Implications of an SEC examination to offshore funds

Kevin Phillip and Wade Kenny of dms Management Ltd discuss the implications that the SEC examination has for the offshore hedge fund and its service providers.

It has long been a fact of life for registered investment advisers – preparing for, and surviving, the SEC examination. While, understandably, no organisation looks forward to such an examination, its importance remains.  With proposed amendments from the SEC, it may become an even more frequent fact of life for the investment adviser.  Though few would argue that this is not in the best interest of investors, or the industry in general, the implications of these examinations raise some interesting questions for the offshore hedge fund and its service providers.

In the wake of unprecedented scandal, fraud and misappropriation of assets, the SEC recently proposed amendments to strengthen and safeguard investor funds controlled by registered investment advisers (  Mary Schapiro, chairperson of the SEC, said, “These new safeguards are designed to decrease the likelihood that an investment adviser could misappropriate a client’s assets and go undetected…”¹ These amendments will include having the investment adviser undergo a surprise audit that will be completed by an independent public accountant firm.  In addition, unless client accounts are maintained by an independent qualified custodian (i.e. a custodian other than the adviser or a related person), the adviser or related person must obtain a written report from an independent public accountant that includes an opinion regarding the qualified custodian’s controls relating to custody of client assets.  Finally, the amendments would provide the SEC with better information about the custodial practices of registered investment advisers.  The amendments are designed to provide additional safeguards under the Investment Advisers Act when an adviser has custody of client funds or securities.

While the proposed amendments may have more of an impact on the custodian of assets than the adviser of these assets, it nevertheless signals the SEC’s renewed vigour in the regulation of the investment management industry.  This, of course, is welcome news.  If the integrity of the industry is to be maintained, or perhaps restored, then we must seek to identify and remove both the unscrupulous and unsophisticated adviser.

While the SEC has jurisdiction over the registered investment adviser, and its books and records, what sort of information can an offshore entity be expected to provide?  Depending on the nature of the examination, the requests can vary from vague letters requesting general information to more specific requests delineating sensitive documents, such as the register of shareholders, board minutes and the official books and records of the offshore entity. 

What does this mean for the service providers to the offshore fund?  Should the adviser, administrator, registered office or director readily provide this information when asked?  Should the minute book and board resolutions be provided?  Should the shareholder register be provided?  These are just a few of the questions that service providers must ask themselves.

Arguably, the most sensitive of this information is that of the shareholder’s identity.  Consequently, the administrator who maintains the register of shareholders finds itself in a very precarious position.  While perhaps wishing to accommodate a foreign regulator, the administrator must bear in mind its own responsibilities and obligations to the fund and its investors. 

The question goes beyond whether the administrator should provide confidential information to a foreign regulator.  Should the administrator provide this information to the adviser itself?  Does the answer to this question change when it is determined the information will then be provided to a foreign regulator?  Doing so may not only violate the terms of its agreement with the offshore fund, but may also be a violation of the law.  Many jurisdictions, including the Cayman Islands, have laws in place to protect the confidentiality of investors.

The situation becomes even more tenuous when a principal of the adviser also serves on the board of directors of the offshore entity.  This dual role can lead to a contradicting set of obligations.  As a director of the offshore fund, the adviser’s principal is clearly entitled to all fund information and, as a registered adviser, may be obligated to provide this information to the SEC during the course of its examination. Adhering to the requirements of one jurisdiction may cause an unintended violation in another – an awkward position for certain.

So what is the solution when the SEC requests sensitive shareholder information?  Is shareholder consent the answer?  Without this consent, one runs the risk of violating the laws of the offshore jurisdiction, or conversely, creating an unintended regulatory problem for the registered adviser.  Perhaps advance disclosure in the offering document and consent via the subscription document is the way to go.  Will the sophisticated investor support this approach?  It is difficult to know.  

Where the SEC has requested the minutes of meetings of the board of directors, it is important to note that these may contain legally privileged information, particularly when legal counsel has participated in the meetings. Therefore, legal review of minutes is a helpful, value-added service counsel can provide.

However we choose to address these requests, it is important to remember that the goals of the SEC and the offshore fund’s directors and service providers are aligned.  In the words of the SEC, its mission is to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. I think we can all agree on the mission – it’s how we achieve it that leads to debate.



Wade Kenny and Kevin Phillip