Articles Posted in Private Equity

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On September 22, 2014, the Securities and Exchange Commission (the “SEC”) charged private equity fund adviser, Lincolnshire Management, Inc. (“Lincolnshire”), with misallocating expenses shared between two portfolio companies. Lincolnshire integrated two portfolio companies that were each owned by a different Lincolnshire private equity fund. Lincolnshire owed a fiduciary duty to each fund and such fiduciary duty was breached when Lincolnshire would charge one portfolio company more than its fair share for expenses benefiting both portfolio companies.

Lincolnshire was aware of the complexity involved in sharing expenses and did have an expense allocation policy in place, though it was not in writing. The instances that resulted in a breach of Lincolnshire’s fiduciary duty were those in which the verbal expense allocation policy was not followed. The SEC also found, with respect to the integration of the portfolio companies, that Lincolnshire did not have sufficient written policies and procedures in place to prevent violations of the Investment Advisers Act of 1940 (“Adviser’s Act”). Lincolnshire agreed to a settlement with the SEC in excess of $2.3 million.

It is interesting to note that, while the SEC announced several months ago it had conducted presence exams and found many issues in private equity managers, Lincolnshire was not one of the companies subject to a presence exam. Private equity managers who have not had a presence exam should not assume they are unlikely to be examined outside of the presence exam protocol. This enforcement action reinforces the requirement that private equity fund advisers are required to have policies and procedures in place that are designed to prevent violations of the Adviser’s Act and other securities laws. More importantly, once in place, such policies and procedures must be monitored by the chief compliance officer and observed by all “covered persons.”

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On September 16, 2014, the Securities and Exchange Commission (“SEC”) announced the latest sanctions in a continuing enforcement initiative against certain hedge fund advisers and private equity firms that have participated in an offering of a stock after short selling it during a restricted period in contravention of SEC rules.

The SEC last year announced the initiative to enhance enforcement of Rule 105 of Regulation M, which is designed to preserve the independent pricing mechanisms of the securities markets and prevent stock price manipulation.  Rule 105 typically prohibits firms or individuals from short selling a stock within five business days of participating in an offering for that same stock.  Such dual activity typically results in illicit profits for the firms or individuals while reducing the offering proceeds for a company by artificially depressing the market price shortly before the company prices the stock.

The SEC’s investigations targeted 19 firms and one individual trader in the latest cases engaged in short selling of particular stocks shortly before they bought shares from an underwriter, broker, or dealer participating in a follow-on public offering.  Each firm and the individual trader have agreed to settle the SEC’s charges and pay a combined total of more than $9 million in disgorgement, interest, and penalties.

Pursuant to this enforcement initiative, the SEC’s Enforcement Division works closely with FINRA and the SEC’s National Exam Program to identify potential violations of Rule 105.  Enforcement staff seeks trading data and certain other relevant information from traders and expedites these cases by using uniform methodologies for determining trading profits and deciding appropriate penalties.

This latest round of administrative proceedings for Rule 105 violations included the following organizations with the monetary sanctions as indicated below:

  • Advent Capital Management – The New York-based firm agreed to pay disgorgement of $75,292, prejudgment interest of $3,836.36, and a penalty of $65,000.
  • Antipodean Advisors – The New York-based firm agreed to pay disgorgement of $27,970, prejudgment interest of $702.83, and a penalty of $65,000.
  • BlackRock Institutional Trust Company – The California-based firm agreed to pay disgorgement of $1,122,400, prejudgment interest of $22,471.13, and a penalty of $530,479.
  • East Side Holdings II – The New Jersey-based firm agreed to pay disgorgement of $26,613, prejudgment interest of $397.38, and a penalty of $130,000.
  • Explorador Capital Management – The Brazil-based firm agreed to pay disgorgement of $83,722, prejudgment interest of $6,936.65, and a penalty of $65,000.
  • Formula Growth – The Canada-based firm agreed to pay disgorgement of $42,488, prejudgment interest of $4,255.15, and a penalty of $65,000.
  • Great Point Partners – The Connecticut-based firm agreed to pay disgorgement of $43,068, prejudgment interest of $1,529.13, and a penalty of $65,000.
  • Indaba Capital Management – The California-based firm agreed to pay disgorgement of $194,797, prejudgment interest of $11,990.79, and a penalty of $97,398.59.
  • Ironman Capital Management – The Texas-based firm agreed to pay disgorgement of $21,844, prejudgment interest of $382.66, and a penalty of $65,000.
  • James C. Parsons – An individual trader who lives in New York City agreed to pay disgorgement of $135,531, prejudgment interest of $3,063.90, and a penalty of $67,765.72.
  • Midwood Capital Management – The Massachusetts-based firm agreed to pay disgorgement of $72,699, prejudgment interest of $5,248.19, and a penalty of $65,000.
  • Nob Hill Capital Management – The California-based firm made sworn statements to the Commission attesting to a financial condition that makes it unable to pay any penalty.
  • RA Capital Management – The Massachusetts-based firm agreed to pay disgorgement of $2,646,395.21, prejudgment interest of $73,394.16, and a penalty of $904,570.84.
  • Rockwood Investment Management (also known as Rockwood Partners LP) – The Connecticut-based firm agreed to pay disgorgement of $156,631, prejudgment interest of $9,222.16, and a penalty of $72,135.23.
  • Seawolf Capital – The New York-based firm agreed to pay disgorgement of $192,730, prejudgment interest of $7,842.28, and a penalty of $96,365.
  • Solus Alternative Asset Management – The New York-based firm agreed to pay disgorgement of $39,600, prejudgment interest of $895.22, and a penalty of $65,000.
  • SuttonBrook Capital Management – The New York-based firm agreed to pay disgorgement of $70,000.
  • Troubh Partners – The New York-based firm agreed to pay disgorgement of $262,744, prejudgment interest of $39,315.13, and a penalty of $106,651.15.
  • Vinci Partners Investimentos – The Brazil-based firm agreed to pay disgorgement of $283,480, prejudgment interest of $23,487.08, and a penalty of $141,740.
  • Whitebox Advisors – The Minnesota-based firm agreed to pay disgorgement of $788,779, prejudgment interest of $48,553.49, and a penalty of $365,592.83

Pillsbury’s Investment Funds Team regularly advises clients on how not to show up on lists such as these.

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Today, the Securities and Exchange Commission published its 2014 priorities for its National Examination Program (“NEP”).  These priorities cover a wide range of issues at financial institutions, including investment advisers and investment companies, broker-dealers, clearing agencies, exchanges and other self-regulatory organizations, hedge funds, private equity funds, and transfer agents.  Similar to the 2013 priorities, the 2014 priorities were published to focus on areas that are perceived by the SEC staff to have heightened risk.

The examination priorities address market-wide issues and those specific to each of the NEP’s four program areas — (i) investment advisers and investment companies(“IA-IC”), (ii) broker-dealers (“B-D”), (iii) exchanges and self-regulatory organizations (“SROs”, and collectively, “market oversight”), and (iv) clearing and transfer agents (“CA” and “TA”).  For investment advisers and investment companies, the SEC has specifically outlined its priorities as follows: 

  • Core Risks
    • Safety of Assets and Custody
    • Conflicts of Interest Inherent in Certain Investment Adviser Business Models
    • Marketing Performance 
  • New and Emerging Issues and Initiatives
    • Never-Before Examined Advisers
    • Wrap Fee Programs
    • Quantitative Trading Models
    • Presence Exams
    • Payments for Distribution in Guise
    • Fixed Income Investment Companies 
  • Policy Topics
    • Money Market Funds
    • “Alternative” Investment Companies
    • Securities Lending Arrangements

The market-wide priorities include fraud detection and prevention, corporate governance and enterprise risk management, technology controls, issues posed by the convergence of broker-dealer and investment adviser businesses and by new rules and regulations, and retirement investments and rollovers. 

The full SEC press release can be found HERE and a full text of the 2014 Examination Priorities can be found HERE. 

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Written by:  Jay B. Gould and Jessica Brown

On July 10, 2013, the Securities and Exchange Commission (“SEC”) voted to lift the ban on general solicitation and advertising by private funds (and other private company issuers) as mandated by Congress in the Jumpstart Our Business Startups Act (“JOBS Act”). In addition to lifting the ban on general solicitation, the SEC approved a disqualification rule that will prospectively prohibit any felon or “bad actor” from relying on Rule 506 exemptions. Finally, the SEC voted to propose amendments to the current private offering rules.

I.          New Rule 506(c) 

Summary

Rule 506(c), as adopted by the SEC, permits private issuers to use general solicitation and general advertising when making a securities offering, provided the issuer only sells to accredited investors.[1] Issuers must take affirmative and reasonable steps to verify that each investor is accredited under the Rule 501 definition, and cannot simply rely upon a representation from the investor.

Verification Rule

The burden now shifts to private fund managers to determine “reasonableness” when making a determination of an investor’s accredited status. In response to comments it received, the SEC has provided some ideas an issuer can consider when determining its verification procedures. The non-exclusive, non-required verification methods published by the SEC include: (i) review federal tax forms, (ii) confirm net worth through documentation, or (iii) obtain written confirmation from a registered broker-dealer, registered investment adviser, licensed attorney in good standing, or registered CPA.  Accordingly, private fund managers will be able to rely upon certain third parties to make a determination of accreditation.

Current Rule 506 Exemptions

Rule 506(c) does not modify or repeal any of the current Rule 506 exemptions and issuers may still rely on those exemptions as written.   Therefore, private fund managers that do not see the value in advertising or soliciting to the public, or find the conditions of the new rules too onerous, may continue under the current private offering regime and will remain subject to all of the same restrictions on communications with the public to which they are currently subject. 

Form D

The current Form D filing document will be amended to include a “check-the-box” option to designate if the issuer is relying on the new Rule 506(c) in its present offering.  For those private funds and other issuers that do intend to generally advertise, the SEC has proposed that a Form D would need to be filed with the SEC 15 days in advance of the offering and again within 30 days after the offering closes.  It is proposed that an issuer that fails to make these filings would be prohibited from using the public advertising rules in the future.

II.        Rule 144A

Similar to the changes to Rule 506, under the new rules, securities sold pursuant to Rule 144A may be “offered” to investors other than qualified institutional buyers, because information about such offerings would be made public by way of general advertising, but the securities may only be sold to investors the seller reasonably believes to be qualified institutional buyers.[2]

III.       Felons and “Bad Actors” Disqualification

The SEC unanimously adopted a rule that disqualifies certain felons and “bad actors” from relying on any Rule 506 exemption.[3] This disqualification will be effective sixty days after the publication of the final rules in the Federal Register. 

The SEC identified a number of events that would disqualify an issuer from relying on Rule 506, such as securities-related criminal convictions, court injunctions and restraining orders, final orders from regulators and agencies, certain SEC disciplinary orders, anti-fraud or registration-related cease-and-desist orders from the SEC, SEC stop orders, suspension or expulsion from membership or association with a self-regulated organization, or recent U.S. Postal Service false representation orders. 

However, much to the consternation of the lone dissenting Commissioner Luis Aguilar, this provision will not bar persons who have committed financial and other crimes in the past.  It will only bar such bad actors on a going forward basis. Presumably, the fact that a principal of an issuer is a convicted felon would be a material fact that would be required to appear in the offering materials of the issuer, and for private funds, this information would, in most cases, get picked up in the Form ADV of the fund manager.

IV.       What Happens Next

Timing

The effective date of Rule 506(c) and the disqualification rule is 60 days following the date the rule is published in the Federal Register. For an ongoing offering under Rule 506 that began before the effective date of Rule 506(c), the issuer may elect to continue the offering after the effective date in accordance with the requirements of either the current Regulation D rule or new Rule 506(c), which permits general solicitation and advertising.  Accordingly, if an issuer chooses to continue its offering under Rule 506(c), any general solicitations that take place after the effective date, will not impact the exempt status of offers and sales that took place prior to the effective date in reliance on Rule 506(b).

What Funds Can Do Now

After the effective date of Rule 506(c), private funds that are not otherwise disqualified from using the Rule 506 exemptions may begin advertising and soliciting generally. An issuer that chooses to advertise or solicit generally must put policies and procedures in place to ensure that reasonable steps are taken to verify that each purchaser is accredited and that no sales are made to non-accredited investors.

Limitations, CFTC Considerations and Fund Advertising

Since February 2012, when the Commodity Futures Trading Commission (“CFTC”) rescinded Rule 4.13(a)(4), most private funds have relied upon the de minimus exemption of Rule 4.13(a)(3) in order to be exempt from CFTC registration. Other funds that trade futures or other instruments that are subject to CFTC oversight above the de minimus threshold, avail themselves of the “registration lite” exemption in Rule 4.7, pursuant to which all fund investors must be “qualified eligible persons.”  However, both of these exemptions require that the fund securities must be offered and sold without any marketing to the public in the United States.  Therefore, until the CFTC acts to amend these exemptive rules on which many private fund managers rely, none of these private funds will be able to use the general solicitation provisions of new Rule 506(c).  The Managed Funds Association submitted an outline of proposed rule amendments to the CFTC that would harmonize the CFTC rules with the SEC’s JOBS Act rules, but it is uncertain when the CFTC will act on this matter.

For a discussion of these provisions, see this discussion on Bloomberg. 

Proposed Amendments to Regulation D, Form D and Rule 156

In connection with the approval of Rule 506(c), the SEC proposed amendments to Regulation D, Form D and Rule 156 under the Securities Act. These proposed “investor protection” amendments are intended to enhance the SEC’s ability to evaluate market changes, the nature of advertising used by issuers, the steps taken by the issuer to verify that all investors were accredited and the intended use of the proceeds of the sale. It is likely that these provisions will soon become part of the new Form D and be applicable to private fund managers that advertise or solicit to the public. 

Finally, fund managers and their compliance officers should familiarize themselves with the requirements of Rule 156, as it appears likely that this anti-fraud rule will soon apply to the sales literature and advertising produced by hedge fund and private equity funds.

Questions regarding new Rule 506(c), the CFTC rules, Rule 156 and other implications regarding this recent SEC action should be directed to your Pillsbury attorney contact.

 

[1] Rule 501 of Regulation D defines an individual as an “accredited investor” if they have individual net worth, or joint net worth with the person’s spouse, in excess of $1 million at the time of the purchase, excluding the value of the primary residence of such person, or with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

[2] Rule 144A defines “qualified institutional buyers” as certain institutions that own and invest at least $100 million in securities of issuers that are unaffiliated with the institutions, banks and financial institutions must also have a net worth in excess of $25 million. A registered broker-dealer qualifies if it owns and invests on a discretionary basis over $10 million in securities of issuers that are unaffiliated with the broker-dealer. 

[3] An issuer will be disqualified from relying on Rule 506 exemptions if any “covered person” has had a “disqualifying event.” The rule defines “covered persons” as: (i) the issuer, (ii) the issuer’s predecessors and affiliated issuers, (iii) directors and certain officers, general partners and managing members of the issuer, (iv) 20 percent beneficial owners of the issuer, (v) promoters, (vi) investment managers and principals of pooled investment funds, and (vii) persons compensated for soliciting investors as well as the general partners, directors, officers, and managing members of any compensated solicitor.

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Last month, the Securities and Exchange Commission (the “SEC”), published its examination priorities for 2013.  As we suggested in our Blog posting at that time, the SEC is fixated on examining and bringing enforcement against its newest class of investment adviser – managers of private equity funds.  Fast forward four weeks, and we should not be surprised to see that the SEC is doing what they said they would do.  Today, the SEC charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a private equity fund of funds they manage.

The SEC investigation alleged that Oppenheimer Asset Management and Oppenheimer Alternative Investment Management disseminated misleading quarterly reports and marketing materials, which stated that the Oppenheimer Global Resource Private Equity Fund I L.P.’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.”  The SEC, however, claimed that the portfolio manager of the Oppenheimer fund actually valued the Oppenheimer fund’s largest investment at a significant markup to the underlying fund manager’s estimated value, a change that made the performance of the Oppenheimer fund appear significantly better as measured by its internal rate of return.  As part of the Order entered by the SEC, and without admitting or denying the regulator’s allegations, Oppenheimer agreed to pay more than $2.8 million to settle the SEC’s charges and an additional $132,421 to the Massachusetts Attorney General’s office.

In its press release, the SEC reiterated its focus on the valuation process, the use of valuations to calculate fees and communicating such valuations to investors and to potential investors for purposes of raising capital.  The SEC’s order also claimed that Oppenheimer Asset Management’s written policies and procedures were not reasonably designed to ensure that valuations provided to prospective and existing investors were presented in a manner consistent with written representations to investors and prospective investors. This claim gave rise to an alleged violation of Rule 206(4)-8 (among other rules and statutes) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), the rule that the SEC passed after the Goldstein case permitted many funds to de-register as investment advisers from the SEC.

This case illustrates the new regulatory landscape for private equity fund managers.  Many private equity fund managers have not dedicated the time and resources to bringing their organizations in line with the fiduciary driven rules under the Advisers Act.  Many of these managers have not implemented the compliance policies and procedures required by the Advisers Act, nor have their Chief Compliance Officers been empowered to enforce such compliance policies and procedures when adopted.  Much of this oversight goes to the fact that many private equity fund managers do not have a history of being a regulated entity nor have they actively sought out regulatory counsel in their typical business dealings.  Private equity fund managers generally use outside counsel to advise them on their transactional or “deal” work and they often do not receive the advice that a regulated firm needs in order to meet its regulatory obligations.  Oppenheimer serves notice that failing to meet these regulatory obligations can have dire consequences.

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Last week the SEC issued a Risk Alert and an Investor Bulletin on the Custody Rule after its National Examination Program (“NEP”) observed significant deficiencies in recent examinations involving custody and safety of client assets by registered investment advisers.  The stated purpose of the Risk Alert was to assist advisers with complying with the custody rule.  The Investor Bulletin was issued to explain the purpose and limitations of the custody rule to investors.  We encourage advisers and investors to review the Risk Alert and the Investor Bulletin, and remind advisers, particularly advisers to private equity funds,  fund of funds and funds that invest in illiquid assets that they may only self custody securities if they satisfy the requirements for “privately offered securities” (i.e., securities are (i) not acquired in any transaction involving a public offering, (ii) uncertificated, (iii) transferable only with the prior consent of the issuer and (iv) are held by a fund that is audited). Many advisers may not be in compliance with the custody rule because they self custody assets that do not satisfy the definition of privately offered securities.  Please feel free to contact us for more information on the Risk Alert, Investor Bulletin or the custody rule.

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Written by:  G. Derek Andreson, James L. Kelly, Christopher M. Zochowski, and Ryan R. Sparacino

This article was also published in Law360.

Until a few years ago, private equity firms enjoyed relative insulation from regulatory scrutiny of overseas acquisitions and the operations of multi-national portfolio companies. No longer is that the case. Spurred by the unfounded belief that PE firms are not invested in compliance or the conduct of their portfolio companies, the DOJ and SEC are now training their attention on how PE firms exert oversight and control over their portfolios, with a particular emphasis on FCPA issues. PE firms should prepare for this new scrutiny by taking proactive measures to demonstrate both their awareness and their commitment to earning profits on a level playing field. Most importantly, PE firms must recognize that these efforts are not about appeasing regulators, but go directly to maximizing return on investment. 

It’s About Deal Risk, Not Legal Risk 

A private equity firm’s foreign investments carry unique risks in the anti-corruption world: the firm may have exposure to substantial fines, penalties and reputational harm through the conduct of a portfolio company, even though the firm maintains only partial control.

This risk arises not only in the context of acquisitions, but also in strategic combinations such as joint ventures. And under successor liability principles, the conduct at issue may have occurred years before the firm considered taking a stake in the company or venture.

These risks permeate the deal cycle, including the exit phase. A sophisticated buyer in today’s market will take a hard look at a target’s anti-corruption compliance. If the compliance program falls short of industry standards, that fact may persuade the buyer to look for other opportunities, or it may convey additional leverage in negotiations.

READ MORE…

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On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk.  The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges.  This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)

As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology.  The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).

The Staff intends to focus its attention on the areas set forth below.   

New and Emerging Issues.

The Staff believes that new and emerging risks related to IA-ICs include the following:

  • New Registrants.  The vast majority of the approximately 2,000 new investment adviser registrants are advisers to hedge funds or private equity funds that have never been registered, regulated, or examined by the SEC.  The Presence Exam initiative, which is a coordinated national examination initiative, is designed to establish a meaningful “presence” with these newly registered advisers.  The Presence Exam initiative is expected to operate for approximately two years and consists of four phases: (i) engagement with the new registrants; (ii) examination of a substantial percentage of the new registrants; (iii) analysis of the examination findings; and (iv) preparation of a report to the industry on the findings.  The Presence Exam initiative will not preclude the SEC from bringing enforcement actions against newly registered advisers.  The Staff will give a higher priority to private fund advisers that it believes present a greater risk to investors relative to the rest of the registrant population or where there are indicia of fraud or other serious wrongdoing.  We expect to see the SEC bring enforcement actions against private equity and hedge fund managers for issues related to valuations, calculation of performance-related compensation and communications to investors that describe valuations and performance-related compensation.
  • Dually Registered IA/BD.  Due to the continued convergence in the investment adviser and broker-dealer industry, the Staff will continue to expand coordinated and joint examinations with the broker dealer examination program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals.  It is not uncommon for a financial professional to conduct a brokerage business through a registered broker-dealer that the financial professional does not own or control and to conduct investment advisory business through a registered investment adviser that the financial professional owns and controls, but that is not overseen by the broker-dealer.  This business model presents many potential conflicts of interest.  Among other things, the Staff will review how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.
  • “Alternative” Investment Companies.    The NEP will also focus on the growing use of alternative and hedge fund investment strategies in registered open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures.  The Staff intends to assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
  • Payments for Distribution In Disguise.    The Staff will also examine the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same.  With respect to private funds, the Staff will examine payments to finders or other unregistered intermediaries that may be conducting a broker dealer business without being registered as such.  Payments made pursuant to the Cash Solicitation Rule will also be a focus of private fund payment arrangements.

Ongoing Risks.

The Staff anticipates that the ongoing risks selected as focus areas for IA-ICs in 2013 will include:

  • Safety of Assets.  The Staff has indicated that recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under the Investment Advisers Act of 1940 (“Advisers Act”) Rule 206(4)-2 (the “Custody Rule”).   The staff will focus on issues such as whether advisers are: (i) appropriately recognizing situations in which they have custody as defined in the Custody Rule; (ii) complying with the Custody Rule’s “surprise exam” requirement; (iii) satisfying the Custody Rule’s “qualified custodian” provision; and (iv) following the terms of the exception to the independent verification requirements for pooled investment vehicles.  Many private equity funds and fund of funds have been slow to adopt policies and procedures that comply with the Custody Rule.
  • Conflicts of Interest Related to Compensation Arrangements.  The Staff expects to review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present.  These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.  These types of compensation arrangements are commonplace among private equity fund advisers, many of which have just recently registered.  In fact, many private equity funds have compensation arrangements that the Staff believes requires broker dealer registration.  We believe that the Staff will make this point quite clearly by bringing enforcement actions against certain private equity fund general partners for engaging in unregistered broker dealer activity.  Enforcement actions are viewed as an effective way to get the message across to an industry that has long ignored this particular issue.
  • Marketing/Performance.  Marketing and performance advertising is viewed by the Staff as an inherently high-risk area, particularly among private funds that are not necessarily subject to an industry standard for the calculation of investment returns.  Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices.  The Staff will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements.   The Staff is starting to think about how the anticipated changes in advertising practices related to the JOBS Act will affect their reviews regarding registrants’ use of general solicitations to promote private funds.  Whether private funds will be permitted to advertise performance under the JOBS Act rules remains to be seen.  Certainly, there have been loud and influential voices that advocated for the position that the SEC should continue to study performance advertising by private funds before allowing it in the adoption of the highly anticipated rules.
  • 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 potential conflicts of interest.  The Staff will attempt to verify that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts and non-performance-based fee accounts with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.  For certain types of strategies, such as credit strategies, where one fund may be permitted to invest in all securities in the capital structure, whereas other funds may be limited in what they can purchase by credit quality or otherwise, these potential conflicts of interest are particularly acute.  Fund managers must have policies in place that account for these potential conflicts, manage the conflicts and document the investment resolution.
  • Fund Governance.  The Staff will continue to focus on the “tone at the top” when assessing compliance programs.  The Staff will seek to 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.  Chief Compliance Officers will want to make sure that those items that are required to be undertaken in the compliance manual actually occur as stated and scheduled.

Policy Topics.

The staff anticipates that the policy topics for IA-ICs will include:

  • Money Market Funds.  The SEC continues to delude itself regarding the regulation of money market funds.  This once sleepy and relatively benign product is now the pillar of the commercial paper market and functions like and deserves the regulation of a banking product.  But the SEC, and the mutual fund trade organization, are loathe to cede authority to banking regulators for this “dollar per share”  product.  Accordingly, the SEC will continue to try to find ways for thinly capitalized advisers to offer and manage  money market funds by requiring money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, such as changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks (i.e., basically, all of the market events that have proven fatal to money market funds in the past and which will be so again as long as these funds remain fundamentally flawed).
  • Compliance with Exemptive Orders.  The staff will focus on compliance with previously granted exemptive orders, such as those related to registered closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds.  Exemptive orders are typically granted pursuant to a number of well-developed conditions with which the registrant promises to adhere.  The market timing and late trading scandals of 2003 illustrated that once a registrant has obtained an exemptive order, it may or may not abide by all of the conditions of that order.
  • Compliance with the Pay to Play Rule.  To prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices), the SEC recently adopted and subsequently amended, a pay to play rule. The Staff will review for compliance in this area, as well as assess the practical application of the rule.  Advisers should be aware that most states have their own pay to play rules and many of them have penalties that are far more onerous than the SEC’s rule.

We will continue to monitor this and other new developments and provide our clients with up to date analysis of the rules and regulations that may affect their businesses.

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By Peter J. Hunt, Susan P. Serota, Matthew C. Ryan1

In welcome news for private equity (“PE”) funds, a recent district court opinion determined that two PE funds and their bankrupt portfolio company were not a “controlled group” and thus the PE funds were not responsible for pension liabilities at the portfolio company. The decision, Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund, explicitly rejected a prior Pension Benefit Guaranty Corporation (“PBGC”) ruling on the same question and illuminated best practices for structuring future PE fund investments.

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Written by:  Jay Gould and Peter Chess

Heath Abshure, President of the North American Securities Administrators Association (NASAA) and Arkansas State Securities Commissioner, sharply criticized the Securities and Exchange Commission’s (the SEC’s) new rulemaking that will lift restrictions on general solicitation and general advertising for hedge funds and other private investment vehicles in a press-teleconference on October 9, 2012.  At the heart of the criticism is the contention that hedge funds and private equity funds could be among the amended rule’s biggest users and beneficiaries. “The SEC’s proposed rule would open the door for private equity and hedge funds, typically only offered to the most sophisticated investors, to advertise to the general public without putting in place basic disclosure requirements that would allow investors to make informed decisions about the products being offered. This is the wrong way to go,” remarked Heath Slavkin Corzo, senior legal and policy advisor of the AFL-CIO’s Office of Investment during the teleconference.

Under the Jumpstart Our Business Startups Act (the JOBS Act), as discussed here and here, the SEC was directed to amend Rule 506 of Regulation D under the Securities Act of 1933, as amended, to permit general solicitation and general advertising in unregistered offerings made under Rule 506, provided that all purchasers of the securities are accredited investors.  In reaction to the SEC’s answer to the directives of the JOBS Act, Abshure called for the SEC to withdraw its proposal and draft a new rule that promotes capital formation without sacrificing investor protection.

“People don’t seem to think so, but this is a drastic change to the face of securities regulation,” Abshure said. “Rule 506 offerings already are the most frequent financial product at the heart of state enforcement investigations and actions. Lifting the advertising ban on these highly risky, illiquid offerings, without requiring appropriate safeguards, will create chaos in the market and expose investors to an even greater risk of fraud and abuse. Without adequate investor protections to safeguard the integrity of the private placement marketplace, investors should and will flee from the market, leaving small businesses without an important source of capital.”

“The Commission itself has acknowledged that lifting the ban on general solicitation in private offerings will increase the risk of fraud, potentially harming investors and issuers alike,” added Barbara Roper, Director of Investor Protection for the Consumer Federation of America and the chair of the Investor Issues task force of Americans for Financial Reform during the teleconference. “While the Commission is required by the JOBS Act to lift the solicitation ban, it also has an obligation to adopt rules that protect investors and promote market integrity and the authority to do so.  A number of reasonable, concrete proposals have been suggested that, if adopted, would significantly improve safeguards for investors in private offerings.  Its rule proposal completely ignores those suggestions.  It cannot in good conscience continue to do so.”

The full press release about the teleconference is available here.