Despite being an overall quieter year with respect to high profile enforcement actions against private funds, in 2017, the U.S. Securities and Exchange Commission (SEC) made clear its intent to maintain its regulatory focus on the industry. The SEC investigated and brought cases against private funds related to the allocation of expenses, valuation of fund assets, and unregistered broker-dealers, making clear that compliance obligations remain a priority.
Last year was highlighted by a change in administration, which naturally brought with it speculation as to the impact of new leadership at the SEC. In 2017, the SEC welcomed a new Chairman, Jay Clayton – a transactional attorney formerly of Sullivan & Cromwell. Chairman Clayton stands in contrast to former Chair Mary Jo White, a well-known former prosecutor. Many commentators believed Mr. Clayton would represent a significant shift from the prosecutorial-minded White, and, combined with President Trump’s anti-regulatory tendencies, result in a lighter touch with respect to the SEC’s enforcement directives. There was also a change in leadership at the SEC’s Enforcement Division, as former federal prosecutor Andrew Ceresney resigned and Stephanie Avakian and Steven Peiken assumed leadership as Co-Directors of Enforcement.
While many in the private funds industry welcome an SEC with a lighter touch, we would not be surprised if, in 2018 and beyond, the SEC maintained an environment of serious scrutiny of the private funds industry. In fact, the SEC, through enforcement actions and public statements, has made clear it will not stand idly by with respect to certain types of issues, including improper disclosures to investors, troublesome fee allocations and conflicts of interest. As 2018 gets off the ground, private funds should continue to remain vigilant and build upon the improvements many already made with respect to compliance, including updating and improving compliance infrastructure and evaluating internal policies and procedures.
Enforcement Results 2017
In November 2017, the SEC’s Enforcement Division issued its annual report highlighting its priorities for the upcoming year and reviewing overall enforcement actions for its fiscal year 2017. The SEC reported a total of 754 actions for the year — including 446 standalone actions, 196 follow-on actions, and 112 actions for delinquent filings — resulting in nearly $3.8 billion in monetary penalties and disgorgements. As a result of the transition in leadership, these numbers are down slightly from prior years. These actions involved a number of substantive areas, with a significant portion being actions related to (1) Issuer Reporting/Audit & Accounting and (2) Securities Offerings. The SEC also noted that individuals were charged in 73% of the standalone actions.
The SEC continues to evolve with respect to its understanding of private fund advisers and firms, building upon its creation of specialized Asset Management Units, which were created in 2010, and the Office of Compliance, Inspections, and Examinations (OCIE), which was launched in 2012 and created its own Private Funds Unit. While the SEC’s Acting Director of OCIE, Peter Driscoll, noted in July 2017 that the SEC is unlikely to continue to canvass most private equity firms for potential violations (stating “I think we’ve hit that area pretty hard”)1, OCIE will continue to focus exams to probe specific concerns and put private fund advisers on notice by its stated exam priorities (which recently have included a focus on fees and expenses, along with other internal controls and disclosure obligations). The SEC also has reminded private fund sponsors that despite a new administration, overall, the SEC has had continuity -- emphasizing that its day-to-day activities had changed very little and that the private equity industry and investment advisers remain an important priority. Industry observers generally agree that private funds should proceed with caution and continue to anticipate SEC attention, especially with respect to hot-button issues. The good news is that a large portion of private funds have made meaningful changes in recent years with respect to internal compliance infrastructure and commitment to adhere to best practices.
Allocation of Expenses
The SEC continues to focus enforcement efforts regarding private equity advisers’ fee and expense allocation and disclosures to their fund clients on how fees and expenses are allocated to the funds.
In September 2017, the SEC issued an order instituting and settling administrative and cease-and-desist proceedings against Potomac Asset Management Company Inc. (PAMCO), an investment adviser, and its principle for improperly allocating certain fees and expenses to two private equity fund clients to whom PAMCO provided investment advisory and management services.2 Among other things, the order alleged that PAMCO improperly allocated to the funds various fees for services to a portfolio company without authorization to do so in the funds’ limited partnership agreements and failed to disclose the misuse of fund assets to the funds’ limited partners.
Also in September 2017, the SEC issued an order instituting and settling administrative and cease-and-desist proceedings against Platinum Equity Advisors, LLC, an investment adviser, for causing its three main private equity funds to pay broken deal expenses that benefited co-investors without disclosing to fund investors that they would bear co-investors’ expenses.3 In addition, Platinum failed to adopt and implement a written compliance policy governing its broken deal expense allocation practices.
In October 2017, the SEC issued an order instituting and settling administrative and cease-and-desist proceedings against Augustine Capital Management, LLC and two principals, for failing to disclose and seek consent in instances of conflicted transactions, improperly charging certain fees and expenses to a managed fund and providing investors with misleading account statements.4The fund and its principals also failed to disclose that the fund’s monies were being used to make undocumented loans without investors’ consent, to cover margin calls of an entity controlled by the principals of the fund’s investment adviser.
Valuation of Fund Assets
Continuing its scrutiny of private funds valuation of assets, in March 2017, the SEC announced an action against Covenant Financial Services, LLC, an Oklahoma-based private fund adviser, for overvaluing municipal bonds held by its funds.5 The fund adviser refunded management fees directly to the funds and paid additional money to the fund to compensate them for overpayment of redemptions. Of note, the adviser had used a third-party pricing service to value the bonds. The SEC faulted the adviser’s continued use of the pricing service’s valuation because the funds previously sold some of the bonds at prices materially lower than this valuation. And the SEC alleged that the adviser’s valuations were done in “bad faith” because they were not consistent with representations it made in the funds’ financial statements, private placement memoranda, written valuation policy (i.e., the stated valuation policies differed from actual valuation practices), and limited partnership agreements.
In December 2017, the SEC filed a complaint charging defendants James Tao and Donna Boyd with acting as unregistered brokers in violation of the Securities Exchange Act of 1934 in connection with the offering and sale of interests in a private equity fund formed by the defendants.6
Creation of Cyber Unit
In September 2017, the SEC announced the creation of a Cyber Unit with the goal of combating cyber-related threats. The Cyber Unit will focus primarily on market manipulation schemes that use social media platforms to spread false information, hacking efforts to obtain material nonpublic information, misconduct on the dark web, and violations involving distributed ledger technology. The Cyber Unit will include staff from the SEC’s Enforcement Division, and the SEC’s approach will include a focus on SEC regulations that implicate cybersecurity practices in regulated entities, including investment advisers to ensure protection of customer information and records. Chairman Clayton has emphasized that OCIE examinations have focused on compliance with cyber-related regulations. Private funds should update their cyber-related controls and response plans, with an emphasis on protecting investors’ information, along with that of portfolio companies – especially consumer-facing portfolio companies upon whose boards private equity professionals sit.
In September 2017 OCIE issued a Risk Alert7 providing a list of compliance topics related to the Advertising Rule (Advisors Act Rule 206(4)-1) that OCIE identified in deficiency letters sent to SEC-registered investment advisers. The Advertising Rule generally prohibits registered advisers from publishing any advertisement that contains an untrue statement of material fact. The Risk Alert identified a number of common deficiencies, including: (i) misleading claims of compliance with voluntary performance standards, (ii) failure to have compliance policies and procedures, (iii) misleading use of third-party rankings or awards, and (iv) misleading performance results – further emphasizing the importance of reviewing advertisements to ensure they meet the obligations under the Advisers Act.
The SEC has highlighted a number of areas of enforcement focus that we expect will continue to be of priority going forward, many of which can impact private funds, including:
- Conflicts of Interest: The SEC remains focused on potential or actual conflicts of interest between private equity advisers and the investors in their funds. The SEC continues to scrutinize advisers’ allocations of investments, fees, and expenses and takes action when the SEC Staff believes the adviser may have acted in contravention of the investors’ best interests.
- Insider Trading: The SEC continued to pursue insider trading cases using various technological and investigative tools, bringing actions against multiple individuals. Along with the Department of Justice, the SEC continues to emphasize its role as policing the integrity of the public markets.
- FCPA: The SEC continued to bring actions for bribery of foreign officials and violations of the statute’s books and records provision, and attained a number of large settlements in this area.
- Individual Accountability: 73% of the standalone enforcement actions in FY 2017 involved charges against individuals – a statistic that has risen to 80% in the six months since Chairman Clayton took office.
While FY 2017 saw a slight decline in the total number of enforcement actions pursued by the SEC, we expect the Commission to ramp up efforts in FY 2018 as the Enforcement Division’s new cyber and other initiatives gain traction. Recent enforcement actions continue to reflect that the SEC appears to consider the lack of harm to limited partners as irrelevant to liability – i.e., the SEC does not typically consider the fact that investors were not harmed to be a complete defense, especially in situations involving an actual or potential conflict of interest. Private funds can prepare for an active SEC Enforcement Division by focusing on internal controls and fostering a culture of compliance, to ensure that they accurately and completely disclosed information, particularly about conflicts of interests, to their limited partners.