Morgan Lewis

SEC enforcement trends for private fund managers

Excerpted from Morgan Lewis’s Hedge Fund University webinar series
Originally published in the June 2018 issue

Speaker Key:
JW Jedd H. Wider
CL Christine M. Lombardo
EP Eric L. Perelman

CL: Thanks, Jedd, and good afternoon, everyone. Thanks for joining us. Just to go through a quick agenda of the topics we’re going to cover, first we’re going to talk about some SEC developments and examination trends that we’ve seen come out of the SEC over the last year.

Then, we’re going to talk through some notable enforcement cases and trends. And on that, there are a number of themes that we’re going to cover. We’re not going to talk about specific cases by name necessarily, and we’re not going to get into every case that came out, but rather talk about some of the conceptual themes and trends at a high level.

What I’ll note is that everyone who is participating in this call will receive, after the call, an email with a link to a white paper that we have authored, which is a more fulsome summary of the trends and themes we’re seeing, and specific cases that we felt were notable throughout the year. It’s a fairly large document that gets into a lot of detail about each of the cases and the trends, and I think it will be a helpful resource for everyone, following the presentation.

We’re going to begin by briefly touching on the 2018 regulatory priorities that the SEC’s examination Staff issues, and then proceed to discuss some hot topics that we think are areas that fund managers and advisers generally should be focused on in the coming year.

So, with that, let’s talk about some developments.

A significant development in 2017 was that the SEC and the various divisions of the SEC had significant turnover in senior personnel. We now have five commissioners. We have not had five commissioners at the SEC for quite a long time.

Jay Clayton was sworn in in May 2017 as the new chair of the Commission. For those who don’t know, Chair Clayton came out of private practice into the role of SEC Chair. He is not a life-long regulator, and many in the industry are curious to see whether his experience as a private practitioner will impact the way that policies come out of the Commission under his leadership.

In addition to Chair Clayton, in January 2018, the final two commissioners joined the Commission. So now we have a full, five-person Commission.

The impact of having a less-than-full Commission was essentially that a lot of policy and rulemaking sort of stalled, because there were only two commissioners and no chair. Now that we have a full Commission, I’m interested to see whether any additional rule-making comes out.

I recently heard a speech by Mr Clayton, and one thing that he noted in his remarks was that he felt there was no reason why one advisory relationship should essentially be regulated by multiple regulators. That was an interesting comment that he made. I’m curious to see how that plays out, and whether one of his key topics for his term will be to try and simplify or consolidate regulation, which I know is a topic that many in the industry are focused on and have been for some time.

In addition to the Commissioners, as I mentioned, there were significant changes among the leadership of the various divisions. We now have two new co-directors of enforcement. We now have a new chief litigation counsel. We have new unit chiefs. There are new regional directors in Atlanta, Chicago, Fort Worth, New York and Philadelphia, and new directors in the Divisions of Corporate Finance, Investment Management, Trading and Markets and OCIE.

So that’s pretty significant, and of course that came about largely because of the change in administration. We’re also seeing an active examination program.

So just a note on what we’re seeing as a result of the change in administration. Other than the significant personnel turnover at the senior positions, I have had a lot of conversations with clients about whether or not certain aspects of regulation were going to go away completely – which would pose an employment problem for lawyers like me! Thankfully I’m still employed, but regulation is still here. We have seen a number of pronouncements come out of the Commission in the form of informal guidance, some of which has been pretty aggressive and had a significant impact on various aspects of the industry, even under the new administration.

In addition, one of the key developments is an emphasis on protecting retail investors as the ultimate goal of the Commission. This has been affirmed in various contexts by Chair Clayton. It’s a theme that we’ve seen throughout many of the cases that came out in 2017; and it’s one of the priorities for 2018.

I know that many of the participants on this call are principally concerned with issues affecting private fund managers, and although often we’re dealing with institutions in that sense, it is my view (and was one of OCIE’s stated examination priorities) that the SEC’s emphasis on protecting retail investors is going to impact private fund advisers that deal with institutional investors that are pension plans or other type of institutions that manage the money of retail investors and retirees, which may lead to a heightened focus from the SEC.

In addition, individual accountability is a principle that the SEC Staff consistently appear to focus on, and we can therefore expect that they will continue to pursue cases against individuals. The pronouncement is essentially that cases against individuals are an effective deterrent for bad acting.

The SEC has repeatedly said, as have other regulators, that they view these cases significantly when deciding to bring them given the impact on an individual’s career that results. Notwithstanding this caution, I expect there to continue to be cases against chief compliance officers in the coming year.

Further, cybersecurity remains a key focus. It’s not only a key priority of the SEC but in 2017 a new unit in the Enforcement Division was created to touch all things cyber. This is the first new unit since the Enforcement Division restructured in 2010. This unit is intended to focus on things like cyber-fraud, cryptocurrencies, and essentially anything that presents some aspect of a cyber connection.

Relatedly, it will be interesting to see how the SEC handles traditional cybersecurity issues; for instance, if you have a breach or you are hacked, whether or not that event results in enforcement action to the extent that you had policies and procedures in place but something nevertheless went awry.

And I say that because one other notable development from 2017 was that the SEC had its own cybersecurity attack, and so I’m curious to see whether that impacts how aggressive they are in sanctioning firms for breaches that were not necessarily the fault of the firm.

The U.S. Supreme Court’s decision in Kokesh v. SEC was a significant development in 2017 that had the effect of instituting a five-year statute of limitation on disgorgement. The effect of the Kokesh decision is that the SEC can’t issue a disgorgement penalty that would cover an unlimited period of time. What we are currently seeing, as a result, is that tolling agreements are coming pretty early and often in cases, and separately the decision is having an impact on how quickly the Enforcement Division brings cases. It’ll be interesting to see how the Kokesh decision continues to shape enforcement actions the next year and thereafter.

One other case that I’ll just touch on really briefly was the Lucia case, which is currently before the Supreme Court. The case centers on the constitutionality of the SEC’s ability to appoint administrative law judges. Many regulators have this type of structure, FINRA included, so it’ll be interesting to see how the Supreme Court decides this case.

So, moving on, I’m going to pass it over to Eric to talk a little bit about the SEC’s use of data and quantitative analysis.

EP: Thanks, Christine. In recent years, the SEC has significantly increased its commitment to enhancing the technology and data analytics tools that it uses, and this has two general aims. The first is detection of potentially violative conduct, prior to an investigation or a matter being referred to enforcement. And that’s typically occurring by screening market data on a regular basis.

The second aim is evaluating existing data that the SEC regularly collects from registrants and industry participants once a matter has, in fact, been referred. And the goal there is to assist the Enforcement Division in prosecuting a case and determining the scope and depth of any misconduct as well as assisting the SEC’s examination division, or OCIE, Staff with probing existing data.

The SEC’s data and quantitative analysis functions are spread across the Commission, and I will talk about three of those. The first is the Center for Risk and Quantitative Analytics within the Enforcement Division. This center grew out of a 2013 initiative, and the goal behind it is to support enforcement by coordinating the use of risk identification, risk assessment and data analytic tools that the Commission uses.

This center aims to serve as an analytical hub, as well as a source of information that the Staff can use to identify possible characteristics and patterns that may indicate violative conduct is taking place.

The second main source of data analytics within the Commission is DERA, the Division of Economic and Risk Analysis. DERA was established in 2009 and is responsible for developing and leveraging sophisticated algorithms that are used both in examinations as well as investigations by the Enforcement Division.

DERA’s algorithms generally leverage the SEC’s observations from examinations as well as enforcement actions, and those are used to train the algorithms using machine learning to better detect possible fraud and misconduct. As a result, DERA actively participates in examination as well as enforcement matters.

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