Podcast: SEC Issues Risk Alert: Compliance Issues for Investment Advisers Managing Private Funds – What You Need to Know

July 22, 2020
18:09 minutes

In this Ropes & Gray podcast, asset management partner Jason Brown and litigation partner Dan O’Connor discuss the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) risk alert providing observations and guidance on compliance issues for registered investment advisers that manage private equity funds or hedge funds. Based on years of experience representing registered investment advisers, Jason and Dan provide their own observations on the compliance deficiencies that OCIE highlighted: (1) conflicts of interest, (2) fees and expenses; and (3) codes of ethics, including material nonpublic information (MNPI).


Dan O'ConnorDan O’Connor: Hello, and welcome to this Ropes & Gray podcast. My name is Dan O’Connor and I’m a partner in the litigation practice. I also co-lead the firm’s securities and futures enforcement group and I’m a former SEC trial attorney. I’m joined today by Jason Brown, a partner in our asset management group. Jason and I work together often with private fund investment advisers on SEC examinations and enforcement investigations. Last month, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published a risk alert offering its observations and guidance on compliance issues for registered investment advisers that manage private equity funds or hedge funds. While the alert did not reveal anything entirely new, it provides a valuable inside look into deficiencies that the SEC has identified in this space over the last several years. 

On today’s podcast, we’ll be discussing the SEC’s risk alert and providing our own observations based on the practical experience that we’ve gained from representing clients in this industry. With that, I’ll turn it over to Jason to provide a summary of the SEC’s alert. 

Brown-Jason-EJason Brown: Thanks, Dan. For starters, the risk alert addresses compliance deficiencies observed by OCIE in three general areas: (i) conflicts of interest; (ii) fees and expenses; and (iii) codes of ethics, including material non-public information (or MNPI). While we will unpack each of these areas, it’s helpful to lay out the sections of the Advisers Act at play here in order to set the stage. Under Section 206 of the Advisers Act, an investment adviser must either eliminate or make full and fair disclosure of all conflicts of interest that may induce the adviser to provide clients with advice that is not disinterested. A full and fair disclosure must be sufficiently specific so that a client is able to understand the material fact or conflict of interest and make an informed decision whether to provide consent. Advisers must also comply with Rule 206(4)-8, which prohibits investment advisers from (i) making any materially untrue statements or omissions to any investor or prospective investor in a pooled investment vehicle; or (ii) engaging in fraud, deceit, or manipulation with respect to any investor or prospective investor in a pooled investment vehicle. Finally, Rule 206(4)-7 requires advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act. 

Turning to the specific deficiencies highlighted in the risk alert, OCIE first addressed conflicts of interest. The alert lists approximately a dozen types of conflicts of interest that they believe have been inadequately disclosed by some advisers. First, OCIE highlighted that advisers did not provide adequate disclosures for conflicts caused by investing client funds at different levels of the capital structure of a company. OCIE also highlighted certain conflicts that can arise based on agreements or relationships with limited partners.  For example, the alert highlights that some advisers failed to disclose the existence of investors with preferential liquidity terms or investors with preexisting ownership interests in investments recommended to clients. Advisers also failed to disclose various financial relationships between the adviser and select investors or clients, including special relationships with seed investors, and special relationships with investors that provided financing to the adviser or its clients that also had economic interests in the adviser.   Additionally, OCIE highlighted inadequate disclosures related to fund restructurings and secondary transactions.  Namely, OCIE found that advisers purchased fund interests from investors at discounts without disclosing the value of the fund interests, advisers did not provide adequate disclosure of options during restructurings, and advisers required secondary purchasers to agree to a staple. 

Dan O’Connor: Right Jason. We also saw this issue in a recent enforcement case for a client. It can be very difficult because advisers, at the end of what is otherwise a very successful fund, are trying to provide liquidity and buy out some limited remaining assets and valuation of those assets at end of fund life can be a tricky issue. It is very important to make sure that GPs provide their limited partners the most up-to-date data as this new information comes in on the assets that are being purchased, as well as describing clearly how the general partner benefits from any such transaction. For many of these transactions what we have seen is that a valuation date is selected but as we know time marches on and the general partner needs to keep its eye on whether the value of the acquired assets has increased before the transaction closes. 

Jason Brown: Thanks, Dan. So OCIE also described conflicts related to investment allocation.  Specifically, OCIE highlighted situations where advisers allocated limited opportunities to new clients, higher fee-paying clients, proprietary accounts, or proprietary-controlled clients.  Additionally, OCIE highlighted situations where advisers allocated securities at different prices or in apparently inequitable amounts among investors. 

OCIE addressed inadequate disclosures related to service providers and cross trades. With respect to service providers, the alert highlights situations where the adviser failed to disclose service agreements entered into between portfolio companies and affiliates of the adviser, incentive payments received by advisers from discount programs for portfolio companies, and situations where the adviser did not follow its disclosures regarding affiliated service providers – for example, stating in disclosure that terms would be “market” but not confirming that terms would be “market”. With respect to cross trades, the alert highlights the importance of using a trade price that represents fair value. 

Dan O’Connor: So Jason, once again this cross trade issue is also something that has been a focus in some recent enforcement cases, and something that we have helped firms address. As we’ve discussed, this issue combines the SEC’s love of big data with some fairly easy to observe rule violations. And helping to design systems to make sure these issues are avoided and traders understand the rules and the relevant cases is something that you and I have helped a number of firms address. 

Jason Brown: Thanks, Dan. Finally, OCIE also addressed co-investment activity, including situations where advisers did not follow their disclosed processes for allocating co-investment opportunities, or enacted agreements to provide co-invest opportunities to certain investors without disclosing those arrangements to all investors. 

Dan O’Connor: So Jason, what do these deficiencies related to conflicts of interest mean for investment advisers? What are some practical things that we can think about?  

Jason Brown: So, most of the deficiencies that the risk alert has highlighted are old news. As with all conflicts, advisers typically meet their fiduciary duties with respect to these issues through fulsome disclosures. As you know, over the past few years, our clients have greatly improved their disclosures. In light of this, together with the fact that certain advisers have discontinued their practice of engaging in certain conflicts, we have not seen many of these deficiencies recently – they were much more common 3 or more years ago. That said, in light of this risk alert, we recommend that clients determine whether they are engaging in any of these activities, and if so, confirm that they have disclosure on point. However, while the types of conflicts on OCIE’s radar are not new, we have seen the Staff move on from its inquiry into whether there is disclosure of the relationship to confirming whether the adviser is complying with the specific disclosure. This transition is most notable – though certainly not unique to – service providers. As most advisers now include disclosure of affiliated service providers, OCIE is looking to confirm whether advisers are complying with the disclosure they have provided – for example, that the nature of the services and personnel providing the services are the same as those disclosed, and as noted above, whether the services are provided consistent with “market” terms.  

Dan O’Connor: Jason, the risk alert also focuses on inadequate disclosures related to fees and expenses that might violate Section 206 or Rule 206(4)-8.  What can you tell us about that? 

Jason Brown: Well, that’s right, Dan.  The alert details four categories of fee and expense issues: allocation of fees and expenses; use of operating partners; valuation practices; and  application of offsets. Looking first at the allocation of fees and expenses, the Staff’s observations are no t surprising. OCIE found that advisers allocated shared expenses, such as broken-deal, due diligence, annual meeting, or consultant and insurance costs among the adviser, its clients, employee funds, and co-invest vehicles in a manner inconsistent with disclosures or applicable policies and procedures. Additionally, advisers charged clients for expenses not permitted by the relevant fund operating agreements (such as adviser-related expenses associated with salaries, compliance, regulatory filings, and office expenses); failed to comply with contractual limits on expenses; and failed to follow travel and entertainment policies. 

As to operating partners, the alert repeats the well-understood issues of adequate disclosures regarding the role and compensation of individuals providing services to the fund or portfolio companies. As you know, “operating partners” in this context refers to individuals who provided services to the fund or portfolio companies, but are not employees of the adviser, and who are therefore not compensated by the adviser.  Absent disclosure, this can lead to investor confusion about who would bear the costs associated with operating partners’ services. 

In terms of valuation, OCIE found that advisers failed to value client assets in accordance with the adviser’s valuation process or disclosure to clients. In some cases, the Staff observed that this failure to value a private fund’s holdings in accordance with the disclosed valuation process led to overcharging management fees and carried interest because such fees were based on inappropriately overvalued holdings. 

Finally, OCIE found numerous issues with portfolio company fees and offsets. Advisers failed to calculate offsets in accordance with the terms of fund documents, including by allocating fees across fund clients, some of which do not pay management fees (thereby reducing the offset amount) and by failing to offset portfolio company fees paid to an affiliate of the adviser that were required to be offset. Advisers also failed to track fees paid by portfolio companies to the adviser or its personnel that would require offset, and in some cases, also charged accelerated monitoring fees. 

Dan O’Connor: Now Jason, there have been a number of cases in this area. Are any of these deficiencies related to fees and expenses at all surprising? And is there any one area where we’ve seen particular cause for concern among our clients? 

Jason Brown: Well, Dan, similar to the conflicts of interest deficiencies, most of these are old news (and in many cases, really old news).  The one area that continues to be a hot topic is allocation of fees and expenses. The SEC is looking carefully at shared expenses to confirm that all parties that enjoy a particular service/investment bear the related expenses. In addition, similar to the issue we just discussed related to service providers, while most clients have good operating partner disclosure at this point, the SEC has been testing carefully whether the actual arrangements are consistent with the disclosure. 

And to answer your question about any particular area of concern, we have certainly seen an uptick in questions from OCIE to our clients related to valuation. Though I would say that the issue we have seen is slightly different than how the alert portrays it. For example, we have seen pointed questions, and some deficiencies, whether investments have been appropriately written down for purposes of calculating management fees. These types of questions may arise from a steep decline in the equity value of an investment or a restructuring when significant assets of an investment are transferred away. 

Dan O’Connor: Jason, it sounds like, as the market continues through an incredibly volatile period, and some advisers may be confronted with these steep write downs, we could expect to see more of these valuation type concerns becoming front and center in OCIE exams. I know in prior enforcement cases we have seen this be an area of significant focus as well, and the saving grace for firms has been their ability to demonstrate a documented process around valuation consistent with their fund documentation and strong disclosure in quarterly and annual financial statements. 

Jason Brown: That is correct, Dan. Finally, the risk alert highlights code of ethics issues that might violate Rule 204A-1 (what’s commonly referred to as the “Code of Ethics Rule”) or Section 204A of the Advisers Act. As relevant background, Section 204A of the Advisers Act requires registered investment advisers to maintain and enforce written policies and procedures reasonably designed to prevent the firm or its employees from misusing material nonpublic information. 

Rule 204A-1 is promulgated under Section 204A, and provides that a registered investment adviser must establish and enforce a written code of ethics that requires individuals identified as access persons to report their personal securities holdings and transactions. 

Dan, what deficiencies did the risk alert highlight with respect to policies and procedures relating to MNPI and the adviser’s Code of Ethics? 

Dan O’Connor: With respect to Section 204A, OCIE found that advisers did not have adequate policies and procedures to address risks posed by their employees interacting with a number of groups. First, insiders of publicly traded companies; second,  individuals associated with expert networks (meaning outside consultants;,  and third, “value added investors” (what we put into groups such as corporate executives or financial professional investors that have information about investments). Advisers also failed to address risks of employees obtaining MNPI through their ability to access office space or systems of the adviser or affiliates that might have MNPI. And similarly, they failed to address risks of employees with access to MNPI about issuers of public securities in connection with a PIPE transaction (a private investment in public equity). With respect to deficiencies related to the Code of Ethics Rule, OCIE found that advisers did not adequately enforce trading restrictions on restricted securities or enact policies that address adding and removing securities from the restricted lists.

Advisers also had issues with enforcing gift and entertainment policies and failed to identify certain individuals as access persons. Finally, OCIE highlighted that adviser personnel failed to submit required reports on time or submit transactions for preclearance. 

Jason Brown: So Dan, what does this all mean for investment advisers? 

Dan O’Connor: Well Jason, we’ve have seen the MNPI procedures deficiencies arise more frequently for hedge fund managers, but they do also come up from time to time for other private fund managers. We have also seen a real uptick in enforcement focus in this area as well, with the recent Ares case as a clear example of how these enforcement matters play out in the private fund space. 

In light of the increased use of PIPEs in recent months, it is important to make sure you have solid procedures around controlling MNPI concerns if you are going to do a PIPE transaction. There is a real focus, of course, in terms of how you deal with trading on a name that is otherwise found on your restricted list. 

The lesson on the code of ethics deficiencies is that you have flexibility in crafting the policies, so make sure that you can comply with the framework that you create. While most firms have good procedures for adding issuers to their restricted lists, what we have seen is a number of clients that follow a more ad hoc approach in removing issuers from the list (and, as a result, have issuers on the list long after any trading restrictions are needed). Finally, when identifying people as access persons, it is important to consider the risks of making such a determinations in an overly conservative manner. The question you need to ask yourself is, are you really in a position to supervise the applicable person and does such a determination create a fee or expense issue? 

Jason Brown: Thanks for providing that overview, Dan.  That’s all we have time for today. Thanks everyone for listening. For more information, please visit our website at www.ropesgray.com. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. And of course, if we can help you navigate any of these challenges, please don’t hesitate to get in touch.