Articles Tagged with Presence Exam

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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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Private equity firms were put on notice last year that they may be subject to registration as broker dealers when David Blass, head of the Division of Markets and Trading at the Securities and Exchange Commission (“SEC”), provided his insights at an industry conference.  Since that time, the SEC has published their examination priorities list, which included the presence exams of new registrants, a portion of which would review that status of private equity fund managers under the broker dealer rules.  Following up on this warning to the industry, the SEC has also targeted unregistered brokers for enforcement action.

Recently, at a speech in front of another industry group, Mr. Blass provided further guidance on how a private equity firm might structure its compensation arrangements in order to avoid the need to register as a broker dealer.  Consistent with the advice that Pillsbury has been providing private fund clients for many years, Mr. Blass warned against paying “transaction based” compensation and further suggested that if a private fund employee has “an overall mix of functions,” and sales is one aspect of those duties, it is less likely that the SEC staff would view such an arrangement as one that would require broker dealer registration.  An employee of a private fund manager would not be prohibited from being compensated on the overall success of the firm, and certainly sales of fund securities contribute to that overall success.  But tying compensation to assets raised looks like the traditional broker dealer compensation and should be avoided.

Mr. Blass indicated that the SEC is close to finalizing guidance on issues connected to private fund manager employee compensation.  However, the SEC staff has further to go before providing guidelines to the industry on the broker dealer registration issues posed by deal fees that private equity firms sometimes collect on transactions.  It is unlikely that Mr. Blass will see his initiatives through to completion, as he will soon be joining the staff of the Investment Company Institute where he will one day lobby against his former positions.

If you would like additional background on how the private fund managers came to find themselves in the gray zone of broker dealer registration as a result of paying their employees for performance, you may want to re-visit this article.

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On April 8, 2013, we reviewed a recent speech by David Blass, the Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (the “SEC”), in which Mr. Blass provided his views on whether certain investment fund managers might be operating in a way that would require registration as a broker dealer.  For hedge fund managers, the problem typically arises in the context of paying internal sales people based on the amount of capital raised.  As we noted, the widespread misreading or abuse of Rule 3a4-1, the issuer’s exemption safe harbor on which so many hedge fund managers rely, is now clearly on the SEC’s radar.

But there are other ways to become entangled in broker dealer registration requirements that many private equity funds (and some hedge funds) will also need to consider.  The SEC staff is aware that advisers to some private funds, such as managers of private equity funds executing a leverage buyout strategy, may collect fees other than advisory fees, some of which look suspiciously like brokerage commissions.  It is not uncommon for a fund manager to direct the payment of fees by a portfolio company of the fund to one of its affiliates in connection with the acquisition, disposition (including an initial public offering), or recapitalization of the portfolio company.  These fees are often described as compensating the fund manager or its affiliated company, or personnel for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions.  These are typical investment banking activities for which registration as a broker dealer is required.

Perhaps through its presence exams, the SEC staff recognizes that the practice of charging these transaction fees is fairly common among certain private equity fund managers.  Blass suggested that if the payment of these investment banking type fees were used to offset the management fee, then a valid argument could be made that no separate brokerage compensation was generated.  However, the industry argument that the receipt of such fees by the general partner of the fund should be viewed as the same person as the fund, so there are no transactions for the account of others was not an argument that the SEC staff appeared ready to endorse.  As long as the fee is paid to someone other than the fund for the types of activities described above, then the general partner or its affiliate would need to go through the analysis as to why broker dealer registration is not required.  The private equity fund bar has also advanced the policy argument that requiring private equity fund managers to register as broker dealers serves no useful purpose.  This policy argument that advocates the position that the SEC should exempt certain firms and not others for the same conduct, as attractive as it might be for managers of private equity funds, is a total non-starter from the regulator’s perspective.  The SEC staff will remain fixated on the type of activity and the fees generated from that activity when attempting to determine whether registration is required.

Particularly among private equity fund managers, many of which have not had a history of being a regulated entity, this violation of the broker dealer registration requirement is not viewed as a serious matter because “everyone else is doing it.”  But the SEC is putting private equity on notice that this is an area that the staff will focus on in examinations and will eventually bring enforcement action.  In addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right to rescission by investors.  A transaction that is intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void.  A purchaser of securities would typically seek to void a transaction if the price had moved against him, leaving the fund manager scrambling to make up the difference between the sales price and the value at rescission.   Private equity fund managers and those hedge fund managers that conduct similar activities should give greater attention to this issue for which the SEC staff has provided fair warning.

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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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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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Written by:  Jay Gould and Peter Chess

On October 9, 2012, the Securities and Exchange Commission (SEC) announced the launch of an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the SEC.  These “Presence Exams” are part of a two year initiative with three primary phases: engagement, examination and reporting.  During the examination phase, staff from the National Exam Program (NEP) will review one or more of five areas identified by the SEC as “high-risk” areas for the business and operations of advisers:

  • Marketing.  NEP staff will conduct evaluations of marketing materials to ascertain, for example, whether the adviser has made false or misleading statements about its business or performance record.
  • Portfolio Management.  NEP staff will review and evaluate an adviser’s portfolio decision-making practices.
  • Conflicts of Interest.  NEP staff will review the procedures and controls that advisers use to identify, mitigate and manage conflicts of interest within their firm.
  • Safety of Client Assets.  NEP staff will review advisers deemed to have “custody” of client assets for compliance with provisions of the Investment Advisers Act of 1940, as amended (the Advisers Act), and related rules designed to prevent theft or loss of client assets.
  • Valuation.  NEP staff will review advisers’ valuation policies and procedures.

Investment advisers should note that access to any advisory books and records will also need to be provided upon request during a Presence Exam.  Prior to the examination phase, NEP staff will engage in a nationwide outreach to inform newly registered investment advisers about their obligations under the Advisers Act and related rules during the engagement phase.  At the conclusion of the examination phase, the NEP will report its observations to the SEC and the public.

The NEP is administered by the Office of Compliance Inspections and Examinations within the SEC.  The letter outlining the NEP’s initiative, available here, was distributed to certain executives and principals of newly registered investment advisers and posted on the SEC’s website.  NEP staff will contact advisers separately if their firm is selected for an examination, and receipt of the letter announcing the launch of the initiative does not ensure that a Presence Exam will necessarily follow.