Recent OCIE Risk Alert Demonstrates SEC’s Continued Focus on Private Fund Advisers

The staff (the “Staff”) of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (“OCIE”) recently issued a Risk Alert focused on certain key compliance issues for registered investment advisers that manage private equity funds or hedge funds (collectively, “private fund advisers”). OCIE’s Risk Alert highlights certain common deficiencies the Staff has observed, and its publication demonstrates the Staff’s continued focus on regulating private fund advisers. For purposes of this Cannabis Business Advisory blog, private fund advisers and investors alike in the cannabis space are advised to carefully take note of this Risk Alert, especially given the already enhanced scrutiny of the industry.

The Staff emphasizes three general areas of deficiencies OCIE has identified in examinations of private fund advisers: (1) inadequate disclosure of conflicts of interest, (2) inaccurate allocations and disclosures of fees and expenses, and (3) failure to properly maintain, establish and enforce policies and procedures relating to material non-public information (“MNPI”).

Conflicts of Interest Disclosures

The Staff underscores the antifraud provisions in Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”).  In particular, the Staff cautions advisers who are subject to these antifraud provisions to eliminate or otherwise make “full and fair disclosure” of all conflicts of interest that could possibly incentivize the investment adviser (even unconsciously) to render advice which is not disinterested. Further, the disclosures must be sufficiently specific to ensure that investors are able to make an informed decision whether or not to consent.

Further, the Staff reminds private fund advisers of their obligations pursuant to Rule 206(4)-8 of the Advisers Act, which “prohibits investment advisers to pooled investment vehicles from (1) making any untrue statement of a material fact or omitting to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or (2) otherwise engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.”

Specifically, the Staff flags specific conflicts of interest that it has consistently observed to be inadequately disclosed and deficient, including:

  • Conflicts related to allocations of investments, such as preferential allocations to favored investors, disparate pricing of securities, or inequitable amounts among investors, all either contrary to disclosures or where the disclosures were silent.
  • Conflicts related to multiple clients investing in the same portfolio company, but at different levels of the capital structure. For example, one client owning debt, and the other owning equity.
  • Conflicts related to financial relationships between investors or clients and the adviser where there was inadequate disclosure about the economic relationships between themselves and select investors or clients.
  • Conflicts related to preferential liquidity rights, such as private fund advisers entering into side letter agreements with select investors, separately managed accounts or establishing side-by-side vehicles that offered special terms, including preferential liquidity terms, yet failing to provide adequate disclosure about these preferential terms.
  • Conflicts related to private fund adviser interests in recommended investments, such as pre-existing ownership interests or other financial interests, including referral fees or stock options in the investments.
  • Conflicts related to co-investments, including disparately favoring and/or selectively providing co-investment opportunities to certain investors and not others.
  • Conflicts related to service providers, such as failing to disclose that an affiliated service provider is also engaged by a portfolio company, as well as failing to disclose financial incentives for the investment adviser to use certain service providers.
  • Conflicts related to fund restructurings, including inadequate disclosure to investors of the value of their interests, their rights and options during a restructuring, and the financial incentives of advisers in “stapled secondary transactions.”
  • Conflicts related to cross-transactions, such as inadequate disclosures surrounding cross-transactions executed to the benefit of either the selling or purchasing account but to the detriment of the other.

Fees and Expenses

The Staff identified the following fee and expense issues that it observed to be deficient under Section 206 or Rule 206(4)-8:

  • Allocation of fees and expenses. Inaccurate allocation of fees and expenses in a manner that was inconsistent with disclosures to investors or policies and procedures, which resulted in certain investors overpaying expenses.
  • “Operating partners.” Inadequate disclosures involving the role and compensation of individuals providing services to the private fund or portfolio companies, but are not adviser employees (i.e., “operating partners”).
  • Valuation. Failure to properly value client assets in accordance with their valuation processes or in accordance with disclosures to clients (such as that the assets would be valued in accordance with GAAP).
  • Monitoring/board/deal fees and fee offsets. Issues involving the receipt of fees from portfolio companies, such as monitoring fees, board fees, or deal fees. For example, advisers (1) failed to apply or calculate management fee offsets in accordance with disclosures, which caused investors to overpay management fees; (2) disclosed management fee offsets, but lacked adequate policies and procedures for tracking the receipt of portfolio company fees, which potentially caused investors to overpay management fees; and (3) failed to adequately disclose to investors long-term monitoring agreements with adviser-controlled portfolio companies (e.g., acceleration of the related monitoring fees upon the sale of the portfolio company).

Material Non-Public Information / Code of Ethics

  • Section 204A. As highlighted by the Staff, Section 204A of the Advisers Act requires investment advisers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI by the adviser or any of its associated persons. The Staff observed private fund advisers that failed to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI as required by Section 204A.
  • Code of Ethics Rule. As the Staff further noted in the Risk Alert, Advisers Act Rule 204A-1 requires registered investment advisers to adopt and maintain a code of ethics, which must set forth standards of conduct expected of advisory personnel and address conflicts that arise from personal trading by advisory personnel. The Staff observed private fund advisers that failed to establish, maintain, and enforce provisions in their code of ethics reasonably designed to prevent the misuse of MNPI. For example, the Staff observed advisers who failed to adequately: (i) enforce the adviser’s trading restrictions on securities that had been placed its “restricted list” or have defined policies and procedures for adding or removing securities from the list; (ii) enforce the adviser’s code of ethics requirements relating to gifts and entertainment from third parties; and (iii) require access persons to timely submit a personal transaction and holdings reports, or submit transactions for preclearance as required by their policies or Rule 204A-1 and their own code, and/or failed to identify all access persons.

Final Thoughts for Private Fund Advisers

As the Staff notes in the Risk Alert, OCIE examinations of private fund advisers have resulted in a range of actions, including no-comment letters, deficiency letters, and, where appropriate, referrals to the Division of Enforcement. The Staff further notes that in response to these observations, many advisers, therefore, modified their practices to address the issues identified by Staff.  Private fund advisers should take this opportunity to assess their supervisory, compliance, and/or other risk management systems related to these risks.  In particular, advisers should carefully review their internal practices, policies, and procedures, as well as their disclosure documents, to determine whether they need to address any concerns identified in the Risk Alert.  To the extent a private fund adviser identifies corrective action is necessary, the adviser is well-advised to make those necessary updates in light of the Staff’s guidance in the Risk Alert.