This article is an extract from TLR The Securities Litigation Review - Edition 8. Click here for the full guide.

I Introduction

In the 12 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.

The 2022 stated priorities (2022 Priorities) for the SEC's Division of Examinations (EXAMS) – formerly, the Office of Compliance Inspections and Examinations – continue to focus on issues impacting private equity fund advisers, including disclosures of investment risks and conflicts of interest.2 Consistent with this focus, and the Commission's recognition of the significant role of private fund advisers in the financial markets, EXAMS recently published a risk alert highlighting compliance issues identified in exams of registered investment advisers.3 Additionally, the SEC recently proposed drastic reforms to the rules governing private fund advisers, which, if implemented, would create seismic shifts in the principles, prohibitions, limitations and requirements for investment advisers in carrying out investment advisory business, including investor and client reporting, limited partnership agreement negotiation and drafting, advertising, annual audits, liquidity transactions, and fee and expense mechanics.4 In this landscape, EXAMS will likely sharpen its focus on conflicts arising from the issues raised in the proposed new rule, including those related to portfolio valuation and resulting fee calculation, 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 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. 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, 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. Since then, 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, in 2018, EXAMS 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 in 2020 shared its views on weaknesses in investment adviser disclosures and compliance programmes.7 This year, the SEC reaffirmed its continued focus on compliance issues related to investment advisers.8

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 with 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. The SEC has long suggested that this model results in conflicts beyond those faced by typical investment advisers.

Indeed, in a February 2015 speech,9 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'.10 Notably, under this model, 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.

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.11

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. In October 2021, SEC Chair Gary Gensler reiterated the Commission's interest in ensuring greater transparency and competition in the private fund space, and indicated that the Commission is exploring certain reforms to this end, particularly with respect to enhancing disclosures regarding potential conflicts of interest and fees.12

As a result of the SEC's highly publicised focus on the private equity industry, investment advisers have matured their practices. However, the SEC's interest in the private equity industry has continued and evolved alongside shifts in industry practice and major economic events, such as the market dislocation seen in 2020. In the fiscal year 2021, EXAMS returned to, and in some respects exceeded, its pre-pandemic workload, conducting over 3,000 examinations (representing 16 per cent of the investment adviser registration population) issued over 2,000 deficiency letters, and made 190 referrals to Enforcement. Changed practices in light of the normalisation of covid-19 includes less accommodation of extended production deadlines in the future and an indicated return to on-site examinations. 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).

Overall, 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.13 However, the current enforcement landscape and emerging risk areas are informative not only to the private equity industry, but also to other types of investment advisers who are evaluating their practices and procedures, including those focused on digital assets, real estate, debt and hedge funds. It is therefore important for all advisers to have an understanding of relevant areas of SEC enforcement and potential conflicts of interest, which are described in more detail below.

III Conflicts of interest

The SEC's interest in the private equity industry encompasses a wide range of topics, from the highly publicised accelerated monitoring fee issue to the lesser-known conflicts-of-interest issues brought up in examinations. Private equity advisers should be aware of significant areas of enforcement that have accelerated in the new political administration, including undisclosed fees and expenses, misallocation of expenses, valuation of investments and 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,14 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's focus on disclosures concerning the fees and expenses of affiliated service providers seen in the case above is a hallmark of its enforcement programme. The SEC reaffirmed their interest in fees and expenses issues in the recent 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. A recent example involved Fortress Investment Management, LLC, the fourth adviser to face charges of undisclosed compensation arising from its funds' investment in the Aequitas enterprise.15 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 $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.16

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.17 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.18

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, the SEC recently entered a settlement with Rialto Capital Management, where Rialto agreed to pay a penalty of US$350,000 for inappropriately allocating expenses for services provided by in-house employees, among other disclosure issues discussed above. Though these in-house services were provided to co-investment vehicles, Rialto charged the entirety of the expenses to two funds. Rialto fully remediated the funds but was still required to pay a civil penalty.19

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.20

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 equity 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,21 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.

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 JH Partners provides a good example.23 In that matter, the SEC alleged that JH Partners and certain of its principals provided loans to the funds' portfolio companies, thereby obtaining interests in portfolio companies that were senior to the equity interests held by the funds. JH Partners also allegedly caused more than one of its funds to invest in the same portfolio company at differing priority levels from another fund, which could have potentially favoured one client over another. In the SEC's view, these undisclosed arrangements could have caused the adviser to favour itself or one of its funds over another fund, as a result of its more senior investment position in the portfolio company. The SEC alleged that JH Partners did not adequately disclose the potential conflicts created by these undisclosed loans to the relevant advisory boards. To settle these allegations, among others, JH Partners agreed to pay a civil penalty of US$225,000.

The proliferation of special purpose acquisition companies (SPACs) may result in heightened regulatory attention to the conflicts of interest that result from their unique structure. The deputy director of the Corporation Finance Unit's disclosure review programme recently opined that the economic interests of the sponsors, directors, officers and management team diverge from those of public shareholders, which could potentially lead to conflicts of interest in evaluating and recommending acquisition targets to shareholders. Moreover, the SEC has issued comment letters in response to the registration statement filed by SPACs prior to mergers in which they requested sponsors to disclose clearly that the sponsor, certain members of the board and officers of the SPAC will benefit from the completion of a business combination.24 As a result, sponsors have started to add disclosures that the personal and financial interests of directors and officers may influence their decision to target an acquisition company and complete a transaction.

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 harm investors.25 The SEC has even considered undisclosed discounts received from third-party service providers to be a conflict of interest.26

One instructive example of an undisclosed relationship with a third party comes from a resolution with Centre Partners Management.27 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 in private equity, 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 equity advisers should consider the SEC to have developed expertise assessing the conflicts inherent 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, SPACs and ESG investing. The new marketing rule's compliance deadline of 4 November 2022 will likely also provide grounds ripe for regulatory and enforcement activity.

iMNPI controls and risk management

The SEC has recently suggested that private equity 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.28 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.

More directly, the Division of Enforcement cautioned that recent market changes resulting from the coronavirus pandemic have increased the risk of violations relating to MNPI. The dramatic economic effects of the pandemic created a context in which many corporate insiders have greater access to MNPI, and many companies' MNPI carries greater economic significance. While private equity firms 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 SPACs, collateralised loan obligations and 10b5-1 plans. In order to offset risk, private fund managers in particular should keep an eye toward 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 resulting from SPAC outreach to portfolio companies.

Alternative data providers have increasingly been examined as potential sources of MNPI, raising issues of outsider trading. Advisers must also exercise caution in working with third-party providers to ensure MNPI is not disclosed. In March 2021, the SEC brought Regulation FD charges against AT&T and three investor relations executives for selectively disclosing MNPI to research analysts. 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 Commission'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.

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 Commission, demonstrated through the litigation of SEC v. Panuwat. 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 2022 Priorities.29 In an early example of the SEC's interest in this area, a private equity 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. 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 equity, 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. 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.30 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.'31

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 a recent SEC enforcement action, In the Matter of Cetera Advisor Networks, LLC et al, brought in August 2021. 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 equity and other investment advisers' disclosures on these matters in order to suss out material misrepresentations. This year, EXAMS announced environmental, social and governance (ESG) investing as a significant area of focus for 2022, including overstating or misrepresenting the ESG factors considered or incorporated into portfolio selection or 'greenwashing'.32 Another prominent recent example of the SEC's increased focus on ESG issues is the issuance of an ESG investing risk alert33 and the announcement of an enforcement division task force mandated to analyse disclosure and compliance issues relating to investment advisers' and funds' ESG strategies.34 Whether the SEC will focus only on private equity 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 2022 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. Until industry standards for ESG terms, performance and reporting emerge, enforcement interest in this field is likely to remain heightened.

v New marketing rule

On 22 December 2020, the SEC adopted amendments to the existing advertising and cash solicitation rules, consolidating them into one new rule with a compliance deadline of 4 November 2022. The new rule 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.

The new rule is likely to lead to increased regulatory scrutiny of solicitation agreements and marketing materials, including those created by distributors. The adopting release states that third-party communications 'may be attributable to an adviser' where the adviser explicitly or implicitly endorses or approves the material after its publication or where the adviser involves itself in the preparation of the materials (referred to as 'entanglement'). Accordingly, an adviser could face liability under the marketing rule in connection with materials prepared and disseminated by third parties just as it would be liable for content it produced itself. This includes sales and marketing materials prepared by third-party distributors that sponsor feeder funds.

The new marketing rule's focus on entanglement suggests that regulators may seek to hold advisers responsible for disclosures applicable to third-party distributors if a regulator takes the view that the disclosures are inadequate and the adviser was so involved in the preparation of the materials to make them liable for the third-party's conduct. As the compliance date for the new marketing rule approaches, advisers should consider updating their policies and practices to mitigate the risk of potential liability under an entanglement theory.

vi Cryptocurrency

The SEC has expressed interest in activities involving digital assets in recent years and has specifically indicated potential areas of enforcement in this area 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.'35 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 2022, EXAMS highlighted its plans to examine registered investment advisers trading in crypto assets.36 Examiners will assess appropriate standards of conduct, particularly: the duty of care; whether market participants initially and on an ongoing basis understand the products (e.g., blockchain and crypto-asset feature analysis); the routine review, update and enhancement of compliance practices; and appropriate risk disclosure.37

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 equity enforcement programme, the SEC remains focused on the possible conflicts inherent in the private equity business model, and 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 equity 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 equity 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.38

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.39

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 equity 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 equity. The SEC takes the position that private equity advisers have always been investment advisers subject to the Advisers Act and were therefore fiduciaries subject to the Advisers Act's anti-fraud provisions.40 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 of SEC scrutiny.

VI Conclusion

Firms are well served by understanding the lessons learned in the private equity 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.