Enforcement actions by the Securities and Exchange Commission have increased in number and sophistication during the past two years and increasingly target hedge funds, according to US attorneys with law firm Shearman & Sterling. 

Speaking on Friday at the Mourant Ozannes seminar “Facing down the big challenge” litigation partner Adam Hakki and Lindi Beaudreault presented a selection of SEC actions involving offshore funds and said in the past two years the SEC has changed dramatically in terms of its power, the resources it has at its disposal and the number of cases it has brought. 

The SEC has made hedge funds a significant priority and this has provided a “fertile ground” to look for cases, Mr. Hakki said. “There had been a historical sense in the US markets that the hedge fund investor was a big boy, a high net worth individual or institution and it could take care of itself and the SEC ought to be out there protecting retail investors. That mentality, to the extent that it ever existed, is dead,” he said. 

In addition, the SEC is suspicious of hedge funds, Ms. Beaudreault said. Quoting Bruce Karpati, the head of the Asset Management Unit in the SEC’s Enforcement Division, who said at a meeting of New York City Bar lawyers about a month ago “he very nature of a hedge funds fee structure makes them problematic and suspicious”. 

She said it is important for service providers to hedge funds to realise the mentality of the SEC enforcement division, according to which the fact that they are paid primarily in performance fees means they would be more likely to insider trade to achieve performance targets. 

In response to the criticism the SEC received over the Madoff Ponzi scheme, the commission has significantly upgraded its personnel and attracted some talented people. Investigations have become much more sophisticated, for example with specialized units for CDOs and other structured or securitised products, Mr. Hakki said.  

“The body is much more nimble than it used to be,” he said. 

Insider trading 

In terms of insider trading, the SEC brought 57 actions in 2011. The focus of these cases is increasingly on non-insiders, he said, such as investment managers and the funds, where the investigation starts and then works backward to find the source. 

Another trend is the cooperation between the SEC and the US Attorney’s Office for the Southern District of New York which has charged 63 defendants with criminal insider trading since August 2009. This involved non-traditional white collar crime investigation techniques such as wire tapping, which were traditionally associated with organised crime investigations.  

The speakers also noted a huge disparity in the sentencing of cooperators compared with the potential sentence under the guidelines if convicted, stating this has proven to be a powerful incentive for defendants to cooperate and plead guilty. 

As a result only a few of the 63 people who were indicted went to trial. In the majority of cases a cooperator would plead guilty and then gather extensive evidence on other people who are then confronted with wire taps and witnesses testifying against them, leading them to plead guilty and settle.  

Ponzi schemes 

In reaction to the criticism for not detecting the Madoff Ponzi scheme, the SEC has sent teams of examiners into the field in recent years, who then uncovered a number of Ponzi schemes. 

Since 2010, the SEC has brought more than 100 enforcement actions against nearly 200 individuals and 250 entities arising out of alleged Ponzi schemes. 

In the majority of the cases the court appoints a receiver to safeguard the assets and distribute what is left to the harmed investors.  

“There are enormous incentives for the SEC to find the missing assets including suing service providers and directors to the extent that there is available insurance,” Mr. Hakki said. 

He distinguished between insider trading cases for which a fund director or an administrator is rarely going to be held accountable by the SEC, and Ponzi schemes. Because for a lot of service providers it is part of the job to see red flags, the SEC takes a more in-depth look at the conduct of service providers in Ponzi scheme cases to determine that they were not “on auto-pilot”.  

Aberrational performance inquiry 

A third area of recent SEC cases involving offshore hedge funds concerns aberrational performance. In March 2011, Robert Khuzami, the director of the SEC Division of Enforcement, announced during his testimony before Congress that the division would be focusing on hedge funds outperforming market indices by 3 per cent on a steady basis.  

“Many of my hedge fund clients said to me so now I am going to be investigated if I do my job, which is to beat the market?” Mr. Hakki said. 

However, what the SEC has in mind is that a lot of Ponzi schemes promised consistent returns irrespective of market conditions and that this should be considered a red flag. In December 2011, the SEC announced its Aberrational Performance Inquiry, which is to be implemented by the Enforcement Division’s Asset Management Unit and is going to use sophisticated proprietary models to evaluate returns against investment strategies and other benchmarks. 

Red flags 

In order to spot potential legal risks in offshore funds, Ms Beaudreault said, service providers should be aware of commonalities among Ponzi schemes. These include complex, convoluted strategies that experienced investors are unable to understand, transaction between related fund entities, in-kind investments such as bonds, stocks or notes, transfer of notes, instruments or funds among entities in a way that does not make sense, an unfamiliar auditing firm or a lack of auditors and aberrational performance.