OCIE Private Fund Adviser Examinations Reveal Common Compliance Issues

Investment Management Update

Date: June 26, 2020

Key Notes:

  • The SEC’s Office of Compliance Inspections and Examinations released a Risk Alert highlighting common compliance issues observed during examinations of registered investment advisers of private funds.
  • OCIE focused on private fund adviser deficiencies with respect to conflicts of interest, fees and expenses, and misuse of material nonpublic information.

On June 23, the SEC’s Office of Compliance Inspections and Examinations (OCIE) released a Risk Alert that provides an overview of compliance issues it observed during recent examinations of registered investment advisers that manage private funds. OCIE noted that over 36% of registered investment advisers manage private funds and that some of the common deficiencies and compliance violations have resulted in increased fees and expenses for the underlying private fund investors. The Risk Alert focuses on three areas of private fund adviser deficiencies and compliance violations: conflicts of interest, fees and expenses, and misuse of material nonpublic information (MNPI).

Conflicts of Interest

Section 206 of the Investment Advisers Act of 1940 (Advisers Act) prohibits an investment adviser from employing any device, scheme or artifice to defraud any client or prospective client and from engaging in any transaction, practice or course of business that operates as a fraud or deceit upon any client or prospective client. Investment advisers must either eliminate or make full and fair disclosure of any conflicts to investors. Moreover, Rule 206(4)-8 under the Advisers Act prohibits an investment adviser from making any untrue statement or omission of material fact and from engaging in fraudulent, deceptive or manipulative practices.

OCIE observed that some private fund advisers did not provide adequate disclosure about conflicts relating to allocations of investments among funds, including instances of more favorable allocations being made to funds with larger and higher fee-paying investors. OCIE also reported instances in which private fund advisers failed to provide adequate disclosure about certain economic or other relationships between the adviser and select investors, including relationships with seed investors and more favorable terms to certain investors through side letter agreements. In addition, OCIE noted instances in which private fund advisers failed to provide adequate disclosure regarding conflicts of interest with respect to service providers or investment opportunities in which the adviser or its affiliates had financial interests.

A private fund adviser has a responsibility to establish policies and procedures to limit or eliminate conflicts of interests, and in the event a conflict cannot be eliminated, the adviser must provide full and fair disclosure of the conflict to afford investors the opportunity to understand the risks and make an informed decision regarding whether to invest in the private fund.

Fees and Expenses

OCIE observed instances in which private fund advisers were improperly allocating fees and expenses among various entities, including the private fund, such as instances in which adviser employees’ salaries were charged to the fund, in violation of the terms of the governing documents. OCIE also described instances in which private fund advisers failed to provide adequate disclosure regarding expenses associated with the fund’s service providers. Additionally, OCIE reported instances in which private fund advisers had issues with respect to the receipt of fees from portfolio companies (including improper calculation of management fee offset), which resulted in investors overpaying management fees.

Misuse of MNPI

Rule 204A under 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, including through the adoption of a code of ethics. OCIE noted instances in which private fund advisers lacked or had insufficient policies and procedures, including policies that failed to address the adviser’s interactions with “network experts” or publicly traded company insiders. OCIE also observed instances in which private fund advisers failed to establish, maintain and enforce provisions in their codes of ethics reasonably designed to prevent the misuse of MNPI, such as instances in which advisers did not have policies regarding a “restricted list” of securities, instances in which they failed to enforce policies related to gifts and entertainment, and instances in which they failed to track or enforce preclearance of certain securities with respect to personal securities transactions.

In light of OCIE’s observations, private fund advisers should consider reviewing and enhancing their compliance programs to ensure conformity and compliance with applicable regulations to avoid actions, including no-comment letters, deficiency letters and potential enforcement actions.

FOR MORE INFORMATION

For more information, please contact:

Andrew J. Davalla
614.469.3353
Andrew.Davalla@ThompsonHine.com

Ryan Wheeler
513.352.6693
Ryan.Wheeler@ThompsonHine.com

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