The Securities Litigation Review: SEC Enforcement: A Practical Guide For Private Fund Managers

This article is an extract from TLR The Securities Litigation Review - Edition 9. Click here for the full guide.

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I Introduction

We are now well over a decade past the enactment of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank), which imposed mandatory reporting and registration requirements on many private fund advisers, and which increased regulatory scrutiny over private fund advisers generally. All private fund advisers, whether with venture capital, private equity, hedge, debt, credit, real estate, hybrid, or other focus, must stay attuned to this attention on the private fund industry by the Securities and Exchange Commission (SEC) and, in particular, to the actions of its Division of Examinations (EXAMS) – formerly, the Office of Compliance Inspections and Examinations – and the Division of Enforcement (Enforcement). With more than 5,500 registered investment advisers (totalling over 35 per cent of all registered investment advisers) managing 50,000 private funds, with gross assets said to exceed US$21 trillion, and with an active SEC Chair, private fund advisers can expect the years to come to be replete with rulemaking and enforcement focused on the private fund industry.

The SEC currently has a host of laws and rules at its disposal to monitor the asset management industry and enforce certain practices. Importantly, now for over a decade, we have seen the SEC's increased application and enforcement of these laws and rules – most pre-existing Dodd–Frank's reporting and registration requirements – to and against private fund advisers. Additionally, we have seen and continue to see the SEC pursue cases against private fund advisers sounding in breach of fiduciary duty and disclosure principles, whether or not there is a rule additionally and expressly on point or tailored to the private fund industry. In 2023, the SEC will likely substantially increase its enforcement arsenal tailored to private fund advisers. In 2022 and continuing into 2023, the SEC has proposed and continues to propose new rules and rule amendments that, if implemented, could create material shifts in the principles, prohibitions, limitations and requirements for private fund advisers in carrying out their investment advisory businesses, including on investor and client reporting, limited partnership agreement negotiation and drafting, vendor agreement negotiation and drafting, advertising, and custody practices, liquidity transactions, and fee and expense mechanics. One proposed set of reforms alone that is likely to be finalised in the coming weeks or months, known as the Private Fund Proposed Reforms, could play a significant role in this shift.²

In this landscape, EXAMS likely will sharpen its focus on conflicts of interest the SEC believes are inherent in the private fund industry and which, the SEC believes, contribute to the perceived problematic issues discussed in the Private Fund Proposed Reforms. These include, for example, those related to portfolio valuation and resulting fee calculations, as well as conflicts related to liquidity. 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 inquiries.

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

Before 2010, private 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 under the Investment Advisers Act of 1940 (the Advisers Act). Dodd–Frank extended the registration requirements of the Advisers Act to most private fund advisers.³ Around the same time, Enforcement created specialised units, such as the Asset Management Unit, to develop expertise on the private fund industry and its common business practices. Similarly, EXAMS formed a Private Funds Unit and began examinations of private fund advisers under the Presence Exam Initiative, a direct response to the new Dodd–Frank provisions and concerns of pervasive conflicts. Since then, EXAMS has acquired additional expertise by including industry experts from outside the agency on its teams.

As a result, over the years, EXAMS and the SEC have more broadly identified a number of perceived deficiencies within the private fund industry and have provided guidance to assist private fund advisers in bolstering their compliance programmes. Notable early examples of this guidance were the highly publicised May 2014 'Sunshine Speech',⁴ the 2018 Risk Alert on frequent advisory fee and expense compliance issues identified during exams,⁵ and the 2020 Risk Alert on deficiencies of compliance programmes.⁶ In 2022, EXAMS issued a Risk Alert wholly focused on 'failures' of private fund advisers, categorised by EXAMS as 'conduct inconsistent with disclosures', 'misleading performance and marketing statements', 'due diligence failures' and 'misuse of hedge clauses'.⁷

One of the common themes discussed in SEC guidance – and seen in examinations and enforcement matters – is the SEC suggestion that the private fund industry presents unique regulatory challenges and conflicts of interest because of its business model. The SEC has long suggested that this model results in conflicts beyond those faced by typical investment advisers. Indeed, in a February 2015 speech,⁸ the SEC said that nearly all SEC enforcement matters involve examining whether an adviser has a conflict of interest and, if so, whether the adviser eliminated or disclosed that conflict. According to the SEC, conflicts of interest include situations where there is a 'facial incompatibility of interests, as well as any situation where an adviser's interests might potentially incline the adviser to act in a way that places its interests above clients' interests, intentionally or otherwise'.⁹ Notably, under this model, the SEC has suggested that a conflict of interest does not require that an investor be harmed by the conflict, or that the adviser intended to cause harm to the investor. It only requires the possibility that an investment adviser's interests could run counter to those of its investors.

Regarding 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, fund documents often contain insufficient disclosure on material terms, for example on fees and expenses, including relating to their allocation and affiliated fees and expenses; valuation procedures; and 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 (ESG).¹⁰

In this context, the SEC suggests that investors and the markets suffer from an overall lack of transparency in the private fund space. SEC Chair Gary Gensler has reiterated the SEC's interest in ensuring greater transparency in the private fund space, particularly with respect to enhancing disclosures regarding potential conflicts of interest and fees.¹¹

Over the past decade, private fund advisers have matured their practices. However, the SEC's interest in the industry has continued and also evolved alongside shifts in industry practice and major economic events, such as the market dislocation seen in 2020 and the recent banking-related events in 2023. In the fiscal year 2022, and even with remaining pressures from covid-19, EXAMS examined 15 per cent of all registered investment advisers and firms returned over US$50 million to investors 'in response to EXAMS' proactive work on examinations'.¹² Deficiencies are issued quickly, and the staff has employed non-traditional information gathering, including interrogatory-based requests and proactive outreach to third parties (e.g., auditors, intermediaries).

While the SEC's enforcement efforts have consistently focused on three groups – (1) advisers that receive undisclosed fees and expenses; (2) advisers that impermissibly shift and misallocate expenses; and (3) advisers that fail to adequately disclose conflicts of interest – the current enforcement landscape and emerging risk areas are growing. Advisers must continue to develop their understanding of SEC examination and enforcement trends, and we describe in more detail below material conflicts of interest and emerging enforcement risks.

III Conflicts of interest

The SEC's interest in the private fund industry encompasses a wide range of topics, from highly publicised accelerated monitoring fee issues to lesser-known conflicts-of-interest issues brought up in examinations. Private fund advisers should be aware of significant areas of enforcement that have accelerated in the new administration, including undisclosed fees and expenses, misallocation of expenses, valuation of investments as that relates to calculation of fees, inadequate disclosure of financial conflicts, and conflicted relationships with third parties.

While the SEC's enforcement actions cover just a few of the potential conflicts of interest,¹³ these actions provide good examples of the SEC's enforcement approach to conflicts and the evolution of obligations arising from Section 206 of the Advisers Act. Notably, under Section 206, the SEC focuses not only on identification of conflicts, but also on the policies and procedures in place for identifying and mitigating such conflicts.

i Undisclosed fees and expenses

The SEC has indicated that the disclosure provided to clients regarding fees and expenses is critical to clients' ability to make informed decisions. Specifically, the SEC's focus on disclosures concerning the fees and expenses of affiliated service providers is a hallmark of its enforcement programme. The SEC reaffirmed their interest in fees and expenses issues in the 2022 release of proposed reforms to the rules governing private fund advisers, which would prohibit advisers from charging certain fees and expenses to clients.

The SEC routinely targets undisclosed compensation resulting from a fund's initial investment. One example involved Fortress Investment Management, LLC, the fourth adviser to face charges of undisclosed compensation arising from its funds' investment in the Aequitas enterprise.¹⁴ According to the SEC, Fortress advised a small fund to invest over 95 per cent of its assets into securities issued by an Aequitas entity, without disclosing to the fund's investors that Fortress received US$15,000 per month from an Aequitas affiliate for consulting and business development services, which included introducing prospective investors. The fund's documents did disclose that Fortress or its personnel 'may' work for and receive compensation from companies in which the fund invested, but the SEC concluded this disclosure was 'insufficient to allow [investors] to provide informed consent to the actual conflict that existed'. As a result, to settle the charges, Fortress agreed to pay US$104,097 in disgorgement, civil penalties and prejudgment interest, while its principal agreed to a US$50,000 civil penalty and a 12-month suspension from the securities industry. Since then, the SEC has reaffirmed its view that disclosures that reference events that 'may' happen, which are, in fact, already happening, are insufficient to disclose then-existing conflicts.¹⁵

ii Misallocation of expenses

The SEC has made clear that an adviser is required to allocate expenses so that the expenses are borne appropriately and proportionately by the entity that incurred and benefited from the expenses, unless the arrangement is otherwise disclosed to investors. Reasserting the SEC's interest in these issues, the proposed reforms would prohibit an adviser from directly or indirectly charging or allocating fees or expenses on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested.

This situation has arisen in a variety of contexts, such as misallocation of expenses between a fund and the adviser, misallocation of expenses between funds, and misallocation of expenses where co-investors have invested in a fund investment. The SEC has found that an adviser is not permitted to allocate its own operating expenses to funds or portfolio companies if this practice has not been disclosed to investors.¹⁶ Increasingly, the SEC is focusing on the specificity of disclosures relating to a fund's obligation to bear the adviser's operating expenses and the effectiveness of an adviser's expenses allocation procedures to ensure compliance with its disclosures.¹⁷

The SEC has also made clear that an adviser must allocate expenses shared by multiple funds or co-investors proportionately or in compliance with the governing fund documents. For instance, in 2022, the SEC entered a settlement with Energy Capital Partners Management, LP (ECP), where ECP agreed to pay a penalty of US$1 million for allocating a disproportionate share of deal expenses to its fund, while co-investors bore no expenses.¹⁸ According to the SEC, ECP failed to disclose this disproportionate allocation to the fund or its Limited Partner Advisory Committee.

iii Valuation and miscalculation of fees

In a similar vein, the SEC has indicated that an adviser is required to accurately calculate its fees, in accordance with disclosures. In light of the illiquid nature of many fund assets, in addition to departures from disclosures, the SEC has expressed concern with the use of bespoke methodologies no investor would reasonably anticipate, and inadequate procedures to guard against inherent conflicts.¹⁹

This shift beyond the fee consequences of valuations to scrutiny of valuations and related policies and procedures for their own sake is becoming an increasing area of SEC scrutiny, particularly in light of recent market conditions. In the SEC's view, market dislocation has heightened the risk that private fund advisers are not fairly valuing their fund assets, which could exacerbate issues under the recently expanded advertising rule or unfairly suppress secondary markets by leading limited partners to believe their investments are more valuable than they are. This level of heightened scrutiny also extends to emerging asset classes, such as digital assets,²⁰ and practices for engaging and interacting with third parties who provide valuation or accounting services. Robust documentation and reliable processes, including those that incorporate back-testing procedures, will be increasingly important as the SEC further explores valuation issues, with a broadening view of related conflicts of interest.

One of the SEC's related enforcement focuses is on an investment adviser's failure to reduce management fees in accordance with the step-down provisions in fund documents, which require the investment adviser to reduce management fees after a certain duration or triggering events, which may include, without limitation, writing down or writing off in value of portfolio securities and disposing a portfolio company.²¹ The SEC has scrutinised underperforming investments to see whether they should be written down or written off and whether an investment adviser is collecting fees on investments when it should not be. The SEC has also scrutinised investments that were written off or written down to see whether it was done at an appropriate time.

iv Undisclosed financial conflicts

The SEC considers undisclosed loans, investments, and other financial interests to be a potential conflict of interest.²² The SEC's settlement with Virtua Capital Management, LLC (Virtua) provides a good example.²³ In that matter, the SEC alleged that Virtua caused its funds to invest almost exclusively in real estate projects that were managed by certain Virtua personnel and related entities, which at times benefited the financial interests of Virtua personnel and related entities over those of Virtua's funds. According to the SEC, Virtua and its personnel were incentivised to direct their clients to invest in Virtua-managed projects because the projects might not otherwise secure enough funding; further, the purchase price of some investments by the funds were based on unvalidated valuations that benefited Virtua and its personnel. The SEC alleged that Virtua did not disclose the conflicts of interest arising from these investments, and Virtua and its personnel agreed to pay disgorgement, prejudgment interest, and civil penalties totalling US$2,099,089, to settle these and other allegations.

v Undisclosed relationships with third parties

The SEC has also focused in recent years on undisclosed relationships with third parties, including third-party service providers. The SEC has determined that these undisclosed relationships can constitute a conflict of interest, even where the undisclosed relationship does not financially harm investors.²⁴ The SEC has even considered undisclosed discounts received from third-party service providers to be a conflict of interest.²⁵

One instructive example of an undisclosed relationship with a third party comes from a resolution with Centre Partners Management.²⁶ In the settlement order, the SEC alleged that Centre Partners failed to disclose relationships between certain of its principals and a third-party information technology service provider, as well as the potential conflicts of interest resulting from these relationships. Specifically, three of Centre Partners' principals were invested in the service provider, two occupied seats on the provider's board, and the wife of one of the principals was a relative of the provider's co-founder and CEO. Although Centre Partners provided extensive disclosure on its use of the service provider and its advantages – and neither Centre Partners nor its principals profited from the relationship – the SEC alleged that the lack of disclosure about the relationships between the provider and the Centre Partners principals constituted a conflict of interest. Put differently, the SEC did not allege any actual conflict (i.e., that the terms were off-market, that the services were not appropriate or that the owners profited from the arrangements). Rather, the SEC asserted that, because this relationship constituted a potential material conflict, it should have been presented to the limited partners' advisory committee under the terms of the limited partnership agreements. To resolve these allegations, Centre Partners agreed to pay a civil penalty of US$50,000.

IV Emerging enforcement risks

As the market has responded to the SEC's view of fiduciary principles for private fund advisers, and considered conflicts more carefully, the SEC has moved from failures to disclose conflicts towards assessing whether firms have acted consistently with their disclosures. In this context, private fund advisers should consider the SEC to have developed expertise assessing the conflicts they believe to be in the industry, and to now be scrutinising the specifics of advisers' disclosures and practices. The focus on fiduciary failures remains fixed, but the prominence of policies, procedures, and practical interactions with investors is increasing. To date, this is most apparent in material non-public information (MNPI) controls and risk management, but recent drivers have further fuelled heightened scrutiny in restructurings, cybersecurity, ESG investing, the new marketing rule, cryptocurrency and electronic messaging.

i MNPI controls and risk management

The SEC has suggested that private fund compliance professionals are responsible for independently verifying the representations of investment team professionals where they relate to material regulatory risks. In a prominent and widely covered example, the SEC alleged that Ares Management LLC had inadequate written policies and procedures to ensure that Ares-designated directors serving on the board of a publicly traded portfolio company did not possess MNPI when Ares' funds traded their shares.²⁷ Ares' compliance staff allegedly relied on the director's assessments of materiality without reliable processes to verify the director's determinations, or to insulate potential MNPI from Ares' investment decisions. The SEC settlement criticised ad hoc utilisation of risk management procedures, such as information walls, and inadequate documentation to show compliance professionals had sufficiently independently inquired into the risk area, concluding that Ares relied too heavily on its designee-director without a reliable process to ensure against the risk that the director erred when representing that Ares had no access to potential MNPI. Notwithstanding not finding that the director misrepresented Ares' access to MNPI, the SEC settlement still required Ares pay a US$1 million penalty. The staff remains focused on the open dialogue between compliance and investment professionals as it relates to the potential receipt of MNPI and related documentation.

While private fund firms (with the exception of hedge funds) generally have limited dealings with publicly traded securities, EXAMS and Enforcement have inquired into MNPI risks arising in scenarios such as take-private transactions, public offerings or block sales of portfolio company equity, or dealings with special purpose acquisition companies (SPACs), collateralised loan obligations and 10b5-1 plans. In order to offset risk, private fund managers in particular should keep an eye towards identifying where SPAC MNPI could be gleaned from the sponsoring affiliate, adviser personnel serving as SPAC directors or officers, public companies that are 'adjacent' to SPAC-related deal activity or that result from SPAC outreach to portfolio companies.

Alternative data providers and 'expert networks' have also increasingly been scrutinised as potential sources of MNPI, raising issues of outsider trading. Advisers must exercise caution in working with third-party providers to ensure MNPI is not disclosed. In 2021, the SEC brought Regulation FD charges against AT&T and three investor relations executives for selectively disclosing MNPI to research analysts.²⁸ The complaint alleges that investment relations executives disclosed to certain analysts that AT&T's first-quarter smartphone sales would be lower than expected. The purpose of the disclosure was allegedly to induce analysts to reduce revenue forecast estimates for the quarter. The action demonstrates the SEC's commitment to investigating alternative data concerns and highlights the importance of monitoring employee use of and educating employees on the risks associated with web-scraped data. EXAMS has further confirmed that, in its view, advisers have not adopted or implemented reasonably designed policies and procedures to address the potential receipt of MNPI through alternative data sources and expert networks.²⁹ Advisers must not only exercise caution in working with third-party providers to ensure MNPI is not disclosed, but also make sure they have in place the appropriate policies and procedures to prevent improper disclosures.

Adjacency issues, which refer to the concept of trading in one company with the benefit of information received or learned from a different company, have also become a focus of the SEC, demonstrated through the litigation of SEC v. Panuwat.³⁰ Matthew Panuwat, an executive at mid-sized biopharma company Medivation, received confidential, MNPI via email from Medivation's CEO that it would be imminently acquired by Pfizer, Inc. Minutes after receiving the email, Panuwat purchased out-of-the-money, short-term stock options in Incyte Corporation, another mid-cap oncology-focused biopharmaceutical company. He made the trade because he believed Incyte's value would materially increase when the Medivation acquisition announcement became public. The SEC alleged that by trading ahead of the announcement, Panuwat enjoyed illicit profits of US$107,066. While the complaint does not suggest that highly developed industry knowledge constitutes MNPI, asset managers should vigilantly consider whether specific information learned from one company has a direct nexus to a potential investment target.

ii Restructuring risks

Recent market dislocation has accelerated the SEC's scrutiny of specific practices regarding adviser-led fund restructurings and other steps taken to address complex liquidity and valuation issues. EXAMS recently confirmed it would continue to focus on the circumstances surrounding these transactions in its 2023 Priorities.³¹ In an early example of the SEC's interest in this area, a private fund adviser and its owner agreed to a US$200,000 civil penalty to settle charges that the adviser misrepresented the value of fund limited partner positions when offering to buy out investors desiring liquidity at a price set by fund asset values that were several months stale, while in possession of preliminary information that net asset values had potentially increased.³² This is indicative of the SEC's interest in scrutinising the bases for valuations associated with secondary transactions and other adviser-led transactions, such as fund cross trades.

More broadly, in this context, EXAMS has inquired into specific investor communications concerning stapled agreements to commit to new funds alongside restructuring events. Other preferential treatment, fee or expense concessions, or other individualised accommodations have similarly been an area of increasing interest. In this context, advisory committee approval is playing a less significant role to deter SEC scrutiny, as the SEC searches for misrepresentations or omissions in specific investor disclosures. The increasing rate of restructuring transactions within private funds, and their complexity, has invited heightened enforcement interest to look behind the shield of sophisticated legal representation to ensure advisers are taking adequate steps to obtain informed investor consent to conflicts.

iii Cybersecurity

Cybersecurity threats have become a global concern as threats span across the spectrum of industries and markets. EXAMS considers the current cybersecurity risk environment elevated given larger market events, geopolitical concerns, and the proliferation of cybersecurity attacks, particularly ransomware attacks.³³ As cyber-threat actors become increasingly aggressive, sophisticated, and state-backed, it is essential that firms and other market participants have the capacity to monitor and assess cybersecurity risk and effectively manage breaches that occur when safeguards fail. The SEC is particularly concerned about market systems, customer data protection, disclosure of material cybersecurity risks and incidence, and compliance with legal and regulatory obligations under the federal securities laws.³⁴ In light of thousands of broker-dealer, investment adviser, clearing agency, national securities exchanges, and other SEC registrant examinations, the SEC has observed the following factors to be at the centre of cybersecurity programmes: '(i) a risk assessment to identify, analyze, and prioritize cybersecurity risks to the organization; (ii) written cybersecurity policies and procedures to address those risks; and (iii) the effective implementation and enforcement of those policies and procedures.'³⁵ The SEC continues to exhibit a focus on cybersecurity, and in 2022, the SEC proposed new rules to require registered investment advisers to adopt and implement written policies and procedures that are reasonably designed to address cybersecurity risks and report significant cybersecurity incidents affecting the advisers to the SEC.³⁶

In furtherance of its enforcement efforts, the SEC has centred its adviser review on the adequacy of cybersecurity policies and procedures. Particular areas of interest include the safeguarding of customer accounts and preventing intrusions, including verifying an investor's identity to prevent unauthorised account access; vendor and service provider oversight; procedures to address malicious email activities, such as phishing or account intrusions; response to incidents, including those related to ransomware attacks; management of operational risk as a result of dispersed employees in a work-from-home environment; and adequate and prompt cybersecurity incident disclosure.

The staff expects asset managers to disclose cybersecurity incidents and breaches to relevant parties even where the alleged harm does not result in unauthorised trades or access to customer accounts. This concept is best illustrated through an SEC enforcement action, In the Matter of Cetera Advisor Networks, LLC et al., brought in 2021.³⁷ Between November 2017 and June 2020, unauthorised third parties gained access to the email accounts of over 60 Cetera personnel, resulting in over 4,388 of Cetera customers' personally identifiable information being compromised. The breaches did not appear to have resulted in any unauthorised trades or transfers in brokerage customers' or advisory clients' accounts. However, the SEC found that respondents' policies and procedures designed to protect customer information and to prevent and respond to cybersecurity incidents were not reasonably designed to meet those objectives. In addition, when respondents notified their customers of the breaches, some notifications had misleading information about the breach's timing. The parties settled the claims, with respondents assuming a US$300,000 civil penalty. To circumvent risk of similar actions, firms must ensure that their cybersecurity policies, procedures and controls are developed, followed and memorialised in writing.

iv ESG investing

As capital deployed in other asset classes is increasingly allocated to socially responsible products, or those that actively pursue strategies rooted in environmental, social or governance criteria, and as other jurisdictions implement comprehensive regulations on adviser-level disclosures concerning certain of these matters, the SEC has publicly announced its intention to continue to analyse private fund and other investment advisers' disclosures on these matters to suss out material misrepresentations. In 2022, the SEC proposed amendments to certain forms and associated rules to require registered investment advisers to provide clients and shareholders with additional information regarding their ESG investment practices.³⁸ This year, EXAMS will continue its focus on ESG-related advisory services and fund offerings, including whether the funds are operating in the manner set forth in their disclosures. In addition, EXAMS will assess whether ESG products are appropriately labelled and whether recommendations of such products for retail investors are made in investors' best interest.³⁹ Another prominent example of the SEC's increased focus on ESG issues is the issuance of an ESG investing risk alert⁴⁰ and the announcement of an enforcement division task force mandated to analyse disclosure and compliance issues relating to investment advisers' and funds' ESG strategies.⁴¹ Whether the SEC will focus only on private funds pursuing impact strategies, or will more broadly assess practices for, and disclosures of, considering ESG topics in risk assessments during the course of investment and portfolio management, remains to be seen. Enforcement actions to remediate and deter materially misleading overcommitments to ESG principles will likely increase under the EXAMS 2023 Priorities and as the rush to market 'green' or 'responsible' advisory services has created a risk that advisers cannot measure up to their disclosures or measure the details they committed to monitor.⁴² Until industry standards for ESG terms, performance and reporting emerge, enforcement interest in this field is likely to remain heightened.

v New marketing rule

The new marketing rule, with its compliance deadline of 4 November 2022, prohibits advertisements that contain any untrue statement of a material fact or that are otherwise false or misleading, and applies a 'fair and balanced' standard that considers the facts and circumstances of the advertisement, taking into account the sophistication of the audience. EXAMS indicates in its 2023 Priorities that registered investment advisers' compliance with the new marketing rule will be a new focus area.

The new rule is a significant change to the review area for advisers and is likely to lead to increased regulatory scrutiny of solicitation agreements and marketing materials, including those created by distributors. EXAMS will, among other things, assess whether advisers have adopted and implemented written policies and procedures that are reasonably designed to prevent violations by the advisers and their supervised persons of the new marketing rule. EXAMS will also review whether advisers have complied with the substantive requirements of the new marketing rule, including the requirement that registered investment advisers have a reasonable basis for believing they will be able to substantiate material statements of fact and requirements for performance advertising, testimonials, endorsements and third-party ratings.

EXAMS recently published a risk alert indicating that it intends to conduct a number of specific national initiatives and a broad review through the examination process focused on the new marketing rule.⁴³ Areas of focus will include, but not be limited to, reviewing whether investment advisers have adopted and implemented written polices and procedures with respect to the new marketing rule, whether investment advisers have a reasonable basis for believing they will be able to substantiate material statements of fact in advertisements, whether investment advisers are in compliance with the rule's performance advertising requirements and whether investment advisers are in compliance with the record-keeping requirements amended in connection with the rule.

vi Cryptocurrency

The SEC has expressed increasing interest in activities involving digital assets (e.g., crypto assets and their associated products and services) and emerging financial technology (e.g., broker-dealer mobile apps and advisers choosing to provide automated digital investment advice to their clients) and has specifically indicated potential areas of enforcement that are applicable to the private funds space. In October 2021, Chair Gensler indicated that the SEC was considering ways to enhance investor protection 'in crypto finance, issuance, trading, or lending', which he likened to 'the Wild West or the old world of “buyer beware” that existed before the securities laws were enacted'.⁴⁴ He previewed that the SEC staff, with other regulators, would work along two tracks to address: (1) how the SEC, with other financial regulators, can best bring investor protection to these markets; and (2) how Congress can help fill regulatory gaps. In a 2022 proposal to amend Form PF, the SEC proposed to add a new sub-asset class for digital assets and define the term 'digital asset.'⁴⁵ In 2023, EXAMS highlighted its plans to examine registered investment advisers trading in crypto assets.⁴⁶ Examinations of registrants will focus on the offer, sale, or recommendation of, advice regarding and trading in crypto or crypto-related assets. Examiners will assess appropriate standards of care when making recommendations, referrals, or providing investment advice and the routine review, update and enhancement of compliance, disclosure and risk management practices.⁴⁷ The heightened focus on digital assets and related activities has motivated the SEC to propose a new safeguarding rule to modernise the existing custody rule and attempt to regulate such assets.⁴⁸ In addition, the SEC issued an investor alert in March 2023 to urge investors to be cautious when considering an investment involving crypto-asset securities.⁴⁹

vii Electronic messaging

A registered investment adviser's policies and procedures for retaining and monitoring electronic communications were listed as an examination focus under the EXAMS 2023 Priorities.⁵⁰ In September 2022, the SEC announced a US$1.1 billion settlement with 15 broker-dealers and one affiliated investment adviser for failing to maintain and preserve electronic communications and reasonably supervise their employees.⁵¹ SEC Chair Gary Gensler indicated that the SEC would continue to ensure registrants' compliance with the record-keeping requirements as part of its examination and enforcement efforts⁵² and there are ongoing reviews of private fund advisers in this area.

V Key takeaways and practice tips

Although investment advisers have begun changing their practices to address and prevent the conflicts of interest that have long been the centre of the SEC's private fund enforcement programme, the SEC remains focused on the possible conflicts inherent in the private fund business model, its wider industry, and scrutinising specific instances where they arise. The SEC's recent statements, examinations and enforcement actions demonstrate the importance of adequate monitoring, evaluation, and disclosure of potential conflicts of interest. Both private fund and other types of advisers should evaluate their practices and procedures for any potential conflicts, keeping in mind the following enforcement trends.

i Mitigate, eliminate or disclose conflicts

Advisers should evaluate any potential conflicts that may exist in their practices, procedures or relationships. If any conflicts exist, advisers should determine whether these conflicts have been adequately disclosed or should be mitigated or eliminated. In particular, advisers should examine their fees and expenses charged to funds and portfolio companies to confirm that the fees and expenses have been adequately described in offering agreements or related disclosure documents, or both. Examples of conflicts in the private fund industry can be found in published enforcement actions, public disclosures, and SEC guidance and speeches. An adviser's counsel is also a good source of this information.

If the conflict is not disclosed in the offering documents, consideration should be given to whether a disclosure to limited partners or their advisory committees may be an option. In certain scenarios, reimbursing investors pursuant to the equitable principles governing the SEC's disgorgement decisions may also be appropriate.⁵³

ii Lack of harm or benefit may be irrelevant to liability

The SEC does not consider the fact that limited partners were not harmed – or even received a benefit – to be a complete defence to a potential conflict. Therefore, when an adviser evaluates a practice or relationship to determine whether it constitutes a potential conflict of interest, the relevant metric is not only whether the arrangement is to the limited partners' benefit, but also whether it could appear that the arrangement could affect the adviser's judgement. In the SEC's view, because an adviser is a fiduciary, it must disclose all material conflicts of interest so that the client can evaluate the conflict and make an informed decision for itself. Any benefit or lack of harm to a limited partner does not relieve the adviser of this duty to inform. Notably, however, SEC speeches have suggested that a potential benefit to an investor may be relevant in assessing a potential remedy, even if it is not relevant in assessing the adviser's liability.

iii Focus on both actual and potential conflicts

The SEC is concerned with both actual and potential conflicts. The SEC pursues enforcement in situations where there is no actual conflict but the mere potential for a conflict exists. Therefore, an adviser must proactively evaluate its practices, procedures and relationships to determine whether they could possibly tempt the adviser to act in its own best interest over that of its investors. As former EXAMS director Peter Driscoll cautioned, firms should monitor their conflict risks with robust, meaningful and supported compliance programmes, rather than take a 'check-the-box' approach to compliance.⁵⁴

iv Disclosures in pre-commitment documents

The SEC has continued to emphasise its view that disclosures regarding potential conflicts of interest should be made in pre-commitment, rather than post-commitment, documents. This includes disclosures in a Form ADV, which have been described in SEC speeches as a 'positive change', but 'not a sufficient remedy'. Post-commitment disclosures have been found generally to be insufficient, according to the SEC, because of the unique nature of the private fund industry. Namely, it is the SEC's view that if limited partners were aware of potential conflicts of interest before committing capital to the fund, they could have bargained for a different arrangement with the adviser. The SEC has generally not been amenable to arguments that it is unfair for advisers to be held accountable for documents drafted long before the SEC began its focus on private fund. The SEC takes the position that private fund advisers have always been investment advisers subject to the Advisers Act and were therefore fiduciaries subject to the Advisers Act's anti-fraud provisions.⁵⁵ Notwithstanding this view, the SEC does appear to take into consideration certain other post-commitment disclosures, including limited partner advisory committee disclosures and consents.

v Detailed disclosures

The SEC expects disclosures to be as detailed as possible. Disclosures involving broad statements in fund documents may be viewed by the SEC as insufficient if a reasonable investor would not have understood the conflict from reading the disclosure. In fact, the SEC has reached out to investors in certain exams and enforcement actions to confirm whether they understood the conflict at issue. In this regard, the SEC has generally rejected arguments that limited partners are sophisticated investors who are aware of industry practices.

Particularly in contexts where advisers are leading inherently conflicted transactions or disclosing details in a dynamically changing environment or emerging area lacking precise definitions, the details matter. Compliance teams should implement processes and have the requisite resources to independently verify financial and strategic disclosures before they become subject to SEC scrutiny.

VI Conclusion

Firms are well served by understanding the lessons learned in the private fund context and using that insight to assess their own practices – asking whether their conduct may be perceived to constitute a conflict or potential conflict and if so, whether those conflicts have been adequately disclosed. Operating with this awareness and taking a proactive approach to remedy any shortcomings will serve firms well in ensuring they are prepared when the SEC eventually comes knocking.