Eugene Grygo, Chief Content Editor, FTF News
Given some of the recent actions by the SEC, it’s reasonable to ask if the regulator may be enforcing a kind of “broken windows policing” effort.
When put into practice, the broken windows theory as applied to non-Wall Street crime by police officers involves acting upon “small crimes such as vandalism, public drinking, and toll-jumping,” according to Wikipedia. Ultimately, the goal is to prevent those who are committing these lesser acts from moving on to greater crimes. It is a controversial theory that has its supporters and harsh critics.
So, is the SEC pursuing a “broken windows” policy by citing securities firms and other market participants for regulatory violations, disclosure failures, misinformation to clients, and faulty policies and procedures?
Over the past several months, the SEC has penalized:
- UBS for not implementing policies and procedures that provided all the relevant information about highly complex instruments;
- Two members of Grant Thornton International (GTI) — Grant Thornton India LLP and Australia-based Grant Thornton Audit Pty Limited — with auditor independence violations;
- And Deutsche Bank and Credit Suisse for failing to deliver accurate regulatory reports.
Some industry observers have noted that the penalties and settlements that firms are paying are hardly making a dent in the in the bottom lines of affected firms.
But I think the critics are missing the point.
We got a clue last week when SEC Chair Mary Jo White in a speech before the Managed Funds Association’s Outlook 2015 Conference in New York, Oct. 16, spoke about “a few of the recurring, specific compliance risks our examiners have seen that each private fund adviser should be addressing every day.”
In reviewing the first five years of Dodd-Frank, White emphasized the need for firms to shore up their fiduciary duties such as the need to “make full disclosure of conflicts of interest, including those related to their organization, operation, and management of client assets.”
White also says that the SEC’s examiners “identified several areas where cracks in this bulwark were found.”
Some of the cracks are in marketing. “Staff was concerned that some hedge fund advisers may have used marketing materials that included back-tested performance numbers, portable performance numbers, and benchmark comparisons without key disclosures,” White says.
Disclosure of conflicts of interest are also another crack in the fiduciary armor.
“Examiners observed that some hedge fund advisers may not be adequately disclosing conflicts related to advisers’ proprietary funds and the personal accounts of their portfolio managers,” White says. “Examiners saw, for example, advisers allocating profitable trades and investment opportunities to proprietary funds rather than client accounts in contravention of existing policies and procedures. In exams of private equity advisers, examiners also observed instances of conflicts involving fees and expenses.”
In particular, SEC staff has been concerned that some advisers are improperly shifting expenses away from the adviser and to the funds or portfolio companies by “charging a fund for the salaries of the adviser’s employees or hiring the adviser’s former employees as ‘consultants’ paid by the funds,” White says. “Examiners also continue to observe advisers collecting millions of dollars in accelerated monitoring fees without disclosing the practice.”
The SEC’s fee and expense observations “go beyond private equity advisers,” White adds. “Our Private Funds Unit in OCIE is completing a review of private fund real estate advisers, many of which may be hiring related parties” The SEC staff will investigating whether disclosures about these arrangements “may be non-existent or potentially misleading, particularly with regard to whether or not the related parties charge market rates.”
In her speech, White cites “recent, important enforcement actions” against private fund advisers.
“Many of these actions also center on disclosure and conflicts of interest, including advisers misallocating expenses to funds; failing to disclose loans from clients; using funds to pay their operating expenses without authorization and disclosure; and failing to disclose fees and discounts from service providers.”
While the aforementioned may constitute offenses greater than toll-jumping in the subway system, White is asserting that the regulator’s oversight and exam program “identifies practices that would have been difficult for investors to discover by themselves. They also illustrate that investment advisers to funds — including private funds catering to sophisticated investors — must disclose material facts to clients.”
By not letting firms off the hook about these “material facts,” the SEC is underscoring that its scrutiny is increasing. But it also reminding firms that things might go better if they would develop what White calls “a strong compliance culture.”
Need a Reprint?
