OCIE Risk Alert – An Aid to Proper Compliance
A Risk Alert was published by the the Office of Inspections and Examinations or OCIE, alerting Investment Advisers of managed private funds to key issues that have arisen in prior examinations. The Alert highlights a series of deficiencies, some of which have resulted in enforcement actions. Risk Alert, Office of Inspections and Examinations (June 23, 2020)(here).
The list of deficiencies identified in the Alert is divided into three sections: 1) Conflicts of interest; 2) Fees and expenses; and 3) MNPI/Code of Ethics.
Conflicts: The largest section of the Alert deals with conflicts of interest. The failure to properly disclose conflicts of interest is a violation of Section 206 of the Advisers Act as well as the pertinent Rules such as 206(4)-8. The conflicts identified include:
Allocations of investments: Certain private fund advisers did not provide adequate disclosure regarding allocations of investments among clients, including flagship funds and others that invested alongside the largest funds. Similarly, limited investment opportunities were preferentially allocated in certain instances; in others, advisers made allocations at different prices or in apparently inequitable amounts among clients.
Multiple clients/same portfolio company: In these situations, advisers caused clients to invest at different levels of a capital structure such as one client owning debt while another owned equity in a single portfolio company without adequate disclosure.
Financial relationships between investors or clients and the adviser: In select instances there was inadequate disclosure of the economic relationships involving the adviser and clients. Some clients could be, for example, seed investors while others may have provided credit facilities or similar arrangements with the adviser.
Preferential liquidity rights: In some instances, advisers entered into side letters with select investors that were given preferential treatment. In other instances, certain funds had preferential rights that were operated, for example, alongside the flagship fund without adequate disclosure.
Adviser interests: Advisers at times had interests in investments recommended to clients where there was inadequate disclosure of that fact.
Co-investments: There was inadequate disclosure of conflicts related to investments made by co-investment vehicles and other co-investors.
Service providers: There was inadequate disclosure regarding service providers and, in some instances, related incentives. For example, there was inadequate disclosure regarding arrangements among portfolio provides, private fund clients and service agreements with entities controlled by the adviser and/or its affiliates or others tied to the adviser. In some instances, private fund advisers did not have procedures to ensure that they properly implemented disclosure requirements.
Restructuring: When funds are restructured advisers did not adequately disclose the transaction and the opportunities available to all of the investors. For example, if a fund is sold there may be opportunities for the investors that are not properly disclosed to all or that are only available to certain investors in the absence of adequate disclosure of that fact.
Cross-transactions. When these types of transactions arise, advisers failed in certain instances, to adequately disclose them to all investors.
Fees and expenses: The exams revealed issues regarding the inadequate disclosure of fees and expenses.
Allocation: In a number of instances advisers incorrectly and/or inadequately allocated various fees and expenses. In some instances, the charges were not permitted and/or contrary to the agreements.
Operating partners: Some advisers failed to make full disclosure regarding those who were not employees but provided services to the private fund or portfolio companies and the related charges.
Valuation: Valuation can be a key issue. In some instances, advisers did not follow GAAP in valuing assets and/or their disclosed procedures.
Monitoring: Fund advisers at times had difficulties with the receipt of fees from portfolio companies such as monitoring fees, board fees and others which resulted in a failure to properly allocate them, account for them, apply appropriate offsets and similar matters.
MNPI/Code of Ethics
Advisers are required to establish policies and procedures with regard to material non-public information under Section 204A of the Advisers Act and to establish a Code of Ethics under Rule 205A-1. Nevertheless, OCIE observed certain deficiencies:
Section 204A: Advisers failed to establish, maintain and enforce written policies and procedures that properly addressed the risks such as employees interacting with public companies, those that may be created because of office space or those created by their employees who periodically had access to MNPI.
Code of ethics: Advisers also at times failed to establish, maintain and enforce the provisions of their code with respect to MNPI such as enforcing the terms of a restricted list, provisions regarding gifts and entertainment and sections governing the reporting of personal securities transactions.
While not every item cited above, many have been the basis of, or included in, an enforcement action. Each was identified as a deficiency. Viewed in this context, the list should be carefully reviewed by advisers not just when an inspection is scheduled but periodically to ensure adherence to proper practices.