Since early 2010, the Securities and Exchange Commission (SEC) has filed over 100 cases surrounding misconduct involving hedge funds. The cases reflect issues such as misusing investor assets, dishonesty about investment strategies or performance, charging exorbitant fees and failing to disclose conflicts of interest, which are just some of the fraud and misconduct risks for private equity firms.

Private equity firms can sometimes be subject to fraud and misconduct as a result of outside actors. For firms that deal with holdings in foreign markets, corruption is often part of the culture, and fraud and bribery are rampant.

Ponzi schemes are another notable issue that put private equity firms at risk. Firms may be tempted to try to protect their company’s reputation by deceiving clients. Firms have gotten caught falsifying reports to hide trading losses and using investment funds for personal or business use.

Good corporate governance demands accountability and transparency. Private equity firms have a long history of transparency with their limited partners and regulators, which can be of major assistance for firms that are dealing with allegations of fraud or misconduct.

The Role of the Securities and Exchange Commission (SEC)

The Securities and Exchange Commission (SEC) is a federal regulatory agency that is in charge of overseeing marketplace issues and activities. The SEC works in conjunction with the Internal Revenue Service (IRS), the Consumer Protection Bureau and the Federal Trade Commission as needed. Highly sophisticated computers provide a channel for thousands of routing and completing financial transactions between buyers and sellers around the world. Whether they’re large or small, every transaction falls under the jurisdiction of the SEC.

The SEC is charged with protecting investors, preventing securities fraud, and assisting in the creation of new capital for businesses and investments. The main purpose of the SEC is to ensure that all securities transactions are fair and orderly.

The SEC regulates all new financial products and services as they become available to the general public. The commission oversees products such as variable annuities, variable life insurance, stocks and bonds, hedge funds, alternative investments and investment advisory services that provide financial planning and asset management for a fee.

The SEC attempts to prevent fraud by:

  • Requiring full and fair disclosures
  • Requiring accurate and transparent record-keeping
  • Conducting inspections and audits
  • Interpreting securities laws
  • Creating additional legislation to protect investors and regulate capital markets
  • Coordinating and overseeing all other regulatory agencies in the industry
  • Enforcing rules and laws by issuing fines, revoking licenses and invoking prison terms for severe violations

Examples of Fraud and Misconduct Risks with Private Equity Firms

As an example, in 2012, the SEC charged a couple of private equity firms with lying to their investors about the money they said they had invested in hedge funds.

In a San Francisco case, Lion Capital Management and hedge fund manager Hausmann-Alain Banet were charged with stealing more than $550,000 from a retired schoolteacher. The teacher believed that her retirement savings were invested in Banet’s hedge fund. Banet told the teacher that the company’s hedge fund would invest in the stock market with a long/short equity investment strategy. The investigation uncovered that Banet took the teacher’s investment of $550,000 and spent it on unauthorized expenses for himself and the business and also paid for the mortgage on his home, office rent payments and salaries for his staff.

In an attempt to cover his tracks, Banet provided false account statements that showed investment gains that didn’t exist and listed an independent administrator that had not worked on the fund. The U.S. Attorney’s Office for the Northern District of California also charged Banet with crimes.

In another case, the SEC charged hedge fund managers in Chicago with taking $147,000 in capital withdrawals and extensive fees from a hedge fund they managed. The SEC’s investigation revealed that Norman Goldstein and Laurie Gatherum from GEI Financial Services had deleted several performance hurdles when they calculated the fees. The pair also got caught making inappropriate capital withdrawals from the fund.

The investigation also revealed that Illinois regulators had stripped Goldstein of his securities licenses in 2011, which meant that he couldn’t legally provide investment advisory services in the state at all. Goldstein, Gatherum and the firm failed to disclose news of Goldstein’s suspension to their advisory clients.

Despite losing his registration status, Goldstein went on with business as usual, continuing to make all investment decisions on behalf of GEI Financial Services. As a result of the actions taken by Goldstein and Gatherum, GEI Financial Services violated the compliance rules that were applicable to SEC-registered investment advisors.

Helping Prevent Fraud and Misconduct

Private equity firms may consider using a forensics team if they find that they’re under investigation by the SEC for fraud or misconduct. While forensic teams can be helpful at this juncture, it’s prudent for some private equity firms to enlist the help of forensics teams earlier. Modern boards should be utilizing a board management system like Diligent Boards and Governance Cloud for storing communications and documents that could help to prove transparency and accountability.

Forensic teams can be helpful on the front end by performing background checks on managers and promoters and helping to identify red flags that signal inappropriate or potentially illegal actions. In addition to assessing general business practices, forensics firms can evaluate regulatory compliance and help private equity firms in finding any undisclosed anti-bribery and corruption violations.

Private equity firms must continually monitor their transactions for investor fraud. Forensic teams provide monitoring and risk management for fraud. In addition, forensic teams can also assist with SEC investigations and help to conduct licensing reviews.

On the back end of allegations of fraud or misconduct, forensics teams can provide expert witnesses, help to determine the volume of loss if necessary, determine the company’s loss of market share, help resolve disputes over claims of loss and evaluate fees.

Private equity firms must take all precautions to ensure that their firms and employees won’t become subjects of fraud or misconduct. The general public has a legal right to know that they’re getting good financial investment advice and that financial advisors are painting an accurate picture of their investments. The stakes in reputational damage, fines and crisis management are extremely high for private equity firms. The SEC is a powerful federal agency. In the most severe cases of fraud, investment managers may be subject to long terms in prison and permanent revocation of their securities licenses.