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SEC focuses on investment performance reporting in recent enforcement cases
By By Nicolas Morgan, DLA Piper; Antonella Puca, KPMG LLP; and Nicole Edwards, DLA Piper
Wednesday, June 11, 2014

Since the enactment of the Jumpstart Our Business Startups ("JOBS") Act and as some of the old-standing restrictions to general solicitation are being released for private funds, the marketing practices of hedge funds, private equity and venture capital firms have been under increased scrutiny by the U.S. Securities and Exchange Commission ("SEC" or "Commission").

Each year, the National Examination Program (the "NEP") (which is part of the Office of Compliance Inspections and Examinations of the SEC) identifies areas that in its view pose heightened risk for investors and the market, and, in turn, are likely to be the subject of increased SEC scrutiny during the year. In 2014, the NEP has specifically identified the accuracy and marketing of private funds' investment performance as an examination priority for the SEC. The NEP's staff expects to "review the accuracy and completeness of advisers' claims about their investment objectives and performance. For example, the staff will review and test hypothetical and back-tested performance, the use and disclosure of composite performance figures, performance record keeping, and compliance oversight of marketing. The staff also expects to review marketing efforts arising out of newly effective rules adopted under the JOBS Act."1

Most recently, the SEC has announced its plan to request an additional 131 positions in FY 2014 for its Division of Enforcement, with the intention, among others, of "expanding and focusing the investigative function by hiring experienced attorneys, industry experts, forensic accountants, paraprofessionals, and information technology and support staff, to promptly detect, prioritize and investigate areas appropriate for enhanced enforcement efforts."2

The SEC Division of Enforcement is also pursuing an initiative that relies upon the use of proprietary risk analytics to evaluate private fund returns and identify firms that warrant further scrutiny. The SEC is searching for "aberrational" performance, namely, performance that appears inconsistent with a fund's investment strategy or other benchmarks. In a recent report, the NEP staff has noted that similar quantitative tools are being used by advisers of entities that invest in private funds to identify managers that have falsified or otherwise manipulated their returns.3 Measures such as bias ratio, serial correlation and skewness of the return distributions are typically used in conjunction with factor analysis of the returns in order to detect suspect returns that may be an indication of manipulation.

Recent Enforcement Cases on Performance Reporting

In recent months, the SEC has brought a number of cases that target private funds for violations attributed to the marketing and reporting of misleading performance information. In May 2014, for instance, the SEC has charged an investment adviser and its principals for allegedly distributing falsified performance results to prospective investors in two hedge funds under management.4 The SEC's complaint alleges, among other things, that the Chief Financial Officer of the funds altered the performance report and the related opinion of an independent auditing firm and distributed false performance statistics to investors.

Other common performance reporting issues raised by recent SEC enforcement cases include:

  1. Inflating the adviser's Assets Under Management ("AUM") and failing to reconcile to the AUM as reported in Form ADV and other SEC regulatory filings.
  2. Presenting rates of returns on a gross basis, without deducting advisory fees and, for funds invested in other funds, without deducting fees and expenses paid to the underlying fund managers.
  3. Overstating the valuation of illiquid assets and/or failing to adopt adequate valuation policies and procedures, resulting in overstated performance.5
  4. Linking model performance results to returns based on actual trading without appropriate disclosure.
  5. Failing to disclose whether and to what extent the results portrayed include the reinvestment of dividends and interest.
  6. Failing to compare fund returns to an appropriate benchmark as a measure of overall economic activity, and/or omitting a disclosure of the significant differences in volatility between the fund returns and the benchmark.
  7. Distributing performance advertisements without the review and approval of the Chief Compliance Officer and/or other members of management with oversight responsibility over performance reporting under the terms of the firm's policies and procedures.
  8. Misrepresenting the period covered by a GIPS Verification (see below) and/or independent auditor's report in investment performance.

The SEC has also emphasized that to the extent the investment performance results are presented to retail clients, it will not only look to the effect that they might have had on careful and analytical persons, but also to their possible impact on those unskilled and unsophisticated in investment matters.

Compliance With The GIPS Standards

Fund managers in search of industry guidance on investment performance reporting, may find a useful framework of reference in the Global Investment Performance Standards ("GIPS" or the GIPS Standards")6. As created and administered by the CFA Institute, the GIPS Standards represent a comprehensive set of performance measurement and reporting standards that has gained wide recognition as industry best practices. In October 2012 the CFA Institute released a Guidance Statement on Alternative Investment Strategies and Structures which specifically addresses issues related to hedge fund strategies, and a new Guidance Statement on Pooled Funds (registered investment companies) is currently in the works.7

Investment firms can adopt and claim compliance with the GIPS standards, and engage an independent party to verify their claim. As noted by the United States Investment Performance Committee of the CFA Institute, "compliance with GIPS is voluntary and is not mandated by any law or regulation, but the SEC and other regulatory organizations may choose to test the legitimacy of a firm's claim of compliance. In addition, GIPS make it clear that firms that choose to comply must also comply with all applicable laws and regulations concerning the calculation and presentation of performance."8

In April 2013, the SEC brought a case against an investment management company and its owner alleging that certain of the firm's advertisements distributed to clients and prospective clients claimed compliance with the GIPS Advertising Guidelines, when in fact they did not comply with GIPS.9 The GIPS Advertising Guidelines require firms to include in their advertisements, among other things: (1) the period-to-date composite performance results; and (2) the composite results for either or both of the following time periods: 1-, 3-, and 5- year annualized composite performance returns with the end-of-period date clearly identified; or 5 years of annual composite performance returns. The SEC noted that the firm had not included period-to-date returns in its advertisement, which would have revealed that the firm was underperforming its benchmark in the most recent period and resulted in the advertisement to be misleading. The SEC further alleged that the firm distributed advertisements to clients and prospective clients that misrepresented the period in which the firm's performance results had been verified by an independent firm.

Management's Responsibilities for Performance Reporting

The SEC has also focused on management's responsibilities for performance reporting. In October 2013, for instance, the SEC brought a case against the Chief Executive Officer and the President of a registered investment adviser for failing to implement their firm's policies and procedures concerning performance calculation and reporting.10 According to the SEC, the two executives:

  1. did not comply with their firm's requirement to either review and approve the performance information or to designate another officer of the firm who was familiar with the applicable rules for performance advertising to review and approve the performance information before it was disseminated to clients;
  2. failed to ensure that annual performance reviews were completed as required by their firm's policies and procedures;
  3. did not take adequate corrective action to prevent repeated failures in performance reporting that the SEC had identified in a prior examination;
  4. did not take adequate steps to determine whether the person designated to supervise the performance reporting function had sufficient experience and familiarity with the Investment Advisers Act of 1940 (the "Advisers Act") and the firm's policies to be able to effectively perform its functions.

Ultimately, the two executives were held accountable for failing to perform their supervisory responsibilities, while the firm agreed to designate a new chief compliance officer in charge of performance reporting, and to retain a compliance consultant for three years.

Action Steps for Fund Managers

In light of the SEC's prior enforcement proceedings and given the SEC's continued focus on investment advisors' and private funds' financial reporting practices, fund managers should consider instituting the following practices to reduce the risk of violation:

  1. Adopt and implement written policies and procedures that are reasonably designed to prevent securities law violations in the area of performance reporting. These policies and procedures should be reviewed at least once a year for adequacy of implementation and effectiveness.

  2. Designate a compliance officer responsible for administering the firm's written policies and procedures on performance measurement and reporting. This individual must be adequately trained to fulfill this role and should not be appointed as merely a nominal placeholder.

  3. Make compliance a priority by ensuring that compliance policies and procedures relating to performance measurement and reporting are implemented and followed as written. If a compliance manual states that certain actions will be taken, then those actions should actually be taken. If they are not, the SEC has shown a willingness to impose sanctions on both firms and the individual managers involved.

  4. Make sure that internal reporting systems are auditable and are understood by more than a small group of employees. As firms increase in size and complexity, they also must update their systems to appropriately handle their growth.

  5. Consider including controls on "aberrational performance" as part of the firm's policies and procedures.

  6. Create tolerance reports on a monthly basis to compare the fund performance to its respective benchmark with any material discrepancy being investigated.

  7. For firms that claim compliance with the GIPS Standards
      o Make sure that the policies and procedures and the advertisement materials are reviewed by a party that has adequate knowledge and experience of GIPS.
      Make sure that all provisions of the GIPS standards are applied at the firm level (and not only for a specific fund or composite).
      o For firms that are subject to the Advisers Act, make sure that policies and procedures are consistent with the applicable requirements under the Act. This might involve additional requirements and/or different interpretations of certain principles as compared to GIPS.11 Firms that comply with GIPS as well as the Advisers Act are typically required to report returns both gross and net of investment management fees.
      o Consider having the GIPS claim verified by an independent verification firm.

  8. Implement adequate recordkeeping policies12
      o Under the Advisers Act, a firm is required to maintain and preserve its performance records in an easily accessible place for at least five years (the first two years in an appropriate office of the adviser) from the end of the fiscal year during which the adviser last published or disseminated the information.
      o In addition to internally-generated information (including the firm's administrator records as well as the firm's own records), consider retaining records prepared by third parties (custodial or brokerage statements) that confirm the accuracy of client account statements and other performance records maintained by the adviser.
      o For advisers that intend to link the performance generated at their current firm with their track record carried over from a prior firm, ensure that adequate records from the prior firm are also available for inspection. Performance records should rely on data that were accumulated contemporaneously with the management of the relevant accounts.

Nicolas Morgan (nicolas.morgan@dlapiper.com) is a partner with DLA Piper in Los Angeles and is the firm's West Coast Chair, Securities Enforcement Practice; Antonella Puca (apuca@kpmg.com) is a senior manager with KPMG LLP, Alternative Investments practice in New York; Nicole Edwards (nicole.edwards@dlapiper.com) is an associate with DLA Piper in Los Angeles.

1 Examination Priorities for 2014, National Exam Program (Office of Compliance Inspections and Examinations), January 9, 2014.
2 FY2014 Budget Request by Program, U.S. Securities and Exchange Commission.
3 National Exam Program Risk Alert, "Investment Adviser Due Diligence Processes for Selecting Alternative Investments and Their Respective Managers", January 28, 2014.
4 SEC V. Vineet Kalucha, George Palathinkal and Aphelion Fund Management, LLC (May 5, 2014), www.sec.gov/litigation/complaints/2014/comp-pr2014-92.pdf.
5 The SEC has brought a number of cases against private fund managers on valuation and related performance misstatement. See also "SEC Continues to Focus on "Fair Value Practices of Investment Advisers", DLA Piper and Rothstein Kass, June 2013.
6 GIPS Standards, 2010 Edition. The CFA Institute, Global Investment Performance Standards Handbook, 2012 Edition.
7 GIPS Guidance Statement on Alternative Investment Strategies and Structures. See also GIPS Guidance Statement on Private Equity (January 2011) and GIPS Guidance Statement on Real Estate (January 2011).
8 Performance Advertising Reconciling the GIPS Standards with the Investment Advisers Act of 1940, United States Investment Performance Committee (USIPC), pg.1.
9 In the Matter of ZPR Investment Management Inc., et.al. Order Instituting Cease-and-Desist Proceedings against ZPR (April 4, 2013), www.sec.gov/litigation/admin/2013/ia-3574.pdf.
10 In the Matter of Equitas Capital Advisors L.L.C., et. al. Order Instituting Cease-and-Desist Proceedings (October 23, 2013), www.sec.gov/litigation/admin/2013/34.70743.pdf.
11 On the Advisers Act, see also the seminal no-action letter on performance advertising issued by the SEC staff, Clover Capital Management, Inc. SEC No-Action Letter (October 28, 1986).
12 See Section 204 of the Advisers Act and Rule 204-2(a)(16) and Jennison Associates LLC, SEC No-Action Letter (July 6, 2000). See also GIPS Guidance Statement on Recordkeeping Requirements.



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