Ponzi is Prologue – What the Dodd Frank Act Means for SEC Fraud Enforcement Actions
By Jay Gould; Partner, Pillsbury Winthrop Shaw Pitman LLP
A recent action against a hedge fund manager by the Securities and Exchange Commission (the "SEC") serves as interesting prologue to the state of enforcement against suspected securities frauds once the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") has been fully implemented. On January 7, 2011, the SEC charged SJK Investment Management LLC, a North Carolina-based hedge fund manager ("SJK"), and CEO Stanley Kowalewski, its owner, with defrauding its hedge fund investors by diverting millions of dollars to themselves through various self-dealing transactions.
Nothing in this case is particularly unique.Investment advisers who steal from their clients have proven to be a fairly routine occurrence and rarely attract mainstream press coverage unless the theft is on a significant scale.Briefly, the SEC alleged that Kowalewski diverted investor money from the SJK hedge funds to pay his personal expenses and placed $16.5 million of the hedge funds’ assets into an undisclosed, wholly-controlled, fund that he created, and then misusedfor, among other things, purchasing a vacation homevalued at $3.9 million.The SEC stated that the agency became suspicious of Kowalewski as a result of an examination.The examination staff referred the matter over to the Enforcement Division of the Atlanta Regional Office which obtained an order to freeze the assets held by Kowalewski.Presumably, a receiver will be appointed by the court that will sift through the rubble and one day return whatever is left over to the investors.In the end, this is just another example of one of approximately 200 Ponzi/investment fraud cases that the SEC has uncovered since the Madoff embarrassment.
What is interesting about this case is that as of July 2011, the SEC will no longer examine the Stanley Kowalewskis of the world. In most cases, that job will be left to state securities commissions.As a result of the Dodd-Frank Act, private fund managers with less than $150 million under management and other investment advisers with less than $100 million under management will no longer register with or be routinely examined by the SEC.The SEC estimates that 4,100 investment advisers that are now registered with it will be forced to de-register and register with their respective state securities regulator.Although the SEC will retain anti-fraud jurisdiction over these state-registered advisers, the primary regulators will be the often ill-equipped, inexperienced and resource strapped state regulators.As a result of the budgetary concerns facing most states, it is unlikely that sufficient resources will be directed to enforcing investment frauds perpetrated by small, "under the radar" investment advisers.
And where do the majority of investment frauds occur?The most recent filing of Kowalewski’s Form ADV indicates that SJK had $71 million under management. This is not exactly an investment adviser that represents a systemic risk to the stability of the financial world, but this is the type of investment adviser that can cause great pain to every day investors seeking to diversify their assets or plan for their retirement.In fact, the vast majority of investment fraud schemes that the SEC has uncovered since Madoff have been perpetrated by investment advisers that willnot be subject to SEC scrutiny under the new regulatory regime.
The Dodd-Frank Act addressed this concern in part by directing the SEC to conduct a number of studies regarding the regulation of investment advisers.One such studydirects the SEC to make a recommendation as to whether investment advisers should be subject to a self-regulatory organization ("SRO"), much the same way broker-dealers are essentially required to become members of the Financial Industry Regulatory Authority ("FINRA").In recent weeks, FINRA has shown great interest in taking on this responsibility, much to the dismay of most independent investment advisers.This SRO membership requirement would add another layer of expense to, and oversight of, investment advisers.And some might argue that FINRA, which opposes the idea of creating a uniform fiduciary standard for investment advisers and retail brokers, is exactly the wrong SRO to oversee advisers that have traditionally been subject to a much more rigorous code of conduct.
This shift in regulatory responsibility to the states does not necessarily bode well for small investment advisers and start-up hedge fund managers.Just as we have seen large investors gravitate toward established investment managers since 2008, the lack of effective regulatory oversight may portend an unwillingness for high net worth and smaller institutions to take a chance on a less well-established investment adviser or fund manager. Such investment advisers or fund managers can expect the lack of SEC oversight to be another hurdle in a very challenging capital raising environment.
But there are steps that state-registered and regulated advisers and fund managers can take to minimize this aspectof the Dodd-Frank Act. Taking seriously the responsibility for full and current disclosure in fund documents, providing transparency to investors and maintaining sufficient operating systems and infrastructure will help to address the concerns of circumspect investors.Also, providing clear and current disclosure in the new Form ADV Part 2 that explains the operations and investment approach and adhering to the traditional fiduciary standard that has applied to investment advisers for decades will provide greater comfort to investors.Finally, choosing the right partners and service providers that can provide the oversight, checks and balances and industry expertise will also be important to investors.
Small investment advisers and fund managers mayinitially welcome theidea of no longer beingsubject to direct SEC oversight, but if investment frauds continue at this end of the investment spectrum, that may prove to be a hollow victory.
Mr. Gould practices in the Corporate & Securities area and is leader of Pillsbury Winthrop Shaw Pitman LLP’s Investment Funds & Investment Management practice team. He counsels clients involved in all aspects of the financial services industry. Mr. Gould represents US registered investment companies, hedge funds, offshore investment companies, investment advisers, retail and institutional broker-dealers, and municipal bond underwriters.
This article was also posted on the Investment Fund Law Blog, which can be found at www.investmentfundlawblog.com.