 2010, the SEC charged a portfolio manager and CEO of an adviser with allegedly misrepresenting risk, diversification and liquidity of the funds he offered, and with making unsuitable recommendations to elderly investors.[25]

Offering Requirements

On November 22, 2010, the SEC charged an adviser with Reg M violations for purchasing securities from an offering after having sold short the same securities; the case settled with a censure, disgorgement of $183,084 in gains and avoided losses, a $100,000 fine and a cease-and-desist order. [26] On September 23, 2010, the SEC charged a hedge fund adviser with Reg M violations for purchasing securities from multiple public offerings after having sold short the same securities, including one instance where the portfolio managers who sold short and bought in the offering were different individuals; the case settled with a censure, disgorgement of approximately $2.3 million in gains and avoided losses, a $260,000 fine and a cease-and-desist order, and the adviser undertook remedial measures, including enhanced policies and procedures and installation of an automated system to help prevent future Reg M violations.[27]

Conflicts

On September 29, 2010, the SEC charged an adviser with failing to tell clients that it would receive additional commissions if they switched from one series of a fund to another; the case settled with a censure, disgorgement of approximately $395,000 in commissions, a $60,000 fine for the adviser’s president, and a cease-and-desist order.[28] On September 23, 2010, the SEC charged an adviser and its principals with failing to disclose conflicts, contrary to statements in the adviser’s Form ADV, arising from their investment of client funds in entities in which the adviser’s principals had interests; the case settled with revocation of the adviser’s registration, a bar of its principals, and a cease-and-desist order.[29]

Books and Records / Form ADV Issues

On November 17, 2010, the SEC charged that an adviser, its broker-dealer parent, and their former chief compliance officer failed to have adequate policies and procedures to prevent misuse of nonpublic information, and that the adviser allegedly supplemented and altered its records before producing them to the SEC’s examination staff; the case settled with a censure, a $75,000 fine for the adviser and a $35,000 fine for the former officer, and a cease-and-desist order.[30]

On November 16, 2010, the SEC charged that an adviser failed to supply books and records to examiners until it received an Enforcement Division subpoena, and that it made misrepresentations in its Form ADV concerning its ownership structure and percentage of high net worth investors; the case settled with revocation of the adviser’s registration, a nine-month suspension of its CEO, and a cease-and-desist order.[31] On October 22, 2010, the SEC charged an adviser with failing to keep required records, custody rule deficiencies, and Form ADV deficiencies; the case settled with a censure, a $60,000 fine and a cease-and-desist order.[32]

D. Conclusion

The Enforcement Division’s heightened interest in investment management issues obviously means that we have entered a period requiring increased attentiveness. As always, the best approach to dealing with stronger enforcement will be recruiting, supporting and retaining competent compliance personnel; establishing and maintaining quality policies and procedures tailored to each entity’s business and operations; and continuing to send a clear message from senior management that compliance is an organizational priority.

Where the new vigor in fund and adviser enforcement at the SEC does turn up matters warranting further attention, the focus and sophistication that the Asset Management Unit promises may do much to facilitate a reasoned and fair resolution of complex problems. Counsel will engage with staff possessing both practical industry knowledge and a comprehensive mandate allowing them to achieve consistent treatment across their program. This will hopefully be a win-win formula for the SEC, the fund industry and their investors.

References

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