SEC Enforcement: A Practical Guide for Private Equity Fund Mangers


This article is an extract from The Securities Litigation Review – Edition 7. Click here for the full guide

I Introduction

In the 11 years since the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) extended regulatory scrutiny to, and imposed mandatory registration requirements on, most private equity fund advisers, the Securities and Exchange Commission (SEC) has brought a variety of highly publicised enforcement actions against the industry. By virtue of the long-tail nature of private equity investments, the SEC’s early cases focused on conflicts arising years after the original investment. Accordingly, these cases were not charged as standard fraud-in-the-sale cases but, rather, were pursued as cases sounding in breach of fiduciary duty. The focus on fiduciary duty led to a host of settlements that shed light on the SEC’s perspective on pursuing private funds and on the development of breach of fiduciary duty principles in the asset management industry. These principles remain highly relevant across the spectrum of private funds, including digital asset, real estate, debt and hedge funds.

Although the stated priorities for the SEC’s Division of Examinations (EXAMS) – formerly, the Office of Compliance Inspections and Examinations (OCIE) – continue the agency’s recent focus on retail investors, the SEC shows no signs of slowing its enforcement actions against private equity fund advisers, and has reaffirmed that EXAMS will continue to focus on private fund advisers’ compliance programmes, including disclosures of investment risks and conflicts of interest.2 Indeed, EXAMS will focus its review on conflicts arising from portfolio valuation and resulting fee calculation issues, as well as conflicts related to liquidity issues. A resurgence of SEC enforcement against private fund advisers is likely to follow.

This chapter provides a contextual backdrop for the current enforcement landscape, highlights the key cases and examination trends, discusses emerging enforcement risks and offers practical guidance for private fund advisers who wish to assess and minimise their potential exposure to enforcement inquires.

II Background on conflicts of interest and SEC enforcement of the private equity industry

Before 2010, with a few exceptions, private equity fund advisers generally did not register with the SEC and, while still subject to the securities laws, largely operated outside the SEC’s regulatory regime. Nonetheless, issues within the private equity industry were identified by both domestic and international entities. For example, in November 2009, the Technical Committee of the International Organization of Securities Commissions (IOSCO) issued a report focusing on conflicts of interest within the private equity industry, including the use of third-party advisers, lack of disclosure, and calculation of fees, which was finalised after public comment in November 2010.3 In May 2011, the SEC cited IOSCO’s final report as a useful public source describing conflicts of interest that private fund advisers may face.4 In March 2012, provisions of Dodd-Frank became effective. Dodd-Frank extended the registration requirements of the Investment Advisers Act of 1940 (the Advisers Act) to most private equity advisers. Around the same time, the SEC’s Division of Enforcement announced the creation of specialised units, such as the Asset Management Unit, to develop expertise on the private equity industry and its common business practices. In addition, the division now known as EXAMS formed a Private Funds Unit with personnel focusing on private equity firms and began examinations of private equity advisers under the Presence Exam Initiative, a direct response to the new Dodd-Frank provisions and concerns of pervasive conflicts. The purpose of this initiative was, in part, to deepen the SEC’s understanding of the private equity industry and better assess the issues and risks associated with this business model. Over the past few years, EXAMS has acquired additional expertise by including industry experts from outside the agency on its teams.

EXAMS and the SEC more broadly identified a number of perceived deficiencies within the private equity industry and have provided guidance to assist private equity advisers in bolstering their compliance programmes. A notable early example of this guidance was the highly publicised ‘Sunshine Speech’ in May 2014, which made clear that the SEC was focusing, and would continue to focus, on the private equity industry.5 Similarly, EXAMS recently offered an overview of frequent advisory fee and expense compliance issues it encounters, including issues of particular relevance to private equity fund advisers,6 and shared its views on weaknesses in investment adviser compliance programmes.7

One of the common themes discussed in SEC guidance – and seen in examinations and enforcement matters – is that the private equity industry presents unique regulatory challenges and conflicts of interest because of its business model. Private equity investors commit capital for investments that may not produce returns for years. Private equity investors therefore enter into agreements that are intended to govern the terms of their investment throughout the fund’s life, which routinely exceeds 10 years. Unlike many other types of investments, it is difficult for an investor to readily withdraw its capital from a private equity fund investment. Moreover, typical investment advisers generally do not wield significant influence over companies in which their clients invest, and when they do, the adviser’s control is generally visible to its investors and the public. In contrast, the private equity model allows a private equity adviser to use client funds to obtain a controlling interest in a non-publicly traded company, thereby obtaining significant influence over that company in private. Private equity advisers frequently are very involved in managing investments, such as serving on the company’s board, selecting and monitoring the management team, acting as sounding boards for CEOs, and sometimes assuming management roles. Thus, in the Sunshine Speech, the SEC explained that: ‘[T]he private equity adviser can instruct a portfolio company it controls to hire the adviser, or an affiliate, or a preferred third party, to provide certain services and to set the terms of the engagement, including the price to be paid for the services . . . [or] to instruct the company to pay certain of the adviser’s bills or to reimburse the adviser for certain expenses incurred in managing its investment in the company . . . or to instruct the company to add to its payroll all of the adviser’s employees who manage the investment’. The SEC has long suggested that this model results in conflicts beyond those faced by typical investment advisers.

Another common theme relates to disclosure. Cases and speeches suggest that, for an adviser to satisfy its fiduciary duty under Section 206 of the Advisers Act, the adviser must disclose all material information at the time investors commit their capital, including potential conflicts of interest. In the SEC’s view, limited partnership agreements often contain insufficient disclosure regarding fees and expenses that could be charged to portfolio companies or the fund, as well as allocation of these fees and expenses. The SEC has also indicated that private equity advisers have often used consultants, or ‘operating partners’, who provided consulting services to portfolio companies and were paid directly by portfolio companies or the funds, without sufficient disclosure to investors. There have also been alleged instances of poorly defined valuation procedures, investment strategies and protocols for mitigating certain conflicts of interest, including investment and co-investment allocation. Of late, the SEC has signalled interest in potentially inaccurate or inadequate disclosures of emerging investment strategies, with a particular focus on strategies reflecting sustainable or responsible investing, which incorporate environmental, social and governance criteria.8

In this context, the SEC has suggested that the private equity industry has suffered from an overall lack of transparency. In the SEC’s view, some limited partnership agreements do not provide investors with sufficient information to be able to monitor their investments and the investments of their adviser. Although investors engage in substantial due diligence prior to investing in a fund, because of the unique nature of the private equity model, there has rarely been meaningful investor oversight after closing. This limited oversight has the potential to increase the inherent temptations and risks already present within the private equity model.

The SEC’s focus on the private equity industry centres on transparency and conflicts of interest. In a February 2015 speech,9 the SEC said that nearly all SEC enforcement matters…



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