The Office of Compliance Inspections and Examinations (“OCIE”) released its expected Private Fund Risk Alert to highlight compliance issues observed in examinations of private equity and hedge fund registered investment advisers. The stated intention of the Risk Alert is to assist private equity and hedge fund advisers to effectively review and enhance their respective compliance programs. OCIE, in other words, provided the industry with OCIE’s expectations regarding the implementation of a compliance program to comply with applicable laws, rules, fiduciary duty to clients, and obligations to investors.
We already have seen a steady stream of private fund enforcement actions. We expect to see a continued stream of private fund examinations. Notably, this Risk Alert was for private equity and hedge fund registered advisers, but the guidance is useful to other private fund registered advisers as well, such as real estate fund managers, and also to non-registered private fund advisers and exempt reporting advisers (exempt reporting advisers technically are not registered advisers). In short, are you ready for your OCIE examination?
The Risk Alert organized the compliance issues, also referred to as deficiencies, into three categories: (1) conflicts of interest, (2) fees and expenses, and (3) policies and procedures relating to material non-public information (“MNPI”). OCIE reported that many of the deficiencies resulted in, or as OCIE put it, “may have caused” investors in the private funds to pay more in fees and expenses “than they should have” or resulted in investors not being informed of relevant conflicts of interest. Read between the lines here: you can have a compliance failure that results in a deficiency letter, or even an enforcement action, in situations where there is no proof of actual investor financial harm.
Here is a Risk Alert summary in brief, organized in parallel to OCIE’s categories and followed by a few tips:
Conflicts of Interest: OCIE reported that the following conflicts often appear inadequately disclosed, eliminated, mitigated, and/or managed, in violation, OCIE said, of Section 206 of the Investment Advisers Act of 1940 (“Advisers Act”) and/or Rule 206(4)-8 thereunder. These conflicts and, primarily their lack of disclosure, relate to:
- allocations of investments (e.g., preferential treatment, inconsistent implementation)
- multiple clients investing in the same portfolio company (e.g., clients investing at different levels of a capital structure)
- financial relationships between investors or clients and the adviser (e.g., economic relationships, seed investors, other select investors)
- preferential liquidity rights (e.g., side letters that could harm other investors if exercised)
- private fund adviser interests in recommended investments (e.g., pre-existing ownership interests, referral fees)
- co-investments (e.g., failing to follow disclosed opportunity allocation processes)
- service providers (e.g., agreements with commonly controlled entities)
- fund restructurings (e.g., discounted pricing, investor options, economic benefits to the adviser)
- cross-transactions (e.g., disadvantaged pricing).
Fees and Expenses: OCIE reported that the following fee and expense issues also often appear as violations of Section 206 or Rule 206(4)-8:
- allocation of fees and expenses (charging in a manner inconsistent with fund documentation and causing some investors to overpay)
- operating partners (misleading investors as to who bears their costs)
- valuation (inappropriately overvalued holdings or not in accordance with expected processes)
- monitoring/board/deal fees and fee offsets (compensation to affiliates that caused investors to overpay management fees and accelerated fees)
MNPI/Code of Ethics: OCIE reported that the following issues appear to be deficiencies under Advisers Act Section 204A or the Code of Ethics Rule, Rule 204A-1:
- Section 204A. Advisers did not adequately address risks stemming from:
- employees interacting with “insiders” of publicly traded companies, outside consultants arranged by expert network firms, and/or “value add investors” (such as corporate executives or financial professional investors) in order to asses whether MNPI “could have been exchanged” (emphasis added)*
- employees who “could” obtain MNPI through their ability to access office space or systems of the adviser or adviser affiliates that had MNPI (emphasis added)*
- employees who periodically had access to MNPI about issuers of public securities, for example, in connection with a private investment in public equity.
*Note that OCIE found deficiencies even where it was not clear whether MNPI actually was exchanged or obtained.
- Code of Ethics Rule. Overall, advisers failed to establish, maintain, and enforce Code of Ethics provisions reasonably designed to prevent “the misuse of MNPI.” This included, failing to:
- enforce Restricted Lists
- have defined policies and procedures for adding and removing securities to and from the Restricted List
- enforce requirements on gifts and entertainments
- correctly identify individuals as “access persons” (an important term in particular regarding who must submit holding and quarterly transaction reports)
- require access person to correctly and timely submit holdings and transactions reports, including for preclearance
So, there is a plethora of information to digest, even if the concerns are not new to you. Compliance, to the regulators, is not just about having a successful fund or happy, non-complaining investors. Regulators want your processes correct, not just the end result.
Here are some additional takeaways:
- Compliance teams are better served when they document, document, document—this is to get credit where credit is due.
- Sound “Risk Management” means having effective policies and procedures, which means they must be in writing, tailored, reviewed, tested, implemented, monitored, followed, and so on.
- Advisers must have written policies and procedures on material non-public information, even where the risk of actual insider trading could be considered low, and even where the adviser itself does not trade in public securities. Investment decision-making and rationales should be well-documented; prove the negative, that you did not need or use any material non-public information.
- Conflicts of interest mapping needs have evolved. We have always understood that the SEC expects certain core documents to be in place, namely, the Code of Ethics, Compliance Manual, and Risk Inventory. In today’s environment, that may not always be sufficient. Some advisers may need another core document: the Conflicts of Interest Chart.
- COVID-19 will amplify the use and concerns on some of the identified topics, for example, on expense sharing, fund restructurings, preferential liquidity rights, cross-transactions, and valuation.
We would like to help you develop and enhance your Compliance Program. Utilize our expertise and industry awareness. Contact us at firstname.lastname@example.org to review your policies and procedures, provide you with Mock SEC Exam Services, or for any number of compliance services and products. This Risk Alert validates to management teams of private fund advisers that compliance is integral to the business—even when all the investors are sophisticated, accredited, institutional, and/or qualified.
 Advisers Act Section 206 prohibits investment advisers from employing any device, scheme, or artifice to defraud any client or prospective client, and from engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client. Rule 206(4)-8 prohibits investment advisers to pooled investment vehicles from (a) making to investors and/or prospective investors any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made not misleading and/or (b) otherwise engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor. Note that both the Section and the Rule apply to all advisers, whether or not the advisers are registered or required to be registered.
 Advisers Act Section 204A requires that investment advisers establish, maintain, and enforce written policies and procedures to prevent the misuse of MNPI. (Note that even exempt reporting advisers must have policies and procedures to prevent the misuse of MNPI.) The Code of Ethics Rule, which in fact only expressly applies to registered advisers and those required to be registered (although other advisers might do well to consider similar protocols) sets forth minimum requirements for a Code of Ethics or similar document that prescribes standards of behavior for employees as well as reporting of the personal holdings and trading of certain employees known as “access persons.”
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