On September 17, 2020, the SEC announced the imposition of a cease-and-desist order against private equity firm Welsh, Carson, Anderson & Stowe (Welsh Carson), an SEC-registered investment manager, in connection with alleged violations of reporting obligations under Section 13(d) of the Securities Exchange Act of 1934 (Exchange Act). The SEC alleged that Welsh Carson had failed to timely amend a Schedule 13D report – commonly known as a beneficial ownership statement – after its investment position changed from an intent to acquire and restructure a company to an intent to liquidate its entire position in the company. In connection with the entry of the SEC’s cease-and-desist order, Welsh Carson agreed to pay a civil penalty of $100,000.
An SEC administrative law judge recently rejected some of the SEC’s fraud charges against hedge fund manager RD Legal Capital, LLC and its owner Roni Dersovitz (“Respondents”) by finding that the SEC did not prove that Respondents made certain material misrepresentations and failed to establish that other alleged material misrepresentations were made with scienter. In the Matter of RD Legal Capital, LLC, and Roni Dersovitz, File No. 3-17342, Initial Decision (Oct. 15, 2018). While ALJ Jason S. Patil did conclude that Respondents were liable for negligence-based fraud violations, his rulings with respect to the scienter-based charges and the drastically-reduced penalties he ordered were largely a defeat for the SEC.
In July 2016, the SEC instituted proceedings alleging, among other things, that Respondents defrauded investors by misrepresenting the types of legal receivables in which two funds managed by RD Legal Capital invested. Id. at 2. In particular, the SEC alleged that Respondents violated the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 by representing that the legal receivables invested in by two of their hedge funds all arose out of binding settlement agreements or judgments and therefore posed no litigation risk, when in fact four categories of legal receivable investments “involved matters that had not settled or reached final judgment at the time of the investments, or . . . were purchased from entities other than law firms.” Id. at 9. Those four categories were: (1) “purchases of attorneys’ and plaintiffs’ receivables arising from the 1983 Beirut barracks bombing” (the “Peterson receivables”); (2) “receivables of attorney Daniel Osborn” (the “ONJ receivables”); (3) “receivables of Barry Cohen” (the “Cohen receivables”); and (4) “receivables arising out of the 2010 oil spill in the Gulf of Mexico” (the “Deepwater Horizon receivables”).
In challenging Respondents’ representations to investors, the SEC specifically focused on the statements made in Respondents’ offering memoranda, marketing materials, investor-directed materials (such as Respondents’ website), and Form ADVs, as well as their conversations with investors. However, Respondents argued “that they were permitted under the offering memoranda,” which contained “flexibility provisions,” “to make the investments challenged by the Division and, to the extent that other written or oral statements to investors were contradicted by the clear language in the offering memoranda, the terms of the offering memoranda control.” Id. at 59.
In deciding whether Respondents made material misrepresentations, Judge Patil found that he “should begin with consideration of the terms of the offering memoranda.” Id. He agreed with the SEC that those documents “gave investors the distinct impression that the Funds were invested exclusively in legal receivables from cases that were resolved by settlement, an agreement between parties, or, in some instances a judgment against a debtor—with little to no litigation risk,” and that “no offering memorandum ever advised a reader that the Funds had ever purchased a legal fee arising out of anything other than a settlement or judgment.” Id. at 59-60. Judge Patil also found that these impressions were reinforced by some of Respondents’ marketing materials and “[o]ther oral and written representations.” Id. at 62. Nevertheless, he determined that these statements were materially inaccurate only as a result of the ONJ and Cohen receivables, which presented a “different class of risks associated with contingent litigation-based receivables,” id. at 78, and found “that the Division failed to establish by a preponderance of the evidence that the statements were materially false or misleading with respect to the Peterson and Deepwater Horizon” receivables. Id. at 63.
Regarding the Deepwater Horizon receivables, Judge Patil held that “the opportunity was consistent with one of the emerging opportunities the Fund manager could reasonably take advantage of under the terms of the offering memoranda’s flexibility provision,” because, while the monies associated with these receivables were not advanced to attorneys, the settlement in that matter authorized “non-attorney representatives . . . to file claims against a settlement fund,” thus making them “something of a surrogate for law firms for purposes of the settlement process,” and otherwise, “the investments were . . . substantially similar to the core investments of the Funds.” Id. at 65-66. With respect to the Peterson receivables, which were the “[t]he focus of the Division’s case,” id. at 70, Judge Patil concluded that “[n]either the Division nor Respondents have convinced me,” and because the Division “bears the burden of proof or persuasion . . . the Division has not proved by a preponderance of the evidence that Respondents’ misrepresentations were material with respect to Peterson.” Id. at 78.
Next, Judge Patil found that, while Respondents made material misstatements concerning the ONJ and Cohen receivables, those misstatements were not made with scienter. Specifically, he reasoned that the following factors “rebut the allegation of scienter”: (1) Respondents’ provision of “quarterly ‘Independent Accountant’s Report[s] On Applying Agreed-Upon Procedures,’ which included detailed information concerning troubled assets . . . including the ONJ and Cohen investments;” (2) Respondents’ provision of “annual audited financial statements that identified the Funds’ top concentration of investments by payor;” (3) the hosting on Respondents’ website of documents “pertinent to the Funds, including the offering memoranda, subscription documents, financial statements, AUPs, and investor communications;” (4) the availability of “a detailed collection of information with respect to the legal receivables agreements;” and (5) the absence of a “policy or practice of denying or providing false information.” Id. at 80-82. In short, Judge Patil found that there was no “intent to deceive because Respondents did not attempt to hide the investments.” Id. at 81. Furthermore, he determined that Respondents’ conduct “did not rise to the level of extreme recklessness,” because, while “the most troubling misstatements were the express disclaimers of litigation risk in the” due diligence questionnaires, those questionnaires are “marketing materials, which investors should treat skeptically,” and “the misstatements were in answer to a question about the Funds’ strategy,” which Respondents testified did not include the ONJ and Cohen receivables, as they were “one-off workouts of other, strategy-compliant positions that had gone wrong.” Id. at 87. As a result of these findings, the SEC’s most serious claims—those under Section 10(b) and Rule 10(b)-5 of the Exchange Act and Section 17(a)(1) of the Securities Act—were dismissed.
However, while Judge Patil recognized that “the Division focused most of its efforts on supporting its claims requiring scienter,” he determined that the Division “did not thereby forfeit or waive its claims based on negligence.” Id. at 84. He further found that there was “sufficient evidence in the record regarding the standard of care to conclude that Respondents did not meet that standard,” and were therefore negligent in making material misrepresentations with regard to the ONJ and Cohen receivables. Id. Specifically, he concluded “that the offering memoranda language with respect to all legal receivables arising from settlements and judgments represented an inaccuracy that is inconsistent with the reasonable care a hedge fund should take when it in fact had substantial positions in receivables based on pending litigation.” Id. at 86-87. As a result, Respondents were found liable under Sections 17(a)(2) and 17(a)(3) of the Securities Act.
Because he determined that Respondents did not act with scienter and it was shown that Respondents were not unjustly enriched and that most investors actually profited from their investments, Judge Patil found that only half of the maximum per-violation civil penalties were warranted. He based the penalties assigned to Respondents on the number of documents containing “actionable misrepresentations” and concluded that RD Legal Capital and Dersovitz should be fined $575,000 and $56,250 respectively. Id. at 96-97. In doing so, he rejected the SEC’s argument that Respondents should be penalized “for each defrauded investor who testified . . . as it could be based on tactical decisions by the Division about how many witnesses to call and who was available to testify.” Id. at 96. Furthermore, Judge Patil determined that disgorgement was not warranted, finding that to award the disgorgement of over $56 million sought by the SEC “may trigger constitutional scrutiny.” Id. at 98. Finally, while he also entered a cease and desist order and suspended Dersovitz from the securities industry for six months and prohibited him from working for an investment company for the same time period, Judge Patil declined to enter the permanent industry bar sought by the SEC.
While the SEC suffered several defeats in this case, it is important to note that despite being unable to prove that the Respondents acted with scienter, the SEC was able to hold Respondents liable for negligence-based charges. Because of the SEC’s ability to bring negligence-based charges, investment advisers must be extra vigilant about their disclosures and in ensuring that their trading practices are consistent with those disclosures.
Nevertheless, ALJ Patil’s decision signals that the SEC staff cannot rely on its “home court advantage” in every case. It also demonstrates that the SEC has a significant burden in proving “scienter” under Section 10(b) and Section 17(a)(1). It is also important that ALJ Patil recognized that the lack of scienter drastically affected the financial and non-financial remedies imposed against the Respondents.
A June 15, 2017 settlement with two former executives of a publicly-traded, multinational freight forwarding and logistics company provides the most recent example of two emerging SEC enforcement initiatives in financial reporting and accounting-based actions that we spotlighted recently – a non-reliance on financial statement materiality and an absence of fraud-based allegations. Exchange Act Rel. No. 80947 (Jun. 15, 2017). According to the SEC, Eric W. Kirchner and Richard G. Rodick, the former chief executive officer and chief financial officer of UTi Worldwide, Inc. (“UTi”), purportedly were responsible for inadequate Management’s Discussion & Analysis (“MD&A”) disclosures in a Form 10-Q that UTi issued during fiscal year 2013. Without admitting or denying the findings, both agreed to settle purported violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-13, and 13a-14, thereunder, and to pay a $40,000 civil penalty.
According to the SEC’s Order, UTi began experiencing serious risks in liquidity and capital resources no later than the third quarter of fiscal year 2013 due to the problematic rollout of a proprietary operating system that hindered the timely transmission of invoices to its customers. These problems allegedly caused UTi to accumulate an unusually high amount of unbilled receivables, thereby delaying its ability to receive payment for both its freight services and significant transportation-related cash outlays that were eligible for customer reimbursement through invoicing. To manage its cash flow problem, UTi supposedly began delaying payment of its obligations and obtained amendments to certain loan covenants from its lead lender.
The Order alleged that Kirchner and Rodick were aware of these liquidity and capital difficulties, yet failed to ensure that UTi provided adequate information in the MD&A section of the third quarter Form 10-Q to allow investors and others to meaningfully assess the company’s financial condition and results of operations. While the SEC acknowledged that the MD&A made reference to a sharp year-to-date decline in UTi’s cash position (and had provided readers with the specific financial impact), it claimed that the company attributed this decline to the seasonal nature of UTi’s business rather than its ongoing billing delays. The Order further contended that, under Kirchner and Rodick’s direction, UTi only revealed the cause and extent of its invoicing problem during the following fiscal year. By that time, the company’s lead lender had notified UTi that it would provide no further loan amendments and the company’s outside auditor had amended its opinion on the annual financial statements for fiscal year 2013 to issue a going concern.
Consistent with other recent settlements, this enforcement action is noteworthy in that the claims related exclusively to the purported incompleteness of a public company’s financial disclosures rather than the material inaccuracy of its financial statements. Here, the Order stated that the MD&A section of the periodic filing gave rise to a Section 13(a) violation because it failed to satisfy Regulation S-K Item 303, which is intended to provide investors with “an opportunity to look at the company through the eyes of management.” The SEC claims that Kirchner and Rodick’s conduct caused UTi to run afoul of Item 303’s requirement that registrants disclose in their MD&A “any known trends or uncertainties that will result in or that are reasonably likely to result in the registrant’s liquidity increasing or decreasing in any material way.”
This enforcement proceeding was also significant in that, similar to other financial reporting and accounting-related settlements during the latter stages of Mary Jo White’s tenure as SEC Chair, it was predicated entirely on strict liability-based claims. As in those previous settlements, this Order recited numerous instances in which the offending parties supposedly became aware of factual circumstances that were contrary to information provided in a later public filing, yet never attempted to assign any state of mind to the particular conduct alleged. There are many occurrences, of course, in which allegations grounded in knowledge or recklessness are simply unwarranted; nonetheless, this apparent pattern of heightened reliance on strict liability-based legal theories suggests that there may be certain instances in which the charges have been strategically designed to eliminate certain defenses and facilitate settlement. This particular proceeding offers a preliminary indication that this enforcement strategy may continue under Chair Jay Clayton’s leadership.
In a recent action, the SEC demonstrated its continuing focus on private equity fund advisers’ fees. On August 23, 2016, Apollo Management V, LP, Apollo Management VI, LP, Apollo Management VII, LP, and Apollo Commodities Management, LP (collectively, “Apollo”), agreed to settle charges brought by the SEC for “misleading fund investors about fees and a loan agreement and failing to supervise a senior partner who charged personal expenses to the funds” in violation of Sections 206 and 203 of the Advisers Act. Press Release No. 2016-165.
According to the SEC Order, Apollo advises a number of private equity funds that own multiple portfolio companies. Like most private equity fund advisers, Apollo charges annual management fees and certain other fees to the limited partners in its private equity funds and charges monitoring fees to certain portfolio companies under separate monitoring agreements. Release No. 4493. Investors benefit from the monitoring fees in that a certain percentage of the monitoring fees are used to offset a portion of the annual management fees. The SEC found that the monitoring agreements allowed Apollo, upon the triggering of certain events, to terminate the agreement and accelerate the remaining years of the monitoring fees to be collected in a present value lump sum termination payment. Triggering events included the private sale or IPO of a portfolio company. The SEC found that the accelerated fees created a conflict of interest for the adviser and noted that while the accelerated monitoring fees reduced annual management fees paid by the funds, the accelerated payments reduced the portfolio companies’ value prior to their sale or IPO, thereby “reducing the amounts available for distribution to the” the funds’ investors. The SEC found that Apollo did not disclose to the limited partners “its practice of accelerating monitoring fees until after Apollo had taken accelerated fees.” Id.
In addition, the SEC found that in June 2008, the general partner of one of Apollo’s funds entered into a loan agreement between the fund and four parallel funds in which the parallel funds loaned an amount to fund equaling the carried interest due to the fund from the recapitalization of two portfolio companies owned by the parallel funds. Until the loan was extinguished, taxes owed by the general partner on the carried interest were deferred and the general partner was required to pay accrued interest to the parallel funds. While the parallel funds’ financial statements disclosed the interest, Apollo’s failure to disclose that the accrued interest would be allocated solely to the account of the general partner was determined to be materially misleading.
The SEC further found that a former Apollo senior partner, on two occasions, improperly charged personal expenses to Apollo-advised funds and the funds’ portfolio companies, and in some instances, fabricated information to conceal his conduct. Upon discovery of the partner’s conduct, Apollo orally reprimanded the partner but did not take any other remedial or disciplinary steps.
Finally, according to the SEC, Apollo also failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the undisclosed receipt of accelerated monitoring fees and failed to implement its policies and procedure concerning employees’ reimbursement of expenses.
Without admitting or denying the SEC’s findings, Apollo agreed to pay $40,254,552, consisting of a disgorgement of $37,527,000 and prejudgment interest of $2,727,552. In addition, the SEC assessed a $12.5 million civil penalty, stating that the penalty is not higher due to Apollo’s cooperation during the investigation and related enforcement action. The SEC reserved the right to increase the penalty should it be discovered that Apollo knowingly provided false or misleading information or materials to the staff during the course of its investigation.
On June 16, 2016, Apex Fund Services (US), Inc., settled charges that it ignored clear indications of fraud while keeping records and preparing financial statements and investment account statements for private funds managed by EquityStar Capital Management, LLC, and ClearPath Wealth Management, LLC, each of which has previously been charged with fraud in SEC enforcement actions. Press Release 2016-120. The settlement highlights the SEC’s focus on gatekeepers and the importance of gatekeepers monitoring red flags, especially when their role includes providing financial information to investors.
With respect to EquityStar, Apex settled charges that it made materially false and misleading statements to investors when it improperly accounted for undisclosed withdrawals from funds (made by EquityStar and manager Steven Zoernack) as receivables even when Apex possessed evidence that neither EquityStar nor Zoernack were willing or able to repay the withdrawals, which totaled over $1 million. After Zoernack stated his intent to repay an initial withdrawal, Zoernack continued to make withdrawals (without making repayments) that Apex repeatedly treated as “receivables,” rather than withdrawals by Zoernack, in the Net Asset Value (“NAV”) reports. Eventually, the “receivables” accounted for nearly 54% of the NAV of one fund and more than 26% of another fund. During this time, Apex learned that Zoernack had previously been convicted for wire fraud. According to the SEC, Apex repeatedly asked Zoernack to make disclosures about the withdrawals that he did not make. The SEC also found Apex ultimately determined that Zoernack would not be able to repay them. Nevertheless, Apex continued to report materially inaccurate NAVs. Release No. 4429.
ClearPath was charged with securities fraud violations relating to a misappropriation scheme last year in the District of Rhode Island. With respect to ClearPath, the SEC found Apex (i) “failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and inter-series and inter-fund transfers made in violation of the fund offering documents”; (ii) failed to correct prior financial reports and continued to issue “materially false reports and statements” to ClearPath and an independent auditor; and (iii) used those false reports in communication financial performance to investors. Release No. 4428.
Without admitting or denying the SEC’s findings, Apex agreed to retain an independent consultant to conduct a review of Apex’s policies and procedures and recommend corrective measures. Additionally, Apex will pay a total of $352,449, which includes (i) disgorgement of $89,050, plus $7,786 in interest and a $75,000 penalty for its actions with respect to EquityStar; and (ii) disgorgement of $96,800, plus $8,813 in interest and a $75,000 penalty for its actions with respect to ClearPath.
On June 1, 2016, the Securities and Exchange Commission (SEC) sent a warning to private equity fund managers who receive transaction-based fees in connection with the purchase and sale of portfolio companies by charging Blackstreet Capital Management (Blackstreet), a private equity fund advisory firm, and its principal, Murry Gunty with, among other things, acting as an unregistered broker-dealer. According to the SEC, Blackstreet received fees, separate and apart from its management fees, for performing “in-house brokerage services” in connection with the acquisition and disposition of portfolio companies for two private equity funds. The fact that Blackstreet Capital fully disclosed the fees did not affect the SEC’s conclusion that Blackstreet acted as an unregistered broker-dealer.
Blackstreet and Gunty settled, on a neither-admit-nor-deny basis, with the SEC and agreed to pay more than $3.1 million in disgorgement and civil penalties. Importantly, the $3.1 million settlement also reflects other charges such as failing to disclose other fees and failing to implement reasonably designed compliance policies and procedures to prevent violations of the Investment Advisers Act of 1940 and rules thereunder.
Section 15(a)(1) of the Securities Exchange Act of 1934, as amended (Exchange Act) makes it unlawful for any broker or dealer to use the mails or any other means of interstate commerce to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker or dealer is registered with the SEC in accordance with Section 15(b) of the Exchange Act. “Broker” is defined in Section 3(a)(4) of the Exchange Act as “any person engaged in the business of effecting transactions in securities for the account of others.” Over the last several years, the SEC has included violations of 15(a) in numerous enforcement actions involving offering frauds and other situations involving the offer and sale of securities to retail investors.
In its Order against Blackstreet and Gunty, the SEC concluded that by being involved in the purchase or sale of securities, including soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, executing the transactions and receiving transaction-based compensation, Blackstreet was performing brokerage services without having registered as a broker-dealer and, therefore, willfully violated Section 15(a) of the Exchange Act.
Private equity fund managers have recognized the potential that the SEC would take the position that they are acting as broker-dealers. In 2014, the SEC issued a no-action letter that relieved firms from the requirement to register as a broker-dealer in connection with facilitating a sale of a private company as long as they complied with a number of detailed conditions. The conditions included requirements that the manager must never have possession of customer funds or securities; that upon completion of the M&A transaction, the buyer must have control of the target; and that the manager should not provide financing for the transaction.
The SEC’s most recent action in the private equity space emphasizes the SEC’s renewed resolve to more strictly enforce non-fraud based violations and to bring Section 15(a) charges in situations beyond traditional transactions with retail investors. In fact, following the settlement, Mr. Robert B. Baker, Assistant Regional Director in the SEC’s Enforcement Division’s Asset Management Unit, stated “That’s the first case of a private-equity adviser violating section 15(a) of the [Exchange Act] for acting as a broker and failing to register as a broker.” However, even if Blackstreet had contemplated reliance on the no-action positon cited above and such position was available, it did not comply with at least one of the conditions of the no-action letter because, according to the Order, Blackstreet appears to have been involved in arranging the financing for the transactions. Moreover, while disclosure of the fees was important, the fact that they were disclosed had no significance to the SEC’s analysis of whether Blackstreet acted as an unregistered broker-dealer.
Fees related to the acquisition and disposition of portfolio companies are not uncommon in the private equity fund context. In light of the SEC’s action, private equity fund managers should reconsider whether they need to register as broker dealers, take care to comply with all of the provisions of existing no-action letters, seek no-action relief of their own or take other appropriate steps.
In a first of its kind case, the SEC last week charged an investment adviser to a hedge fund with, among other things, retaliating against an employee who reported allegedly illegal trading activity to the agency. The SEC exercised its authority under a Commission rule adopted in 2011 under the Dodd-Frank Act, which permits enforcement actions based on retaliation against whistleblowers.
Under the Exchange Act, employers may not “discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower.” 15 U.S.C. § 78u-6(h)(1)(A). The Act also provides that the Commission “shall pay an award or awards to 1 or more whistleblowers who voluntarily provided original information to the Commission that led to the successful enforcement of the covered judicial or administrative action, or related action, in an aggregate amount equal to (A) not less than 10 percent, in total, of what has been collected of the monetary sanctions imposed in the action or related actions; and (B) not more than 30 percent, in total, of what has been collected of the monetary sanctions imposed in the action or related actions.” Id. § 78u-6(b)(1).
The alleged retaliation at issue centered on the investment adviser’s former head trader, who reported allegedly improper principal transactions to the SEC under the SEC’s Bounty Program. According to the SEC, the investment adviser engaged in trades with an affiliated broker-dealer on behalf of one of its hedge fund clients. The SEC alleged that the investment adviser’s owner had a conflicted role as owner of the brokerage firm while subsequently advising the hedge fund client. In an attempt to satisfy written disclosure and consent requirements, the investment adviser formed a conflicts committee to review the transactions, which consisted of the investment adviser’s CFO and chief compliance officer. The SEC alleges that the conflicts committee was also conflicted because the two-person committee reported to the investment adviser’s owner and because the investment adviser’s CFO also served as CFO of the investment adviser’s affiliated broker-dealer. As a result of this conflict, the SEC contended the investment adviser did not provide effective written disclosure to its hedge fund client, and it did not obtain consent to engage in the transactions.
According to the SEC Order, the trader subsequently informed the owner of the investment adviser that he had reported these potential securities law violations to the SEC. After the company learned of the whistleblower’s submission, it allegedly engaged in a series of retaliatory actions to strip the trader of his responsibilities. Approximately one month after doing so, the whistleblower resigned citing constructive discharge. Of note, the former trader filed a lawsuit against the investment adviser, its owner, and its affiliated broker-dealer under § 78u-6(h)(1)(B), which permits whistleblowers to bring enforcement actions, alleging unlawful retaliation, but the lawsuit was voluntarily dismissed in December 2012. It is not clear why the lawsuit was dismissed or whether the dismissal was related to a settlement.
In settling the matter with the SEC, the investment adviser neither admitted nor denied the charges. It agreed to pay $2.2 million, which includes disgorgement of $1.7 million, prejudgment interest of $181,771, and a civil penalty of $300,000. The Order expressly provides that the disgorgement relates to administrative charges relating to the principal transactions. The Order is silent, however, on whether the civil penalty of $300,000 is related to those principal transactions or has something to do with the retaliation claim. The Commission acknowledged in its order that the principal transactions were effected at the prevailing market price and the affiliated broker-dealer did not charge a markup or commission on the transactions. Significantly, the Order does not contain any finding that the funds were harmed by inadequate prices and the fact that the disgorgement relates to administrative charges strongly suggests there was a lack of monetary injury to the funds.
The SEC has authority to award the whistleblower between 10 and 30 percent of the recovery because the tip led to sanctions in excess of $1 million. According to Andrew J. Ceresney, Director of the SEC’s Division of Enforcement, a whistleblower is eligible for a whistleblower award. We have previously pointed out that the SEC intends to vigorously protect whistleblowers by using it authority under Dodd-Frank to bring retaliation claims against employers in a previous post: “Arbitration Agreements and Whistleblower Protections.” This case is proof.
Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, private funds have become the subject of heightened scrutiny by both the SEC’s Division of Enforcement and the Office of Compliance Inspections and Examinations (“OCIE”). Based on recent announcements, this trend is likely to continue.
In 2012, OCIE announced an initiative to conduct “Presence Exams” or focused, risk-based examinations of investment advisers to private funds who recently registered with the SEC. See the OCIE’s National Exam Program letter. More recently in the SEC’s 2014 CCO Outreach Program, the SEC announced that it had conducted 250 Presence Exams. The SEC added that many of the exams revealed “significant findings,” but did not disclose whether those findings led to enforcement referrals or were resolved in the deficiency letter process. The SEC reiterated that focus areas of the Presence Exams included: (1) investment conflicts of interest including personal and affiliates’ transactions and fees paid to advisers and expenses charged to funds; (2) marketing, including the use of placement agents and using past performance; (3) valuation; and (4) custody.
Recently, the SEC formed a new “group” within OCIE to focus on the approximately 1,500 newly registered advisers to private equity and hedge funds. The new group is being led by two “industry experts” hired by the SEC in the last few years and will include staff from four regional offices across the country. If the group is successful, the SEC intends to expand the unit to additional regional offices.
Traditionally, the SEC has created working groups or specialized units in the Division of Enforcement to focus on what it perceives to be high-risk areas, i.e., where investor funds are most at risk. The Division of Enforcement currently has five specialized units: (1) Market Abuse, (2) Asset Management, (3) Municipal Securities and Public Pensions, (4) Foreign Corrupt Practices Act, and (5) Complex Financial Instruments. These units were formed in significant part due to the criticism of the agency for failing to detect Bernie Madoff’s massive Ponzi scheme. Each of these units is led by a senior officer who reports to the Director of the Division of Enforcement and is staffed by members of regional offices across the country.
It is very likely that the new private equity group will coordinate closely with the Asset Management Unit as that unit has developed significant expertise with respect to hedge funds, investment advisers and private equity funds. One of the group’s leaders, Igor Rozenblit, was with the Asset Management Unit since 2010. Moreover, the Asset Management Unit has been very active in bringing “message” cases against the very funds that the new group is charged with policing.
In addition to forming the new group, the SEC has also asked Congress for additional funds to support its examination program. The SEC seeks to add 316 staff to its examination program. Currently, there are approximately 450 examiners, accountants and lawyers in 12 regional offices. If the SEC receives the additional funds, it could almost double the size of its examination staff allowing it to conduct significantly more exams and assist with more enforcement investigations.
In the last few months, the Division of Enforcement formed three other new “groups” to focus on different areas. Last summer, the SEC announced the creation of: (1) the Financial Reporting and Audit Task Force, (2) the Microcap Fraud Task Force, and (3) the Center for Risk and Quantitative Analytics. These groups, unlike the formal units, will not conduct investigation. They are intended to identify potential violations and make referrals to the investigative staff.