The removal of restrictions on general solicitation, a consequence of the Jumpstart Our Business Startups (JOBS) Act, has created new opportunities for the U.S. Securities and Exchange Commission (SEC) to probe the depth of hedge fund pockets. The National Examination Program, part of the SEC’s Office of Compliance Inspection and Examinations, has made it clear that the accuracy of performance data used for marketing purposes will be an SEC priority.

Hedge fund firms also need to be cognizant of the SEC’s heightened scrutiny of actual marketing practices as permitted under the new rules arising from the passage of the JOBS Act. Private equity and venture capital firms will be impacted as well.


What This Means

Using proprietary risk analytics, the SEC’s enforcement division will be scouting the horizon for firms whose performance claims are inconsistent with published strategies and/or deviate from established benchmarks. These analytics are not dissimilar to those already employed by hedge fund clients to ferret out managers who have manipulated their returns. These indicators include skewed return distributions, bias ratios which detect smoothing, and serial correlations. Any red flags will likely result in enhanced enforcement efforts.

What it Doesn’t Mean

This does not signal any relief from other enforcement efforts, as the SEC will add around 130 new positions to beef up its enforcement division.  As a result, compliance officers will not only need to maintain a vigilant stance, they would do well to review all policies and procedures in place relative to their firm’s marketing efforts and, of course, ensure the accuracy of any and all performance claims made in conjunction with the firm’s retail clients.

As recently as May of this year, an investment advisor and its principals were charged with distributing false performance statistics to potential investors. The SEC also alleges that the CFO altered the opinion of an independent auditing firm to parallel the altered performance statistics.

Other Enforcement Allegations

Under the new rules additional enforcement cases have arisen as a result of:

  • Failing to disclose if, and to what extent, performance results reflect the reinvestment of dividends or interest earnings
  • Reporting gross rates of return that fail to deduct advisory fees
  • Neglecting to report fees and expenses incurred on funds invested in funds
  • Failing to distinguish between model performance results and actual trading results
  • Making inappropriate comparisons of a fund’s return to a benchmark that had significantly different volatility
  • Distributing marketing materials which include performance claims without the review and approval of the Chief Compliance Officer and /or other members of the management team as directed by the firm’s policy and procedure terms

Remarkably, as the last example indicates, the SEC’s enforcement effort extends to ensuring that a firm enforces its own internal policies!

A Proactive Course of Action

  1. Formulate and execute written policies designed to ensure compliance
  2. Employ a qualified compliance officer to administer the firm’s written policies
  3. Ensure that internal reporting systems are auditable and well understood by a majority of the firm’s employees
  4. Establish internal controls to detect anomalies and investigate the cause
  5. Create tolerance reports to compare fund performance to appropriate benchmarks and investigate discrepancies immediately and thoroughly

Making compliance a top priority from the “top” down is an absolute necessity in the current regulatory environment.




If the Internal Revenue Service is the governmental agency most feared by Americans in general, then the U.S. Securities and Exchange Commission (SEC) is the agency most feared by Wall Street, in general, and by hedge funds in particular.

Illegal insider trading has been the SEC investigators’ priority target for decades and with the 2011 adoption of a bounty offered to whistle-blowers pursuant to Rule 21f of the Securities Exchange Act, the SEC has enhanced its ability to reach potential targets. As recently as June 3, 2014, a pair of whistle-blowers were awarded almost one-half million dollars each, one of 8 bounties paid since 21f’s implementation.

The Irony Is Palpable

Running a successful hedge fund requires keen insight—insight gained from a variety of sources. Geo-political events, market trends, corporate strategies, mergers, acquisitions, innovations, interest rates, unemployment, government policy shifts, inflationary trends and deflationary signals represent but a fraction of the information a hedge fund manager must consider when making an investment decision.

The information gathering process necessary to make sound investment decisions continually exposes hedge funds to the possibility of arousing the suspicion of regulators as it relates to insider trading. As a consequence, many hedge fund firms engaged the services of political intelligence companies. These enterprises, usually manned by former lobbyists and other political insiders, gather and sell information to investors of all stripes. This information is not secret, not classified; it is simply difficult for any single individual or firm to compile.

Ironically, many of these political intelligence firms, also reeling from regulatory pressure, are turning to computer algorithms which analyze public data, eliminating the need for any interaction with Congress or other policy makers. This makes it extremely difficult for regulators to build a case against them for insider trading because no direct link can be made between the intelligence firm and any individual.

Maneuvering Through the Minefield

To what degree the fund manager’s fiduciary responsibility to his investors is thwarted by the regulatory process is impossible to gauge. One thing, however, is certain; ambiguities in regulation and law have blurred the line between the legal and the illegal to such an extent that investment decisions are being made in the absence of information that might have been routinely accessed just a few years ago. Now it is judged to be too dangerous to exploit.

Of course hedge funds and other Wall Street firms are not the only targets of regulators. There is the recent case involving allegations of insider trading against golfing great Phil Mickelson. Mickelson, involved in a trade of Dean Foods (DF) shares, netted around $1 million in gains.

Hedge funds and all other investors should have the right to seek information from government sources as long as trades are not based on non-public information. Furthermore, investors of all stripes have the right to expect unambiguous laws and regulations. Until these ambiguities are eliminated, no one is well-served. In such an ambiguous regulatory and legal environment, all available information is not pursued for fear of investigation and, as a result, the decisions made are not as well-informed as they might otherwise be. Does anyone believe this serves the public’s best interests?


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