Private funds should be prepared for increased oversight from
the Securities and Exchange Commission (SEC), following a landmark
year of enforcement cases. In 2021, the Commission brought 159
enforcement actions against registered investment advisors or
investment companies, amounting to 23 percent of the total agency
cases.1 Indeed, the SEC brought more
enforcement actions against registered investment advisors and
companies than any other class of registrant last year. We
expect-and have already seen-the SEC continue to be active in its
enforcement against private funds this year.
Priorities Set by SEC Chair Gensler in the Private Funds
Space
Chair Gary Gensler addressed the SEC’s priorities in the
private funds space during remarks that he made last November
during the Institutional Limited Partners Association Summit.2 In his
remarks, Chair Gensler ran through a laundry list of specific focus
areas that he has identified in the private funds industry. While
Chair Gensler framed his comments as a discussion “about
policies around market structure,” the SEC’s Division of
Enforcement is likely to follow his lead. His remarks therefore can
be viewed as a roadmap to the SEC’s developing enforcement
priorities in the private funds space.
- Fees and Expenses: As previously reported, Chair
Gensler questioned “whether fund investors have enough
transparency” with respect to the multiple levels of fees
charged by private fund managers, such as management fees,
performance fees and in the private equity space, portfolio company
fees. He set the goal of promoting “additional transparency
around fees and expenses to fund investors.” - Fiduciary Duties and Conflicts of Interest:
Chair Gensler expressed concerns about efforts by fund managers to
seek waivers of their state level fiduciary duties to investors. He
stressed that, in addition to state law duties, “[a]n
investment adviser to a private fund has a federal fiduciary duty
to the fund enforceable under the Advisers Act” and
“[t]his federal fiduciary duty may not be waived.” He
also has directed the Commission’s staff to examine “how
we can better mitigate conflicts of interest between general
partners, their affiliates, and investors” and suggested that
this “could include considering the need for prohibitions on
certain conflicts and practices.” - Performance Metrics: Chair Gensler also tasked
the Commission’s staff with examining how to enhance
transparency to private fund investors around performance metrics.
In doing so he acknowledged, but did not weigh in on, the
“debate about whether private equity outperforms the public
markets net of fees, or taking into account leverage and
liquidity.” - Side Letters: Chair Gensler expressed concerns
about side letters that give certain private fund investors, but
not others, preferred liquidity terms or disclosures. He stated
that the SEC is examining how it can “strengthen
transparency” to investors regarding side letters and
“whether certain side letter provisions should not be
permitted.” - Form PF: Chair Gensler emphasized the
importance of Form PF, the means by which the SEC gathers
information about hedge funds and private equity funds for the
purpose of assessing market risk. He described Form PF as
“critical to the Commission’s oversight of private fund
advisers” and previewed his agenda of amending Form PF to
require the reporting of “more granular or timelier”
information.3
Since Chair Gensler’s remarks only a few months ago, the
SEC’s Division of Enforcement has already brought actions
against investment advisers touching on several of these areas. In
this alert, we review some of these enforcement actions and provide
recommendations on what private fund managers can do to mitigate
their regulatory risk going forward.
Fees and Expenses
SEC v. Glob. Infrastructure Mgmt., LLC
On December 20, 2021, the SEC announced a $4.5 million
settlement with a private equity fund manager for false and
misleading statements to investors concerning fee offsets.4
According to the SEC, the firm failed to offset certain portfolio
company fees against management fees charged to clients, as it was
required to do under its offering and governing documents.
Provisions of the firm’s limited partnership agreements and
private placement memoranda also inconsistently described the
methodology used to calculate management fees for investors. In
addition, the firm failed to adequately implement policies and
procedures to ensure proper accounting of fees and expenses. As a
result, investors overpaid the firm millions of dollars.
The SEC charged the manager with negligence based violations of
the antifraud provisions and failing to adopt reasonable policies
and procedures under Sections 206(2) and 206(4) of the Investment
Advisers Act of 1940 and Rules 206(4)-7 and 206(4)-8. Without
admitting or denying the findings, the adviser agreed to pay a $4.5
million penalty to settle the SEC charges and voluntarily repaid
$5.4 million to affected investors.
This case demonstrates the ongoing importance of private fund
managers having strong policies and procedures to ensure that fees
and expenses are being calculated and applied in a manner that is
consistent with the language of governing fund documents.
Conflicts of Interest and Waivers of Fiduciary Duties
SEC v. Comprehensive Cap. Mgmt., Inc.
On January 11, 2022, the SEC announced settled charges against a
registered investment adviser that primarily served retail clients,
alleging two separate sets of violations.5
First, the SEC found that, from 2017 through March 2021, the
adviser falsely stated that it would mitigate conflicts of interest
related to its use of an affiliated broker-dealer by ensuring that
its clients would not bear the cost of any related brokerage
commissions. As a result of these misleading disclosures, the
adviser improperly charged 11 clients a total of $66,635.
Second, the firm’s advisory agreements included liability
disclaimer language, characterized as a “hedge clause,”
which the SEC found to be misleading. While the language of the
hedge clause was modified over time, the final version cited in the
SEC order read as follows:
[Adviser] and its [representatives] will be liable only for
their own acts of gross negligence or willful misconduct.
[Adviser] and its [representatives] will not be liable for any act
or omission, or the failure or inability to perform any obligation,
of any broker, dealer, investment adviser, sub-custodian or other
agent, including affiliates, whom [Adviser] selected with
reasonable care. [Adviser] will not be liable for any incidental,
indirect, special, punitive or consequential damages. Federal and
state securities laws may nonetheless impose liability on persons
who act in good faith and nothing in this Agreement shall serve to
waive or limit any rights Client may have under those laws.6
The SEC took the position that the hedge clause inaccurately
purported to relieve the adviser from liability for conduct for
which its clients had a non-waivable cause of action under federal
law. In particular, the SEC took issue with the language stating
that the adviser would be liable only for its “own acts of
gross negligence or willful misconduct.” The SEC found that
this was an inaccurate statement of the liability standards under
the federal securities laws as they apply to investment advisers.
The SEC found the language was misleading even though the final
sentence of the clause acknowledged that “[f]ederal and state
securities laws may nonetheless impose liability on persons who act
in good faith and nothing in this Agreement shall serve to waive or
limit any rights Client may have under those laws.”
The primary concern of the SEC appears to center on a belief
that the language could mislead unsophisticated clients into
foregoing the exercise of their legal rights. The SEC placed
particular emphasis on the fact that “[m]ost, if not all, of
the [adviser’s] clients” were retail investors. The SEC
also criticized the adviser for failing to have “policies and
procedures to assess a client’s sophistication in the law or to
explain the meaning of the non-waiver disclosure.” As support
for this position, the order also cited the June 5, 2019,
“Commission Interpretation Regarding Standard of Conduct for
Investment Advisers,” which states that “there are few
(if any) circumstances in which a hedge clause in an agreement with
a retail client would be consistent with [] antifraud
provisions[.]”
The SEC charged the adviser with negligence based violations of
the antifraud provisions, as well as violations of the policies and
procedures and recordkeeping provisions, under Sections 204(a),
206(2) and 206(4) of the Advisers Act, along with Rules 204-2 and
206(4)-7. Without admitting or denying the findings, the adviser
agreed to pay to affected investors disgorgement and prejudgment
interest totaling $75,654.
This case shows that, in line with Chair Gensler’s comments,
the SEC’s Enforcement Division is willing to scrutinize hedge
clauses and similar fiduciary duty modifications, particularly when
those clauses may impact retail investors. The case also highlights
the risks associated with failures to identify and appropriately
address conflicts of interest, regardless of whether the dollar
amounts involved may be relatively small.
Performance Metrics and Marketing Materials
SEC v. CMG Cap. Mgmt. Grp., Inc.
On January 13, 2022, the SEC announced settled charges against a
quantitative fund manager for failing to adopt and implement
reasonable policies and procedures concerning its client
advertisements.7In particular, between April 2017 and July
2018, the adviser advertised hypothetical, backtested performance
results without disclosing certain dissimilarities between the
backtest and the live versions of the strategy. For instance, the
adviser did not disclose that the backtest and live strategy
utilized different securities when constructing a model portfolio.
The adviser also failed to preserve the advertisements as required
by the recordkeeping rules.
The SEC charged the adviser with failing to have reasonably
designed policies and procedures and violations of the
recordkeeping rules under Sections 204(a) and 206(4) of the
Advisers Act and Rules 204-2(a)(11) and 206(4)-7 thereunder.
Without admitting or denying the findings, the adviser agreed to
pay a civil penalty of $70,000. The settled order did not contain
any findings of violations of the antifraud provisions of the
Advisers Act.
This case shows the importance of funds maintaining strong
policies and procedures regarding the reporting of performance
metrics in marketing materials. In particular, private fund
managers should ensure that disclosures are fulsome enough to avoid
allegations that they have omitted facts, which could be material
to an investor’s ability to assess fund metrics. While this
case involved hypothetical performance, it holds similar lessons
for advisers preparing marketing materials or other similar
investor facing documents, which contain track records or other
performance metrics.
Key Takeaways
We expect the SEC’s Division of Enforcement to continue to
step up its efforts to police the private funds industry throughout
2022, with a focus on what Chair Gensler chose to highlight in his
remarks this past fall. Accordingly, private fund managers should
consider taking the following steps:
- Review practices regarding the calculation and allocation of
fees and expenses and ensure consistency with the language in the
firm’s governing documents. Consider whether disclosures
sufficiently address multilayered fees and expenses, such as
portfolio company fees. - Assess the language of hedge clauses and exculpation
provisions, especially if clients include retail investors. - Assess potential conflicts of interest between investment
advisers and other fund entities and key firm personnel. Consider
whether additional procedures are needed to identify potential
conflicts and whether applicable disclosures should be
revised. - Review policies, procedures and practices regarding the
preparation of marketing materials and other investor disclosure
documents that contain hypothetical or actual fund performance
metrics. - Assess disclosures and practices regarding side letters. While
we have not yet identified a recent enforcement action on this
topic, Chair Gensler’s comments suggest this is an area where
there may be heightened enforcement going forward. - Review internal policies, procedures, and practices to ensure
proper and timely Form PF filings. While Chair Gensler’s
remarks on this topic focused on his rulemaking agenda, the SEC has
a history of conducting enforcement “sweeps” involving
coordinated actions against private fund managers with delinquent
Form PF filings.8
Under Chair Gensler’s leadership, the SEC has taken on an
ambitious agenda for 2022, which includes increased regulation of
the private funds industry. The Division of Enforcement will play
an important role in implementing that agenda by stepping up its
efforts to investigate potential misconduct involving private
funds, particularly within the focus areas that Chair Gensler has
staked out in his public remarks. The Division of Examinations can
be expected to follow a similar agenda in close collaboration with
their colleagues in Enforcement. This of course means increased
regulatory risk for private fund managers. However, managers can
effectively mitigate that risk by being attentive to the SEC’s
agenda and taking proactive compliance measures, especially in the
areas where the SEC has expressed concerns.
Footnotes
1. See Kenneth Corbin, Investment
Advisors Are Most Targeted by SEC Enforcement in 2021,
Barron’s (Nov. 22, 2021), https://www.barrons.com/advisor/articles/investment-advisors-sec-enforcement-2021-51637587930.
2. Chair Gary Gensler, SEC, Prepared Remarks
At the Institutional Limited Partners Association Summit (Nov. 10,
2021), https://www.sec.gov/news/speech/gensler-ilpa-20211110.
3. The SEC voted to propose amendments to Form
PF on January 26, 2022. SEC Press Release 2022-9, SEC Proposes
Amendments to Enhance Private Fund Reporting (Jan. 26, 2022),
https://www.sec.gov/news/press-release/2022-9.
The vote triggers a public notice and comment period on the
proposed amendments.
4. Global Infrastructure Mgmt., LLC,
Release No. 5930, File No. 3-20683 (SEC Dec. 20, 2021), https://www.sec.gov/litigation/admin/2021/ia-5930.pdf.
5. Comprehensive Cap. Mgmt., Inc.,
Release No. 5943, File No. 3-20700 (SEC Jan. 11, 2022), https://www.sec.gov/litigation/admin/2022/ia-5943.pdf.
6. Id. at ¶ 13 (emphasis
added).
7. CMG Cap. Mgmt. Grp., Inc., Release
No. 5945, File No. 3-20702 (SEC Jan. 13, 2022), https://www.sec.gov/litigation/admin/2022/ia-5945.pdf.
8. See SEC Press Release 2018-100,
SEC Charges 13 Private Fund Advisers for Repeated Filing
Failures (June 1, 2018), https://www.sec.gov/news/press-release/2018-100.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
