Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, recently described enforcement priorities with respect to hedge funds. He noted the Asset Management Unit, comprised of 75 staff across 11 offices, focuses its investigations on investment advisers, investment companies, hedge funds, mutual funds and private equity funds.
Mr. Karpati believes understanding the varying business motivations behind investment advisers’ actions and decisions helps us identify problematic issues and trends within the asset management industry. For example:
- Because hedge fund managers are compensated by both management fees and performance fees, the manager has incentives to over-prioritize compensation. For example, the temptation to overvalue assets to boost compensation has emerged repeatedly in enforcement cases.
- The hedge fund business model and industry growth put a great deal of pressure on the manager to demonstrate and market consistently positive performance.
- Because some hedge fund managers may control every aspect of their business, severe conflicts of interest can arise.
Mr. Karpati stated “The incentives and opportunities provided by the hedge fund operating model may be in tension with a manager’s role as a fiduciary. As you know, the Investment Advisers Act of 1940 imposes on investment advisers a broad fiduciary duty to act in the best interest of their clients. This means that investment advisers have “an affirmative duty of ‘utmost good faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’… clients.” As a fiduciary, a hedge fund manager must guard against conscious and unconscious incentives that might cause him or her to provide less than disinterested advice since an investment adviser may be faulted even when he or she does not intend to injure a client or even if a client does not suffer a monetary loss. The fiduciary duty is the lens through which the AMU looks at many of the issues it investigates, and the anti-fraud provisions of the Investment Advisers Act (including Sections 206(1) and (2) and Rule 206(4)-8)) enable the AMU to pursue breaches of fiduciary duty and other forms of misconduct.”
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