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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