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NY SEC Head Gives Perspective on Hedge Fund Exams


Date: Tuesday, January 5, 2010
Author: Paula Schaap, Hedgefund.net

There’s a new sheriff in town at the New York office of the Securities and Exchange Commission and he wants the hedge fund industry to listen up.

“We have planned a number of significant sweeps of investment advisors,” George Canellos, the N.Y. SEC Regional Director tells HedgeFund.net. “In the last few months -- really in the last year or two -- we have tried to orient our program, especially the investment management program, more toward cause- and risk-based exams.”

The Bernard Madoff $65 billion Ponzi scam, and more recently, an alleged $20 million insider trading scheme at hedge fund firm Galleon Group, has trained the SEC’s sights on the private investment industry.

“Investment management, and especially hedge funds, is a big area of emphasis,” Canellos acknowledges. “Since I started, investment management inspection and enforcement work has consumed a significant portion of my time.”

A risk-based approach, Canellos says, focuses on institutions with particular profiles that have been determined to pose a greater risk of violating the law. Those are as opposed to “cause” exams, that is, examinations triggered by specific allegations of misconduct.

Now, “almost all of the investment management exams are cause- or risk-based exams as distinguished from routine exams,” he says.

The SEC was widely criticized for missing the Madoff fraud for years even after whistleblower Harry Markopolos sent several complaints to the agency.

The agency’s inspector general issued a 477-page report in September detailing how Madoff slipped through the SEC’s examination protocol. One big problem, the IG said, was the SEC put junior investigators on Madoff’s case who often had no experience with Ponzi schemes.

Canellos says the SEC is taking several initiatives to address the problems that let Madoff escape detection for so long.

“A great deal of attention at every level of the SEC, including the commissioners themselves, is being given to developing areas of specialization; trying to make staff smarter and swifter and on the cutting edge of markets,” he says.

Increased training is another aspect of staff reorientation.

“We bring in some academics,” Canellos says, “but mostly industry people to mine all sorts of information to better enable us to understand products and markets and improve our ability to assess financial and compliance risks.”

In that regard, Canellos applauds the addition of Norm Champ to the SEC staff as associate regional director for examinations in the New York office. Champ was general counsel at hedge fund firm Chilton Investment Company. He was also on the board of the Managed Funds Association, a trade group for the hedge fund industry.

“I feel as though it’s very important to have an industry perspective,” Canellos says. “Norm’s addition will bring great knowledge of the investment advisory industry and the compliance and legal issues they face.”

For his part, Canellos joined the SEC in July from the law firm of Milbank, Tweed, Hadley & McCloy, where he was a partner in the litigation group since 2003. This wasn’t the first time he had been in government service; he was in the U.S. Attorney’s office from 1994 through 2002 as senior trial counsel for its securities and commodities fraud task force.

It is his perspective of a government prosecutor that gives Canellos an appreciation of the SEC’s newly enhanced subpoena power.

“There is a new ethos at the SEC of delegation and empowerment of those who are in the field doing the day-to-day work of the SEC,” Canellos says.

Under prior regimes, in order to get a subpoena, SEC staff had to write a detailed memorandum, which had to run the full gauntlet of agency scrutiny before being approved by all five commissioners.

It would be no surprise, then that staff members could be discouraged from going through a lengthy process when a firm chose to stall on information requests.

That has changed under Robert Khuzami who was brought in by SEC Chairman Mary Schapiro to head up the agency’s enforcement division. Now, although senior SEC officers have to sign off on subpoenas, the process has been streamlined.

“This ethos, this spirit of confidence in the staff, more than anything else has been a huge boon for productivity and creativity,” Canellos says.

At the same time, Canellos says, as a former defense attorney, he is aware of industry criticisms that wholesale document production demands can place an undue burden on an asset class that is primarily composed of smaller firms.

“We try to be as surgical as possible in our document requests,” Canellos says. “So rather than issue a blunderbuss request for any and all documents relating to broad topical categories, we are trying to obtain documents in stages.”