SEC Associate Director Gohlke Discusses Registered Adviser Compliance and the SEC Inspection Process at Fund of Hedge Funds Forum

By Elizabeth Shea Fries and Jackson B.R. Galloway

In a speech at the Fund of Funds Forum, a conference for the fund of hedge funds ("FOF") industry, held in New York City, Gene A. Gohlke, associate director of the SEC’s Office of Compliance Inspection and Examinations ("OCIE"), discussed compliance programs for registered investment advisers, with a particular focus on conflicts of interest issues facing FOF managers, and the SEC inspection process, including steps to take to prepare for an SEC exam. Mr. Gohlke reviewed guidance provided in the SEC release adopting Rule 206(4)-7 under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), regarding the establishment and ongoing maintenance of compliance programs by registered advisers. (See the December 23, 2003 and July 13, 2004 editions of the Financial Services Alert for a more detailed discussion of Rule 206(4)-7 and its requirements.) In discussing means to identify violations of the Advisers Act, Mr. Gohlke mentioned the use of quality control testing (transaction-by-transaction testing coupled with exception reporting to supervisory personnel responsible for the tested activity) and forensic testing (periodic testing focused on whether the outcomes of operational and investment activities over time are consistent with expectations).

Conflicts of Interest. Mr. Gohlke stressed the critical role that ongoing identification, monitoring and resolution of conflicts of interest play in adviser compliance programs. He identified the following areas in which conflicts of interest may exist for FOF managers, among others:

• Allocations of investment opportunities among clients.
• FOF manager relationships with underlying hedge fund managers.
• Banking and investment banking relationships between an FOF manager affiliate and issuers of securities held in underlying hedge funds.
• Advisers to underlying hedge funds purchasing for those funds’ investments underwritten or distributed by an FOF manager or its affiliates.
• Proprietary trading by an FOF manager or personal trading by its staff.
• Side letter agreements with FOF investors.
• Calculation of FOF performance numbers, particularly when performance in excess of a high water mark will entitle an FOF manager to an incentive allocation.

Mr. Gohlke noted that he was aware of only two means by which advisers could properly address conflicts of interest – either by eliminating the arrangements or activities that create the conflict, or by making appropriate disclosure to clients and then ensuring that its conduct is consistent with those disclosures. Mr. Gohlke also listed a number of situations commonly encountered by OCIE where advisers fail to disclose or otherwise manage their conflicts of interest, as follows:

• Use of clients’ assets to secure products and services that fall well outside the safe harbor for research services provided by Section 28(e) of the Securities Exchange Act of 1934, as amended.
• Use of clients’ assets to encourage referrals from brokers of clients or fund investors.
• Inflation of fund or FOF manager performance to make the firm or its managed funds more attractive to fund investors or prospective clients.
• Allocation of profitable investment opportunities to insiders’ accounts rather than to clients.
• Allocation of profitable investment opportunities to clients whose fees include a performance adjustment in preference to clients that do not.

Valuation Practices. Mr. Gohlke identified valuation as a significant issue for FOF managers and emphasized the importance of careful attention to disclosures a fund makes to its investors regarding its valuation policies. Risk factors cited by Mr. Gohlke in the area of valuation include weaknesses in underlying funds’ valuation policies and procedures, "stale" underlying fund valuations, incentives to inflate underlying fund valuations to keep FOF performance above a high water mark, failure to properly implement FOF fair value procedures and errors in calculating FOF net asset value or allocations among FOF interest holders. Mr. Gohlke also identified a number of policies and procedures FOFs can use to address the foregoing risk factors. Although Mr. Gohlke did not mention it in his speech, advisers should note that the Financial Accounting Standards Board is working on a statement designed to increase consistency and compatibility in estimates of fair value, and to enhance disclosure regarding those estimates, which will also factor into advisers’ compliance efforts.

SEC Inspections. Mr. Gohlke’s discussion of the SEC’s inspection program reviewed the various types of inspections, the inspection process and steps advisers can take to prepare for SEC examinations. (The SEC’s revamped inspection program is discussed in greater detail in the September 27, 2005 and November 1, 2005 issues of the Financial Services Alert.) Mr. Gohlke noted that the SEC’s examination staff divides registered advisers into those with high risk profiles and those with low risk profiles. Those with a higher risk profile are subject to a routine examination every three years. Firms rated lower risk are not examined on a cyclical basis. Instead, a group of lower risk advisers are selected each year for examination using a random selection methodology under which, in any given year, any firm in this group may be selected for examination. Mr. Gohlke explained that firms are rated high risk based on three criteria: assets under management, responses to Form ADV and compliance weaknesses. Examination results are used to update a firm’s risk rating. In conclusion, Mr. Gohlke suggested a number of ways in which advisers could prepare for OCIE examinations, many of which echo guidance previously provided by the SEC and its staff with respect to establishing and maintaining effective compliance programs, e.g., maintaining a compliance "tone at the top." Among Mr. Gohlke’s suggestions were the following:

• Conduct forensic tests in critical areas of the firm’s operations that may harbor possible illegal acts, schemes and arrangements.
• Assign specific responsibility for implementing applicable compliance policies and procedures to individual managers at all levels throughout the firm and hold these persons accountable for their staff’s implementation of compliance policies and procedures and for compliance failures in their areas of responsibility.
• Act promptly to remedy the inevitable compliance breaches that occur and evaluate whether their occurrence indicates the existence of compliance program weaknesses that should be addressed.
• Be aware of the usual range of information OCIE staff requests during inspections and be prepared to respond promptly and fully to specific requests for documentary information, including "appropriate and timely handling of information that may be protected under the attorney-client privilege."

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.