On June 23, 2020, the U.S. Securities and Exchange Commission (“SEC”) Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert that highlights its observations of commonly encountered deficiencies from its examinations of private fund advisers. This guidance provides advisers with the opportunity to review and remedy issues with improved compliance programs before facing any regulatory or enforcement issues.
The OCIE Risk Alert does not set forth new standards of conduct, but rather, it highlights three categories of deficiencies that the SEC regularly finds in its reviews of advisers to private funds: (1) gaps in client and investor disclosures regarding conflicts of interest; (2) deficiencies in disclosures related to fees and expenses and related issues; and (3) issues with policies and procedures regarding the treatment of material nonpublic information (“MNPI”).
Conflicts of Interest Disclosures
The SEC identified nine broad categories of conflicts of interest issues that it has identified as deficient in disclosures from its recent examinations. The OCIE Risk Alert does not assert that any of the conflicts of interest issues set forth below are inconsistent with or violative of an adviser’s fiduciary duty or otherwise in violation of any rule.
- Allocation of Investment Opportunities — OCIE noted deficiencies in disclosures regarding the allocation of investment opportunities among client vehicles and accounts, including flagship funds and co-investment vehicles. Deficiencies included inconsistent application of allocation policies, preferential allocations of limited investment opportunities to proprietary accounts, clients paying higher fees without adequate disclosure, and preferential allocations of limited opportunities to new accounts without adequate disclosure.
- Conflicting Client Investments — OCIE cited deficiencies in disclosures of conflicts that arise when different clients invest in different parts of a portfolio company’s capital structure, such as with one client owning debt and another owning equity in the same portfolio company.
- Economic Relationships — OCIE identified deficiencies in the disclosures of potential conflicts related to financial relationships between a manager and select clients or investors, such as seed investors and investors that provided financing to the adviser or its funds.
- Preferential Liquidity Rights — OCIE recognized deficiencies in the disclosures of certain side agreements that provide preferential liquidity to certain investors or other special terms, without adequately notifying other investors of the potential harm that could be caused. OCIE also identified side-by-side vehicles or separately managed accounts (“SMAs”) investing alongside a fund with more frequent liquidity as creating the same risk.
- Principal Investments — OCIE cited failures in disclosures regarding conflicts associated with principals or managers holding interests in investments recommended to clients, such as pre-existing ownership interests, referral fees, or stock options in the investments.
- Coinvestments — OCIE noted deficiencies in the accuracy and depth of disclosures on how coinvestment procedures actually operate, including their scale and allocation to investors, as well as situations where managers did not follow their stated policies or processes.
- Service Providers — OCIE recognized deficiencies in disclosures regarding the use of affiliated service providers or service providers with a special relationship to the adviser or its portfolio companies, including the failure to disclosure certain financial incentives, such as incentive payments from discount programs, which could influence advisers’ choice of service providers for its clients and their portfolio companies.
- Fund Restructurings — OCIE identified situations where advisers failed to provide sufficient disclosures concerning conflicts raised by fund restructurings and “stapled secondary transactions,” including deficient disclosures regarding (1) the valuation of the fund interest that the adviser is purchasing from investors; (2) investor options during a restructuring; and (3) the conflict of interest of the adviser about the economic benefits to the adviser.
- Cross-Transactions — OCIE noted deficient disclosures regarding purchases or sales between clients, also known as cross-transactions, which typically have inherent conflicts of interest, including, for example, where the adviser determines the price of the securities.
Fees and Expenses Deficiencies
The OCIE Risk Alert highlighted issues with advisers improperly splitting fees among fund investors, causing some to pay more and others less than stated in relevant documents, and widespread deficiencies related to fund managers overcharging and failing to properly reimburse investors for fees and expenses. These included expense disclosures that were deemed by OCIE to be “too general” or otherwise imprecise to constitute informed consent by investors and impermissible expenses in violation of a fund’s organizational documents or otherwise. Examples cited by OCIE included insufficient disclosures regarding the role of and compensation provided to “operating partners” and the allocation, disclosure, and monitoring of portfolio company fees.
Section 204A of the Advisers Act requires that advisers establish and maintain written policies and procedures to prevent misuse of MNPI. Relatedly, Code of Ethics Rule 204A-1 obligates advisers to establish standards of conduct for advisory personnel and resolve conflicts raised by their personal trading. Despite these rules and the significant risks associated with misuse of MNPI, OCIE identified general failures in policies and procedures addressing such risks. For example, OCIE cited policies that fail to address (1) insider trading risks posed by employees interacting with people with access to MNPI, such as public company insiders, consultants retained through “expert networks” and “value-added investors;” (2) risks related to general employee access to MNPI; (3) lack of specificity with restricted trading lists; and (4) employees’ receipt of gifts from third parties.
Conclusion and Recommendations
Private Fund Advisers should carefully evaluate their policies and procedures to ensure that they are consistent with the positions described in the OCIE Risk Alert. While the Risk Alert focuses on SEC-registered investment advisers, which are subject to routine examination by the SEC, it also notes that certain of the deficiencies fall under Section 206 of the Investment Advisers Act of 1940, which applies equally to registered investment advisers and to exempt reporting advisers.
Several recent penalties imposed on entities by the SEC have been for problems identified in the OCIE Risk Alert. For example, in April, the SEC alleged that Monomoy Capital Partners inadequately disclosed fees related to its internal Operations Group, and failed to obtain consent to the associated conflicts of interest. Penalties and disgorgement against Monomoy totaled approximately $2 million.
High-level policies that do not reflect operational realities or specific risks, compliance procedures that are not both tailored and detailed, and clear procedures that are not consistently enforced can lead to potential deficiency letters, investigations, or penalties against an adviser.
Conflicts of Interest Disclosures
Private fund advisers should undertake a review of their disclosures relating to conflicts of interests. While the Risk Alert highlighted disclosure deficiencies, OCIE did not provide any indication of the type of disclosure language that would be satisfactory; it merely focuses on the fact that disclosures need to be better, particularly in times of market dislocation. Again, OCIE is not describing any of the deficiencies set forth in the Risk Alert as per se violations of rules, but following its guidance will help Private Funds avoid deficiency letters or other investigative issues related to disclosures, internal policies and procedures.
Regarding conflicts of interest disclosures, best practice would be to ensure that disclosures are more specific, such as with conflicting client investments, co-investment opportunities, and allocations. Further, as a matter of process, advisers should seek to ensure that their practices with respect to affiliated service providers follow their disclosures.
Fees and Expenses
Entities should assess advisory fees and expense practices and related disclosures. This should include a comparison of compliance policies with fund governing documents and Form ADV disclosures to ensure consistency. Fund governing documents should clearly set forth expenses allocated to the fund. Disclosures to investors regarding fees and expenses should be specific.
Regular reviews should be conducted regarding the allocation of expenses. Compliance personnel should periodically perform tests to confirm that fees charged were properly calculated and expenses properly allocated.
Finally, internal policies should set forth a procedure to remediate any violations regarding fees and expenses and prevent future violations.
The SEC has already made clear earlier this year that it intends to maintain, if not increase, its focus on insider trading actions, particularly in the context of COVID-19. In the SEC’s Division of Enforcement public statement on March 23, 2020, the SEC specifically highlighted its concerns about incentives to trade illegally on MNPI during these difficult times. In doing so, the SEC underscored its expectation that regulated entities take active steps with their internal controls and disclosure procedures to keep MNPI confidential and protect against the improper dissemination and use of such information, minimizing the potential for illegal trading. The OCIE Risk Alert again highlights the SEC’s focus on advisers’ obligations to prevent the misuse of MNPI.
We have previously identified the importance of reviewing internal controls regarding the treatment and protection of MNPI. The OCIE Risk Alert identified three general failures in advisers’ ethics policies related to MNPI, which should be considered as internal policies and procedures are assessed.
- First, as set forth above, OCIE identified inadequate policies and procedures around advisers’ restricted trading lists. Policies related to restricted trading should have sufficient specificity regarding the internal process for adding and removing securities from the restricted trading list and procedures to identify and enforce trading restrictions based on this list.
- Second, OCIE observed policy deficiencies regarding the receipt of gifts and entertainment by employees. Again, specificity regarding restrictions and disclosures on the receipt of gifts and entertainment from third parties is important.
- Third, OCIE cited policy deficiencies regarding defining personal securities transactions approval and reporting. Internal policies should define procedures for the submission of such approvals, including setting strict deadlines for reporting.
Beyond the failures identified by OCIE, entities should provide written guidance to all officers, directors, and employees that clearly sets out written policies for how to deal with MNPI when received and emphasizes the importance of their obligations to keep MNPI that they may have access to confidential. Further, entities should continue regular compliance training via video conferencing or other means to address the expected increased scrutiny on the treatment and use of MNPI. Robust compliance and internal controls, including reminders and training on the permissible handling of MNPI and monitoring of employee communications, are critical.