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Tuesday, July 28, 2020

SEC - June/July Guidance on Cybersecurity, Private Funds, and new EERT Team

By Cory Roberson, Principal of FIN Compliance, Lancer, Ventures
By David McNeal, Contributor of My Compliance Blog 




















June/July Updates on SEC Risk Alerts

Emerging Risks Examination Team (EERT) 

July 28, 2020. The Securities and Exchange Commission announced the creation of the Event and Emerging Risks Examination Team (EERT) within the Office of Compliance Inspections and Examinations (OCIE).  The EERT will be responsible for engaging with financial firms about emerging threats and current market events. 

Cybersecurity Alert

July 10, 2020.  OCIE Risk Alert on Cybersecurity -  Ransomware Attacks - See here 

Private Fund Guidance

June 23, 2020.  The Office of Compliance Inspections and Examinations (OCIE) issued a risk alert in its review of investment advisory firms who manage private funds. In its findings, the commission concluded that many advisory firms failed to address these common compliance issues:         

Providing Disclosures of Conflicts: Many private fund advisors failed to disclose Conflicts of Interest that can cause private fund investors to pay more fees and expenses than they would otherwise.  Investors were also kept in the dark about these conflicts with the fund advisor and its underlying investment allocations.

Allocation of Investments Disclosures: Advisors provided insufficient disclosures to explain the differences relating to Investment Allocations between clients, including its largest fund managers, private funds invested alongside flagship funds in the same portfolios, sub-advised mutual funds, collateralized loan obligation funds, and separately managed accounts. Notably, advisors failed to implement transactions in a manner that was consistent with the allocation process reported to investors, and in return, this caused many investors to pay more fees while receiving less than their fair share of the investment.  In addition, many fund advisors who assigned securities at different rates or in seemingly inequitable amounts to clients failed to provide a clear notice of this allocation to investors.  

Multiple clients investing in the same portfolio company: Many advisors failed to divulge conflicts caused by clients investing at different capital structures, such as one debt-holding client and another equity-holding in a single portfolio company.

Financial relationships between (investors or clients) and the adviser: The Advisers Act imposes a fiduciary obligation on investment advisors, which requires both a duty of care and a duty of loyalty. Too frequently, private fund advisors disclosed inadequate documentation of economic relationships between themselves and/or select investors or clients.  In certain situations, investors served as initial backers in the private funds of the advisors.  In other cases, preferred investors provided credit facilities, additional funding to the planner or the advisor's other private fund clients. 

Preferential liquidity rights: Private fund advisors, who enter into agreements with selected investors for special conditions, such as preferential liquidity conditions, must document these stipulations in-side letters.  Likewise, private fund advisors, who set up unrevealed side-by-side vehicles or separately managed accounts (SMAs) that invested alongside the flagship fund, must disclose preferred liquidity terms.  Many conflicts were presented given the involvement of private fund investors in these suggested investments.  Advisors may provide investment interests to clients but some failed to document these conflicts in a timely manner.

Undocumented contractual obligations, disputes and benefits:  Contractual disputes between Service providers and private fund consultants often go undocumented.  In another example, portfolio firms owned by private fund clients of advisors entered into service agreements with organizations operated by the company, its associates, or the family members of the principals without reporting the conflicts correctly.
Private fund advisors, who offer financial benefits for portfolio companies to use other service providers, such as bonus payments from discount schemes, should report rewards and conflicts to investors accurately.  Many private fund contractors failed to document the processes to ensure that their reports related to affiliated service providers are followed.

In some cases, advisors represented to clients that services offered by affiliates to private funds or portfolio companies would be provided with more favorable terms than that which could be received from non-affiliated third parties.  However, the affiliates and advisors lacked procedures to determine whether comparable services could be obtained from an unaffiliated third party on better terms (including at a lower cost).

Advisers must detail the restructuring of funds in interactions with investors.  In some cases, advisers allowed future investor interest buyers to consent to a stapled secondary deal or to provide the contractor with other economic benefits without providing investors with adequate notice of the deal. Through restructuring, the seller must also provide current investors the opportunity to sell their interests or to turn their investments into a new, restructured private fund.

Cross-transactions: Private fund advisors were inadequately reporting conflicts relating to purchases and sales between customers (or thru “cross-transactions”).  For example, consultants set the price at which securities can be exchanged between client accounts in a manner that is unfavorable to either the selling or buying party, often without offering enough notice to its clients.  As a result, advisors of private funds may wrongly distribute payments and expenditures.  

Fees and Expenses: Advisors are prohibited from combining the acquisition of a private fund portfolio with the purchaser's commitment to contribute money to the consultant's potential private fund.  In OCIE findings, advisers charged private fund clients for disallowed expenses in the relevant fund operating agreements. These included advisor expenses such as staff salaries, compliance, regulatory filings, and office expenses, resulting in investor overpayment.
In other cases, advisers refused to comply with statutory limitations on such costs that can be paid to investors, such as legal fees or investment advisor fees, thus causing investors to overpay.  In addition, advisers exceeded their travel and entertainment spending plans, possibly resulting in investors overpaying for these expenditures.

Allocation of fees and expenses: Advisors failed to include notices of the position and compensation of individuals (other than consultants and employees) who might provide services to a private fund or portfolio companies.  These activities can potentially require investors into bearing the costs associated with the assistance of these operating partners'.

Valuation: Private fund advisors devalued client assets per their valuation processes or disclosures to clients.  In actuality, many of its management charges focused on unfairly overvalued securities.  In some cases, this inability to value an individual fund's assets in compliance with the valuation process contributed to overcharges of management fees and interest.  

Operating Partners: Private fund advisors disclosed payments received from portfolio firms, such as reporting payments, board fees, or fees. With that said, some advisors wrongly assigned portfolio company fees to fund customers, including private fund customers who forgot to pay management fees. Advisors often charged the portfolio company fees paid to the consultant's partner, which had to be offset against the management fees.

Monitoring / board / deal fees and fee offsets: Advisers reported management fees but overlooked the requirement for policies and procedures to track receipt of portfolio company fees, including compensation that their operating professionals received from portfolio companies.  In some cases, advisers signed long-term monitoring arrangements with portfolio companies. Afterward, they increased the associated monitoring fees on the selling of the portfolio business, without the required disclosure of the arrangement to investors.

Material Non-Public Information (MNPI) / Code of Ethics: Section 204-A of the Advisers Act requires investment advisors to develop, maintain, and implement written policies and procedures that are adequately intended to avoid the misuse of MNPI by the advisor or any of its associates. Rule 204 A-1 requires a licensed investment advisor to adopt and maintain a Code of Ethics, which must set standards of conduct expected of employees and resolve disputes resulting from an advisors' trading activities.

Private fund advisors often failed to develop, maintain, and implement written policies and procedures adequately designed to prevent the misuse of MNPI as required by Section 204-A. Advisers must discuss the threats raised by their employees who acquired MNPI through their ability to access the portfolio company's office space or facilities or its associates.   Advisers must discuss the risks raised by their employees who regularly had access to MNPI for public securities issuers, for example, in connection with private investment in public equity (PIPE).

Code of Ethics Rule: Private fund advisors failed to create, implement, and enforce provisions in their Code of Ethics that addressed the use of MNPI.  Advisers breach compliance with their Code of Ethics requirements in: (1) the receipt of gifts and entertainment from third parties and (2) in not prompting its “authorized persons” employees to send transactions and holdings reports, (3) failure to submit other specific securities transactions for pre-clearance as needed by their policies or the Code of Ethics Laws, and lastly, (4) advisers inaccurately classified "authorized persons" under their Code of Ethics while examining transactions of personal securities. In response to these findings, several advisors changed their procedures to resolve the conflicts found within it private fund advisory firms.

Conclusion: Advisors need to review their business activities and written policies and procedures (including the execution of such policies and procedures) to resolve the issues addressed in this risk warning.

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Our product line consists of:  RIA Consults-Roberson Consults Group, a compliance consulting firm, RIA Review, a compliance-management system, B-D Review, a Hybrid-management system (est. in 2020)*, and FIN Lancer, a Business/Task Management system. 

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