On June 23, 2020, the U.S. Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (OCIE) issued a risk alert (the Alert) providing an overview of the OCIE staff’s observations from examinations of advisers to private funds (i.e., private equity and hedge funds).1 According to the staff, the Alert is intended to (1) assist private fund advisers in reviewing and enhancing their compliance programs and (2) provide investors with information regarding private fund adviser deficiencies.
This Sidley Update summarizes the staff’s observations from the Alert, offers practical tips to develop and enhance existing policies and disclosures, and references the historical context for these actions and interpretations from enforcement proceedings, staff statements and other issue specific risk alerts from the staff.
The staff identified three general areas that cover familiar territory: (1) conflicts of interest, (2) fees and expenses, and (3) material nonpublic information (MNPI) and related code of ethics procedures and controls. SEC enforcement actions, staff guidance, stated exam priorities, and statements and speeches from staff and Commissioners over the past few years have addressed all of these issues at length.
As you review this Sidley Update, which is organized based on the three general areas in the Alert, we recognize that not all of the staff’s observations apply to every adviser. However, a hallmark of strong compliance programs is an ongoing and continuous assessment of risks and control improvements reasonably designed to mitigate those risks. The Alert provides an opportunity for each adviser to review its current practices and disclosures and adopt enhancements in applicable areas the staff identified as recurring issues for advisers to ensure that the kinds of weaknesses observed by the staff do not arise. In addition, the Alert provides important reminders of the need to memorialize analyses and rationales underlying the issues covered in the Alert and to maintain meticulous books and records. Enhancing a firm’s compliance program could also yield longer-term benefits for an inadequately prepared adviser as examinations can be distracting, burdensome, and expensive.
Conflicts of Interest
The Alert describes several situations where examiners found disclosure to investors deficient. In the context of these deficiencies, the staff described what constitutes full and fair disclosure of conflicts by reference to the SEC’s “Commission Interpretation Regarding Standard of Conduct for Investment Advisers” (the IA Interpretation).2 In the IA Interpretation, the SEC stated that disclosure should “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.” Based on the staff’s observations, some steps private fund advisers can take will enhance controls across all of the conflicts-of-interest deficiencies noted by the staff.
- Assess the adequacy of disclosures, not only under the circumstances described by the staff but under the adviser’s similar or related circumstances to ensure that disclosures contain details sufficiently specific for the adviser’s unique situation (and do not overuse “may” language to describe actual practices or conflicts).
- Review procedures relating to identifying, interpreting, and disclosing conflicts of interest and governance procedures for addressing identified conflicts.
- Verify and document the execution of existing procedures.
Allocation of Investments. The IA Interpretation noted that an adviser must not give preferential treatment to some clients or systematically exclude eligible clients from participating in specific opportunities without providing the clients with appropriate disclosure regarding the treatment.3 The staff noted in the Alert observations of inappropriate preferential allocations of limited investment opportunities in three contexts: (1) new clients, (2) higher-fee-paying clients, and (3) proprietary accounts or proprietary-controlled clients.
Without addressing specific allocations or methods, the staff generally observed deficiencies when private fund advisers
- inadequately disclosed the allocation process
- failed to execute the allocation process disclosed to investors (causing investors to bear undisclosed unintended fees or not receive equitable investment allocations)
The staff periodically reminds private fund advisers of the risks of inadequate disclosure of investment allocation practices4 and has made review of these practices an examination priority for several years.5
- Review allocation policies and procedures to ensure they are reasonably designed to avoid inequitable allocation or systematic favoritism of certain clients over others.
- Implement and monitor execution of procedures to ensure adherence (including testing); when exceptions arise, memorialize the rationale for those exceptions.
- Test or validate allocations periodically to ensure that they comply with procedures and have not inadvertently resulted in inequitable favoritism.
- Review disclosures to confirm clear and unambiguous descriptions of allocation procedures, especially for procedures designed to allocate certain opportunities to some clients and not others (note, however, that where allocation procedures result in inequitable allocation without a clear rationale, disclosure may not cure the problem).
Specific Portfolio Transactions. The staff also commented on conflicts arising from specific portfolio transactions, such as these:
- investments by multiple clients in the same portfolio company (e.g., investing at different levels of an issuer’s capital structure, such as one client owning debt and another client owning equity in a single portfolio company)
- purchases and sales between clients, or cross-transactions (e.g., disclosures of transaction details such as pricing methodologies and anticipated limitations or conflicts among clients participating in cross-transactions)
The staff’s principal and cross-transactions risk alert issued in September 2019 contains additional observations and staff concerns about the risks advisers should consider and address regarding principal and cross-transactions.6 The staff’s active engagement on these issues and circumstances outlining their areas of concern also appear in a number of enforcement proceedings.7
- Review transactions that involve multiple clients investing in the same portfolio company.
- Confirm, in conjunction with each transaction, the adequacy and accuracy of disclosures and the administration of policies to ensure they are sufficiently and specifically disclosed, policies are followed, and adherence is appropriately documented.
- Memorialize the rationale (with necessary backup to support the rationale) for any exceptions to existing policies that may be deemed necessary or appropriate under the circumstances.
Fund Structures and Investor Rights. The staff also addressed two other common conflicts of interest between private fund advisers and their clients: (1) fund structures and (2) access to investment opportunities and investor rights.
For fund structures and investor rights issues, the staff focused on instances where they observed that private fund advisers
- failed to completely or adequately disclose preferential liquidity rights for funds or side-by-side vehicles
- failed to adequately disclose investment allocation practices (including co-investments) or
- failed to follow disclosed processesfailed to provide sufficiently detailed disclosure of pricing terms, valuation practices or investor options for restructurings
These issues have also been the focus of prior enforcement proceedings.8 Among other things, the Alert also specially mentions observations and potential deficiencies regarding stapled secondary transactions.
- Analyze fund structures and rights granted to individual investors for potential conflicts (e.g., through share classes, side letters, or side-by-side funds of one).
- Review disclosures and confirm that identified conflicts are disclosed with sufficient specificity.
- Maintain and periodically review a written inventory of side letters and other arrangements with individual investors to ensure that those conflicts are disclosed and that such commitments are honored.
Advisers’ Economic Interests. The staff noted deficiencies arising from private fund advisers’ interests in the investments they recommended to clients. The staff observed issues where advisers
- failed to disclose preexisting ownership interests or other financial interests held by principals or employees
- inadequately disclosed economic relationships between the adviser or fund and select investors or clients (e.g., relationships with seed investors or financing arrangements)
- failed to disclose financial incentives for the adviser or conflicts where portfolio companies controlled by private funds entered into service agreements with the adviser, its affiliates, or other portfolio companies
- failed to follow disclosed practices regarding these types of conflicts or adopting procedures reasonably designed to address conflicts arising from interests in client investments
SEC enforcement proceedings also have highlighted these issues and provide additional details for consideration.9
- Review financial relationships with private funds and portfolio companies as well as policies to identify new financial relationships or arrangements that may require new or amended disclosure.
- Assess ownership and economic interests in fund portfolio companies to ensure that those interests are consistent with the adviser’s fiduciary duty to the fund.
- Review and memorialize any analysis with respect to the use of affiliated service providers to ensure that the nature and quality of the services are at least as good or better than, and costs are comparable to or less than, services available from third parties.
- Raise awareness among employees of the need for timely reporting and identification of financial conflicts through reminders and retraining.
Fees and Expenses
Among the four kinds of deficiencies the staff observed related to fees and expenses, a few themes emerged, including practices where private fund advisers (1) failed to sufficiently disclose practices for different types of fees and expenses, (2) failed to adhere to disclosed practices, (3) lacked appropriately tailored policies based on the types of fees and expenses or the adviser’s specific combination of clients, and (4) failed to follow existing policies (including documentation of policies or discrepancies between the documented policies and those that were followed).
Each of these observed themes applies to the deficiency categories noted below along with the unique deficiencies in each category.
Allocations for Fees and Expenses. Staff observations of deficiencies for private fund advisers’ handling of fee and expense allocations included instances where advisers
- failed to sufficiently disclose specific allocations (i.e., broken-deal, due diligence, annual meeting, consultants, and insurance costs)
- failed to review or incompletely reviewed specific allocations to confirm appropriate allocations and policy compliance
- failed to review allocation methodologies used to allocate fees and expenses among private fund clients (including private funds, employee vehicles, and coinvestment vehicles)
- allocated expenses that were not permitted by the relevant fund operating agreements, such as salaries of adviser personnel, compliance expenses, regulatory filing fees, and office expenses
- failed to follow contractual limits on expenses that could be charged to investors
- failed to follow their own travel and entertainment expense policies
Annual examination priorities over the past several years reinforce the staff’s continued focus on allocations of fees and expenses.10 The allocation of fees and expenses and observations regarding the adequacy and specificity of disclosures has been a multiyear initiative of the SEC, both in exams and in enforcement proceedings.11
- Review expense practices, including adviser expenses shared with or among clients and on what basis.
- Confirm authorization for all shared expenses under organizational documents and the specific disclosure of both the expenses and the allocation practices.
- Confirm the details and execution of procedures used to identify and monitor contractual obligations for expenses limitations or policy-based exclusions.
- Confirm the details and execution of controls to identify new types or categories of expenses and procedures for identifying the proper allocation.
Operating Partners. The staff noted that many private fund advisers engage “operating partners” for services used by the private funds or their portfolio companies. With respect to these arrangements, the staff observed that advisers
- used “operating partners” (sometimes the employees of the adviser or an affiliate) to provide services to the private fund or its portfolio companies without sufficiently specific disclosure
- failed to provide adequate disclosure regarding the role and compensation arrangements of individuals who provide services to the private fund or its portfolio companies
This topic has gathered more attention from the staff recently including recent enforcement activity.12
- Review arrangements to provide support services to a portfolio company or fund and the related disclosures regarding these arrangements.
- Confirm sufficient disclosure of services provided and compensation or other benefits received by the adviser and expenses borne by the client.
Valuation. Staff observations regarding deficiencies with private fund adviser valuation practices included circumstances where advisers
- failed to apply certain standards such as “in accordance with GAAP” or determining “fair value in accordance with Accounting Standards Codification 820” when determining valuations
- failed to keep sufficient documentation to demonstrate how the firm’s policies were administered to apply adopted valuation standards
The OCIE staff has frequently included valuation among examination priorities for private fund managers,13 and the SEC has brought multiple enforcement actions addressing these issues.14
- Review disclosures regarding valuation procedures and the use of fair value practices.
- Confirm the accuracy and sufficiency of prior disclosures regarding valuation and fair value practices.
- Confirm that policies and procedures address valuation issues in sufficient detail.
- Confirm consistent execution and documentation of disclosed valuation procedures and standards.
- Monitor and track changes to valuation practices and review and update policies, procedures, and disclosures accordingly.
Monitoring/Board/Deal Fees and Fee Offsets. The staff noted this subset of fees and observed that some private fund advisers
- failed to apply or calculate management fee offsets
- allocated portfolio company fees across clients incorrectly
- made payments to affiliates without applying the adviser’s policy to offset such fees against management fees
- did not have adequate policies and procedures to detect payments that required disclosure, allocation, or offsets
- failed to adequately disclose long-term monitoring agreements with portfolio companies and related fees that were received by the adviser that were accelerated upon the sale of the portfolio company
These issues receive regular attention from the staff focused on the specific observations noted above and also raised in prior enforcement actions.15
- Review disclosures regarding additional revenues received by the adviser through arrangements between the adviser or its affiliates and portfolio companies.
- Confirm the sufficiency and adequacy of the firm’s disclosures and policies addressing these arrangements.
- Confirm monitoring controls to validate the application of offsets or waivers.
- Confirm awareness and processes for the identification of new revenue sources or agreements that may require offsets.
Material Nonpublic Information/Code of Ethics
The staff reiterated in the Alert advisers’ obligations under Advisers Act Section 204A to establish, maintain, and enforce written policies and procedures reasonably designed to prevent misuse of material nonpublic information (MNPI). The staff also noted obligations under Advisers Act Rule 204A-1 for advisers to adopt and maintain standards of conduct expected of advisory personnel to address personal trading conflicts.
Receipt of MNPI. Referring to the Section 204A and Rule 204A-1 standards, the staff addressed MNPI controls and observed that some private fund advisers
- lacked policies reasonably designed to deal with risks of potential MNPI exposure from interaction with
(1) insiders of publicly traded companies,
(2) outside consultants arranged by “expert network” firms, or
(3) “value added investors” (e.g., corporate executives or financial professional investors that have information about investments)
- lacked controls to address risks posed by employees obtaining MNPI through access to office space or systems or though transaction-based access to information about public issuers (such as through pursuing private investments in public equity)
- failed to adopt policies and procedures reasonably designed to prevent the misuse of MNPI
This issue received significant attention from the staff in recent adviser examinations, staff statements,16 and enforcement proceedings.17
- Confirm the implementation and enforcement of policies narrowly tailored to address the MNPI risks specific to the adviser’s business.
- Ensure substantive and consistent documentation of steps taken to confirm that the adviser is not in possession of MNPI.
- Review the sufficiency of information barriers in light of the nature and structure of the adviser’s business.
- Independently review the status of information received; do not rely exclusively on assurances from an issuer that the adviser has not received MNPI.
Code of Ethics Implementation. The staff observed several common deficiencies by private fund advisers implementing their code of ethics including instances where advisers
- failed to establish, maintain, or enforce provisions of their code of ethics intended to prevent the misuse of MNPI
- failed to enforce trading restrictions on securities that had been placed on an adviser’s restricted list
- did not timely address procedural weaknesses for adding to or removing securities from an adviser’s restricted list
- failed to enforce requirements in their code of ethics relating to employees’ receipt of gifts and entertainment
- failed to administer timely transactions and holdings reporting requirements or preclearance requirements under their policies or the code of ethics rule
Code of ethics rule compliance has been a recurring theme for the staff both in its examination priorities18 and in prior risk alerts19 observing common code of ethics rule deficiencies across all types of registered advisers.
- Review code of ethics reporting practices, and confirm the existence and administration of controls for the adviser’s personal trading policies, including the firm’s restricted list.
- Confirm collection and documentation procedures to ensure timely receipt of required reporting of transactions, holdings, trading preclearances, and reportable gifts and entertainment under the adviser’s policies and the code of ethics rule.
1SEC OCIE Risk Alert: Observations from Examinations of Investment Advisers Managing Private Funds (Jun. 23, 2020).
2Commission Interpretation Regarding Standard of Conduct for Investment Advisers (Jun. 5, 2019) (IA Interpretation).
4Private Equity: A Look Back and a Glimpse Ahead, Marc Wyatt, Acting Director, Office of Compliance Inspections and Examinations (May 13, 2015).
5See, e.g., SEC OCIE Examination Priorities 2020 (OCIE Priorities 2020); SEC OCIE Examination Priorities 2017 (OCIE Priorities 2017); SEC OCIE Examination Priorities 2016 (OCIE Priorities 2016).
6SEC OCIE Risk Alert: Investment Adviser Principal and Agency Cross Trading Compliance Issues (Sept. 4, 2019).
7Inv. Adv. Act Rel. No. 5448 (Feb. 24, 2020); Inv. Adv. Act Rel. No. 4983 (Aug. 10, 2018); Inv. Adv. Act Rel. No. 5050 (Sept. 27, 2018).
8Inv. Adv. Act Rel. No. 5001 (Sept. 7, 2018).
9Inv. Adv. Act Rel. No. 4896 (Apr. 24, 2018); Inv. Adv. Act Rel. No. 5453 (Feb. 27, 2020); Inv. Adv. Act Rel. No. 5452 (Feb. 27, 2020); Inv. Adv. Act Rel. No. 5363 (Sept. 24, 2019); Inv. Adv. Act Rel. No. 5319 (Aug. 13, 2019); Inv. Adv. Act Rel. No. 4973 (Jul. 19, 2018).
10See, e.g., OCIE Priorities 2020, OCIE Priorities 2017, OCIE Priorities 2016.
11SEC OCIE Risk Alert: Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers (Apr. 12, 2018); Inv. Adv. Act Rel. No. 5096 (Dec. 26, 2018); Inv. Adv. Act Rel. No. 5079 (Dec. 17, 2018); Inv. Adv. Act Rel. No. 4772 (Dec. 21, 2017); Inv. Adv. Act Rel. No. 4494 (Aug. 24, 2016); Inv. Adv. Act Rel. No. 4131 (Jun. 29, 2015).
12See, e.g., Inv. Adv. Act Rel. No. 5485 (Apr. 22, 2020); Inv. Adv. Act Rel. No. 5074 (Dec. 13, 2018).
13See, e.g., OCIE Priorities 2020, SEC OCIE Examination Priorities 2018.
14See, e.g., Inv. Adv. Act Rel. No. 5373 (Sept. 27, 2019); Inv. Adv. Act Rel. No. 5070 (Dec. 3, 2018).
15Inv. Adv. Act Rel. No. 5229 (May 6, 2019); Inv. Adv. Act Rel. No. 4952 (Jun. 29, 2018); Inv. Adv. Act Rel. No. 4951 (Jun. 29, 2018); Inv. Adv. Act Rel. No. 4830 (Dec. 21, 2017); Inv. Adv. Act Rel. No. 4219 (Oct. 7, 2017); Inv. Adv. Act Rel. No. 4493 (Aug. 23, 2016).
16Statement from Stephanie Avakian and Steven Peikin, Co-Directors of the SEC’s Division of Enforcement, Regarding Market Integrity (Mar. 23, 2020) (issuing a broad reminder to all market participants of the importance of following controls and procedures and a specific reminder to investment advisers “to comply with [their] policies and procedures that are designed to prevent the misuse of” MNPI).
17Inv. Adv. Act Rel. No. 5510 (May 26, 2020); Inv. Adv. Act Rel. No. 5441 (Feb. 4, 2020); Inv. Adv. Act Rel. No. 4909 (May 8, 2018). The Sidley Update dated June 11, 2020, covered many of these issues in greater detail. https://www.sidley.com/en/insights/newsupdates/2020/06/navigating-interactions-between-investment-advisers-and-their-portfolio-companies.
18OCIE Priorities 2020; SEC OCIE Examination Priorities 2019.
19SEC OCIE Risk Alert: Five Most Frequent Compliance Topics (Feb. 7, 2017).
Sidley Austin LLPはクライアントおよびその他関係者へのサービスの一環として本情報を教育上の目的に限定して提供します。本情報をリーガルアドバイスとして解釈または依拠したり、弁護士・顧客間の関係を結ぶために使用することはできません。
弁護士広告 - ニューヨーク州弁護士会規則の遵守のための当法律事務所の本店所在地は、Sidley Austin LLP ニューヨーク：787 Seventh Avenue, New York, NY 10019 (+212 839 5300)、シカゴ：One South Dearborn, Chicago, IL 60603、(+312 853 7000)、ワシントン：1501 K Street, N.W., Washington, D.C. 20005 (+202 736 8000)です。