Although the SEC did not bring as many headline enforcement actions against private funds as in years past, it continues to devote substantial resources and attention to investment advisers.
- SEC scrutiny of private funds underscores the importance of remaining vigilant, including updating and improving compliance infrastructure and evaluating internal policies and procedures.
- Private funds continue to face heightened secondary liability risks arising from their portfolio investments, emphasizing the importance of pre-acquisition due diligence.
- Cybersecurity remains an enforcement priority, and advisers should review and update their cyber-related controls and response plans to ensure protection of investors' information.
Private funds continue to live in an age of heightened litigation risk and an emboldened Securities & Exchange Commission (SEC). Firms should take steps to mitigate risks—including documenting oversight, observing corporate formalities, creating and implementing strong internal controls, and adequately training professionals who serve as directors.
The level of SEC scrutiny on private funds has not let up over fiscal 2019. The SEC has reminded private fund sponsors that, despite less frequent public statements focusing on private equity and fewer big-name enforcement actions, the day-to-day activities of the SEC minimally have changed and the private equity industry remains an important oversight priority. While some speculated that the Commission's prioritization of Main Street investors would detract from its focus on the private equity industry, 2019 signaled that that is unlikely to be the case when it comes to examinations and enforcement.
The SEC continues to improve its post-Dodd-Frank understanding of private fund advisers and firms, building upon its creation of a specialized Asset Management Unit within the Enforcement Division, and its Private Funds unit within the Office of Compliance Inspections and Examinations (OCIE). And, with respect to the political climate, private funds remain a whipping boy of sorts for the Democratic party, most prominently within the crosshairs of presidential candidate Elizabeth Warren—who unveiled the Stop Wall Street Looting Act. There are echoes to 2012, when then-Republican presidential candidate Mitt Romney faced repeated attacks on his private equity industry experience. Moreover, within the investment community, limited partners continue to evaluate their investments into private funds and call for increased focus on the industry's practices; for example, the Institutional Limited Partners Association has been advocating for increased regulatory scrutiny of the industry. The confluence of regulatory focus, LP scrutiny, and imaginative private plaintiffs is an important reminder for private fund advisers to create best-in-class risk management and compliance infrastructure—reinforced by a top-to-bottom healthy culture.
SEC Enforcement Results Summary for FY 2019
According to the SEC Enforcement Division's report on its annual results for the fiscal year ending September 30, 2019, despite a government shutdown that halted most enforcement activity for four weeks and an ongoing staffing shortage, the Commission brought 862 total enforcement actions, surpassing fiscal 2018 for the second highest total ever. Standalone actions against investment advisers/companies soared from 108 in fiscal 2018 to 191 in fiscal 2019, consistent with Chairman Clayton's ongoing focus on violations impacting retail investors. Interestingly, insider trading actions plummeted by over 40 percent, from 51 in fiscal 2018 to 30 in fiscal 2019, notwithstanding court decisions favorable to the SEC on the "personal benefit" question first raised by Newman in 2014, and the agency's continuous efforts to enhance its trading surveillance capabilities through technology.
The SEC lifted its approximately two-year-long hiring freeze during fiscal 2019, and the Enforcement Division hired a limited number of attorneys, suggesting that its robust enforcement program will continue into the current year and beyond. The Asset Management Unit remains smaller today than it was three years ago.
OCIE Examination Priorities
On January 7, 2020 OCIE released its annual examination priorities. Consistent with Chairman Clayton's public remarks and the Enforcement Division's priorities, OCIE continues to focus on protecting the interests of retail investors. OCIE has made clear that it will continue to target in 2020 Registered Investment Advisers (RIAs) to private funds that have an impact on retail investors, with a focus on adequacy of disclosures to clients (e.g., conflicts of interest, undisclosed fees and expenses). The SEC has expressed its view that private equity's impact on retail investors is important due, in large part, to the exposure of pension funds and insurers to the industry. As in recent years, OCIE has indicated that it intends to prioritize examinations of RIAs that have never been examined, including both new RIAs and those that have been registered for several years. As part of its "risk-based approach," OCIE will also prioritize RIAs, regardless of when and whether they were previously examined, that have undergone significant growth or changes in their business models to assess whether their compliance programs have been appropriately adapted. RIAs that have expanded significantly should evaluate their compliance functions to determine whether any adjustments are warranted.
We also urge investment advisers to review OCIE's entire report for a more in-depth discussion of key areas where OCIE intends to focus in 2020, keeping in mind that examinations can lead to enforcement referrals. For perspective, of the 3,089 exams that OCIE completed in fiscal 2019, approximately 150 have resulted in enforcement referrals to date (in addition to over 2,000 deficiency letters). OCIE has committed to enhancing its understanding of private funds, thus there is a reasonably strong likelihood that such enforcement referrals will increase.
Continued Focus on Cyber
As the businesses increasingly incorporate technology into their business models and operations, the private equity industry predictably has followed with more technology-focused private equity deals—a trend we expect to continue. With a greater focus and reliance upon technology comes heightened risk concerning cybersecurity and data privacy. Accordingly, it is not surprising to us that the SEC continued to bring cybersecurity cases in fiscal 2019. Likewise, the SEC will continue to devote significant enforcement resources to cybersecurity matters in 2020. The SEC's Cyber Unit, created in 2017, focuses on market manipulation schemes, hacking efforts to obtain and trade on material nonpublic information, misconduct on the dark web and violations involving distributed ledger technology. Tellingly, in December 2019, Chairman Clayton appointed one of his close advisors on enforcement matters, Kristina Littman, to serve as the second director of the SEC's Cyber Unit—emphasizing cyber-related misconduct as a priority for the SEC.
We also expect the agency to continue to emphasize the importance of public company disclosures regarding cybersecurity matters, along with the need to design and implement appropriate controls and procedures. Private funds should regularly review and update their cyber-related controls and response plans, with an emphasis on protecting investors' information, and similarly maintain controls over their portfolio companies. (Notably, on the state regulatory front, the California Consumer Privacy Act (CCPA) took effect on January 1, 2020. The CCPA will impact many private funds doing business in California, most notably those who collect (or whose portfolio companies collect) personal information from natural persons who are California residents.)
SEC Enforcement Actions v. Private Equity Advisers
When it came to SEC enforcement actions against private fund advisers, 2019 was a lot like 2018. And while the SEC did not secure as many headline settlements as in years past (including years when it was criticized for regulating by enforcement), in 2019 the SEC continued to bring charges for:
- Improper allocation and/or disclosure of fees and expenses. Settling charges with private fund managers over improper expense allocation practices, overcharging of management fees, and misuse of fund assets.
- Improper valuation practices. Settling charges with private fund managers over failure to create adequate valuation policies and procedures or, conversely, failing to adhere to such policies and procedures.
- Conflicts of interest. Settling with private fund managers who entered into conflicted transactions without adequate controls or disclosures to their investors.
While these sorts of actions made 2019 feel a bit like the movie Groundhog Day, the repeat themes serve to remind private funds of the SEC's rising expectations when it comes to overall transparency and compliance—i.e., the SEC has put the industry on notice of a new normal.
Portfolio Company Risk—Instill Robust Compliance Programs and Adequate Controls
An analog of regulatory enforcement risk is the threat of private litigation against private funds. Private equity managers face a difficult balancing act of managing portfolio company investments while protecting against litigation risk as a result of their roles in such investments. As these risks multiply, along with plaintiffs' ability to creatively allege claims, investment firms should remain diligent with respect to the portfolio companies in which they invest.
As an example, private equity firms should be aware of increasing False Claims Act (FCA) scrutiny in the health care industry and other industries where business with the government is a regular occurrence. We previously highlighted the September 2019 settlement between the Department of Justice, a pharmacy, two of its executives, and a private equity firm to resolve an FCA lawsuit alleging involvement in a kickback scheme. The DOJ had filed a complaint-in-intervention, naming as defendants not only the pharmacy involved and its executives, but also the private equity firm which had a significant ownership stake in the pharmacy. This case serves as a reminder of potential liability for private funds; it also underscores the importance of board designees playing an active role to ensure compliance with applicable laws.
Moreover, the long-running Sun Capital Partners ERISA litigation saga has attracted the attention of the private equity industry, as the courts tackled whether Sun Capital's investment funds could be liable for obligations to a pension fund of its bankrupt portfolio company. In the waning days of 2019, the First Circuit found in favor of Sun Capital, giving private funds a win—at least for the moment.
It therefore remains important for private equity firms to confirm that portfolio companies design and implement strong compliance programs and internal controls. Likewise, it is important that PE-designated board members be trained to discharge oversight duties concerning the compliance functions of portfolio companies. Today's litigious environment emphasizes the significance of conducting thorough pre-acquisition diligence, considering opportunities for alternative structures, appointing independent directors at the portfolio company level, ensuring portfolio companies engage qualified advisers, documenting good-faith efforts, and respecting corporate formalities.
A Word or Two About Insurance
With regulatory and litigation risk remaining significant, it is important for private funds to continue to assess their insurance coverage and coordinate such coverage with that of portfolio companies. Coverage disputes continue, further emphasizing the importance of negotiating for the most favorable policy language possible at the outset—maximizing the chances of recovery. Often overlooked is securing policy wording to provide coverage for potential regulatory investigation costs.
Private equity firms entered the year with record amounts of cash on hand, which understandably has led many to predict increased deal activity. With strong deal volume comes enhanced regulatory and litigation risk. One potential trend to watch is the rise of litigation funds, whose capital can inject uncertainty into litigation impacting private funds.
On the regulatory front, in addition to the OCIE Examination Priorities highlighted above, the SEC continues to emphasize various areas of enforcement focus, including:
- Pay-to-play. As the 2020 election cycle begins and the country becomes increasing enmeshed in perpetual campaign mode, it becomes increasingly important for private funds to re-evaluate their pay-to-play policies and ensure proper implementation.
- Valuation of Illiquid Securities. The SEC continues to assess the valuations and methodologies behind illiquid securities, including assessing whether advisers consistently apply valuation policies.
- Insider Trading. The SEC continues to pursue insider trading cases using increasingly sophisticated technological and investigative tools. Unless Congress adopts an insider trading statute, the law will likely remain in flux, necessitating safeguards to protect material nonpublic information and appropriately tailored trading policies.
- FCPA. FCPA remains a top priority for the DOJ and SEC. Private funds should assess their corruption risks and continually re-evaluate their compliance programs.
We expect the Commission to keep its foot on the pedal for FY 2020. The SEC appears to consider the lack of harm to limited partners as irrelevant to liability—and only minimally relevant to the question of appropriate sanctions. There also are potential regulatory developments worth watching, including the SEC's proposed amendments to the Advertising Rule and its proposed amendments to accredited investor and qualified institutional buyer standards. Private funds should prepare for an active SEC Enforcement Division and private litigation by focusing on internal controls and fostering a culture of compliance, including increased oversight at the portfolio company level.
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