United States: The SEC's Continued Focus On Private Fund Managers 

The SEC's Continued Focus On Private Fund Managers 

In recent weeks, the SEC has continued to provide private fund managers with important guidance regarding the SEC's enforcement and examination priorities.

On February 21, 2013, the SEC's National Examination Program (NEP) published its examination priorities and, on February 22, during the "SEC Speaks" conference in Washington, DC, the Division of Enforcement's Asset Management Unit (AMU) announced certain enforcement initiatives affecting alternative investment vehicles.

These announcements follow on the heels of V&E's earlier alert regarding the SEC's announcement of its 2013 Enforcement Priorities in the Alternative Space, which Bruce Karpati, Chief of the AMU, described during an industry speech.

SEC's Examination Priorities

The NEP's examination priorities publication is intended to inform investors and registrants about areas that are perceived by the Staff to have heightened risk. Through the NEP, the SEC will continue to focus on a number of initiatives that apply to nearly all registrants, including fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and understanding new trading technologies and their implications for maintaining the integrity of the markets.

In addition, the NEP set forth four distinct program areas — investment advisers and investment companies, broker-dealers, clearing and transfer agents, and market oversight. We focus primarily on the examination priorities for investment advisers and investment companies, which the NEP identified in connection with its Investment Adviser-Investment Company (IA-IC) Program.

Since Dodd-Frank became effective in early 2012, approximately 2,000 investment advisers have registered with the SEC for the first time. To establish a meaningful presence with these newly registered advisers, the IA-IC Program will launch a two-year initiative that will consist of engaging with the new registrants, examining a substantial percentage of the new registrants, and analyzing and reporting the examination findings to the industry. The focus of the IA-IC Program will include:

• Safety of Assets. The Staff will review measures taken by registrants to protect client assets from loss or theft, the adequacy of audits of private funds and the effectiveness of policies in the area. It will be important for investement advisers to have well-documented custody arrangements in place. Private equity sponsors should ensure that internal controls at their portfolio companies are adequate to ensure accurate financial reporting and protect against fraud.
• Conflicts of Interest Related to Compensation Arrangements. The Staff will review financial and other records to identify undisclosed compensation arrangements, which may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. The SEC reportedly is focused on expenses charged by investment advisers to their clients, particularly travel and entertainment and "consulting" expenses. It may also focus on fees paid by portfolio companies to fund sponsors.
• Conflicts of Interest Related to Allocation of Investment Opportunities. Advisers managing accounts that do not pay performance fees (e.g., most mutual funds) side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face unique conflicts of interest. The SEC may focus on how investment opportunities are allocated between funds and portfolio companies (e.g., in roll-up transactions), and how investment opportunities are allocated between funds whose performance fees are "in the money" versus funds that are below their high water mark or hurdle rate. As always, the SEC will focus on deviations or departures from stated allocation policies.
• Fund Governance. The Staff will confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability. In the private fund context, the SEC may focus on the role that advisory boards play in addressing valuation issues and reviewing conflicts of interest concerning the fund sponsor, and the regularity with which these issues are brought to advisory boards.

Examination deficiencies can have potentially serious ramifications and investment advisers should take care to consider whether they have adequately evaluated an effective risk assessment of their business, ensured that their compliance policies are well-designed to manage the business, and remediated, to the extent necessary, any prior deficiencies flagged by examination Staff or as a result of self-review.

AMU Enforcement Priorities

During February's "SEC Speaks" conference, the AMU announced certain enforcement priorities with respect to alternative investment vehicles, including private equity and hedge funds. The AMU will focus on the oversight of advisers and boards regarding fee arrangements, the distribution of fees and due diligence conducted with regard to subadvisors.

Private equity firms should anticipate increased enforcement activity by the AMU, whose focus includes:

• Propriety and Transparency of Fees. Ensuring that fees charged to the fund and portfolio companies are adequately disclosed to investors. Funds should expect the SEC to focus on whether managers are conducting proper analysis, where required by fund documentation or otherwise, to ensure that fees are on arms' length terms, and whether managers are fairly valuing illiquid assets for purposes of calculating net asset values (which are used to determine the fee base).
• Conflicts of Interest. Preventing self-dealing with respect to investment opportunities that are taken by fund managers away from fund portfolio companies. The SEC may focus on the creation by sponsors of side-car or other investment funds that pursue investment opportunities that fall within the same strategy as an existing fund, as well as the allocation of investment opportunities to sponsor personnel and other "insiders."  In the private equity space, the SEC likely will focus on how follow-on investment opportunities are allocated.
• Successor Funds and Marketing Efforts. Precluding the artificial marking up of value of a fund's holdings during the period in which managers are fundraising for a new fund and the subsequent marking-down of those investments after the conclusion of the fundraising efforts. This issue has been on the SEC's radar for at least a year. As illustrated by the SEC's recent settlement with Oppenheimer & Co., described below, the SEC may initially focus on targets, such funds of funds, who mark assets inconsistently with underlying managers, or on multiple sponsors' valuations of the same asset in so-called club deals and co-investments.
• Fiduciary Duty: Ensuring that actions taken by managers are consistent with their fiduciary duty to act in the best interests of their investors.

Continued Focus on Valuations and Marketing Activities

The SEC continues to focus on the potential for exaggeration of valuations by private-equity firms, specifically on instances in which private-equity firms inflate returns to help raise money from investors. A well-publicized example of this focus is the SEC's March 11 announcement that it charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a fund they manage. Oppenheimer agreed to pay more than $2.8 million to settle the SEC's allegations that two of its units told investors — in quarterly reports and marketing materials — that a private equity fund they managed was performing better than it actually was. According to the SEC, Oppenheimer's portfolio manager reported the value of the fund's largest investment to be well above what the underlying investment's own manager estimated its worth to be.

The SEC has also continued its focus on solicitation arrangements employed by investment advisers. It recently announced that investment firm Ranieri Partners LLC (Ranieri Partners) and its former managing partner, Donald Phillips, agreed to pay a total of $450,000 to settle the SEC's allegations that Ranieri Partners and Phillips caused a "finder" to violate Section 15(a) of the Securities Exchange Act of 1934. The SEC also alleged that Phillips willfully aided and abetted the finder's violation. Section 15(a) of the Exchange Act requires persons engaged in the business of effecting transactions in securities to register as broker-dealers. Ranieri Partners hired the finder to locate investors for Raneri Partners' funds and paid transaction-based fees for his solicitation efforts. In a separate proceeding (which also resulted in a settlement), the SEC alleged that the finder's conduct, which included providing subscription documents for Rainieri Partners funds to investors, providing analysis of Raneri Partners' investment strategy to investors, and advising investors to adjust their asset allocations to permit investments in Raneri Partners funds, required the finder to register as a broker under Section 15(a). The SEC alleged that Ranieri Partners and Phillips caused the finder's violation of Section 15(a) by allowing the finder to access fund subscription documents and failing to limit or monitor his conduct.

The SEC in 2013 and Beyond
While the calls for action may not be as strong as during the immediate aftermath of the 2008 financial crisis, the SEC continues to be under pressure to report ever-higher numbers of cases. The nomination, and expected confirmation, of well-known former prosecutor Mary Jo White as SEC Chairman and the expected appointment of another former prosecutor as enforcement chief, Andrew Ceresney (who worked with Ms. White at the Manhattan U.S. Attorney's office and Debevoise & Plimpton) further underscores the demands for a tough tone at the top of the SEC. During a Senate hearing, Ms. White said she would strengthen the SEC's enforcement function. And, the agency has touted its record results in enforcement as one of the main achievements of Mary Schapiro's tenure. But, cases stemming from the events of 2008 are dissipating, driven in significant part by statute of limitations concerns. Assuming she is confirmed, Ms. White is expected to continue Ms. Schapiro's efforts to aggressively root out misconduct in the financial markets.

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