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.
The take-away here is that the Commission is increasingly reliant on data analytics tools to investigate possible misconduct and bring enforcement action.
The third source of data analytics is the Office of Risk and Strategy within OCIE. The office was created recently, in 2016, and includes quantitative analysis teams that support OCIE’s risk assessment and market surveillance functions, and assists by identifying market or conduct issues that are of heightened risk, and therefore should be the subject of examination.
And that’s based on what OCIE has seen in prior exams that they’ve conducted, but it also helps examination teams in passing through a lot of the data that they collect when they actually go on site, for instance to investment advisers to identify potentially violative conduct or probe a little bit deeper in data that they have collected, where they have a sense that some type of conduct may not have been consistent with the federal securities laws.
The take-away here is that the Commission is increasingly reliant on data analytics tools to investigate possible misconduct and bring enforcement action. It’s also reasonable to infer, given the extent to which those tools are used in examination and enforcement matters currently, as well as the emphasis of the Commission on developing robust quantitative capabilities, that the Commission would have other tools in the pipeline that are currently being developed.
CL: Where we are seeing this in practice is that the SEC is asking for more extensive information in their requests during the exam process, so it’s not unheard of for the Staff to ask for multiple years’ worth of trading data.
That likely would not have happened many years ago given an absence of robust resources to effectively analyze that data.
Now, the SEC can not only request that level of information and that level of detail, but they can actually analyze it in many ways, and expeditiously. And what that winds up meaning is that in many cases the SEC examination Staff may have presumptions already about activities that they view as improper, following their review of initial data that was produced at the outset of an exam, before even arriving on site.
That could have the effect of putting the examined adviser on the defensive, and who then either has to explain why the data does not present an issue, or defend themselves. And so this is something that has changed the tenor of exams. And the other thing I’ll say is that the regulators always used to be behind the industry with respect to technology. That is no longer the case. The technological resources the SEC has works to its advantage because it enables them to allocate less resources to cover a broader ground. It’s important that firms have internal capabilities to be able to run similar types of analytics on their trading or whatever the case may be, in order to test that their operations are functioning as intended and that their compliance policies and procedures are working.
Also, in the examination context, if, for example, the Staff asks how many cross-trades an adviser performed in the last year, and you give them a number and they come back, after they have analyzed the data, and note that they found an additional 1,000 cross-trades, you are starting off on the wrong foot and possibly raising additional concerns for the Staff. So, it’s really important to have a robust technology foundation to ensure you’re providing accurate information in response to their requests.
EP: Yes, and just to build on that for a moment, we think that one of the key things to look out for is that the SEC continues to develop ever-more sophisticated algorithms and means of actually analysing data, which gives them enhanced visibility into the application of technology to new types of investment strategies that it may not have previously had the data analytics tool to analyse.
As a result, quantitative investment strategies, as well as other investment strategies that rely heavily on algorithms, may be more readily evaluated and tested now that the SEC has the data analytics tools to consider them more thoroughly.
EP: Moving ahead, let’s talk about statistics. In 2017, the SEC Enforcement Division brought 754 cases. Of those 754 cases, 446 of those were independent actions for substantive violations of the federal securities laws. The remainder are more administrative in nature, and those include delinquent filing cases as well as administrative actions that seek bars for individuals or firms, based on parallel injunctions or criminal conviction.
The 754 cases do represent a 6.5 percent decrease over fiscal year 2016. The key take-away here is that the statistics evidence that there was a significant transition occurring at the agency in terms of Staff turnover and leadership. The last time there was a parallel decrease in enforcement actions was in 2013, when Mary Jo White became chair and brought in her team.
The SEC, in its last annual report, attributed much of the case decline to its Municipalities Continuing Disclosure Cooperation Programme, which was a self-reporting scheme for particular violations, and so the rationale there was that it accounted for a large number of actions in 2016 and, as a result, there was a bit of a dip in 2017.
As a result of the 754 cases that were brought, the SEC took in $3.78 billion in penalties and disgorgement. That $3.78 billion figure consisted of $832 million in civil penalties and then nearly $3 billion in disgorgement.
As a result of the 754 cases that were brought, the SEC took in $3.78 billion in penalties and disgorgement. That $3.78 billion figure consisted of $832 million in civil penalties and then nearly $3 billion in disgorgement. Of that nearly $3 billion in disgorgement, about $1.07 billion was returned to investors.
There were 82 actions involving investment advisers or investment companies in 2017. That’s 18% of the cases that were brought, which is the third-largest grouping of cases in terms of subject matter. The important thing to note here is that this indicates that cases arising under the Investment Advisers Act and also, the Investment Company Act to a certain degree, remain a key priority of enforcement as well as a disproportionately large chunk of all the cases that were brought. Before discussing those cases, we will first discuss the whistle-blower programme.
CL: Thanks, Eric. In fiscal year 2017, the whistle-blower program received approximately 4,500 tips, which is an increase over 2016.
Last year, the SEC awarded nearly $50 million to 12 whistle-blowers. More than $20 million was paid to one individual, which is the third-highest award in the history of the programme. Recently (in 2018), the SEC announced the largest-ever whistle-blower award, which consisted of $50 million shared between two individuals, with a third receiving more than $33 million.
So, the SEC views this program as really important to their initiatives to protect investors. The SEC gets a significant numbers of tips, as you can see, but obviously, only a very small percentage actually result in a whistle-blower award. And a practice point on this, there was a case a few years ago for having improper language in a confidentiality agreement relating to whistle-blowers; the language was essentially restricting employees from speaking to anyone about their employment at the firm.
As alleged by the SEC, that sort of broad confidentiality language made the individual think that they were precluded from speaking to a regulator about improper conduct at the firm, and so even though there was no improper conduct at that particular firm, and there was no whistle-blower issue necessarily, the firm was sanctioned because of the broad confidentiality language and the fact that the SEC thought that that would deter individuals from raising issues with the Staff.
So, something to be mindful of, just as a practice point. It continues to be something that we see the Staff very focused on, so it’s helpful when doing a refresh of employment agreements and related documents, to take a look at the confidentiality provisions.
Now, we’ll look at some of the cases. The first topic I’m going to talk about is fees and expenses, and there were a number of cases relating to fees and expenses across the board. Some of them were specific to private fund managers, and those are the ones I’m going to touch on a little bit.
Something to keep in mind now is that the SEC won’t necessarily dictate what your expense allocation arrangements are. The SEC is generally not in the business of telling you how to run your business or negotiate your agreements with your clients, particularly your institutional clients, but a point to consider is that while they won’t tell you how to allocate expenses on the front end, they will hold you to whatever your agreements are and whatever your disclosure says.
And to the extent that your disclosure is not crystal clear on how you will allocate expenses, you may have an issue. And that’s the case of many of the firms that wound up getting these types of actions in the last year. The most traditional is where you have an improper allocation of expenses based on organisational documents, where you say that you’re going to reimburse expenses across multiple funds, and you don’t do that.
And there are cases where the firms said that they would reimburse expenses to one fund, and expenses attributable to other funds were included in that expense reimbursement as well. So, it’s important to focus on what you disclose with respect to allocation, in particular whether or not you’ve disclosed that you will be allocating among funds and co-investors or not. And co-investment vehicles are where this largely has come up.
We saw cases this past year where there were co-investment vehicles that were formed either by the adviser, for related parties or for third-party investors, and there was a lack of disclosure about the fact that those co-investment vehicles would not share in certain expenses that the primary fund would. This, in particular, is an area to remain mindful of.
The other thing to be mindful of is situations in which you have an expense or any type of arrangement that based on organizational documents, requires the adviser or the general partner to go to your limited partner advisory committee (“LPAC”) or fund advisory board to get consent or approval of a practice, and you don’t do it. There was one case in particular in 2017 where an adviser was supposed to obtain approval of expenses from the advisory board of the fund in order to obtain reimbursement, and the fund’s manager didn’t seek such consent.
And it just so happens in that case that the party that benefited was a related party of the manager, which was also not a helpful fact for the firm’s case.
Another issue that came up this past year, again, was broken-deal expenses, where a manager didn’t allocate broken-deal expenses to co-investors with appropriate disclosure.
So here you had fund documents that said that the fund would share in broken-deal expenses but didn’t mention co-investors. And in this instance, the fund bore all of the broken-deal expenses and potential co-investors did not. And so the fact that the disclosure was silent on the fact that there could be potential co-investors and that those potential co-investors wouldn’t share in those expenses, the SEC found that the firm had violated its fiduciary duty.
The take-away here is that it is really important to think about both what your disclosure says, and make sure you’re doing what your disclosure says, as well as what it doesn’t say, which we know can be a tricky exercise. You really have to think about instances where you’re carrying out a practice and your documents are silent on that practice, whether or not the investors would have a reasonable belief that the practice was occurring, despite the fact that your documents are silent on it.
An area where this comes up a lot, and there were cases about this as well, are where a manager is allocating expenses not between funds but between the manager and the funds. When you have instances where these funds cover some of the regulatory or other expenses of the adviser, managers need to be careful about that.
If certain management company expenses are going to be borne by the fund, you should have explicit disclosure in the fund documents indicating that. And sometimes what happens is everyone’s well-intentioned when you do fund one, but when you get to fund two and three and four, the fund one document may not adequately cover the evolution of the firm’s practices.
And so it’s really important to review your existing fund disclosure, to make sure that your practices haven’t evolved away from what that original disclosure said. And if it has, then you have to consider whether to go out to investors and make them aware of those current practices in order to obtain consent.
Calculation of management fees is another big area where the Staff is very focused. The focus here is primarily in the retail space more than anything, but there were cases in the institutional space, where there was failure to disclose the method for calculating fees.
We’ve seen this focus on calculation of management fees in the retail space this year, as well as in the institutional space. There were two big cases involving related entities in the retail space, where those two entities did a joint venture, many years ago, and as a result of the joint venture and a system glitch, they incorrectly calculated fees for advisory client accounts.
The underlying issue did not involve fraud or any sort of intentional misappropriation of clients’ funds, but rather a systems issue following the business combination that resulted in the improper determination of fees. And cases were brought against both of those institutions as a result. So, it’s really important to make sure that your disclosure is appropriate and that you’re calculating and applying fees as set forth in relevant account agreements.
The one other thing I’ll note, for a practical point, is fee offsets. We’ve seen a lot of cases in the past relating to instances in which a manager says that they are going to do an 80% offset if X, Y, Z happens, and don’t actually do that. The more complicated your structure on offsets, the more careful you have to be at times, making sure that you’re sticking with the calculations and methodologies that you originally disclosed.
Cybersecurity and cryptocurrency are not going away and are going to continue to be front and centre. If you’re trading in those types of instruments, you need to be mindful of the fact that you’re probably going to get some scrutiny about that.
Moving on to disclosure, conflict of interest disclosure remains a key priority of the SEC Staff across six or seven key categories of conflicts.
One such category is related party transactions. We saw a number of cases this past year, where there were either affiliated entities that were providing services for the portfolio companies of a fund or to a fund directly, without appropriate disclosure of the fact that the adviser was going to use a related party to provide such services and, therefore, there was a conflict in selecting that related party to provide those services.
We also saw instances where there were company loans that were granted between funds or between a fund and a manager, or between a fund and some other related party without appropriate disclosure of consent. So, you have to be very mindful of using your affiliates. This isn’t to say that you can’t use your affiliates to provide services to your portfolio companies or to your fund, you absolutely can, it’s just imperative that you make sure that that’s appropriately disclosed in your fund documents and in your Form ADV, so that investors are on notice of that when they make a determination to invest in your vehicle.
Another area that we saw, which also was largely in the retail space, were forgivable loans and brokerage–related expenses. In recent years, we have experienced several exams where OCIE was focused on recruiting benefits and transition assistance. And what that is, in the simplest terms, is when you’re providing some form of incentive to get a portfolio manager or a financial advisor to join your team, so if you say, I’m going to give you a $5 million forgivable loan if you come join my firm and you bring your book of business with you, and your book of business stays, we’ll forgive that loan and we’ll give you all these other benefits.
The SEC brought a few cases last year relating to this type of practice. The issue in this instance was that it wasn’t necessarily the fact that these types of benefits were being provided and not disclosed; it was that, in most cases, these issues were not disclosed with enough specificity. The use of the word “may” was at issue in many of these cases.
Moving along, there was an interesting case brought in 2017 regarding misrepresentation of investment strategy in the private fund space. A real estate fund was marketed as a real estate fund, intended to make real estate and real estate-related investments, but invested in other types of instruments, as well, without appropriate disclosure. This case was actually both a misrepresentation of investment strategy case from an investment adviser perspective, but also was an investment company registration case, because of the fact that the fund deviated from its real estate and real estate-related investment strategy and invested greater than 40% of its total assets in securities interests, it was deemed to be an investment company.
The other point that the Staff made in this case was that the fund was investing in instruments for which the document didn’t have risk factors. So, the PPM was all about real estate and real estate-related investments, and although the fund deviated from the strategy which the documents likely gave it broad authority to do, there wasn’t sufficient risk disclosure regarding the additional types of instruments the fund invested in outside of real estate.
Quickly, on insider trading, I’d like to discuss the misuse of material non-public information relating to research firms. There was a case here against an adviser for using a political intelligence firm that gave insights into the healthcare sector. The employees of the political intelligence firm communicated material non-public information to fund analysts who then traded on the information. The firm also had inadequate procedures to protect against this type of activity, and the SEC brought a case against the firm for both issues.
Suitability remains a large concern. In the institutional space, we saw a case this year where a recommendation was made for a pension plan to invest in a feeder fund that the adviser knew wasn’t permitted under the pension plan mandate. In this case, the SEC said that the recommendation from the adviser was unsuitable for the client.
While not of particular relevance in the private fund context, the SEC brought a number of cases against advisers for mutual fund share class selection. There were a number of issues with those cases. One issue that I thought would be helpful for these purposes is that there was one case where the SEC took issue with the fact that the adviser stated that they ‘may’ receive 12b-1 fees from the mutual fund companies where clients were invested in that particular share class, when in fact they were receiving 12b-1 fees. The use of the word ‘may’ is something we have been focused on for a long time, but yet again, here’s an instance where you have an adviser that did disclose a practice but didn’t disclose it definitively enough for that disclosure to be effective in the SEC’s eyes. So just something to keep in mind. With that, I’m going to pass it over to Eric to talk about AML.
EP: AML has been a consistent focus of the SEC’s Division of Enforcement year over year, and this year was no exception. To bring up one case from July 2017, the SEC brought a case against a broker-dealer firm in connection with a penny stock offering, for failing to file SARs, or suspicious activity reports, with the treasury department.
Specifically, that firm ignored numerous red flags that customer transactions might have been illegal. Those red flags generally were the reluctance of customers to provide complete information about the nature and purpose of their business transactions, as well as presenting questionable background facts. In general, the firm didn’t perform adequate due diligence such that they would have identified the underlying issues for which they should have filed suspicious activity reports.
It’s important to note that that action was against a regulated broker-dealer firm that is currently required to file suspicious activity reports by law. Treasury’s Financial Crimes Enforcement Network unit, or FinCEN, has proposed in 2016, but not adopted yet, AML rules that would apply to many private fund managers. However, as a technical matter, many private fund managers currently aren’t subject as a matter of law to the suspicious activity reporting and AML requirements that other regulated entities may be.
Although many private fund managers do have AML policies as a matter of best practice, the SEC Enforcement Division’s continued attention on this issue, together with the proposed rules lurking out there, warrants a continued focus on this. For private fund managers, best practices would include (among others) enhanced attention to suspicious activity at the investor subscription and redemption stages as well as having a well-defined and robust framework for monitoring and reporting suspicious activity reports.
Moving on to valuation, the SEC’s Enforcement Division has been focusing on valuation issues for private fund managers in a number of contexts.
There were two enforcement actions that were brought last year that are of note. The first relates to fixed-income securities, where the SEC filed an action against a private fund manager and its chief investment officer for materially misstating the value of municipal bonds held by a private fund that it advised.
The Staff specifically alleged that the manager engaged a third-party pricing agent to value the instruments, which were muni-bonds, but in periods of market volatility, the values that were provided by the pricing agent were inconsistent with GAAP fair value measurements and requirements. The Staff thought that that should have been visible to the manager since the municipal bonds were sold by that manager at a significant discount from the valuation that was given by the pricing agent. The Staff said that, as a result of this erroneous valuation, investors ended up paying over $400,000 more in management fees to the manager, and a lot of investors ended up redeeming at an inflated valuation.
A second case of note involved valuation of the assets of a privately held portfolio company of a fund. In July 2017, the SEC brought a case against a private fund manager for materially overstating the value of the main asset of two private funds that it advised, which was a private company. Specifically, the Staff alleged that the manager didn’t use reasonable assumptions regarding the projected revenues of the private company that was a fund portfolio asset, and also failed to properly value a loan for that company. In connection with that, the Staff said that the manager violated the Advisers Act custody rule, and the audit exception available to private funds under that rule specifically, since the fund’s financial statements weren’t compliant with generally-accepted accounted principles.
The take-away here is that implementing robust controls around valuation of portfolio investment, particularly for liquid investments, is really important, and managers should regularly review and validate valuation methodologies they develop.
I’m quickly going to talk about allocation of investments. That’s always been a key focus of SEC enforcement, between fund clients and, as Christine mentioned, between fund clients and any GP co-investment vehicles or proprietary personal accounts.
The Staff brought a number of cases in 2017 involving improper allocation by managers for their own proprietary or personal accounts. There are two cases in particular where an adviser has allocated profitable trades to their own accounts and unprofitable trades to their clients.
Moving on to talk about registration, enforcement has brought cases over the last few years against private fund managers that rely on an applicable exemption from registration under the Advisers Act, generally under Advisers Act Rule 203(m)-1, the Private Fund Adviser Exemption, on grounds that the adviser is so operationally integrated with another advisory entity that is its affiliate, such that it can’t rely on the exemption and, therefore, was in violation of the registration provisions of the Advisers Act.
In July of last year, there was one case that the SEC brought against an adviser and its chief compliance officer, stating that the adviser was under common control and integrated with its affiliate registered investment advisers. The factors that the Staff looked to that are worth considering were – shared employees between the two advisers, the fact they operated in the same office, used the same technology systems, and, importantly, they didn’t maintain any policies and procedures addressing registration or exemptions.
So, consideration of those factors, and maintenance of strong internal policies and procedures to demonstrate independence is a key consideration where an adviser is relying on an exemption, or its affiliate is, and it exists within a larger complex of affiliated advisory entities.
Turning to advertising, performance advertising remains a key focus of the Staff, particularly the use of hypothetical and back-tested performance. We expect to continue performance advertising as a key focus of the SEC. There were a number of cases last year for failure to adopt and implement policies and procedures around performance advertising and misrepresenting performance.
In one case, the SEC alleged that a manager misled investors about the performance track record of an investment strategy, when in reality no assets actually tracked that strategy, and then also, materially inflated back-tested performance figures.
The quick take-away there is that performance marketing is a hot issue for the SEC Staff. Performance figures should be calculated according to well-defined methodologies. Ideally, those should be reflected in policies and procedures and should be tested and validated regularly in order to confirm their accuracy.
Finally, outsourced chief compliance officers is a focus of the SEC Staff. On this note, the new Form ADV amendments that have come into effect for Part 1A, do require identification of any outsourced CCOs that are used.
Last year, there was a case against an outsourced CCO who was also an attorney. That CCO failed to file a Form ADV in an annual amendment for an adviser that was undergoing a merger. As a result of failing to file that Form ADV, the adviser entered materially overstated AUM figures by over $100 million, and also over-represented the amount of client accounts that were advised by more than 1,000.
So, it’s important to note that to the extent an outsourced CCO is used, that they’re actually undertaking a robust annual review of the firm’s compliance policies and procedures, effectively implementing such firm’s procedures, and filing Form ADV amendments in a timely manner.
CL: One other point of note is that that case is interesting because the CCO relied on information that the CIO provided to him in making the ADV report.
So, the CCO went to the CIO and asked for the figures, and the CIO gave him the figures, and the CCO put it into the ADV and signed the ADV and then was sanctioned for it. Now, this shouldn’t be read to mean that CCOs need to recalculate all of the figures, but you have to have a reasonable basis to understand whether information you’re being provided is accurate, because at the end of the day, the CCO is the one who’s signing the ADV. In addition, it is critical that CCOs are mindful of red flags and take appropriate action if a red flag arises.
Moving on, really quickly, I’m going to touch on some of the priorities for 2018. I mentioned some of these earlier, but there remains a focus on retail investors. This isn’t new, but it is Chair Clayton’s principle one, so it’s at the top of the list.
So how does this impact private fund managers? With respect to the retail investors, I think the way that it impacts you the most, as I mentioned earlier, is where you have investors that are pension plans or other types of institutions that invest on behalf of retail clients. For fund managers that manage the assets of non-profits, public pension plans, or other similar types of entities, I think you have to be much more mindful, or at least focused on the fact that the Staff is going to consider the fact that you’re investing on behalf of those types of entities as indirectly impacting retail investors.
Other issues for private fund managers. Not new, but fees and expense disclosures, accurate fee and expense calculations, and valuation are going to be a continued focus in 2018. With respect to valuation, based on the cases we’ve seen come out, it’s no longer just that you follow your valuation methodology, but that you have a methodology that is reasonable in the first place.
So, you really need to make sure that you’re assessing whether your methodology is reasonable and going back and testing whether the values you reached, particularly in the private equity space, were reasonable.
Cybersecurity and cryptocurrency are not going away and are going to continue to be front and centre. If you’re trading in those types of instruments, you need to be mindful of the fact that you’re probably going to get some scrutiny about that. Managers also need to consider whether or not such instruments are securities, and to ensure that you have procedures in place to make sure that you’re appropriately conducting due diligence on those types of investments.
Additionally, custody remains a key focus of the Staff as well as performance advertising. And we’ve seen a number of exams relating to cross-trading. And Jedd, with that, I’m going to pass back over to you.
JW: Sure. Thanks, Christine. So, thank you all for joining this edition of Morgan Lewis’s Hedge Fund University Webinar Series. To the extent we did not get to your question, we will be following up directly afterwards. Certainly, look out for the link to today’s materials as well as the white paper that Christine referenced.
We hope you found this to be useful and informative. Again, if you have any feedback or suggestions, please let us know. And thank you for participating. We look forward to your attendance at next month’s Hedge Fund University Webinar Series.