Regulatory Game Changers on the Horizon

By Ken C. Joseph, Kroll*

May 31, 2022

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Approximately 10 years after the enactment of the Dodd-Frank Act, which obliterated the private fund adviser exemption and subjected many private fund advisers to the requirements of the Investment Advisers Act of 1940, the SEC has unleashed a flurry of rule proposals that, if enacted as proposed, will significantly alter the regulatory, disclosure, and reporting obligations for managers who cater to the private fund market. Chief among those rule proposals are:

1. The SEC’s proposal on February 9, 2022, to require both registered investment advisers and advisers that are required to be registered with the SEC (among others) to, in sum, adopt and implement written policies and procedures to address cybersecurity risks; report certain cyber incidents to the SEC within 48 hours on a new Form ADV-C; and publicly disclose cybersecurity risks and incidents in their brochures.
2. The SEC’s proposal on January 26, 2022, to amend the reporting requirements under Form PF to, among other things, require large hedge fund advisers and private equity advisers to file certain information with the SEC within one business day of the occurrence of certain specified events; classify private equity fund advisers with assets under management of $1.5 billion or more as a “large” private equity adviser, subject to the enhanced reporting requirements; and generally, increase the amount of information that is required to be reported in Sections 4, 5, and 6 of the amended Form PF.
3. The SEC’s mother lode of proposed rules from February 9, 2022, which, if enacted as proposed, would require private fund advisers to provide periodic standardized reporting to investors, obtain independent verification of valuation, require third-party fairness opinions for certain transactions, and document the review of the adviser’s compliance program, among other burdens. The intent of these requirements is to address concerns around fees and expenses, reporting, fund audits, conflicts, valuation, liquidity and preferential treatment, conflicted transactions, and overall fiduciary duty concerns. (The SEC has extended the period for the public to comment to June 13, 2022.)

 

While we expect vigorous debate before the determination of the final rules and litigation post-passage, we believe that increased regulation is a near certainty.

This article seeks to achieve three objectives: to provide an update on the SEC’s examination and enforcement approach relating to private fund managers; to provide a summary of the February 9 private fund rule proposal package, as it relates to private fund managers; and to provide some recommended action items to prepare for and potentially mitigate the risk of a negative regulatory outcome under the anticipated new rules.

Although the SEC is an independent federal agency, there’s an increasing concern that its agenda, evidenced by the flurry of rule proposals, risk alerts and enforcement actions, is being driven by political winds and is being directed to focus on perceived misconduct in the private fund industry. During the second year of the Biden administration, we have seen several high-level personnel changes: a new chairman; the departure, or planned departures, of commissioners; a new director for the Division of Enforcement (continuing the line of former federal prosecutors in that role); a new director for the Division of Investment Management; and a new acting director for the newly christened Division of Examinations (EXAMS).

New leadership has brought a renewed focus on getting tough on violators, demonstrated by a return to the to the focus on “gatekeepers,” a return to seeking admissions in settled enforcement actions and more discretion granted to enforcement staff to start cases and negotiate settlement terms.

Despite these senior-level changes and even through the challenges of remote work necessitated by COVID-19, the agency’s examination program in FY 2021 reported that it conducted approximately 3% more exams than in 2020, issued more than 2,100 deficiency letters, returned approximately $45 million to investors, made approximately 190 referrals to enforcement, and examined 16% of registered investment advisers. For both systemic and investor protection reasons, it is evident why the SEC continues to focus on participants in the private fund market.

On March 29, 2022, EXAMS released its FY 2022 annual priorities, which include a focus on private funds; climate and environmental, social, and governance (ESG) investments; and emerging technologies and crypto assets. Relating to private funds, the 2022 priorities reflect familiar themes, almost all of which can be linked to adherence to fiduciary duty, safety of client assets, conflicted transactions and practices, representations to clients and investors, fees and expenses, valuation, and the design and implementation of the compliance program. However, private fund advisers should not be lulled into complacency. The fact that EXAMS continues to highlight what by now should be basic “blocking-and-tackling” compliance issues, suggests that even after repeatedly identifying these as high-priority concerns, the staff is still identifying a significant amount of actual or apparent violations of the applicable provisions.

For the first time in years, EXAMS has specifically called out its focus on private fund compliance practices. This explicit focus coupled with proposed rulemaking and proposed reforms to Form PF and cybersecurity disclosure obligations indicates that the SEC is on a quest to increase transparency and its oversight of a sector of the market that many perceive as less transparent but equally risky. Private fund advisers should pay particular attention to the stated priorities related to safety of client assets (custody rule), conflicted transactions (special purpose acquisition company sponsorship and cross, principal and stapled secondary transactions), fees and expenses (changes in valuation impact on fee calculations, asset-level expense allocations), and preferential treatment to investors. In addition, material nonpublic information (MNPI) controls – regardless of whether actual insider trading is identified  – should be high on the compliance agenda, where applicable. (On April 26, EXAMS issued its latest in a series of risk alerts that have direct applicability to private fund managers; this alert specifically focuses on MNPI risks related to value-add investors and persons who are not treated as access persons but should be subject to the code of ethics.) Although not directly mentioned in the priorities, private fund advisers should also pay attention to their risk disclosures relating to geopolitical factors, including the collateral impact that supply chain challenges can have on financial performance, volatility, and liquidity.

Based on our experience providing expertise to clients who are involved in complex and sometimes novel scenarios with the regulators, we have noticed several trends that suggest examiners are reinvigorated and are better suited to pursue alleged or actual violators.

For example, the emboldened staff is not shy about plainly stating in deficiency letters that certain activities violate the federal securities laws. Gone in some instances are the hedge words such as “may appear to.” (Think about the collateral impact on advisers who are requested to show deficiency letters to investors and insurers.) The staff is increasingly getting into the weeds and digging for more and more data, requesting that the adviser format such data in a manner that facilitates data analytics by proprietary batch-processing technology tools that employ machine learning. And, when financial harm is alleged, the staff does not hesitate to use “moral” persuasion to ensure that reimbursement, with interest, is paid to clients and/or investors in an effort to make them whole. We have even observed a few instances where the staff has used stronger language to call out chief compliance officers (CCOs) who, in the staff’s view, are not knowledgeable, empowered, or effective.

CCOs, principals, and supervisors should take special note. Despite the explicit agency focus on gatekeepers, we do not expect a return to a rash of CCO liability cases—except, of course, in instances where the CCO is complicit in the misconduct.

What is clear is that EXAMS expects compliance to be engaged across business lines, to be knowledgeable about the business and compliance risks, and for the firm’s principals to demonstrate a commitment to compliance through their words and actions.

In short, tone at, or from, the top is no longer the accepted messaging. A robust compliance culture throughout all levels of the organization—regardless of geographic location—with testing, documentation, training, and accountability built in, is the expected norm. Such a compliance approach by the organization could potentially give the adviser a credible basis to argue against the most serious consequences in the event of the discovery of violative conduct or practices.

While it may be foolhardy to handicap the likelihood of passage of the private fund-related rules, we do believe that the SEC will enact rule changes that will significantly increase costs and compliance risks for private fund managers. For example, we expect that new rules will:

1. Impose limitations or prohibitions on the fund’s obligations to indemnify the adviser for certain litigation, compliance, and reporting costs
2. Mandate a requirement for advisers to obtain an annual audit and to notify the SEC of certain material findings
3. Require the adviser to engage third parties when the adviser engages in conflicted transactions, such as GP-led secondaries
4. Prohibit the adviser from collecting fees for services yet to be performed, such as accelerated monitoring fees
5. Prevent the adviser from providing preferential terms to certain investors, at least not without robust disclosures to investors

Danger lurks when it comes to the potential lowering of the standard for legal liability. The proposed rules, if adopted as proposed, will prohibit advisers from seeking reimbursement, indemnification, exculpation, or limitation of the adviser’s liability by the private fund or from investors in private funds for misconduct that stems from a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund. The impact of this change to the indemnification/reimbursement threshold will lower the bar for aggrieved investors to bring legal claims against advisers and shift the cost and financial consequences of such litigation to the adviser.

The SEC recognizes the crucial role that private funds play in economic development and capital markets, justifying a need to intensify its efforts to ensure transparency and compliance. Of course, many retail investors have at least indirect exposure to the private fund market through their pension or retirement investments. The SEC’s vigilance is squarely in line with its core investor protection and capital formation missions, although there are lingering concerns over the regulatory exposure that private fund advisers may face as a result of the looming more prescriptive approach to private fund regulation.

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* Ken C. Joseph is a managing director and head of the Financial Services Compliance and Regulation practice for the Americas at Kroll. Ken served with distinction for a total of over 21 years at the SEC and has a unique combination of front-line expertise and experience in U.S. securities law, regulatory compliance, and corporate governance. Ken can be contacted via email at ken.joseph@kroll.com and by phone at 646-315-4450. Kroll’s Financial Services Compliance and Regulation practice assists registered investment advisers, broker-dealers, and other financial market participants with assessing the risk or potential risk specific to the firm’s business, developing comprehensive policies and procedures, and assisting with testing adherence to such policies and procedures. 

 

This article is for general information purposes and is not intended to be and should not be taken as legal or other advice. The views and opinions expressed in this article are those of the author and do not necessarily reflect those of the IAA.