In a recent speech to the Practising Law Institute’s Private Equity Forum, Norm Champ, Director of the SEC’s Division of Investment Management, discussed the SEC’s increasing attention to the growth in ‘alternative mutual funds’, or open-end mutual funds that feature investment strategies more typically seen in private funds.1 Similar to recent speeches and discussions related to the SEC’s oversight of hedge funds2, previously discussed in this newsletter last November3, Champ’s speech contained useful guidance about the types of risks the SEC is monitoring in the alternative mutual fund space, but it also conveyed that the SEC will be ramping up inspection into whether investment advisers to these funds are fully complying with their duties.
What are alternative mutual funds and why are they becoming more popular?
Champ defined an alternative mutual fund as a fund whose primary investment strategy focuses on ‘(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).’4 As for why these funds are growing, Champ offered several reasons, but essentially, investors are seeking alternative investment strategies that will provide greater yield within the current low interest rate environment (and one suspects greater diversification as well), and these mutual funds are more accessible and cost-effective for a greater number of investors than private funds are. Further, mutual funds have more transparent pricing and disclosures, as well as greater liquidity, than private funds due to mutual funds’ regulation under the Investment Company Act of 1940 (the ‘40 Act) and regulations thereunder.5 This growth and increasing accessibility reflects a trend similar to what Bruce Karpati, the former chief of the SEC’s Asset Management Unit, referred to as the “retailisation” of hedge funds.6 This has led to greater participation by “unsophisticated investors” and thus has likewise led to greater SEC scrutiny.
The SEC’s areas of concern
Champ identified the following particular risks and concerns with alternative mutual funds: valuation, liquidity, leverage and disclosure.7 Demonstrating the SEC’s avowed commitment to transparency and dialogue with industry participants, Champ went on to provide useful guidance related to each of these areas. For example, he explained how mutual funds under the ‘40 Act must calculate their net asset values (i.e., through market quotations when readily available, and through the calculation of a fair value for assets when quotations are not readily available), but he also provided suggestions for advisers’ valuation policies and procedures. He also unsurprisingly focused on the need for ‘clear, concise disclosure’ regarding the fund’s investment strategies and principal risks. And he emphasised the importance of board oversight and board review of fund compliance programs.8
Presence exams and the upcoming industry sweep
The Investment Management Division is not the only SEC unit paying attention to these funds. Champ confirmed that, as announced in its ‘Examination Priorities for 2014’, the National Exam Program (NEP) continues in its pledge to conduct so-called ‘presence exams’ of ‘a significant percentage of advisers who have been registered with the Commission for more than three years, but have not yet been examined by the National Exam Program.’9 The SEC’s Office of Compliance Inspections and Examinations first announced this Presence Exam Initiative in 2012,10 through which NEP Staff would visit and examine a significant percentage of hedge fund and private equity fund advisers who registered with the Commission following Dodd-Frank’s expansion of registration requirements to such advisers. As announced in 2012, during these exams, NEP Staff will review what they perceive to be higher-risk areas of advisers’ operations, namely, marketing, portfolio management, conflicts of interest, safety of client assets, and valuation.11 Champ also noted that the National Exam Program issued a risk alert12 in January summarising the Staff’s observations of advisers’ due diligence processes for selecting alternative investments.13
Finally, and perhaps most importantly, Champ confirmed that beginning this summer or fall, OCIE will conduct a nationwide sweep exam of alternative mutual funds, which will focus on liquidity, leverage, and board oversight.14 Of course, while these ‘exams will produce valuable insight into how alternative mutual funds attempt to generate yield and how much risk they undertake’,15 they also raise the spectre of potential enforcement referrals if the Staff discovers potential illegality. In light of the Staff’s increased focus on alternative mutual funds, the continuation of presence exams, and the upcoming sweep exam, advisers must act now to ensure that they are in compliance with regulatory requirements.
The SEC’s increased scrutiny of both hedge funds and alternative mutual funds reflects an SEC trend to apply greater oversight to investment strategies that historically were limited to wealthier private investors, but which have recently become more accessible to ‘main street’ investors. The SEC’s obvious concern is that unscrupulous advisers could take advantage of these new market participants, so its solution is to encourage greater transparency, ensure more fulsome disclosure, and increase enforcement as necessary. It is attempting to accomplish these goals through more active engagement with the industry, but also through a robust examination program and more zealous enforcement. It is thus critical that advisers pay close attention to the rules and regulations, listen to what the SEC is saying, assess and update their compliance policies regularly, and prepare for the perhaps inevitable visit from the SEC.
Nicholas Lewis is an Associate in the Washington, DC office of McGuireWoods LLP. He focuses his practice on securities enforcement and white collar criminal defense, and has represented financial institutions, corporations and individuals under investigation by government entities, including the U.S. Securities & Exchange Commission and the U.S. Department of Justice.
McGuireWoods LLP is a full-service law firm with more than 900 lawyers in 20 offices worldwide. The firm’s top-ranked Government, Regulatory and Criminal Investigations (GRCI) practice draws on a team of lawyers devoted exclusively to these difficult, serious and high-stakes inquiries..For more information, please visit www.mcguirewoods.com.
1 See Norm Champ, Director, Division of Investment Management, U.S. Securities & Exchange Commission, "“Remarks to the Practising Law Institute, Private Equity Forum,” (June 30, 2014) [“Champ Speech”].
2 See, e.g., Mary Jo White, Chair, U.S. Securities & Exchange Commission, “Hedge Funds – A New Era of Transparency and Openness,” Managed Funds Assoc. Outlook 2013 Conference (Oct. 18, 2013).FactSet SharkWatch.
3 See Nicholas Lewis, “A New Era of Openness, or Open Season on Hedge Funds?”, Eurekahedge, November 2013.
4 See Champ Speech.
5 See id.
6 See Bruce Karpati, Chief, Asset Management Unit, U.S. Securities & Exchange Commission, “Enforcement Priorities in the Alternative Space,” Remarks before the Regulatory Compliance Association (Dec. 18, 2012).
7 See Champ Speech.
8 See id.
9 See National Exam Program, Office of Compliance Inspections and Examinations, U.S. Securities & Exchange Commission, “Examination Priorities for 2014,” (Jan. 9, 2014), available at: http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf.
10 See Letter from U.S. Securities & Exchange Commission, Office of Compliance Inspections and Examinations to “Newly Registered Investment Advisers,” (Oct. 9, 2012), available at: http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.
11 See id.
12 Risk Alert, National Exam Program, Office of Compliance Inspections and Examinations, U.S. Securities & Exchange Commission, “Investment Adviser Due Diligence Processes for Selecting Alternative Investments and Their Respective Managers,” Vol. IV, Issue 1 (Jan. 28, 2014).
13 See Champ Speech.
14 See id.