Private Fund Regulatory Update: 2021 SEC Enforcement Priorities

April 14, 2021
17:11 minutes

In this Ropes & Gray podcast, asset management partner Joel Wattenbarger and counsel Nicole Krea discuss the new developments in the SEC during the changeover of administrations, including the recent release of a report from the Division of Examinations concerning their 2021 priorities. The Private Fund Regulatory Update is a series of podcasts discussing key issues of interest and updates in the regulatory and compliance space, focusing in particular on private fund managers.  


Joel Wattenbarger: Hello, and thank you for joining us today for this Ropes & Gray podcast. This is one of a series of podcasts discussing key issues of interest in the regulatory and compliance space, focusing in particular on private fund managers. My name is Joel Wattenbarger and I'm a partner in the asset management group. Joining me today is Nicole Krea, counsel in our asset management group. We will be discussing the new developments in the SEC during this changeover of administrations, including the recent release of a report from the Division of Examinations concerning their 2021 priorities. This podcast will be a regular source for updates in the regulatory and compliance space. 

The first topic we were going to cover was just the pending confirmation of Gary Gensler as the new chair of the SEC. As we're recording this podcast, Gensler has not yet been confirmed, but we expect that he will be by the time you're listening. So far, his confirmation has gone relatively smoothly in this hyper-polarized political era. Most recently, on March 10, the Senate Banking Committee voted 14-10 to advance his nomination to the full Senate, which means that two Republican senators did join all 12 Democrats on the committee in forwarding his nomination to the full Senate. And just as a brief reminder on Gary Gensler's background: he had a successful career at Goldman Sachs, then moved into the government, and ultimately served as chair of the U.S. CFTC from 2009 to 2014. That of course, was in the immediate aftermath of the credit crisis, and he was a very active regulator during this time at the CFTC. The CFTC was a very active agency during his time there. They regulated credit default swaps using the authority given to them by the Dodd-Frank Act. The CFTC under Gensler's watch wrote 68 new rules and expanded its regulatory reach to include the $400 trillion swaps market. He also pursued numerous large enforcement actions, including against big banks accused of manipulating the London Inter-Bank Offered Rate (or LIBOR), so it definitely has a reputation as an active regulator. Also interesting to note that in the time after he finished his service at the CFTC, he has been working as an academic. He's been a professor at MIT, and amongst other things, has been teaching a class for several years on cryptocurrencies, and so has expertise in that areacertainly one of the areas that we think will be of interest to him during his time at the SECthe evolving regulatory landscape for digital assets and cryptocurrency. 

We mentioned that he recently appeared before the Senate Banking CommitteeI think the testimony was, for the most part, unexceptional. I think, certainly, he indicated an interest in increased or stronger enforcement activity. He indicated that ESG disclosure was going to be a priority. He certainly fielded questions from senators on, as I said, cryptocurrencies and digital assets, and I think he will be active in that area. I also think that there have been some very recent developments in the market that are likely to become priorities for him, whether or not he expected they would be priorities when he was first nominated for this position. So first, the recent so-called “meme stock” activity in GameStop and certain other stocks where there's just been a real trading frenzy in certain stocks, which is in some ways I think without precedent in the U.S. stock markets, and there's already been a lot of calls for inquiry into that activity by various members of Congress. There have been some statements from the current SEC commissioners in the midst of this trading activity, and there were questions about it during Gensler's confirmation hearing. I'm sure that that's something that is going to be a subject of further study by the SEC over the next year and something that will inevitably be an area that he will be expected to look at closely, at least during the beginning of his term. 

Another area probably most everyone listening to this podcast knows is that the SPAC market has been also just incredibly hot recently. And while there weren't questions about SPACs during his Senate Banking Committee hearing, I anticipate that this will be a continued area of focus and interest to the SEC, so long as the market continues to run as hot as it is currently. We've already seen a couple of signs of that. CorpFin actually issued some guidance back in December around disclosure guidance, disclosure requirements for SPAC issuers themselves. We saw an investor alert just earlier this month from the SEC regarding the speculative boom in SPACs, and in particular, celebrity-sponsored SPACs. I think we're beginning to see signs of investigatory activity in the SPAC space from the SEC, and I fully expect that we're going to continue to see a significant amount of exam and enforcement interest in SPACs, conflicts associated with SPACs, and SPAC issuances in the months to come. And that is, I think, a good segue into our next topic, which is as I mentioned previously, the FCC's Division of Examinations (which was recently referred to as OCIE, but is now its own division) recently released a report on its 2021 priorities. And I'm going to turn things over to Nicole to talk more about that document. Nicole? 

Nicole Krea: Thanks, Joel. As Joel mentioned, on March 3, the SEC Division of Examinations published its 2021 examination priorities. Much like last year, there's nothing terribly groundbreaking or novel in the priorities, but as always, they do give us some useful insight into what the SEC will focus on during the new administration and the ways in which the COVID pandemic and work-from-home have influenced the focus for the coming year. Generally speaking, for registered advisers, the 2021 examination priorities indicated that examiners will be focusing on things like portfolio management practices, custody, best execution, season expenses, and (not surprisingly, given the current environment) business continuity plans and valuation of client assets for consistency and appropriateness of methodology. And, as mentioned, that last piece is not surprising and is consistent with what we've been seeing in exams during this past year during the ongoing COVID-19 pandemic. Examinations will also focus on whether advisers have sufficient resources to perform core compliance responsibilities. And not surprisingly, for advisers that have not been examined for a number of years, the SEC is also going to be looking at whether compliance programs (those advisers) have been appropriately adapted in light of any substantial growth or change in their business models. And, of course, the SEC will be looking at never-before-examined advisers, and will also be looking at advisers that are dually registered or affiliated with broker-dealers or have supervised persons that are registered representatives of unaffiliated broker-dealers. 

One key focus of SEC examinations as indicated in the examination priorities will be, not surprisingly, ESG. As expected, examiners will continue to review the consistency and adequacy of the disclosures that advisers provide to clients regarding ESG practices. The SEC is going to be looking to determine whether those firms' processes and practices match their disclosure and taking a look at advertising materials for false or misleading statements. The SEC has been signaling this for some time and, as has been the case, firms will generally be well served in this area to assess their ESG disclosures and representations to ensure that their practices are in fact consistent. 

Another area of continued focus, and this is certainly nothing new, is the area of fiduciary duty and conflicts of interest. As we've seen for many years now, examiners are going to continue to focus on season expenses, conflicts related to complex products, best execution, and as always, undisclosed or inadequately disclosed compensation arrangements. And I'll actually hand it over to Joel to continue through some of the additional SEC enforcement priorities.

Joel Wattenbarger: Great. Thank you, Nicole. So I'll just cover a couple of the topics in the report. The first falls under the broad heading of fraud, sales practices and conflicts within the Division of Exam report. And the issues identified in the report specifically are first, how firms are complying with the recent changes in the definition of accredited investor when recommending and selling certain private offerings. I think for most of our clients, that's not going to be a huge issue, but you should be aware that that's something that is amongst the exam staff's priorities. Secondly, revenue sharing arrangements between an adviser and issuers, service providers and others. And third, several different issues around management fee calculations, including errors in calculating advisory fees, failure to refund prepaid fees for terminated accounts, and then what I would say is the most significant in my view is written down investments and how firms are going about the process of analyzing and ultimately writing down investments, where writing down those investments means that they're excluded from the definition of “invested capital” for purposes of calculating management fees. We're seeing a lot of attention on that specific issue on exams currently, and so it's important that firms are really being rigorous in terms of their process for valuing and writing down or writing off assets, particularly when the value of those assets then determines the base for advisory fees. 

Then the next set of topics is information security and operational resiliency. Certainly during the COVID era, we've seen a lot of focus in this space, including the effect of remote operations. Are firms ensuring that they have appropriate safeguarding of customer accounts, overseeing their vendors and service providers, addressing phishing and other malicious email activities, responding to data breach incidents, and managing risk generally from work-from-home, where you may have personnel who are accessing firm systems in ways that wasn't the case previously and may create greater risks? We've also seen the SEC asking advisers to ensure that their business continuity plans adequately account for the risks created by various forms of disruption, but in particular, climate change. And there's an emphasis across the SEC now in incorporating concerns over climate change into a number of their regulatory priorities more generally, and one of those is going to be looking at whether advisers have taken into account risks in climate change in their own practices. I will say that while we've seen a lot of exam inquiries in this space over the last year during COVID, we haven't seen a lot of deficiencies in this space. So I think these are issues that our clients are already focused on, but you should be prepared to answer questions about these topics on exam. And with that, I'll turn it back to Nicole.

Nicole Krea: Thanks, Joel. A particular focus in the financial technology and innovation segment of the SEC priorities was on digital asset investments, and specifically the following topics: whether those digital asset investments are in the best interests of investors, portfolio management and trading practices, safety of client assets, (and as we know) the custody rule-related issues related to digital assets has been an ongoing question, pricing and valuation, effectiveness of compliance programs and controls, and supervision of representatives' outside business activities. And that will continue to be an SEC focus. 

Another area of interest on exams will be the LIBOR transition. The SEC has indicated this in other contexts, but it will be one of the SEC's examination priorities to focus on firms' preparedness for the discontinuation of LIBOR and the transition to an alternative reference rate. 

Finally, specific to private fund managers, the SEC indicated that there will be a focus on preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity. They'll be looking at portfolio valuations and their impact on management fees, issues regarding disclosure and compliance with regulatory requirements of cross trades and principal trades or distressed sales, and conflicts around liquidity such as adviser-led fund restructurings, which is something that we've all seen a focus on in exams during the last few years. The SEC also indicated that in the private fund space, examiners are going to be focusing on advisers to private funds that have a higher concentration of structured products such as CLOs and mortgage-backed securities to assess whether those funds are at a higher risk for holding non-performing loans and having loans with higher default risk than disclosed to investors. And finally, examiners are going to be looking at advisers to private funds where, again, not surprisingly in the current COVID era, there may have been material impacts on portfolio companies owned by the private fund. For example, certain real estate investments that may have been hit particularly hard due to recent economic conditions. And with that, I will hand it back over to Joel for a couple of additional regulatory updates. 

Joel Wattenbarger: Thanks, Nicole. I maybe had one more observation with respect to the Division of Exam report on its 2021 priorities, which is simply to observe that that document, though it's full of good insight into what the Division is thinking, it is just a snapshot of a moment in time. And given the bureaucratic process, if anything, it's probably a snapshot of the moment of time a couple months ago in terms of much of the content of that report. So it's important not to assume that the items appearing in that report are the only or even the primary priorities of the SEC over the course of the year. And so areas that have become a real focus of market activity, or in which the SEC is seeing evidence of wrongdoing from its ongoing exam and enforcement activity can become priorities over the course of the year, I think. So SPACS, SPAC offerings and conflicts is a classic example of something that I expect is going to be a priority, even though it wasn't given a place of prominence in the report. 

With that having been said, just had one other quick regulatory update we wanted to be sure folks are aware of, which I'm sure probably everyone listening to this podcast is aware that there was a new Marketing Rule that was adopted by the Commission last December that will take the place of the old Advertising Rule and the old Cash Solicitation Rule. We have been waiting for that Rule to be published in the Federal Register—that finally happened earlier this month. And the reason that's significant is because we now know what both the effective date and the compliance date of the Rule will be. The effective date will be May 4, 2021 and the compliance date will be November 4, 2022. So the Rule provides for an 18-month transition period, thankfully, so advisers do have a long period to prepare their marketing materials and their process for creating and reviewing marketing materials to ensure that they are complying with the Rule. But we now have a date certain—again, that's next November 2022, by which firms will be required to comply with the Rule. 

Thank you all for joining us, and thank you to my co-host, Nicole. Please watch this space for more podcasts like this one where we will continue to keep you up-to-date with key regulatory developments. For more information on the topics that we discussed or other topics of interest to the asset management community, please visit our website, And of course, if we can help you navigate any of the topics we've discussed, please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple and Spotify. Thanks again for listening.

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