As we discussed in our recent post “What to Expect from the SEC Under the Biden Administration,” market participants can expect a more vigorous SEC enforcement program under the new administration. President Biden’s nominee to chair the SEC, Gary Gensler, was known as a tough enforcer while serving as chairman of the CFTC during the financial crisis. If confirmed as SEC Chairman by the Senate, Mr. Gensler is sure to bring an assertive approach to SEC enforcement.
Investment advisers and fund managers would be wise to prepare for heightened regulatory scrutiny of their sectors in particular. In the recent past, the SEC relied heavily on deficiency letters from exam staff and remedial responses to those deficiency letters, sometimes in lieu of enforcement action. Meanwhile, the SEC Division of Enforcement was focused on then-Chairman Clayton’s priority of policing retail investor fraud, potentially diverting enforcement resources away from the investment advisory community. Now, however, increased emphasis on enforcement actions in the investment adviser realm seems almost certain.
The following are likely to be areas of inquiry in the coming years:
- Valuations of client assets. Valuation of assets is a perennial concern for the SEC, and that is unlikely to change. The SEC has focused in particular on the failure to follow valuation processes that are disclosed to investors. One sure way for firms to make themselves vulnerable is by failing to comply with their own procedures. Thus, it is important to review valuation processes to ensure that they are being followed and applied consistently from period to period. If a change in valuation methods and processes occurs, the change and the reasons for the change should be documented thoroughly.
- Disclosures of conflicts and potential conflicts of interest. Conflicts of interest must be disclosed fully and fairly. In this vein, it is important not to downplay an existing conflict by treating it as a potential one. Here is one trap for the unwary: the SEC has displayed a fascination with disclosures that make use of the word “may.” In light of this regulatory preoccupation, it is unwise to disclose that a conflict “may” arise rather disclosing that one actually exists. Also notable is the SEC’s continued scrutiny of revenue-sharing arrangements with third parties and the quality of associated disclosures (or the lack thereof). We expect this trend to not only continue, but expand into questions about whether conflicts associated with revenue-sharing arrangements – even if adequately disclosed – could have been mitigated more fully.
- Transparency about fees and expenses. It is important that fund advisers fully disclose and obtain client consent regarding costs of services to be charged to the client. Furthermore, advisers should take care to properly allocate expenses related to co-investments, funds and clients that have overlapping investments and investment strategies, and not have one client or set of clients shoulder more than their fair share. And advisers should carefully document and disclose performance fees and how they are calculated. Failure to follow these principles could lead to enforcement action.
- This is another area of concern that is unlikely to go away anytime soon. Firms should maintain appropriate controls concerning private information, implement and follow procedures reasonably designed to protect customer data against tactics such as credential compromise, and guard against cyber threats that exploit lax internal controls. We note that the SEC has issued a risk alert on common deficiencies in this area and has contacted firms that have known breaches.
- Issues pertaining to funds focused on ESG criteria. Environmental, social, and governance investing has increased in popularity. Private fund managers must implement and follow appropriate policies and procedures surrounding ESG. Part of the job for fund managers is deciding which ESG factors to consider, and how much weight to give them. Is climate change most important? How does one weight it against other considerations, such as diversity and inclusion? Must the fund manager take into account evolving science and social standards? As with other areas, it is critical to document these considerations and follow the firm’s own policies.
- General Solicitation – Private fund managers – especially in private equity and venture capital – often maintain websites discussing their funds’ portfolio companies. We have recently observed the SEC suggesting that simply listing existing portfolio companies on a public website , even a website that has no discussion of a fund offering, could constitute “general solicitation” compromising the private funds’ reliance on registration exemptions. This is not a position that we had seen expressed previously. Ultimately, there are persuasive legal arguments to support private equity and venture capital funds listing their portfolio companies on public websites. But private fund managers would be wise to review their websites to address any weaknesses that could complicate the legal arguments, such as references to fund offerings.
These are just a handful of the issues expected to draw SEC attention. Now is the time to revisit compliance policies and procedures – not only to help ensure compliance with the securities laws, but to provide a bulwark against enforcement action if a violation does occur. Firms that can point to robust compliance systems and processes will be better positioned to negotiate favorable resolutions – or combat potential charges – than those with lax or superficial compliance programs.
 The exam staff was previously known as the Office of Compliance Inspections and Examinations, or “OCIE.” It has recently been rechristened the Division of Examinations. The Division of Examinations recently issued its 2021 Examination Priorities alert, available at https://www.sec.gov/files/2021-exam-priorities.pdf.