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Private Equity Beware: Securities Exchange Commission (SEC) Official Predicts Increased Scrutiny, Enforcement Action in 2013

In late January, the SEC published remarks from a high-ranking SEC official that included projections that the private equity industry would see more scrutiny and enforcement in 2013. “It’s not unreasonable to think that the number of [enforcement] cases involving private equity will increase,” said Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit.* In his comments, Karpati rooted his prediction in private equity’s “significant growth spurt” preceding the financial crisis, the substantial increase in assets under management, and the fact that only recently have many private equity managers become registered investment advisers.

VALUATION & CONFLICTS OF INTEREST IN CROSSHAIRS

The misconduct that the SEC is most likely to target falls under two broad categories: valuation and conflicts of interest, according to Karpati.

As to valuation, Karpati described one form of manager misconduct that occurs when assets are “written up” during a fund raising period, only to be immediately written down after the fund raising period closes.

Karpati further identified the following common conflicts of interest that require control and disclosure:

  • Conflicts between the profitability of the private equity management firm and the best interests of investors, particularly where the firm is publicly traded;
  • Conflicts that arise when expenses are shifted from the management firm to the funds;
  • Conflicts that arise in charging additional fees to the portfolio companies where allowable fees are poorly defined in the partnership agreement;
  • Conflicts relating to the challenges of managing different clients, different investors and different products “under the same umbrella …,” with the potential that “preferred clients” will be favored at the expense of others;
  • Conflicts generated by a manager’s other business interests, including the possibility of diverting investment opportunities.

COOS/CFOS ‘CRITICAL’ IN MEETING FIDUCIARY DUTIES

Karpati deemed the roles of chief operating officer and chief financial officer “critical” in ensuring a firm satisfies its fiduciary duties to clients. This is true due to the unique, broad perspective they enjoy in running the business of the manager.

Karpati specified a number of “best practices” that private equity firms should consider:

  • Compliance risk explicitly should be integrated in overall, enterprise risk management;
  • COOs, CFOs and compliance personnel should proactively identify and resolve practices giving rise to conflicts of interest;
  • Firms should implement a set of compliance procedures appropriate for the particular business model in place;
  • COOs and CFOs should act as investor advocates, and be sufficiently empowered in the firm by, for example, securing membership on important, decision-making firm committees.

Karpati concluded his remarks by encouraging collaboration with legal and compliance resources whenever potential conflict of interest issues are identified.

Note:  The Asset Management Unit is one of five specialized units within the SEC’s Division of Enforcement, each designed to address specific areas of the financial markets. The other units are the Market Abuse Unit, the Structured and New Products Unit, the Foreign Corrupt Practices Act Unit, and the Municipal Securities and Public Pension Unit.

© 2014 Neal, Gerber & Eisenberg LLP.

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About this Author

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Mark Carberry is a veteran financial services legal and compliance professional whose industry-rich background provides financial services entities and employees with a powerful legal resource to help them craft creative solutions and workable policies and procedures to further business strategies and growth. Mark represents his clients in a slate of civil, regulatory and enforcement matters in actions across the country.

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