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Proactive Compliance Is the Best Defense Against SEC Enforcement

By June 1, 2020May 23rd, 2022No Comments

By Fizza Khan

This article has been reprinted with permissions from Bloomberg Law. The article was published by Bloomberg Law on June 1, 2020. 

The SEC is continuing to carry out compliance exams, turning to electronic and remote exams as Covid-19 has stalled on-site exams. Fizza Khan, founder and CEO of Silver Regulatory Associates, offers several proactive steps for investment advisers to prepare for an exam and ensure proper compliance.

Few things can cause as much trepidation among investment management firms as a letter or phone call from the Securities and Exchange Commission announcing an upcoming examination.

Even though on-site visits from the SEC are impossible due to coronavirus containment efforts, there is already a general uptick in electronic and remote exams. While stressful, exams are a routine part of how SEC officials monitor behavior in the investment management industry.

However, there continues to be a lot of confusion about what areas the SEC is focused on, especially in the fast-growing private funds space. Looking at recent enforcement actions and statements made by SEC officials provides a lens into what private equity firms, private credit firms, hedge funds and other private fund managers can expect during their SEC exams.

There are several proactive steps that investment advisers can and should take to prepare for these exams and to make sure they are in compliance with SEC guidelines and requirements. Here are the four biggest areas where the SEC is focusing its attention in 2020, and some recommendations on how to address potential deficiencies to avoid the risk of regulatory fines or penalties.

Valuations: Are Individual Securities and Investment Portfolios Being Valued Fairly and Consistently?

One of the first things the SEC will want to look at is policies and procedures around the valuation of securities. While the SEC is aware that there is some gray area around coming up with a fair market value for illiquid securities such as private debt investments, there is an expectation that investment managers can at least substantiate how they arrived at that particular value.

Importantly, the SEC is looking for signs that an adviser may be intentionally inflating valuations to mask poor performance in an attempt to try to retain or attract investors.

There is no single universal standard for conducting these valuations, though there are best practices. One way for managers to gain more credibility with regulators is by engaging a trusted third party to value their underlying assets, thereby removing a potential source of bias.

If, however, managers decide to internally value their portfolio’s underlying assets, then they should ensure their valuation policies and procedures specify the metrics and internal models that they are using. It is also obviously necessary that the team involved in the valuation process has experience with conducting valuations.

Whatever the specific approach, there should be a clear process in place for calculating and reporting the valuation numbers on a consistent basis. The absence of such an approach will be a trigger for the SEC to investigate further, especially to make sure poor policies don’t result in a systemic issue that snowballs into overall financial statements and reporting.

Related Party Transactions: Are There Conflicts of Interest in How Decisions Are Made?

In the SEC’s eyes, it is often a short jump from a conflict of interest to misbehavior, especially if that conflict isn’t immediately disclosed to all relevant parties. These conflicts can bubble to the surface in all sorts of ways. For example, a private equity manager may engage an affiliated service provider for an underlying portfolio company for which the investors in the fund would pay a fee in addition to the fund’s management fee. In other instances, we have seen fund transactions taking place between and among the manager and its related persons.

These types of cases can lead to potentially uncomfortable questions for fund managers, such as:

  • what is the purpose of the transaction?
  • does the related person provide comparable services as would an unrelated person? and
  • are the fees that are being charged to the fund by the related persons in line with what would be charged by an independent third party entity?

The SEC knows that some conflicts are unavoidable. After all, it is natural for an investment manager to want to work with businesses and advisers with whom they already have a positive working relationship. The key for investment firms is to disclose these conflicts and make it clear that the decision being made won’t negatively affect investor returns, whether through weaker performance or higher fees.

In other words, a conflict of interest is typically only punishable if it interferes with an adviser’s fiduciary duty.

Fee and Expense Allocations: Are Fees and Expenses Relevant to the Management of the Fund?

The SEC has been increasingly critical in recent years of any fees or expenses that are not directly relevant to the management of the fund. The days of lavish parties and extravagant getaways being charged back to investors are long gone. But the SEC has also shown an interest in how more nuanced expenses are billed, such as compliance costs or marketing costs, which may only be indirectly related to the management of a fund.

The expectation from the SEC is that any fees or expenses being charged to the fund need to be in line with the fund mandate as well as the terms of the limited partnership agreement (LPA). These fees should be closely tracked in all governing documents and reported to investors with details on each line item and why that expense is in compliance with fund documents.

Custody Rule: Which Assets Should Be Held With a Qualified Custodian?

The Custody Rule continues to be an area of focus for the SEC, especially in the private equity industry. Private equity fund structures typically have intermediary entities between the fund vehicle and the underlying portfolio company that creates confusion over which assets at what level of the fund structure need to be held at a qualified custodian.

The manager needs to carefully analyze each entity within the fund structure to determine if such an entity, in fact, meets the definition of a “client” and, if so, does the manager have possession of or have the discretion to move the entity’s assets held at the custodian. This analysis may trigger Custody Rule requirements that the manager may have otherwise overlooked.

The Custody Rule also includes a provision that allows private fund managers to comply with the rule’s requirements to verify the assets of a fund by providing investors with audited financial statements within 120 days of the fund’s fiscal year end. However, part of the problem with this is that private equity firms sometimes struggle to get financial information from their underlying portfolio companies within the 120-day deadline. Private equity firms can mitigate this issue by informing all portfolio companies that they need regular financial reporting and by implementing a consistent process for gathering and sharing financial information with investors.

At the end of the day, what the SEC tends to care about more than anything is transparency and clear and consistent reporting. By putting in place institutional-quality processes throughout the organization, investment firms should be able to get through their regulatory exams with relative ease and avoid giving the SEC any reasons to dig further.