When is an SEC Investigation Transformed into an Enforcement Action?

Sylvia M. Scott serves as Freeman, Freeman, and Smiley, LLP's partner and head of securities practice group. Additionally, Sylvia M. Scott of Los Angeles contributes her expertise in the field of financial regulatory law to the NSCP Currents publication, among others. One topic of particular interest in the investment adviser community is whether an examination will result in an enforcement referral and the current enforcement environment. Ms. Scott had the following to say on this topic in one published article: The SECs enforcement program has also undergone substantial reforms including the creation of five specialized units in early 2010 to address priority areas. One of those units is the Asset Management Unit, whose co-chief previously led the SECs hedge fund working group. One of the key objectives of the Asset Management Unit has been to gain specialized insights into the hedge fund industry by conducting multiple investigations in the same subject area. The Asset Management Unit is part of the enforcement division and works with OCIE to formulate examination and investigative strategies and techniques, among other things. This collaborative relationship is a recipe for more enforcement actions in the hedge fund industry. This aggressive regulatory atmosphere is also fueled by various audit reports focusing on what the regulators could have done or should have done to prevent various scandals such as Madoff and Stanford. Following the Stanford Ponzi scheme case, there were allegations that certain enforcement staff mishandled referrals by OCIE. See, SECs Response to Concerns Regarding Robert Allen Stanford's Alleged Ponzi Scheme Report of Investigation (OIG Investigative Report No. 526 (March 31, 2010) www.sec.gov/news/studies/2010/oig-526.pdf. During an examination, the staff will typically focus on one or more of the following areas: insider trading, disclosure, conflicts of interest, portfolio management, valuation, performance, advertising and asset verification. If OCIE finds that an advisers compliance controls are weak or non-existent, the staff will zero in on the potential rule violations implicated by those weaknesses. For example, if a firms procedures are weak on privacy protection or monitoring electronic communications, this will be treated as a red flag that even larger compliance problems are present and the examiner will dig deeper. With the SECs well publicized focus on insider trading activities, hedge fund advisers should anticipate that examiners will focus on the use of expert networks, compliance procedures and walls concerning material, non-public information, and front running. Other areas ripe for examination include activities impacted by the SECs adoption of new rules applicable to investment advisers. In such instances, examiners will audit the areas affected by such rules and review relevant documentation to assess compliance with the new requirements. To stay abreast of the SECs examination priorities, you can go to the SECs website and review the many press releases and reports.