Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, NY
Sept. 11, 2014
Thank you, Nora, for the kind introduction. Good morning and thank you for inviting me to speak to you today. Before proceeding, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.
I worked in and around the private fund industry for over twenty years before joining the SEC in 2010, and experienced firsthand the unique role that private funds, and the advisers to private funds, perform in creating innovative investment strategies and products to meet the ever-evolving demands of their investors. And now, in my role at the Commission, I have the privilege of working with the creative and dedicated staff of the Division of Investment Management – nearly 200 talented staff members who are committed to carrying out the Division’s critical mission to protect investors, promote informed investment decisions, and facilitate appropriate innovation in investment products and services through the regulation of the asset management industry. I am joined here today by two of my Investment Management colleagues – Dan Townley, who will be discussing the Volcker Rule later this afternoon, and Aaron Schlaphoff, who will be participating shortly in the “Registration and Regulation” panel.  We are also joined by our colleague Marc Wyatt from the Commission’s Office of Compliance Inspections and Examinations (OCIE), who will be speaking this afternoon on the “Operational Issues and Ethical Compliance Considerations” panel.
What We Now Know About the Industry
It is difficult to overstate how much the regulatory landscape for hedge fund managers has changed over the past four years. Title IV of the Dodd-Frank Act directed the Commission to implement a number of provisions designed to enhance the oversight of private fund advisers, including registration of advisers to hedge funds, private equity funds and other private funds that were previously exempt from SEC registration. Due to the Dodd-Frank Act and the Commission’s new registration rules, the number of SEC-registered private fund advisers has increased by more than 50%. As of September 2014, the registrant population consisted of about 11,438 advisers, with 2,691 of these advising at least one hedge fund. Overall, registered advisers of hedge funds manage approximately $5.4 trillion in cumulative reported regulatory assets under management. (For comparison, the registrant population includes approximately 1,237 advisers to at least one private equity fund, managing approximately $2 trillion in cumulative reported regulatory assets under management.) In addition to advisers registered with the Commission, there also are exempt reporting advisers, or ERAs, who are those advisers that are exempt from registering with the Commission, but are subject to limited reporting about their businesses and their private fund clients. There are approximately 2,693 ERAs, with 875 advisers or 32% of these managing hedge funds that account for approximately $846 billion in regulatory assets.
The improved information on private funds is the result of upgrades to Form ADV and the arrival of Form PF. In 2011, the Commission adopted amendments to Form ADV requiring significant additional information with respect to, among other things, the identity of hedge fund clients, amount of gross assets, names of service providers to these hedge funds, and the number and types of hedge fund investors. Also in 2011, the Commission adopted new Form PF jointly with the Commodity Futures Trading Commission. Form PF requires most registered advisers to hedge funds to report, among other things, the use of leverage, counterparty credit risk exposure, and trading practices for each hedge fund managed by the adviser. Larger hedge fund advisers report more detailed information.
With these registration and reporting reforms, we have a more complete picture of the hedge fund universe than we did four years ago. It is now incumbent upon us as regulators to incorporate this information into our regulatory programs, a process that is ongoing but well underway. While the information collected on Form PF primarily is intended to assist the Financial Stability Oversight Counsel (FSOC) in its systemic risk monitoring obligations under the Dodd-Frank Act, the Commission makes use of the information obtained from Form PF in its regulatory programs and investor protection efforts relating to private fund advisers. For example, OCIE staff uses Form PF to obtain an understanding of the nature of a private fund adviser’s business and investment strategy as part of its routine pre-examination evaluations. OCIE staff also generally reviews information contained in the Form PF filing for inconsistencies with an adviser’s publicly available documents, the investment strategies disclosed to investors, and other information obtained during an examination. Enforcement staff – and in particular, Enforcement’s Asset Management Unit – also obtains and reviews Form PF filings in connection with its investigations of certain private fund advisers. Form PF information also is used by Commission staff in connection with its Aberrational Performance Inquiry, which seeks to identify hedge fund advisers that report aberrational returns relative to certain benchmarks for further investigation, and has resulted in the identification of fraudulent or improper conduct.
With the benefit of enhanced reporting on Form ADV and information from Form PF, the Division is working hard to enhance its awareness of developments in the asset management industry. One important tool in these efforts is our Risk and Examinations Office, or “REO,” which was formed in 2012. REO is a multi-disciplinary office staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers, and accountants. REO maintains an industry monitoring program that provides ongoing quantitative and qualitative financial analysis of the investment management industry, with a particular focus on strategically important investment advisers and funds. REO seeks to obtain a representative sample of asset management firms for this purpose, and selects firms based on various factors, including the types of products offered (such as mutual funds, money market funds, ETFs and private funds). The REO monitoring program’s work includes analysis of the information the industry provides through various regulatory reports, including Form PF, as well as industry information from third party providers. In addition to financial analysis, REO conducts an examination program that gathers information from the investment management industry to inform the Division’s policy making. Although REO may conduct its own exams, where practical, REO will work together with OCIE to obtain information about OCIE’s examinations. REO’s work will inform the initiatives to which the Division devotes resources and will help inform the rules we recommend. I am excited at the prospect that REO can help the staff to be proactive and get out in front of new industry risks, rather than reacting when unanticipated issues manifest to the detriment of investors.
Review of Advisers Act and Recent Division Guidance
Although the principles-based Advisers Act regime has largely stood the test of time, despite being applied to an increasingly diverse set of adviser business models, for the past two years the staff has been reviewing the Advisers Act and its rules and providing guidance regarding their application to private fund advisers. This initiative has been particularly important now that close to 40% of our registered investment advisers advise private funds. We have provided IM Guidance Updates on several key issues for investment advisers that are reflective of our efforts in this area. For instance, the Division’s staff issued guidance regarding (1) the application of the custody rule to private stock certificates, which focused on investor protections provided by fund audits; (2) the application of the custody rule to escrows typically used by private equity funds; (3) the application of the custody rule to special purpose vehicles; (4) when certain private fund investors are “qualified clients” under the Advisers Act; and (5) the application of the venture capital exemption in certain common scenarios. The Division also issued a no-action letter that provided guidance regarding the definition of “knowledgeable employee” under the Investment Company Act of 1940. The letter updates and modernizes views of the Division on what a firm’s principal business units may be and what it means to participate in the investment activities of an adviser for the purposes of advisory staff investing alongside other fund private fund investors.
The inquiries and feedback that we receive from industry stakeholders, especially from new registrants, help inform our efforts, and we hope that you will continue to bring your issues and challenges to our attention.
In addition, the staff is continuing to review the 450 comments we received on last summer’s proposal to enhance the agency’s ability to evaluate the development of market practices in Rule 506 offerings.
Compliance, Examinations and Enforcement
Now that I’ve given you an overview of some of our key policy and industry outreach initiatives, I’d like to shift focus and discuss some important compliance, examination and enforcement topics for hedge fund advisers.
In 2014, OCIE’s National Examination Program launched an initiative to engage with the roughly 20% of investment advisers that have been registered for three years or more, but have never been examined. This initiative includes both risk-assessment and focused reviews. The risk-assessment approach is designed to obtain a better understanding of a registrant and may include a high-level review of an adviser’s overall business activities. The focused review approach includes conducting comprehensive, risk-based examinations of one or more higher-risk areas, which could include, among others, the compliance program, portfolio management, or safety of client assets. In addition, OCIE has continued examining newly registered private fund advisers through its “presence exam” initiative, which began in late 2012, and is nearing completion of its goal of examining 25% of these newly registered advisers. These “presence” examinations are more streamlined than typical examinations, and focus on the key areas of marketing, portfolio management, conflicts of interest, safety of client assets, and valuation. We look forward to hearing more about OCIE’s findings through this initiative.
Next month marks the ten-year anniversary of the compliance date for Rule 206(4)-7 – the compliance program rule under the Advisers Act. As you are no doubt aware, Rule 206(4)-7 requires registered advisers to adopt, implement and annually review compliance policies and procedures that are reasonably designed to prevent violations of the Advisers Act. The rule also requires that advisers designate a chief compliance officer. The rule, which was adopted against the backdrop of the late trading and market timing scandals, stresses the importance of strong compliance programs in preventing violations of law as well as the important role that compliance professionals play in ensuring a strong culture of compliance. When proposing Rule 206(4)-7, the Commission stated: “Our experience is that funds and advisers with effective internal compliance programs administered by competent compliance personnel are much less likely to violate the federal securities laws. If violations do occur, they are much less likely to result in harm to investors. In contrast, we have learned to regard weak controls as an indicator that undetected (and uncorrected) violations may have occurred, and we have assumed that, until improved controls are implemented, investors are at risk.” I believe those words are as true today as they were ten years ago.
Compliance policies and procedures must be specifically tailored to your firm’s advisory business, and should evolve and grow with your business. For example, earlier this year, the Commission charged an investment adviser with issuing false and misleading advertisements. The Commission noted that the firm’s policies and procedures only parroted the Commission’s rule, and were not specifically tailored to prevent advertisements from violating the advertising rules. It is crucial that policies and procedures be reviewed and updated as your business changes, as regulations change, and as new guidance is issued.
Advisers must be equally vigilant in identifying, disclosing and managing conflicts of interest. Earlier this year my colleagues in OCIE’s National Examination Program indicated that, as part of their examination priorities for 2014, OCIE staff would be conducting examinations focused on conflicts of interest inherent in the investment adviser business model. In making this announcement, OCIE noted that “[o]ver time, the staff has observed instances of non-compliance with the federal securities laws very often arise in situations where there are unaddressed conflicts of interest,” which leads advisers to “engage in activity that puts their own interests ahead of their clients in contravention of their fiduciary duty and existing laws, rules and regulations.”
As with compliance programs generally, it is important for advisers to continuously review their business models to identify emerging conflicts and risks. Keep in mind that conflicts need to be disclosed to investors before they invest in a fund, and the disclosure must be meaningful. Among other things, this means that the disclosure should be sufficiently tailored for investors to understand the nature and magnitude of a conflict and the particular risk that it presents. A corollary of this is that an adviser should not assume that conflicts which are generally inherent in the advisory model do not need to be disclosed. For example, I believe that the failure to disclose a fee or expense borne by investors is not justified by arguing that the allocation is “industry practice” or “market standard.”
Of course, conflict situations can arise after an investor has already invested in a fund. In some cases, an adviser may seek approval or clearance of a conflict from a fund’s independent board members or from a conflicts committee. Advisers who seek to rely on this approach should consider, among other things, whether the authority of the conflicts committee to act on behalf of a fund is appropriately documented and disclosed to investors. If a conflicts committee approves or clears a particular conflict or transaction, the adviser should still consider whether appropriate disclosure regarding the conflict is being provided to investors. In addition, an adviser should keep in mind that the involvement of a conflicts committee may not, by itself, ensure that the approval or clearance will be valid. Among other things, all material facts regarding the conflict should be disclosed to the committee, and the committee should have a meaningful opportunity and ability to consider and evaluate these facts. It is also important to consider whether the conflicts committee itself might be conflicted. A settled enforcement action brought by the Commission against a hedge fund adviser this summer illustrates this point. According to the Commission’s order, the adviser’s owner caused the adviser to enter into principal transactions with an affiliated broker-dealer while trading on behalf of a hedge fund client. Such principal transactions pose conflicts between the interests of the adviser and the client, and therefore advisers are required to disclose that they are participating on both sides of the trade and must obtain the client’s consent. According to the Commission’s order, the adviser attempted to satisfy these requirements by establishing a conflicts committee to review and approve each of the principal transactions on behalf of the hedge fund. However, the committee consisted of two people who were themselves conflicted – namely, the adviser’s chief financial officer and chief compliance officer. Further, the adviser’s chief financial officer also served as the chief financial officer of the affiliated broker-dealer. The Commission’s order therefore found that the adviser failed to provide effective written disclosure to its hedge fund client and failed effectively to obtain the hedge fund’s consent prior to the completion of each principal transaction. (This particular case was also notable because, in addition to Advisers Act violations, the Commission also charged the adviser with retaliating against its head trader for reporting the conduct to the SEC in a whistleblower submission – the first case brought by the Commission under its new authority to bring anti-retaliation enforcement actions.)
Now I would like to turn to another topic that has received a fair amount of recent attention: alternative mutual funds. In contrast to private funds, mutual funds are subject to registration and regulation under the Investment Company Act and (in most cases) their shares are registered under the Securities Act of 1933, which means that they can be offered to retail investors. While there is no clear definition of “alternative” in the mutual fund space, an alternative mutual fund is generally understood to be a fund whose primary investment strategy falls into one or more of the three following buckets: (1) non-traditional asset classes (for example, currencies), (2) non-traditional strategies (such as long/short equity positions), and/or (3) illiquid assets (such as private debt).
There are several reasons that I believe it is important to discuss alternative mutual funds. First, the market for these funds is large and growing rapidly. As of the end of May 2014, alternative mutual funds had over $300 billion in assets. Although alternative mutual funds only accounted for 2.3% of the mutual fund market as of December 2013, the inflows into these funds in 2013 represented 32.4% of the inflows for the entire mutual fund industry, with almost $95 billion of inflows into alternative mutual funds in 2013. That is over five times more than the amount of inflows into alternative mutual funds in 2012. Second, many hedge fund advisers are becoming involved with alternative mutual funds, either as sub-advisers to funds launched by traditional registered investment company managers, or by launching their own registered investment companies. Third, and perhaps most importantly, alternative mutual funds present heightened risks in all of the areas that I just mentioned – compliance programs, conflicts of interest, valuation, portfolio management, and marketing.
Why do alternative mutual funds present heightened risks? As I said earlier, alternative mutual funds are registered under the Investment Company Act. The Investment Company Act – intended to protect all investors in registered funds but, in particular, retail investors – subjects funds to an expansive, substantive regulatory regime that imposes significant requirements and restrictions on the funds, as well as on their advisers and other service providers. These requirements relate to, among many other things, a fund’s capital structure, liquidity, valuation, leverage and disclosure. While I do not have time today to discuss all of these topics, they were the subject of a speech that I gave at another PLI conference in June, which is available on the SEC’s public website. The key point that I wish to make today, however, is that managing a registered fund is very different from managing a private fund, and a hedge fund adviser must carefully consider this before becoming an adviser or sub-adviser to a registered fund.
Earlier in my remarks today I described the Advisers Act regime as “principles-based.” While the Advisers Act and related SEC rules impose substantive requirements on advisers, the Advisers Act is largely focused on ensuring that an adviser fulfills its fiduciary duties and provides full and fair disclosure to investors. While fiduciary duties and disclosure are also key elements of the Investment Company Act, the Investment Company Act regime imposes many additional, substantive restrictions. For example, Section 206 of the Advisers Act permits an adviser (or an affiliate of an adviser) to engage in a principal transaction with a fund or other client, provided that the client consents to the specific transaction after receiving full disclosure of all material facts. By contrast, Section 17(a) of the Investment Company Act generally prohibits such transactions for a fund, not only with its adviser, but with any affiliate of the fund, or with any affiliate of an affiliate of a fund. Furthermore, Section 17(d) and Rule 17d-1 under the Investment Company Act generally prohibit an adviser to a registered fund, or any other affiliate or affiliate of an affiliate of a registered fund, from engaging as principal in any “joint enterprise or other joint arrangement or profit-sharing plan” in which the registered fund is a participant, without first obtaining an exemptive order from the Commission. The breadth of these provisions can capture many types of transactions and arrangements, and may present concerns for advisers who manage registered and private funds alongside each other. For example, the Commission brought settled enforcement actions in 2012 and 2014 against two affiliated investment advisers and a portfolio manager for, among other things, aiding and abetting and causing violations of Section 17(d) and Rule 17d-1, by causing a hedge fund client to participate in a joint arrangement with an affiliated registered fund client without an exemptive order. The joint arrangement cited in the Commission’s settlement orders involved a transaction between the hedge fund and the registered fund, in which the registered fund purchased largely illiquid bonds from the hedge fund in order to alleviate liquidity problems that the hedge fund was experiencing.
I encourage private fund advisers to proceed thoughtfully and cautiously before becoming advisers to registered funds. Consider carefully your reasons for taking on a registered fund client, and the potential conflicts with your existing business. For example, most hedge funds charge performance-based fees, while registered funds typically charge fees based solely on assets under management. This creates numerous conflicts, including with respect to allocations of investment opportunities, which must be managed carefully.
You should also consider whether you have an appropriate compliance framework for managing a registered fund. The Investment Company Act has its own compliance rule, Rule 38a-1, which was adopted at the same time as Rule 206(4)-7 under the Advisers Act. While the two rules are similar in many ways, Rule 38a-1 imposes numerous additional requirements. Among other things, the board of directors to a registered fund must approve the fund’s compliance program and the compliance programs of its adviser and other service providers. A registered fund also must have its own chief compliance officer, who is appointed (and can only be removed) by the board. The fund’s CCO must administer the fund’s compliance program, must report directly to the board regarding the fund’s compliance program (including any material compliance violations), and cannot be unduly influenced by the adviser or its agents. These and other requirements mean that a private fund adviser may need to make significant changes to its compliance program in order to take on a registered fund client. Merely “tacking on” new policies and procedures to the adviser’s existing program, without considering the overall impact to the adviser’s business model, may increase the risk of compliance weaknesses, deficiencies or violations.
I appreciate the opportunity to share my thoughts on these issues of interest to investment advisers and the larger hedge fund community. The Division works to protect investors, promote informed decision making, and facilitate appropriate innovation in investment products and services through regulating the asset management industry. Thank you for your time this morning.
 I would like to thank Aaron Schlaphoff for providing vital assistance in preparing these remarks.
 Investment Adviser Registration Depository (IARD) data as of September 2, 2014.
 See Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisers, Investment Advisers Act Release No. 3308 (October 31, 2011), available at http://www.sec.gov/rules/final/2011/ia-3308.pdf.
 IM Guidance Update 2013-04, Privately Offered Securities under the Investment Advisers Act Custody Rule (August 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-04.pdf.
 IM Guidance Update 2014-07, Private Funds and the Application of the Custody Rule to Special Purpose Vehicles and Escrows (June 2014), available at http://www.sec.gov/investment/im-guidance-2014-07.pdf.
 IM Guidance Update 2013-10, Status of Private Fund Investors as Qualified Clients (November 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-10.pdf.
 IM Guidance Update 2013-13, Guidance on the Exemption for Advisers to Venture Capital Funds (December 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-13.pdf.
 SEC No-Action Letter, Managed Funds Association (February 6, 2014), available at http://www.sec.gov/divisions/investment/noaction/2014/managed-funds-association-020614.htm.
 See Letter to Industry Regarding Presence Exams (October 9, 2012), available at http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.
 In the Matter of Navigator Money Management, Inc. and Mark A. Grimaldi, Investment Advisers Act Release No. 3767 (January 30, 2014), available at http://www.sec.gov/litigation/admin/2014/33-9521.pdf.
 National Examination Program – Examination Priorities for 2014, available at http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf.
 In the Matter of Paradigm Capital Management, Inc. and Candace King Weir, Investment Advisers Act Release No. Investment Advisers Act Release No.3857 (June 16, 2014), available at https://www.sec.gov/litigation/admin/2014/34-72393.pdf.
 These investment strategies generally seek to produce positive risk-adjusted returns (or alphas) that are not closely correlated to traditional investments or benchmarks. These investment strategies differ from those of traditional mutual funds that historically have pursued long-only strategies in traditional asset classes.
 Based on staff analysis of Morningstar DirectSM open-end mutual fund data.
 Norm Champ, Remarks to the Practising Law Institute, Private Equity Forum (June 30, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542253660.
 In the Matter of Martin Currie Inc. and Martin Currie Investment Management Ltd., Investment Company Act Release No. 30026 (May 10, 2012), available at https://www.sec.gov/litigation/admin/2012/ia-3404.pdf; In the Matter of Christopher B. Ruffle, Investment Company Act Release No. 31066 (June 2, 2014), available at https://www.sec.gov/litigation/admin/2014/ic-31066.pdf.