SEC Speaks: 2017 Enforcement and Exam Trends for Private Funds
At the recent SEC Speaks program, sponsored by PLI, senior SEC staff members provided valuable insight into the SEC’s 2017 priorities for private funds. While the tenor of this year’s discussion seemed to focus more on retail investors, the staff discussed several topics that private fund advisers should keep in mind from both an enforcement and exam standpoint.
The SEC’s Asset Management Unit (AMU) Co-Chief Dabney O’Riordan outlined several areas that the AMU will focus on this year. As a general matter, O’Riordan underscored that the structure of private funds can impair transparency for investors, which compounds risks in all of the areas that she discussed. In particular, she noted the following areas of focus for private funds:
Valuation: This is a perennial priority for the SEC staff, as we’ve noted in the past. Even in matters where the SEC does not challenge valuations per se, the staff tends to focus on structural issues around valuation, such as failure to follow firm policies and procedures or breakdowns in controls. For example, O’Riordan noted recent matters where registered advisers failed to follow appropriate procedures in valuing illiquid bonds or thinly-traded mortgage-backed securities. We also expect that the SEC will focus on valuation of shares in privately-held tech companies over the next year.
Undisclosed Fees: O’Riordan noted that the AMU is highly focused on failures to adequately disclose fees or compensation that directly or indirectly benefit an adviser. This focus is nothing new – fee and expense allocations are classic examples of a potential conflict of interest between the adviser and the fund.
Trade Allocation: O’Riordon noted that enforcement will look at trade allocation practices for private funds as well as retail client advisers. The AMU is looking for situations where favorable trades are allocated to accounts where an adviser receives higher fees – so-called “cherry-picking”— or allocated in a manner inconsistent with guidelines disclosed to clients.
Gatekeepers: O’Riordan also specifically mentioned gatekeepers – entities such as auditors, prime brokers, custodians, administrators and marketers that the SEC has stated perform critical roles for advisers and private funds. She indicated that when the SEC identifies a significant issue with an adviser or a fund, the AMU will evaluate whether the gatekeepers failed to perform their duties. For example, the SEC last year charged an accounting firm with conducting deficient surprise exams required under the custody rule.
Insider Trading: Joseph Sansone, Co-Chief of the Market Abuse Unit, stated that 78 different entities and individuals were charged with insider trading during 2016. He devoted much of his discussion to cyber fraud issues, such as unauthorized hacking, but noted that both cyber fraud and traditional insider trading cases are investigated using similar data analytics to track patterns of suspicious trading. As Sansone explained, by utilizing advanced data analytics, the staff is able to uncover patterns of trading among seemingly unafilliated traders, even where transactions are kept small to avoid detection.
It remains to be seen whether the incoming Commission will push the envelope further by pursuing new enforcement theories against private funds. Regardless of the number of cases, however, the staff is likely to continue its focus on these types of cases under traditional theories – undisclosed conflicts and violations of fiduciary duties.
The OCIE panel also highlighted three areas of focus from the SEC’s National Examination Program 2017 Examination Priorities announcement published on January 12, 2017:
Newly-Registered Advisers: The staff’s focus on never-before-examined registrants will be expanded to all newly-registered investment advisers.
Public Pension Advisers: The staff will focus on investment advisers to public pension plans and specifically how they: (i) manage conflicts of interest; (ii) adhere to fiduciary duties; (iii) comply with pay-to-play restrictions; and (iv) supervise the provision and receipt of gifts and entertainment.
Cybersecurity: OCIE will continue its focus on cybersecurity, with an emphasis on ensuring that investment advisers’ cybersecurity policies and procedures are both sufficient and being followed, and that investment advisers have conducted a cybersecurity “risk inventory.”
In addition, the staff noted that there are now more than 12,000 investment advisers registered with the SEC, including over 300 new registrants since the November elections. This trend demonstrates that the staff needs to continue to focus on higher level areas of concern, rather than taking a scattershot approach.
Jane Jarcho, OCIE’s Deputy Director, stated that the staff was looking to find the “sweet spot” in terms in balancing examination effectiveness with efforts to reach as many registrants as possible. As opposed to the routine cycle examinations of years past, the OCIE examination program is now more data-driven and risk-based. The panel noted that over 100 examiners have shifted from other areas of OCIE into the agency’s Investment Adviser / Investment Company (IA/IC) examination program, which now has over 600 staff members. OCIE conducted more than 2,400 exams in 2016, which represented a 7-year high and a 20% increase over 2015, and is already ahead of that pace for 2017. SEC examiners completed an average of 4.91 examinations during 2016 compared to 4.31 examinations in 2015 and 3.26 in 2014.
OCIE is also looking for additional ways to reach the registrant population; for example, using more risk alerts targeting specific areas of regulatory compliance. The staff specifically noted the recent risk alert discussing the five most frequent compliance deficiencies identified in adviser exams. For private fund advisers, this risk alert noted the SEC’s vigilance to inconsistencies between regulatory filings including Forms ADV, PF, and D, as well as concerns relating to the Compliance, Custody, Code of Ethics, and Books and Records Rules.