Advisers Need to Know How to Avoid Becoming an “Enforcement Referral”

With Hedge Funds a Priority of the SEC’s Examination Program, Advisers Need to Know How to Avoid Becoming an “Enforcement Referral”

By Sylvia Scott

For a hedge fund adviser, it’s one thing to have the SEC’s Office of Compliance, Inspections and Examinations (“OCIE”) visit your office. It’s another matter entirely when the enforcement division comes knocking at your door based on a referral from OCIE. If the matter stays with OCIE, a firm’s non-compliance results in a deficiency letter. If the enforcement division gets involved and concludes the firm committed serious violations, an enforcement action is likely to follow that could involve severe sanctions, not to mention reputational damage.

Hedge fund activities continue to be in the regulatory spotlight. This state of affairs is likely to continue in light of the SEC’s recently finalized rules requiring registration of most hedge fund advisers as well as other recent regulatory developments. Consequently, it has become more important than ever for hedge fund advisers to focus their attention on how to prepare for regulatory examinations and how to avoid becoming an “enforcement referral.”

What are the Regulatory and Political Dynamics at Play?

First the basics. The SEC’s nationwide examination program is run by OCIE. The group consists of attorneys, accountants, MBAs, and former industry professionals. OCIE’s Office of Investment Adviser/Investment Company Examination is responsible for the examination of all registered investment advisers and investment companies, with total assets of well over $30 trillion. OCIE has examination staff located in Washington, D.C. and 11 regional offices. Until recently, hedge fund advisers have been able to avoid registration and the SEC examination process due to a statutory exemption that applied to advisers with fewer than 15 clients. Dodd Frank eliminated that exemption.

In June 2011, the SEC finalized rules requiring registration of most hedge fund advisers with either the SEC or their state regulator. This new registration requirement goes into effect in March 2012, which means that more advisers face the possibility of a visit from OCIE or a state regulator. The good news is that if the examination stays with OCIE, the adviser is in good shape. However, OCIE may refer the matter to the enforcement division for further investigation and possible enforcement action. OCIE examinations of broker-dealers may also be referred to FINRA for further investigation and possible enforcement action.

The enforcement division investigates the matter by issuing subpoenas, taking investigative testimony and conducting various analyses of the voluminous documents it obtains from the adviser and other sources. At the end of the investigation, the enforcement division decides whether or not to recommend enforcement action. Given the risk-based nature of investigations and examinations adopted by the regulators in the wake of Madoff and other financial scandals, the probability of an enforcement action resulting from an enforcement referral has increased substantially.

The SEC’s enforcement program has also undergone substantial reforms including the creation of five specialized units in early 2010 to address priority areas. One of those units is the Asset Management Unit, whose co-chief previously led the SEC’s hedge fund working group. One of the key objectives of the Asset Management Unit has been to gain specialized insights into the hedge fund industry by conducting multiple investigations in the same subject area. The Asset Management Unit is part of the enforcement division and works with OCIE to formulate examination and investigative strategies and techniques, among other things. This collaborative relationship is a recipe for more enforcement actions in the hedge fund industry.

This aggressive regulatory atmosphere is also fueled by various audit reports focusing on what the regulators could have done or should have done to prevent various scandals such as Madoff and Stanford. Following the Stanford Ponzi scheme case, there were allegations that certain enforcement staff mishandled referrals by OCIE. In May 2010, “[the SEC’s Office of Inspector General] found that the SEC’s Fort Worth regional office had been aware since 1997 that Robert Allen Stanford was likely operating a Ponzi scheme. The investigation also discovered that after a series of OCIE examinations of Stanford Group Company (Stanford’s registered investment adviser) in which each examination concluded that the likelihood of a Ponzi scheme or similar fraud existed, the SEC’s Fort Worth Enforcement unit did not take significant action to investigate or stop such expected fraud until late 2005.” See, SEC’s Response to Concerns Regarding Robert Allen Stanford’s Alleged Ponzi Scheme Report of Investigation (OIG Investigative Report No. 526 (March 31, 2010)

This report was followed by another report issued by the SEC’s Office of Inspector General in March 2011, titled OCIE Regional Offices’ Referrals to Enforcement. See, Report No. 493 A survey of examiners referenced in that report indicated that the Asset Management Unit, which is focused on the hedge fund industry, is more willing to take on referrals that were typically rejected in the past.

What is OCIE’s Selection Process for Conducting Examinations?

Because OCIE’s resources are very limited and there is tremendous pressure to weed out the next Madoff or Stanford, the office applies a risk-based approach for identifying examination candidates. The investment adviser examination program conducts three types of examinations: (1) examinations of “high risk” advisers; (2) “cause examinations” resulting from tips, complaints or referrals; and (3) special purpose exams such as sweeps that focus on specific areas of concern. “High risk advisers” are identified based on the following sources: 1) regulatory filings; 2) findings from prior examinations; 3) news/media coverage; 4) referrals from other regulators, and 5) other tips and complaints it receives. As to the second type of examination, the SEC’s Whistleblower Program, provides a steady flow of complaints and referrals. The third type of examination (special purpose exams) includes initiatives such as the SEC’s recent canvassing of hedge funds for “aberrational performance,” which is defined as a fund that outperforms market indices by a certain significant percentage.

What are OCIE’s Examination Priorities?

During an examination, the staff will typically focus on one or more of the following areas: insider trading, disclosure, conflicts of interest, portfolio management, valuation, performance, advertising and asset verification. If OCIE finds that an adviser’s compliance controls are weak or non-existent, the staff will zero in on the potential rule violations implicated by those weaknesses. For example, if a firm’s procedures are weak on privacy protection or monitoring electronic communications, this will be treated as a red flag that even larger compliance problems are present and the examiner will dig deeper.

With the SEC’s well publicized focus on insider trading activities, hedge fund advisers should anticipate that examiners will focus on the use of expert networks, compliance procedures and walls concerning material, non-public information, and front running. Other areas ripe for examination include activities impacted by the SEC’s adoption of new rules applicable to investment advisers. In such instances, examiners will audit the areas affected by such rules and review relevant documentation to assess compliance with the new requirements.

On the disclosure front, a priority area includes disclosures regarding a fund’s investment strategies and whether the fund is making investments that are contrary to the disclosed strategy. Disclosures connected to valuations are also a top priority. The staff will be looking for false and misleading valuations that are designed to attract new investors, induce current investors to forego redemptions and/or generate increasing management fees.

With conflicts of interest, a perennial examination favorite, the examiners will be looking at whether there is adequate disclosure of investments between funds, financial arrangements with affiliates, personal investments by fund managers, side letter agreements providing preferential treatment to some investors, and other undisclosed conflicts of interest.

To stay abreast of the SEC’s examination priorities, you can go to the SEC’s website and review the many press releases, reports and speeches of senior executives.

What are Some Tips for a Hedge Fund Adviser Facing an OCIE Examination?

There a number of best practices that advisers should adopt when faced with a regulatory examination. Below is a non-exhaustive list of examination “Dos and Don’ts”:


  • Be courteous and reasonably accommodating.
  • Review past deficiency letters.
  • Familiarize yourself with new regulations that impact your firm.
  • Review the examination request list, ask the examiner for clarification if necessary and flag possible areas of concern for follow-up.
  • Designate a reliable point person at your firm to interface with the examiner.
  • Maintain a log of documents requested and produced.
  • Address and correct any apparent miscommunications. If there are any contested issues, address them before the fieldwork portion of the exam is concluded.


  • Do not treat an examination as routine. All exams are now risk-based.
  • Do not “wing it” in responding to an inquiry or submitting to an interview. Give thoughtful responses or ask for more time so that you can provide a thoughtful and accurate response. Remember, everything you say can and will be used against you.
  • Do not lie to the regulators. Remember the old maxim, “the cover-up is often worse than the crime.”
  • Do not behave in a manner that gives the examiner the impression that you are causing delay or being disrespectful.
  • Do not let a deadline on a request letter pass, unless you have received an extension.
  • Do not turn over any attorney-client privileged communications; be sure these confidential items are removed from any document production, including electronically stored information.
  • Do not volunteer information unless you are absolutely certain it is helpful; err on the side of not volunteering information until after you have had time to carefully consider the matter. [The issue of self-reporting is a separate and complicated issue, to be addressed in another article. It is strongly recommended that a firm consult with in-house or independent counsel in evaluating this issue.]

How Can an Adviser Avoid Becoming an “Enforcement Referral”?

The goal of every adviser faced with an OCIE examination is to keep the exam with the examiner and avoid an “enforcement referral.” The vulnerability of a firm turns on what the firm has done before it become the target of an examination. By acting now and adopting the following recommendations, your chances of becoming an enforcement referral can be dramatically reduced:

  • Make sure your compliance controls and infrastructure are sound, strong and tailored to your firm’s business model.
  • Follow your own compliance manual, policies and procedures. Sounds obvious, but this is a recurring problem found by examiners and is “low hanging fruit” for examiners to spot.
  • Identify weaknesses in your supervisory system. Make sure your firm has a strong supervisory system for, among other things, monitoring insider trading, adequacy of disclosures, accuracy of valuations, investor communications and all significant areas peculiar to your firm’s business model.
  • Make sure your written procedures lay out clear and concise procedures regarding reporting lines.
  • Make sure you have compliance staff that is experienced and that there are sufficient resources to get the job done.
  • Training is key, including staying abreast of the ever-changing regulations that impact your firm’s activities.
  • Evaluate whether your firm’s technology is adequate to handle the compliance demands. For example, IT systems inadequate to prevent insider trading will set off alarm bells for examiners and could be a breeding ground for abuse.

Many of these recommendations require lead time. While it is tempting to put them off, in this aggressive regulatory environment that would be a mistake. Think of it like working out. If you avoid going to the gym, it’s that much more painful when you do finally get around to it. But if you just do it, you’ll be in better shape when you do have to face the challenge.

The information included in this Newsletter is intended for guidance purposes only and should not be regarded as a substitute for taking proper legal advice.

Author: Sylvia Scott at Freeman Freeman & Smiley, Los Angeles


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