The U.S. Securities and Exchange Commission settled an enforcement action late last year with a private fund firm for an eye-catching $170 million.  The agency’s press release stated that the settlement amount would be paid to “harmed investors”.  But who are the harmed investors, and should they get the money? 

This two-part series will suggest that the SEC should weigh the impact on incentives before distributing money from settled enforcement cases to private fund investors.  This first post reviews the basic conduct and the SEC’s theory behind the case.  This post also describes the regulatory “grand bargain” that allows sophisticated investors to place their money in potentially riskier assets and why that may be relevant here.  The second post next week will break down how distributing money to investors can disrupt the grand bargain and create skewed incentives.

What Happened

To recap, the SEC’s alleged that a private fund firm transferred top traders from its flagship client fund to a proprietary fund and also replaced those traders with an underperforming algorithm for the client fund.  The SEC further alleged that the firm made some related inadequate disclosures, material misstatements, and misleading omissions.

The enforcement case presented a novel twist on an old theme: the misalignment of interests between an asset management firm and its clients that, according to the SEC, ultimately resulted in a breach of fiduciary duty.  In this instance, the misalignment involved shifting a valuable asset – top trading talent – from a client account to a proprietary account. The SEC deserves credit for pursuing the case. 

A Note About the Role of Operational Due Diligence

The SEC settlement order also noted that the alleged improprieties came to light when operational due diligence consultants for certain investors saw a reference to a previously undisclosed proprietary account.  The consultants started asking questions about the account.  That eventually led them to discover the broader set of issues.  The ODD teams who uncovered and expressed their concerns did their job well.  They saved their clients a lot of money and aggravation. 

Remember the Grand Bargain

Before addressing the issue of where to send the settlement money, consider again the regulatory “grand bargain” for private funds.  The grand bargain generally works as follows.  Managers need not register their funds under the Investment Company Act.  This exemption allows private funds (and indirectly their managers) to avoid many of the restrictive provisions of the Act, including restrictions on investing, reporting, internal governance and fees.  The flip side of the bargain limits funds to offering and admitting only sophisticated investors (defined as “qualified purchasers” in the case of 3(c)(7) funds). 

The grand bargain also extends to investors.  Because private funds face fewer regulatory restrictions, including with respect to investment strategies and the use of leverage, etc., these funds provide for the possibility of higher (and/or uncorrelated) returns than might be achieved through registered funds.  For their part, sophisticated investors are expected to use their superior knowledge and bargaining power to assess the risks of a fund’s investment strategy, as well as those risks associated with the firm’s operational soundness.  If sophisticated investors identify areas of concern, they can simply walk away.  And of course, sophisticated are presumably better positioned to bear the risk of loss.

Up NextPart Two will look at the how distributing money to investors can disrupt the grand bargain and create skewed incentives.

About the Author

Terrance J. O’Malley ( is a 25-year veteran of the alternative fund business and one of its leading practitioners and thought leaders.  He is also co-author of The Insiders’ Guide to Hedge Funds: Successfully Managing the Middle and Back Office (Wolters Kluwer, 2018) (along with Michael C. Neus, SEC Private Funds Attorney Fellow) and The Investment Adviser’s Legal and Compliance Guide (Wolters Kluwer, 2004-Present) (along with John H. Walsh, former Director of the SEC’s Division of Examinations).