Private Fund Regulatory Update: Recent Developments Regarding Management Fee Calculation and Electronic Communications

January 24, 2022
18:44 minutes

In this Ropes & Gray podcast, asset management partners Joel Wattenbarger and Jason Brown discuss the regulatory consequences of recent enforcement actions involving management fee calculation and offset issues, and their respective electronic communication recordkeeping requirements. 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 practice and co-head of the private fund regulatory group, along with my partner Jason Brown, who's joining me today. We will be discussing the regulatory consequences of two recent enforcement actions involving management fee calculation and offset issues, and electronic communication recordkeeping requirements, respectively. This podcast will be a regular source for updates in the regulatory and compliance space. And with that, I will turn it over to Jason to discuss the first case.

Jason Brown: Great—thank you, Joel. So, the SEC recently brought an enforcement action against Global Infrastructure Management, a private equity adviser for i) failing to properly offset management fees and ii) making inconsistent statements in fund documents and to investors about how management fees would be calculated following the partial disposition of fund portfolio companies. I'll start with a brief summary of the two issues and ultimate outcome, and then provide you with some thoughts on key implications from the case.

First: Failure to properly offset management fees. The adviser failed to properly offset the management fees of two funds, and did not have reasonable policies and procedures in place to ensure that management fees were calculated consistent with fund docs. Specifically, the adviser failed to offset advisory fees for one fund over a ten-year period, and portfolio company director fees for a second fund over a three-year period, as required by relevant fund documents. Prior to the enforcement settlement, the adviser voluntarily reimbursed both funds, totaling roughly $5 million.

Second: There were inconsistencies in fund docs regarding management fee calculations upon partial disposition. The funds’ PPM stated that, following a partial disposition, the management fee would be based on the fund's remaining interest in the portfolio company, so any partial dispositions would result in a decrease in the fee base for calculating the management fee. However, the funds’ LPAs stated that the management fee would be based on each LP's capital contribution that was used to acquire the portfolio company, meaning that a partial disposition would not reduce the management fee. So, the LPAs and PPMs were inconsistent on this point. One LP inquired about the inconsistency in 2011. The adviser informed the inquiring LP that partial dispositions would reduce the management fee, but subsequently told several other LPs that partial dispositions would not reduce the management fee. Ultimately, the adviser did not reduce management fees following partial dispositions, consistent with fund LPAs, but contrary to PPM disclosures. Prior to the enforcement settlement, the adviser voluntarily reimbursed the inquiring LP by recalculating management fees based on partial dispositions. The SEC determined that the adviser failed to have reasonable policies and procedures in place to confirm the fund LPAs and PPMs were consistent on two points, including how management fees would be calculated following partial dispositions, and to ensure that adviser personnel communicated accurate, consistent information to LPs. As a result of this conduct, the firm violated Sections 206(2) and 206(4) of the Advisers Act, and Rules 206(4)-7 and 206(4)-8, and agreed to pay a $4.5 million penalty.

So, what are the key implications? Well, first, this shows the SEC's continued emphasis on the calculation on private equity management fees. For the past year or two, on exam, the SEC is carefully reviewing the base for calculating the management fee to confirm it is calculated in accordance with the LPA. In fact, it is now a standard first day request on exams to list all partial realizations and how they affected management fees. And unrelated to partial realizations, there also continues to be an emphasis on other portfolio company transactions (such as dividend recaps or sales of subsidiaries), as well as write-downs and write-offs, and whether those should have affected the base for calculating management fees. If you have not done a review of your practices regarding the calculation of management fees in light of such events, I would recommend doing so—it will likely be a topic on your next exam.

Now, second, practitioners take the position generally that the PPM cannot amend the LPA, but can be used to interpret the LPA. Here, the SEC takes the position that the PPM should, in effect, be read as amending the LPA if it gives a better deal to LPs (as the LPA provision in this case was more generous to the adviser than the PPM provision). It serves as a warning to make sure that all fund docs are consistent, as the SEC will compare them and hold you to the “highest” standard. Most clients rely on outside counsel for consistency of the LPA and PPM, but I would recommend that someone at the adviser engage in the same exercise. And as it's less common for outside counsel to review certain marketing materials, such as DDQs, for consistency with fund docs, it heightens the obligation of the adviser to review those.

Now, I'd also like to note that we see in this case two common themes and enforcement actions that are worth noting. The first is that remediation does not prevent an enforcement action and fine. While the SEC states that the remediation was taken into account in determining the fine, the fine was still substantial (and, from a practical perspective, the greatest harm from enforcement is often the PR implications). Coupled with the very substantial find in the recent enforcement case against a broker-dealer for failure to archive certain messages (as will be discussed by Joel in a few minutes), this case suggests that, as we anticipated, SEC enforcement under new SEC Chair Gensler is returning to a more aggressive posture, reminiscent of the early- to mid-2010s. In this case, the SEC seemingly expects advisers to have written policies and procedures to compare fund docs to each other. As the SEC has suggested that an adviser should have such policies (as well as the more commonly-found procedures on confirming that offset is calculated correctly, and making sure that personnel are communicating accurate information to investors), it is worth examining your compliance manual to consider whether such provisions are needed.

Joel Wattenbarger: Jason, this case focused on inconsistencies in fund documents relating to fees and expenses. Curious whether you've seen other areas where inconsistent disclosures have hurt clients?

Jason Brown: Yes, another common example occurs in the ESG space, where we have seen this issue arise several times on exams where the adviser's statements about ESG in a DDQ or another piece of marketing are stronger than those in the PPM, and the SEC holds the adviser to the higher ESG standard in the DDQ. You could spend a lot of time carefully crafting your ESG disclosure in a PPM, but an inconsistent statement in other docs, such as a deck or a DDQ, can override that. And as a result, it is critical to get those other marketing docs reviewed as well for consistency.

So, with that, I will turn it over to Joel to talk about electronic communications and related recordkeeping matters.

Joel Wattenbarger: Great—thank you, Jason. So, the obligation of registered investment advisers to maintain certain electronic communications and how one satisfies those obligations in an environment in which there are an ever-proliferating number of ways in which folks communicate with one another in writing has become a source of interest for the SEC and a source of concern for our clients for some number of years now. We wanted to flag for you all that last month, in two separate but related enforcement actions, the SEC and the CFTC together levied $200 million in penalties on a leading financial firm for violations of recordkeeping requirements applications to broker-dealers under the Exchange Act, and to swap dealers and futures commission merchants under the Commodity Exchange Act. And in addition to those financial penalties, the SEC order also required the firm to engage an outside compliance consultant to review the firm's policies, procedures, training, and surveillance practices with respect to electronic communications. These actions did not involve registered investment advisers or the Advisers Act recordkeeping rules (and we'll talk in a bit about the differences between those rules and the rules that were actually at issue in this case). But they are further evidence of the SEC's continued focus on the use by regulated firms of texts, WhatsApp, other forms of instant messaging, and other communications platforms, as well as the use of personal devices for business communications.

So, just to go over the facts with respect to last month's cases, the orders indicated that over a period of at least three years (from 2018 to 2020), employees of the firm often communicated about securities and commodities business matters on personal devices using text messaging applications (including WhatsApp) and personal email. These records, these communications, were not preserved. The orders indicated that the failures to comply with the firm's policies were “firmwide” and happened “at all levels of authority.” And further, the supervisors at the firm “routinely communicated using their personal devices.” The order recounted thousands of examples of texts, group chat messages, and email messages that were sent during the period relating to business matters and not preserved.

An interesting question in these cases always is: How is the issue identified? How did the regulators identify that there was a problem here? And it appears, based on the orders, in this case the answer is that during investigations potentially of other firms on various matters, the SEC staff obtained communications from third parties that reflected numerous texts and WhatsApp messages that had been conducted by those third parties with personnel of the firm that was the subject of these cases. So, subsequent to that realization, the SEC alerted the firm—the firm began producing responsive messages, but the firm also informed the staff that certain responsive messages had been deleted and were unrecoverable. And just worth noting here as an aside, that of course it's not just registered broker-dealers, registered swap dealers and future commission merchants, but also very much registered investment advisers that routinely find themselves communicating with third parties that are themselves regulated. It's not unusual in our experience to see questions arise on exam or investigations that either clearly reflect or appear to reflect information that the SEC has received from third parties in connection presumably with exams or investigations involving those third parties. So, it's always worth bearing in mind that in terms of how the SEC may identify these issues, it's not just through regular way exams—whether they be comprehensive exams or sweep exams, or perhaps from whistleblowers associated with a firm—it can also arise just by virtue of the SEC's examination and investigation authority over third parties.

Jason Brown: Joel, how does this compare to prior SEC actions in this area?

Joel Wattenbarger: Great question, Jason. The SEC brought a very similar action in early 2020 involving another broker-dealer. That case involved a much smaller firm. The fine was also much, much smaller—it was only $100,000 in that prior case versus, again, $200 million in the more recent cases. It's hard to say what factor or factors really motivated the difference between the outcomes. It's certainly reasonable to think that the significant difference in size of the firms in question was a factor. It’s also possible that the change in administration was a factor. And as you mentioned previously, Jason, we're seeing a difference between the Clayton SEC and the Gensler SEC in terms of the aggressiveness and the intensity, both on the exam front as well as the rulemaking front, and other fronts from a regulatory perspective. But I also think this was just an opportunity for the SEC to deliver a message. They have had some real concerns about recordkeeping practices around electronic communications across a range of different regulated entities for some time, and I think this just produced an opportunity for the SEC and the CFTC to send a message to regulated firms that this is a hot-button issue for them that they take very seriously—firms' obligations in connection with maintaining electronic messages.

Jason Brown: Joel, in light of these cases, how should private fund managers be thinking about their responsibilities regarding electronic communications?

Joel Wattenbarger: Another good question. So, in terms of the takeaways, I think the first thing is just to reiterate something that I mentioned at the outset, which is that the recordkeeping standard is broader for certain other regulated entities than it is for registered investment advisers. And as an example, broker-dealers are effectively required to preserve all communications relating to their business as such. In contracts, registered investment advisers are required to preserve certain specific categories of communications, which includes all recommendations made or proposed to be made, or advice given or proposed to be given. But what we've experienced is that in practice, the SEC will interpret that Advisers Act obligation broadly, and will also expect registered investment advisers to both understand how their personnel are communicating (both internally with one another as well as externally with third parties), and that registered investment advisers will have an ability to surveil communications to ensure that they are in fact maintaining the records that they are required to maintain. Therefore, in practice, it's very difficult in a registered investment adviser context for advisers not to have some means of effectively archiving all substantive communications relating to their fund manager or other investment advisory business.

In thinking about how to move forward in this area, I think it's first and foremost important to bear in mind the risk alert that was published by what was then OCIE, now the Division of Examinations, back at the end of 2018 that was specifically focused on registered investment advisers and electronic messaging. That alert really set forth in a fairly comprehensive fashion what the SEC's expectations and sense of best practices are in this area. And amongst other things, that alert contemplated that RIAs would have procedures for moving exchanges with third parties that were initiated by third parties on prohibited communications platforms on to firm-approved and archived platforms. The alert emphasized the importance of regular training and attestations from employees, as well as the need for an ongoing dialogue between the compliance function at an RIA and the investment personnel as to how clients are seeking to communicate with the firm. And then finally, it suggested various means of overseeing electronic communications. Some of those I think in practice it proved to be more practicable than others, but a good starting point in reviewing your own firm's policies and procedures in this area is to review not just these most recent enforcement cases, but also take a close look at that 2018 risk alert and ask yourself the question: "How would our policies and procedures, and how would our training and testing look in the context of the SEC's expectations as set forth in that document?" I'll just close by noting that we routinely see the SEC ask about this question on exams, as well. I wouldn't say this comes up as a topic on every exam of a private fund manager, but it is a fairly common question to ask: "What are your practices around archiving communications? What sort of media do your personnel use in connection with communications?" And potentially, we see requests for productions around these topics, and so, it's important to understand what the questions may be and what your answers would be in light of these most recent cases.

With that, I want to thank you all for joining us today. And also thank my co-host, Jason. 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.

Subscribe to RopesTalk Podcast