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.



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