We regularly comment on the ever-changing “regulatory agenda.” In our last issue, we noted that even though the current Administration may be struggling to advance legislative reform, including rescinding or amending the Dodd-Frank Act, agency appointees have taken steps to revise many of the rules enacted after the start of the financial crisis. We also noted that the agencies’ enforcement efforts, at least in certain areas, seemingly have waned.
Not all developments are de-regulatory, however. Whether the staffs of the agencies are simply concluding enforcement matters commenced during the prior Administration or are being more selective about which rules they will actively enforce, it does seem that certain rule violations continue to attract regulatory scrutiny.
One such area is the improper allocation of expenses by private fund advisers. As indicated by several news items in this issue of The Financial Report, during the past week, the Securities and Exchange Commission announced charges or settlements against a number of investment advisers for improperly allocating fees and expenses to funds they advised, for improper disclosures regarding the timing of fund distributions and the impact on fund adviser fees, and for inadequate disclosure of an adviser’s methodology for computing fees and expenses.
This should come as no surprise. In January, the SEC’s Office of Compliance Inspections and Examinations identified its “Examination Priorities for 2017.” OCIE indicated that the Staff “will continue to examine private fund advisers, focusing on conflicts of interest and disclosure of conflicts as well as actions that appear to benefit the adviser at the expense of investors.”
Why is the SEC deploying its limited resources on the private equity industry, especially given the level of sophistication of most investors? In a May 2016 speech, Andrew Ceresney, then the Director of the SEC’s Division of Enforcement and now back in private practice, stated that retail investors, indirectly through public pension plans, are invested in private equity funds. He noted that the underlying plan beneficiaries generally are not in a position to protect themselves if an adviser defrauds a private equity fund in which their retirement savings are invested. Mr. Ceresney also observed that private equity has certain “unique characteristics,” particularly the investment structure of private equity and the nature of private equity investments, that lend themselves to potential misconduct.
The SEC’s enforcement actions against private equity fund advisers continue to fall into three interrelated categories: (i) advisers that receive undisclosed fees and reimbursement of expenses; (ii) advisers that impermissibly shift and misallocate expenses; and (iii) advisers that fail to adequately disclose conflicts of interests, including those relating to fees and expenses. Many of the cases involve issues of “horizontal misallocation,” in which an adviser is misallocating fees or expenses across the private funds or separately managed accounts (or “co-investor accounts”) it manages. Others involve “vertical misallocation,” in which an adviser (or its “related parties”) misallocates expenses between the adviser and the funds and accounts it manages.
Private fund advisers, particularly private equity fund managers, should be careful not to be lulled into a false sense of complacency by the nascent deregulatory wave. The focus on misallocation of fees and expenses, and related conflicts of interest or possible breaches of fiduciary responsibilities, are likely to remain a focus of regulatory enforcement efforts for the foreseeable future.