2014 SEC Compliance Outreach Program: Key Takeaways for Private Fund Advisers’ Chief Compliance Officers

2014 SEC Compliance Outreach Program: Key Takeaways for Private Fund Advisers’ Chief Compliance Officers

February 28, 2014 | By Keith Martin in Washington, DC

The Securities and Exchange Commission (SEC) held its Compliance Outreach Program’s national seminar for investment companies and investment advisers on January 30, 2014. The event was held to assist Chief Compliance Officers (CCOs) and other senior personnel to enhance their compliance programs to comply with the federal securities laws. During the program, officials from the SEC’s Office of Compliance Inspections and Examinations (OCIE), the Division of Investment Management, the Asset Management Unit of the Division of Enforcement[1] and market participants spoke about the trends in compliance in 2013, SEC and National Exam Program (NEP) priorities in 2014, private fund advisers, registered investment companies and the general role of the CCO.

Topics of particular interest to private fund advisers of both hedge funds and private equity funds included the following:

  • Presence exams (i.e., focused, risk-based examinations that typically take approximately 90 days, including an on-site portion) which are being conducted through the NEP and will continue to focus on portfolio management, marketing, conflicts of interest, valuation and custody issues in 2014. 
    • Portfolio Management: An investment adviser must act in the best interests of its advisory clients and identify, mitigate, and disclose any material conflict of interest. The NEP staff will continue to evaluate investment advisers’ portfolio decision-making practices, including the allocation of investment opportunities and whether advisers’ practices are consistent with disclosures provided to investors. 
    • Marketing: The NEP staff will continue to review marketing materials to evaluate whether an investment adviser has made false or misleading statements about its track record or made any untrue statement or omission of a material fact (particularly inadequate disclosures of fees).
    • Conflicts of Interest: The NEP staff will continue to review how advisers identify, mitigate and manage conflicts of interest within their firms. Potential conflicts of interest that NEP staff will review include: allocation of investments, fees and expenses; sources of revenue; payments made by private funds to advisers and related persons; employees’ outside business activities and personal securities trading; and transactions by advisers with affiliated parties. The SEC noted in particular that “zombie funds,” which are funds that continue to retain investors and charge fees even though hopes of profiting from investments are remote, raise conflicts of interest concerns.
    • Valuation: Investment advisers must follow effective policies and procedures regarding the valuation of client holdings and assessment of fees based on those valuations. The NEP staff will continue to review advisers’ valuation policies and procedures, including their methodology for valuing illiquid investments. They will also review advisers’ procedures for calculating management and performance fees, and allocation of expenses to private funds.
    • Custody Issues: Registered investment advisers that have “custody” of client assets must take specific measures to protect client assets. In 2014, the NEP staff will continue to review advisers’ compliance with the relevant provisions of the Investment Advisers Act of 1940, as amended (Advisers Act) and related rules that are designed to prevent the loss or theft of client assets. When obtained, the NEP staff also will review independent audits of private funds for consistency with the Advisers Act’s custody rule.
  • The seminar included a session that specifically addressed private fund adviser topics. The panelists at this session noted four particular areas of concern with respect to private funds (primarily private equity funds):
    • Expense Shifting: Charging funds with expenses customarily borne by investment advisers without proper disclosure or consent was a frequently discussed topic. For example, charging a fund fees for related party service providers that appear to be members of a manager’s team but are in fact consultants can create concerns if the arrangement is not fully disclosed. The SEC noted that a carefully worded limited partnership agreement or other operating document can be a helpful guidepost as to how a fund’s expenses should be allocated. 
    • Ancillary Revenue and Hidden Fees: The SEC is concerned that some advisers may generate additional revenue while reducing available cash to funds without proper disclosure and/or investor consent. Areas of concern include inadequate disclosure of accelerated monitoring fees (i.e., fees charged by an adviser to its fund’s portfolio company for ongoing advisory and management services) and portfolio companies’ use of service providers that kick cash back to the adviser. 
    • Favoritism: Favoring certain funds or investors without proper disclosure may raise concerns with the SEC (e.g., improperly lending funds to favored investors or directing a fund to make investments that support the adviser’s secondary or co-investment business). The SEC noted that disclosure is a helpful way to alleviate concerns about favoritism. 
    • Marketing: The SEC stated that managers “stretching for capital” are vulnerable to misstating material facts, including improperly constructing interim valuations and failing to disclose the known post-closing departure of key investment team members.
  • The seminar included two unscripted “Question & Answer” sessions. In response to requests from attendees, several panelists shared information. Topics of particular interest to private fund advisers included the following: 
    • OCIE Chooses Which Registrants to Examine Based on Risk Assessments and Tips, Referrals and Complaints (TRCs): The registrants that are examined are not just unlucky - OCIE relies heavily on TRCs and risk assessments to determine which registrants will be examined. 
    • The “Custody Rule” will Remain a Focus: In the panel’s view, one of the most common examination deficiencies is violation of the Advisers Act’s custody rule. The panel recommended paying careful attention to identifying advisory clients and ensuring the auditor used is sufficiently independent.
    • The Commission is Concerned about Recidivism: Firms that have failed to appropriately address deficiencies noted by OCIE in previous examinations are likely to be targeted because, in the eyes of the panel, repeated failures that go unaddressed can lead to larger failures and potential harm to investors. 
    • Prepare Your Firm by Setting and Implementing Good Policies and Procedures: The panel suggested that CCOs begin by writing down the risks at their firms, and then work with management to create appropriate policies and procedures to address those risks. Next, test the policies and procedures periodically throughout the year, and document the tests. If the tests uncover a deficiency, do not cover it up. Instead, document the deficiency and find a way to correct it.
  • The final scheduled presentation of the day dealt solely with the obligations of CCOs, and offered the following advice on best practices from the SEC:
    • Be prepared to serve as the main contact for an examination, including organizing reviews and meetings, accommodating requests pre-, during and post-exam and responding to any comment letter or deficiency letter that results; 
    • Perform periodic reviews, document the results and escalate any unresolved issues to management; 
    • In the case of a firm with multiple offices, visit those offices and maintain compliance staff in each office;
    • Educate firm employees on the fundamental legal requirements that apply to the firm’s business;
    • Write and implement clear policies and procedures; and
    • Obtain training and education for the CCO, emphasizing both compliance and the details of the firm’s business.

Throughout the seminar, the panelists emphasized that disclosure of material facts is a valuable tool to alleviate concerns.[2] When in doubt, advisers to private funds should put themselves in their investors’ shoes and try to imagine how they would react to a particular set of facts. Additionally, CCOs should strive to instill a culture of compliance in their firms in order to facilitate compliance with the federal securities laws. 

  1. With regard to enforcement, throughout the seminar panelists referred to the following enforcement actions as illustrative of enforcement trends (listed in reverse chronological order): In re Western Asset Management Co. (Jan. 27, 2014),  In re Parallax Investments, LLC (Nov. 26, 2013),  In re Equitas Capital Advisors, LLC (Oct. 23, 2013),  In re J.S. Oliver Capital Management, L.P. (Aug. 30, 2013),  In re Carl D. Johns (Aug. 27, 2013),  United States v. S.A.C. Capital Advisors, L.P. et al (Jul. 23, 2013),  In re Steven A. Cohen (Jul. 19, 2013),  In re Northern Lights Compliance Services, LLC (May 2, 2013),  In re Harborlight Capital Management, LLC (Apr. 22, 2013),  SEC v. Yorkville Advisors, LLC (Oct. 17, 2012),  SEC v. GEI Financial Services, Inc. (Oct. 3, 2012),  In re OMNI Investment Advisors Inc. (Nov. 28, 2011), and In re Axa Rosenberg Group LLC (Feb. 3, 2011).
  2. Panelists echoed the priorities, guidance and decisions previously published by various offices and divisions of the SEC, which can be found at the following web addresses: