On January 12, 2017, the staff of the Office of Compliance Inspections and Examinations (OCIE) of the Securities and Exchange Commission (SEC) released its annual announcement on examination priorities in the coming calendar year. The 2017 examination priorities are organized around three thematic areas: (i) examining matters of importance to retail investors; (ii) focusing on risks specific to elderly and retiring investors; and (iii) assessing market-wide risks.As we have reported on previously, OCIE incorporates data analytics into the vast majority of its examination initiatives to identify industry practices and/or registrants that appear to have elevated risk profiles.

Advisers should note that on October 11, 2016, the SEC announced a record number of investment adviser enforcement cases for the agency’s fiscal year 2016, which ended on September 30, 2016. Accordingly, advisers can expect that the SEC will lean heavily on OCIE as a resource for maintaining similar statistics for fiscal year 2017. While the 2017 announcement contains broad and general descriptions of areas on which the staff intends to focus, there are several key points to which advisers to hedge funds, private equity funds and other private funds should pay close attention.

Conflicts of Interest and Disclosure

Specific to private fund advisers, the announcement expressly affirms the staff’s continuing attention to conflicts of interest and disclosure of conflicts as well as actions that create the appearance of benefitting an adviser at the expense of fund investors. In 2016, the SEC secured settlements with several private fund advisers in areas involving (i) charging portfolio companies operating partner oversight fees, and acquiring defaulting limited partner interests, without adequate pre-capital-commitment disclosure, (ii) the disclosure of accelerated monitoring fees, and (iii) the disclosure of how management fee offset provisions were calculated. In the days preceding the 2017 announcement, the SEC announced a settlement with a private equity fund adviser involving the alleged failure to disclose conflicts of interest arising from the adviser’s principals’ personal investments, board positions and familial relationships with several funds’ due diligence providers. In articulating its focus in this area, the staff appears to indicate that there remain conflicts of interest and commensurate disclosure practices which it seeks to review and influence through its examination (and potentially enforcement) programs.

Pension Plan Advisers

The staff also references its interest in reviewing advisers to pension plans of states, municipalities, and other government entities. The announcement specifically noted that OCIE will assess how these advisers are both managing conflicts of interest and fulfilling their fiduciary duties. OCIE also will review other risks specific to these advisers, including potential pay-to-play arrangements and undisclosed gifts and entertainment practices.

Cybersecurity

As in the 2016 announcement, the staff also indicated that it will continue to focus on the area of cybersecurity in 2017. Specifically, the staff will be evaluating cybersecurity compliance procedures and controls, including testing the implementation of those procedures and controls.

Other Areas of Focus

As a continuation from 2016, the 2017 announcement reiterates a focus on both never-before examined investment advisers and advisers employing individuals with what the announcement describes as a “track record of misconduct,” whom the SEC refers to as recidivists. On September 12, 2016, OCIE published a National Examination Program Risk Alert, which announced the staff’s intention to focus on these advisers and, specifically, registered advisers’ compliance programs and the supervision of advisory personnel that may pose an increased risk to advisory clients based upon prior infractions.

Whistleblowers and Other Tips

The SEC concluded its 2017 announcement by highlighting its receipt of tips, complaints, and referrals as a source of information guiding its examination program. The announcement also provides a hyperlink to the agency’s webpage describing the process for reporting suspected misconduct to the SEC staff. As we highlighted previously, advisers should review the October 24, 2016 risk alert published by OCIE, which announced that the SEC exam staff intends to examine registrants’ compliance with the Dodd-Frank Act’s whistleblower provisions, as well as SEC enforcement activity in this area.

In conclusion, the staff’s 2017 announcement sets forth a basic roadmap registrants subject to SEC oversight can expect the agency to follow. While the announcement itself covers all entities regulated by the SEC, advisers to private funds would be well-served to devote time and resources to assessing and assuring their preparedness in the specific areas articulated above.

Private investment funds and advisers are likely to face new regulatory challenges and increased litigation risks in 2017, not only because of a change in the administration, but also because many advisers have not corrected and aligned past practices with current regulatory guidance.  In this post, we have highlighted ten areas that should be on the top of every private fund adviser’s list for 2017 – and how to assess and manage the associated risks.

1.  Managing Regulatory Uncertainty: Is the Tide Rolling In or Out?

The 2016 Election exacerbated the uncertainty around regulation for advisers to private funds.  Prior to the 2016 Election, the biggest operational challenge was managing the uncertainty of where the regulatory lines would be drawn.  There was no question, however, that the proverbial regulatory tide was still “rolling in.”

Post-election, the new administration has pledged to “roll-back” Dodd-Frank, making it unclear whether the regulatory tide is rolling in or out.  This uncertainty will likely continue through 2017 – and certainly until the new administration appoints the full slate of new federal agency heads.

Advisers, however, should not treat this uncertainty as an opportunity to defer compliance.  Instead, the prudent approach is to assume that the existing guidance, in the form of SEC Orders, stated staff priorities, and policy speeches, will continue to be enforced.  Absent a wholesale repeal of Dodd-Frank – which seems unlikely for the reasons that we have discussed previously – advisers must assume that they will remain subject to regulatory oversight.  This assumption is particularly true with respect to the proper allocation of fees and expenses because that obligation is grounded in the core fiduciary relationship between the adviser and the fund – which exists regardless of Dodd-Frank requirements or past industry practices.  As such, an adviser’s highest priority should be ensuring that current practices comply with existing standards and expectations.  It would also be prudent to consider an audit of past practices to assess regulatory risks in light of current SEC guidance.  Advisers who delay compliance while waiting for greater clarity on the direction of regulatory activity do so at their own peril.

2. Conflicts of Interest

In the SEC’s 2017 priorities announced last month, the exam staff noted that conflicts of interest and disclosures of actual or potential conflicts remain primary risks for advisers.  As we have seen in recent enforcement actions, the SEC has focused on conflicts relating to the disclosure of fees and expenses.  While fee and expense allocations are classic examples of a potential conflict of interest between the adviser and the fund, they are by no means the only instance where conflicts arise.  Advisers must always be mindful that they are fiduciaries to the funds that they advise, and any act that benefits the adviser can be viewed as a creating a potential conflict of interest.

To avoid such a conflict, the adviser must evaluate whether an act or practice that benefits the adviser was specifically and expressly disclosed to the LPs up front at – or prior to – the time of the investment decision, such that the investors were informed when they agreed to it.  Advisers should not assume that historical industry practices are conflict-free just because “that’s the way we have always done it.”  There is certainly a conscious trend among advisers to view any potential conflict or contractual interpretation in the light most favorable to investors.

3. Whistleblowers

If advisers needed any added motivation to proactively address suspected violations, one word should suffice:  whistleblower.  Dodd-Frank’s whistleblower protections and incentives, including bounties to certain whistleblowers, are now an established and fruitful pipeline for SEC tips.  The SEC has continued to market this initiative broadly, and this year the agency has continued to file enforcement actions alleging retaliation against whistleblowers.  The SEC’s program means that the clock starts ticking for advisers as soon as management becomes aware of a potential regulatory issue, because the universe of potential whistleblowers can be vast.

4. Pay-to-Play

In early 2017, the SEC announced a series of settlements involving a sweep of alleged pay-to-play violations, with resolutions involving monetary penalties and censures but not disgorgement.  As in prior years, the SEC will continue to police and enforce the pay-to-play rule.  The lesson from the sweep is that even a small contribution by an adviser’s personnel, with no intent to influence or apparent connection whatsoever to any investment decision, can give rise to an inquiry, potential enforcement action, and the resulting negative consequences.  In our experience, and as the pay-to-play sweep confirms, even small-dollar contributions from someone who the adviser does not consider to be a “Covered Associate” can trigger enforcement activity that is expensive and disruptive for the adviser.  A carefully crafted and vigilantly enforced compliance policy in this area will pay for itself.

5. Unicorns and Internet Bubble 2.0:  Separating the Wheat from the Chaff

A successful IPO of Snap will be an inflection point for so-called unicorns and will lead to a cleaving between the winners and the losers.  The winners will receive additional funding and face pressure to go public or otherwise create liquidity for their investors and employees.  The losers – or “undercorns” – will go out of business or be acquired on less than favorable terms. In either case, these events will result in an intense focus on unicorns – and the private funds that invested in them.  Advisers to private funds naturally tend to celebrate their winners and downplay their losers.  This time, however, advisers should expect some unwanted attention around “undercorns” that fail to meet expectations.

The cleaving of unicorns creates at least three primary risks for advisers in 2017.  First, advisers must manage SEC and LP scrutiny of valuations (see #6 below).  Second, the SEC will scrutinize pre-IPO equity transactions and other investments in privately-held shares, so secondary trading and late-stage investments will come under scrutiny.  Third, the insolvency or bankruptcy of former unicorns will give rise to numerous potential conflicts, between and among shareholders (including private funds), officers and directors, employees, and creditors of former unicorns.  Advisers should also focus on potential disputes involving a fund’s designee on a failed unicorn’s board of directors and the potential for conflicts between the adviser and the funds over failed investments.

6. Valuation Practices

The commercial and economic failure of a number of unicorns will bring further scrutiny to industry valuation practices, particularly for private funds.  Rather than challenging the significant professional judgment needed to determine fair value, the SEC will likely focus on issues “around” valuation practices.  For example, regulators will examine whether actual valuation practices were consistent with disclosures to investors, review gaps between stated valuation policies and practices, and scrutinize inconsistencies in applying those policies.  The SEC is already focused on potential issues concerning auditor independence.  It is natural for an adviser to be proud of, and confident in, its valuation practices and procedures.  That pride is about to be tested.

7. Performance Marketing and Advertising

Disclosure of prior performance has also come under the regulatory microscope.  For example, a misstep in a fund’s initial performance figures – such as presenting performance gross of fees – will invite SEC scrutiny of disclosures to investors.  Over the past year, the SEC sanctioned a number of advisory firms for repeating misleading third-party performance claims and also enhanced the recordkeeping obligations for performance advertising.  Challenges concerning valuation practices will likely bring challenges concerning performance marketing and advertising.  Regulatory scrutiny of this area will continue.

8. Internal and External Response to Potential Regulatory Violations

Advisers who are (or should be) aware that their practices are inconsistent with SEC guidance and expectations will face heightened risk of an enforcement proceeding.  It is critical, therefore, that advisers take steps to proactively identify and address potential violations before an OCIE examination.  We recommend that advisers consider engaging counsel to (a) evaluate the relevant facts to determine the risk of a finding of a violation, (b) recommend appropriate remedial measures, and (c) provide guidance on internal messaging to employees and, if needed, external messaging to fund investors, the media, and the regulators.

9. Navigating Conflicts in Fund Restructurings

As we have discussed, conflicts inevitably arise in most fund restructurings because they typically occur when things have not gone according to plan.  For example, fund restructurings – and in particular so-called “stapled” secondaries – are fertile ground for potential conflicts involving advisers.  Practically every relationship could involve a conflict of interest: (i) within the adviser/management company; (ii) between the adviser and fund; (iii) between the adviser and cashing-out LPs; (iv) between the adviser and rolling LPs; (v) between the adviser and new LPs; and (vi) between the adviser and the portfolio company.  As is evident from this list, the adviser is in the cross-hairs of almost every potential conflict of interest.

10. Funds and Advisers as Defendants

While there is always the potential for conflicts between GPs and LPs (particularly during restructurings, see #9), one commonly overlooked scenario that is trending and likely to rise in 2017 is where the fund and its adviser are named as defendants in litigation.  For example, plaintiffs’ lawyers are increasingly reaching beyond traditional defendants in M&A disputes to name both funds and fund advisers (and their principals) as defendants.  This is especially true where the funds and advisers made – or could be deemed to have made – representations and warranties in connection with a sale or merger transaction.  Unfortunate as it may be, funds and advisers are viewed as easy targets and deep pockets for acquirers looking to pass the blame following an unsuccessful acquisition.

At the recent SEC Speaks program, sponsored by PLI, senior SEC staff members provided valuable insight into the SEC’s 2017 priorities for private funds.  While the tenor of this year’s discussion seemed to focus more on retail investors, the staff discussed several topics that private fund advisers should keep in mind from both an enforcement and exam standpoint.

Enforcement

The SEC’s Asset Management Unit (AMU) Co-Chief Dabney O’Riordan outlined several areas that the AMU will focus on this year.  As a general matter, O’Riordan underscored that the structure of private funds can impair transparency for investors, which compounds risks in all of the areas that she discussed.  In particular, she noted the following areas of focus for private funds:

Valuation:  This is a perennial priority for the SEC staff, as we’ve noted in the past.  Even in matters where the SEC does not challenge valuations per se, the staff tends to focus on structural issues around valuation, such as failure to follow firm policies and procedures or breakdowns in controls.  For example, O’Riordan noted recent matters where registered advisers failed to follow appropriate procedures in valuing illiquid bonds or thinly-traded mortgage-backed securities.  We also expect that the SEC will focus on valuation of shares in privately-held tech companies over the next year.

Undisclosed Fees:  O’Riordan noted that the AMU is highly focused on failures to adequately disclose fees or compensation that directly or indirectly benefit an adviser.  This focus is nothing new – fee and expense allocations are classic examples of a potential conflict of interest between the adviser and the fund.

Trade Allocation:  O’Riordon noted that enforcement will look at trade allocation practices for private funds as well as retail client advisers.  The AMU is looking for situations where favorable trades are allocated to accounts where an adviser receives higher fees – so-called “cherry-picking”— or allocated in a manner inconsistent with guidelines disclosed to clients.

Gatekeepers:  O’Riordan also specifically mentioned gatekeepers – entities such as auditors, prime brokers, custodians, administrators and marketers that the SEC has stated perform critical roles for advisers and private funds.  She indicated that when the SEC identifies a significant issue with an adviser or a fund, the AMU will evaluate whether the gatekeepers failed to perform their duties.  For example, the SEC last year charged an accounting firm with conducting deficient surprise exams required under the custody rule.

Insider Trading:  Joseph Sansone, Co-Chief of the Market Abuse Unit, stated that 78 different entities and individuals were charged with insider trading during 2016.  He devoted much of his discussion to cyber fraud issues, such as unauthorized hacking, but noted that both cyber fraud and traditional insider trading cases are investigated using similar data analytics to track patterns of suspicious trading.  As Sansone explained, by utilizing advanced data analytics, the staff is able to uncover patterns of trading among seemingly unafilliated traders, even where transactions are kept small to avoid detection.

It remains to be seen whether the incoming Commission will push the envelope further by pursuing new enforcement theories against private funds.  Regardless of the number of cases, however, the staff is likely to continue its focus on these types of cases under traditional theories – undisclosed conflicts and violations of fiduciary duties.

Exams

The OCIE panel also highlighted three areas of focus from the SEC’s National Examination Program 2017 Examination Priorities announcement published on January 12, 2017:

Newly-Registered Advisers:  The staff’s focus on never-before-examined registrants will be expanded to all newly-registered investment advisers.

Public Pension Advisers:  The staff will focus on investment advisers to public pension plans and specifically how they: (i) manage conflicts of interest; (ii) adhere to fiduciary duties; (iii) comply with pay-to-play restrictions; and (iv) supervise the provision and receipt of gifts and entertainment.

Cybersecurity:  OCIE will continue its focus on cybersecurity, with an emphasis on ensuring that investment advisers’ cybersecurity policies and procedures are both sufficient and being followed, and that investment advisers have conducted a cybersecurity “risk inventory.”

In addition, the staff noted that there are now more than 12,000 investment advisers registered with the SEC, including over 300 new registrants since the November elections.  This trend demonstrates that the staff needs to continue to focus on higher level areas of concern, rather than taking a scattershot approach.

Jane Jarcho, OCIE’s Deputy Director, stated that the staff was looking to find the “sweet spot” in terms in balancing examination effectiveness with efforts to reach as many registrants as possible.  As opposed to the routine cycle examinations of years past, the OCIE examination program is now more data-driven and risk-based.  The panel noted that over 100 examiners have shifted from other areas of OCIE into the agency’s Investment Adviser / Investment Company (IA/IC) examination program, which now has over 600 staff members.  OCIE conducted more than 2,400 exams in 2016, which represented a 7-year high and a 20% increase over 2015, and is already ahead of that pace for 2017.  SEC examiners completed an average of 4.91 examinations during 2016 compared to 4.31 examinations in 2015 and 3.26 in 2014.

OCIE is also looking for additional ways to reach the registrant population; for example, using more risk alerts targeting specific areas of regulatory compliance.  The staff specifically noted the recent risk alert discussing the five most frequent compliance deficiencies identified in adviser exams.  For private fund advisers, this risk alert noted the SEC’s vigilance to inconsistencies between regulatory filings including Forms ADV, PF, and D, as well as concerns relating to the Compliance, Custody, Code of Ethics, and Books and Records Rules.

On Thursday, March 23rd, the Securities and Exchange Commission announced the opening of registration for its compliance outreach program seminars for investment companies and investment advisers.  The seminars will be offered in four U.S. cities and are intended to help Chief Compliance Officers (CCOs) and other senior personnel enhance compliance programs at investment companies and investment advisory firms. The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and the Asset Management Unit of the Division of Enforcement jointly sponsor the compliance outreach program.

All regional seminars will include an overview of OCIE’s 2017 priorities and individual seminars will feature the following panel discussions on current topics in investment management regulation:

• Portland, Oregon – May 17 (8:30 a.m. to 12:30 p.m.): Key examination program initiatives, examination procedures and selection process, and recent trends and issues in the Enforcement Division’s Asset Management Unit.
• New York – June 7 (12:30 p.m. to 5:00 p.m.): Staff examinations and observations, and topics of interest to advisers to private funds.
• Boston – June 13 (8:30 a.m. to 1:00 p.m.): Key examination program initiatives, typical examination process, and topics of interest to advisers to private funds.
• Chicago – June 13 (8:00 a.m. to 4:30 p.m.): Key examination program initiatives, examination procedures and selection process, common examination deficiencies, data analytics, and several hot topic panels generally applicable to both small and large firms.

Interested participants may register here to attend one of the compliance outreach program regional seminars.  Registration for individual events will be closed at least two weeks before the event.  Seating is limited and only the Chicago seminar will be webcast.  If registrations exceed capacity, investment company and investment adviser CCOs will be given priority on a first-come, first-registered basis.

For more information, interested participants may contact the SEC staff at ComplianceOutreach@sec.gov.

We are pleased to announce that Proskauer has released Regulation of Investment Advisers by the U.S. Securities and Exchange Commission, by Robert E. Plaze, who recently joined Proskauer as a partner.  Bob previously served as Deputy Director of the Division of Investment Management of the SEC.  This publication, which draws on Bob’s nearly 30 years of service with the SEC, is the definitive outline summarizing SEC regulatory issues for Investment Advisers.

Regulation of Investment Advisers is regularly updated and covers extensive ground in key areas for fund managers.  It synthesizes regulation of advisers by the SEC, identifies legal and regulatory precedents, and provides hyperlinks to the underlying authorities.  We hope that you will find it to be a helpful resource.

Please feel free to bookmark or download Regulation of Investment Advisers by the U.S. Securities and Exchange Commission.

We are reaching out to our investment firm clients to advise them of an email “spear phishing” scam that has targeted investment firms recently, attempting to lure their personnel into inadvertently revealing their email account credentials to criminal fraudsters, and making wire transfers to the criminal’s account instead of the intended account.

There has been a significant uptick in this scam against investment firms. We recommend that our clients advise their personnel who are involved with wire transfers to:

• Examine “reply to” email addresses carefully to verify that the email came from the exact email address of the person who purportedly sent it
• Beware of emails that appear to be from someone the recipient knows, that link to a log-in page where the recipient is required to enter his or her username and password in order to access something
• Beware of emails that change wire transfer instructions from what they had been in the past or anything abnormal about the wire transfer authorization process
• Prior to initiating any wire transfer, confirm instructions by telephone with an authorized representative of the recipient

Firms are also advised to consider the legitimate emails that their personnel receive regularly that request passwords or authorize wire transfers, and to configure their email filters to block mimicked versions of those emails that are not from the email address that they should be from.

According to recent news reports, the DOJ and the SEC are investigating the possible improper use of third-party broker quotes by hedge fund managers to value illiquid debt securities in their portfolios. Prosecutors are reportedly focused on possible instances where fund managers allegedly solicited predetermined or improper quotes from brokers, and used those estimates to inflate their own valuations of thinly-traded mortgage bonds.

In addition, the co-head of the SEC’s Asset Management Unit recently highlighted that unit’s focus on valuation, particularly where registered advisers failed to follow their own internal procedures when valuing illiquid positions. The SEC’s focus is further demonstrated by a recent action against a fund manager for improperly valuing municipal bonds inconsistently with GAAP.

In light of the SEC’s focus on valuation policies and procedures, fair valuing illiquid assets should be a key concern for fund managers. Although the alleged use of “bogus” marks to inflate the value of a trading book is an extreme example, the regulatory attention to valuation should not be ignored.  As we have noted here before, although valuation can be more art than science, there are heightened regulatory risks in the following areas:

(1) breakdowns in controls/policies/procedures,

(2) violations of Generally Accepted Accounting Principles (GAAP); and

(3) incomplete or inaccurate disclosures to fund investors and auditors.

Why are valuation policies important?

First, managers need to be concerned about potential violations of the anti-fraud provisions (e.g., sections 206(1) and (2) of the Advisers Act).  They should have policies and procedures (and training) in place to ensure that the valuation of all securities is done in an appropriate manner that is consistent with the manager’s fiduciary duties and the disclosures provided to investors.

Second, valuation policies fall under the compliance rule (Rule 206(4)-7 under the Advisers Act). Under this rule, the SEC expects registered advisers to adopt and implement policies and procedures to value client holdings.  SEC staff typically request and scrutinize a firm’s valuation policies either during their exams, or when following up on enforcement tips.  Problems can arise when a fund manager fails to follow its disclosed valuation policies to the letter, turning internal control issues into potential disclosure issues. Even if the government cannot prove that valuations were “wrong” they may allege that disclosures regarding the valuation policies themselves were false or misleading.

Covenant Financial Services:

The SEC’s March 2017 case against hedge fund manager Covenant Financial Services demonstrates how SEC enforcement might approach a typical valuation matter. Covenant settled claims involving its use of a pricing service to value certain municipal bonds.  According to the order, the manager’s valuation policy appeared consistent with GAAP, but in practice, the execution fell short.

Covenant’s policy recognized the principles of Accounting Standards Codification 820 (“ASC 820”). Consistent with ASC 820, the policy prioritized the use of Level 2 inputs (“inputs other than quoted prices . . . that are observable for the asset or liability, either directly or indirectly.”) over Level 3 inputs (“unobservable inputs for the asset or liability.”).

The problem arose because the pricing service used by Covenant estimated values based on a model that used Level 3 unobservable inputs, rather than Level 2 inputs. Covenant allegedly used this model despite being aware of Level 2 indicators that were inconsistent with the model’s valuations, including actual trades it made in the same or similar bonds, and broker quotes and marks it obtained.

The SEC determined that because Covenant allegedly overstated its funds’ performance during those time periods, it violated the anti-fraud provisions of the Advisers Act. In addition, because it failed to follow its own valuation policy, the SEC alleged that the adviser also violated the Compliance Rule by failing to implement its written policies and procedures.

Lessons Learned: What should be included in valuation policies?

Fund managers should follow a disciplined and documented internal process. This process should involve finance/accounting personnel along with investment professionals.  The overarching principles, in our view, are (1) consistency when applying the policies over time and (2) accurate disclosure of the policies (and deviations) to LPs.

Best practice may also include establishing an internal valuation committee. The policies should be reviewed at the outset and periodically by the fund’s valuation committee.  And although a manager may choose to retain an outside valuation firm, the valuation of fund assets is ultimately the manager’s responsibility. Ultimately, the best way to reduce risk is to consistently apply and follow the documented valuation policies.

The SEC has been active in pursuing several insider trading cases this year on both the large and the small-scale, some of which involved trades that yielded profits as small as $40,000-$60,000. Why does the enforcement division spend resources on these smaller cases? And how will the SEC continue to investigate new leads through data analysis?

For additional guidance, please see our post on the Corporate Defense and Disputes blog.

For private fund managers, the valuation of privately-held securities has been subject to heightened regulatory scrutiny. As the IPO on-ramp for private “unicorn” investments has lengthened, fund managers may hold illiquid investments for longer-than-expected time periods—and valuation-related risks increase as the time lengthens between purchase and exit.  This is the second of two blog posts regarding valuation issues; part one addressed regulatory and litigation concerns regarding valuation of traded securities. This post addresses valuation of private equity portfolio companies.

For private fund advisers that are registered with the SEC, valuation will always be a key component of any exam, and disclosures about valuation to current and prospective LPs are always a key point of inquiry. Over the past year, the SEC has requested information from mutual fund companies about how they value private technology companies, looking for discrepancies. We’ve previously noted that although regulators may not challenge a fund’s valuations as wrong per se, they tend to focus on issues “around” valuation practices:

• Absence of adequate controls/policies/procedures
• Failure to adhere in practice to stated valuation policies
• Incomplete statements to auditors regarding assumptions & process
• Disclosures to investors regarding valuation policies

Problems typically arise when a fund fails to follow its disclosed valuation policies to the letter, turning internal control issues into disclosure issues or potential violations of the anti-fraud provisions.

Private litigation involving portfolio company valuations and projections also has the potential to affect funds and advisers. For example, investors or employees may purchase company stock based on overly optimistic valuations, only to discover that shares are later worth much less.  They may look to the fund as a deep pocket.

Can a fund simply hold investments at cost? Over time, fair value will deviate from initial cost, because fair value is generally focused on the anticipated “exit price” as of the measurement date.  A cost approach may have been typical in the past (and might seem conservative in a rising market), yet that approach is generally considered to be inconsistent with fair value.  For example, the Private Equity Industry Guidelines Group (PEIGG) guidelines note that use of cost basis or the value of the latest financing round, without taking into account changed circumstances, “is incompatible with” the concept of fair value.

In our view, regulators may be concerned if they see cost-based valuations, especially if they remain the same from period to period, without taking into account changing economic conditions.

Can valuations track the last round of funding? Even if the round is not a so-called “down round,” the headline per-share valuation may not reflect fair value if the deal includes certain structured terms that only benefit later investors.  For example, a recent round could include preferences such as guaranteed IPO returns backed by ratchet mechanisms, vetoes, or liquidity rights.  These structured transactions (called “dirty term sheets” by some), involve hidden terms that add complexity at the expense of prior investors, regardless of the calculated value per share.

According to the PEIGG guidelines, valuation methodology should start with an estimate of the value of the portfolio company as a whole as an initial step, then determine how the enterprise value is distributed among different classes of securities within the capital structure. If later terms give preferences, a discount for pre-existing share classes may be appropriate.

Should a manager follow outside firms’ valuations? Ignoring these outside valuations is risky, and most relevant guidance indicates these should, at a minimum, be considered.  For example, as reported in the Wall Street Journal various mutual funds last year marked down their valuations of private tech startup companies. One could argue that these public valuations are observable inputs that should be incorporated into any analysis.  If conflicting external valuations exist, especially if those valuations are public, it would be wise to document the rationale behind choosing a different valuation.

Internal valuation discrepancies. For example, Section 409A valuations.  When private companies want to issue stock or options to employees, under Section 409A of the Internal Revenue Code, they need an independent, third-party valuation of those shares.  The New York Times recently noted that it is a “dirty secret” that these valuations are often very precise yet have little practical value. They allow a private company to issue shares to employees at a cost that is much lower than the price that preferred shares are sold to outside investors.  Although common stock is obviously different from preferred, a concern is whether inputs and assumptions are consistently applied across different valuations.

Another data point: Based on recent statements by senior staff from the SEC’s San Francisco Regional Office, the SEC will continue to focus on privately-held companies over the next year. In the near future we may see a case against a pre-IPO issuer relating to Rule 701 under the Securities Act.  That rule requires disclosure of detailed financial information to employees or consultants in connection with certain stock or option grants.  If so, there may be a spillover effect for funds that have invested in those companies or have board representation.

Conclusion. As the IPO on-ramp has appeared to speed up in 2017, there will be winners but also companies left behind.  Valuation is an area where risk typically increases in times of market disruption.  As SEC senior officials have noted, the enforcement division looks closely at valuation and asset impairment in times of economic turmoil, when managers might look to enhance performance using valuation adjustments and subjective discretion. In this environment, fund advisers can reduce risk by following robust and documented valuation procedures.

Proskauer partners Jeff Neuburger, Robert Leonard, Josh Newville and Jonathan Richman recently invited hedge fund executives to discuss the complex regulatory and compliance issues raised by the use of alternative data.   Jeff, Robert and Josh also contributed an article to the Hedge Fund Law Report on Best Practices for Private Fund Advisers to Manage the Risks of Big Data and Web Scraping.

Fund managers have been capitalizing on methods to refine and analyze big data to assist investment decisions.  What types of alternative data are being used to gain new insights?  Sources include: e-commerce receipts and credit-card transaction data; sensors from internet-connected machines or smart devices; and online data collected via “screen scraping” (or “web scraping” or “spidering”).

Yet alternative data does not come without risks.  For example, data collected as a result of web scraping may be considered material nonpublic information (MNPI).  If that data were collected in a manner considered deceptive, then trading on that information might implicate the anti-fraud provisions of the securities laws.  Circumventing security protocols or disguising a scraper’s identity on a site (where required), among other behaviors, could be viewed as misrepresentations or “deceptive devices” under Section 10(b) of the Securities Exchange Act.d

Hedge fund managers and other financial services firms using information in this new environment should therefore understand the legal risks and fashion appropriate policies and procedures (both internal and with respect to vendor diligence).  We have made the materials from Proskauer’s presentations available here, outlining the complex regulatory, compliance and contractual issues raised by the data aggregation, web scraping and other data science methods.  These topics include:

• Types of Data Aggregators
• Web Scraping and Other Data Collection Methods
• Securities Law Concerns, Including Deceptive Conduct and MNPI
• Best Practices for Due Diligence and Internal Processes
• Compliance with Other Federal Laws and Regulations

For questions regarding any of the topics discussed, please contact Jeff, Robert, Josh or Jonathan, or Christopher Wells or Michael Mavrides from our Hedge Funds group.

On July 12, 2017, newly appointed SEC Chairman Jay Clayton delivered a speech at the non-partisan Economic Club of New York wherein he set forth several high-level guiding principles for the agency.  In general, these remarks focused on (i) ensuring protections for retail investors, (ii) positioning the SEC as a regulator which is able to evolve on pace with industry, and (iii) taking a more measured and effects-focused approach to rulemaking.   In addition, Chair Clayton stated that he opposed any wholesale changes to the SEC’s fundamental regulatory approach. 

Underlying Mission: Focus on Retail Investors

On a global level, Chair Clayton cited the SEC’s three-part mission of: (i) protecting investors; (ii) maintaining fair, orderly, and efficient markets; and (iii) facilitating capital formation. Furthermore, Chair Clayton stated that his analysis of whether the SEC is meeting its mission starts and ends with the long-term interests of the “Main Street investor.”  With this end in mind, he specifically identified affinity and microcap fraud as areas where Main Street investors were “most exposed,” as well as fraudulent schemes conducted through the use of technology.

Keeping Pace with the Industry

In the area of regulatory evolution, Chair Clayton stated that the agency is now applying sophisticated analytic strategies to detect companies and individuals engaging in suspicious behavior. Furthermore, the agency is adapting machine learning and artificial intelligence to new functions, such as analyzing regulatory filings.  Chair Clayton also announced that he had asked the SEC staff to develop a plan for creating a Fixed Income Market Structure Advisory Committee.

Rulemaking: Looking for Efficiency

With respect to rulemaking, Chair Clayton opined that the SEC should review its rules retroactively and accept input from sources outside of the agency as to whether the SEC’s rules are functioning as intended. He expressed concern that vaguely worded rules created the risk for either subpar compliance solutions or, conversely, an overinvestment in compliance control systems.  In perhaps a reference to an upcoming rulemaking initiative, Chair Clayton made reference to a statement he had previously issued in June which sought public input on standards of conduct for investment advisers and broker-dealers.

Enforcement: More of the Same

Turning to enforcement, Chair Clayton cautioned that the SEC would continue to deploy significant investigative and enforcement resources. Perhaps alluding to a continued focus in the private funds industry, he delivered a pointed notice to “sophisticated participants” in the securities markets in noting that the agency would continue to use its enforcement and examination authority to support market integrity.

Cybersecurity

Chair Clayton also cited a continuing focus in the area of cybersecurity. He specifically noted that information sharing and coordination among regulatory agencies was a key component of addressing potential cyber threats.  However, Chair Clayton also suggested that the SEC should be cautious about punishing responsible companies that find themselves as victims of sophisticated cyber penetrations.

***

With these basic tenets in place, Chair Clayton is likely to set upon establishing the means to achieve the policy goals that he has articulated. Time will be the ultimate barometer to determine the resemblance that the SEC under Chair Clayton’s leadership will bear to that of its predecessors.

The recent IPOs of Snap, Inc. and Blue Apron indicate that while the IPO pipeline continues to flow, there may be a cautionary tale for “unicorns” – venture-backed companies with estimated valuations in excess of $1 billion.

After Snap went public in March, it posted a $2.2 billion loss in its first quarter, yielding a 20% same-day drop in stock price that erased much of the company’s gains since its IPO. A snapshot of Snap’s stock price shows the obvious risks faced by late-stage investors in unicorns.  High valuations are not a guarantee of continued success, particularly where historical performance and profitability are lacking.  Although one commentator recently asked: “Are Blue Apron and Snap the worst IPOs ever?”, there is plenty of time for those stock prices to recover, especially in the months after their insider lockup periods expire.

Less well-known is how those risks can create conflicts that lead to litigation in the private fund space. The unicorn creates a dilemma for the private fund backing it.  On the one hand, an exit through a public offering is desirable as demonstrating cash-on-cash return is generally better than maintaining an illiquid holding, particularly when the company is facing the potential for down round funding to survive.  On the other hand, going public puts the unicorn’s financials in public view, and employees and private funds risk losing big if the company cannot sustain its predicted value.

Ultimately, a choppy IPO outlook for unicorns will lead to tightening of markets. As more unicorns linger and fall into distress, some will fail, leading to litigation.  Overly optimistic valuations lead to inflated expectations, especially those of employees expecting a payout and investors expecting gains.  Below are some types of disputes that can arise.

Employee claims: Employees paid in common stock may sue in the event of a dissolution or bad sale ahead of a public offering.  As in the case of former unicorn Good Technology, a bad sale may involve a payout on the common stock that amounts to only a fraction of its estimated value.  Employees of Good Technology (who held common shares) filed claims asserting that the company’s board breached its fiduciary duties by approving the sale.  They alleged that the board (whose members represented funds that owned preferred shares) favored the preferred over common shareholders.  While the case has been slow to progress, its outcome will inform the market whether such suits will provide viable recourse when employee shareholders believe their interests have been disadvantaged.

SEC Scrutiny: As we’ve previously noted, valuation-related regulatory risks increase as the time lengthens between purchase and exit. The SEC’s exam and enforcement staff have been focused on valuation of privately held companies for years. Further, the SEC sees itself as a protector of investors, even when those investors are employees of a private startup.   We are likely to see a disclosure case against a pre-IPO issuer relating to Rule 701 under the Securities Act.  That rule requires disclosure in certain circumstances of detailed financial information to employees in connection with certain stock or option grants.  This would lead to a spillover effect for funds that have supported those companies.

Claims arising in an acquisition: If the company is fortunate enough to reach some liquidity in a private sale, the acquiring company may pursue litigation against the board or other investors. The buyer may later allege fraudulent inducement and breach of contract on the grounds that the company and its investors misrepresented the company’s value.  In addition, investors can often break even in a merger by holding preferred shares with liquidation preferences.  However, like employees, investors still may sue the board or the company to try to recover a better return on their investment.

Fund LP/GP disputes: Unicorns are no different than other portfolio companies, in that when they fail, there may be disputes between a fund’s GP and its LPs. Those claims may vary.  For example, the fund’s designee on a failed unicorn’s board of directors will typically owe fiduciary duties to both the portfolio company and the LPs.  An LP may allege that the board representative favored the interests of the company over the interests of the LPs, or failed to adequately address or disclose concerns raised to the board level.  Furthermore, LPs may allege that the fund manager failed to address the potential for conflicts between the adviser and the funds.

While unicorns can generate extraordinary returns for early investors, they may also carry increased litigation risk even when they are successful. In addition, as more unicorns linger and fail to achieve successful exits, there is a higher likelihood that investors or employees will seek to recoup losses through litigation.  Fund managers should keep in mind the potential for these conflicts before a unicorn stumbles.  Addressing these relationships at early stages of the investment can help minimize litigation risk.

A veil piercing claim can be a worst-case scenario for a private fund manager dealing with a struggling portfolio company investment – the company fails, and ensuing legal claims are brought not only against the portfolio company, but also against the fund and its GPs. How can fund managers manage that risk?

Limited liability is a hallmark of the corporate structure. Yet the legal doctrines of veil piercing and alter ego permit courts to “pierce” or bypass the corporate structure in order to hold shareholders and directors personally liable for a corporation’s actions or debts.  These doctrines have important implications in the context of a fund that owns large stakes in portfolio companies.

If a fund is found to be the alter ego of a portfolio company, the fund may be exposed to significant liabilities even in the absence of direct claims against the fund. For example, if a portfolio company falters and implements a large-scale layoff, there is a high likelihood that plaintiffs will file a WARN Act action.  Outside investors or employee shareholders may pursue misrepresentation and fraud claims against the company based on rosy predictions.  When the portfolio company is insolvent, plaintiffs will seek out the “deep pockets” of the fund itself on a veil piercing or alter ego theory.

This post outlines the general standards for veil-piercing under Delaware law and provides concrete steps that can help to limit the exposure of a fund and its managers to derivative liability claims. We chose Delaware law because of the state’s popularity as a state of incorporation.

An important caveat: As we will discuss in a later post, California law differs in several important respects from Delaware law on this topic.

What Law Applies?

Most states, though not all, choose the law of the state of incorporation when considering veil-piercing claims under the “internal affairs doctrine.” That doctrine generally states that the law of the state of incorporation (e.g. Delaware) controls the “internal affairs” of a corporation.  So, for corporations organized in Delaware, even if a claim is brought in New York or Illinois, Delaware law will typically apply to the veil-piercing claims under the internal affairs doctrine. See, e.g., Fletcher v. Atex, Inc. (2d Cir. 1995) (“Under New York’s choice of law rules, the law of the state of incorporation determines when the corporate form will be disregarded”).

Why is this important? The law in Delaware (like New York and Pennsylvania) is regarded as particularly favorable to owners/managers resisting a veil-piercing claim.  California, on the other hand, is typically considered an easier jurisdiction to pierce the veil.  And rather than looking to the state of incorporation, California courts generally apply California law to alter ego claims, as we will discuss in a later post.

Another difference between states is whether veil piercing is treated as an equitable matter for the judge to decide or a factual question for the jury. In Delaware, for example, a judge decides veil-piercing claims.  Texas is an outlier, where such claims are left to the jury.

These differences are important because choice-of-law determinations in veil piercing cases are, unlike in breach-of-contract lawsuits, not governed by a contractual provision; indeed, by definition no contract could exist between the plaintiff seeking to pierce the corporate veil and the parent corporation, otherwise there would be no need to pierce the veil.  Instead, the applicable law will be determined by the choice-of-law provisions of the forum state.  Most often, courts apply either the law of the state of incorporation of the entity subject to piercing or the law of the forum state.

General Standards in Delaware

Delaware law, which governs many veil piercing claims, provides robust piercing protections. A plaintiff seeking to pierce the corporate veil in Delaware needs to show that the corporation, through its alter-ego, has created a sham entity designed to defraud investors and creditors.  In other words, Delaware requires a plaintiff to demonstrate “an element of fraud” or something like it. See, e.g., Winner Acceptance Corp. v. Return on Capital Corp., No. 3088-VCP, 2008 WL 5352063, at *5 (Del. Ch. 2008).  This is a very high standard.

The veil-piercing analysis in Delaware, as in most jurisdictions, is fact-intensive. Delaware courts consider factors such as:

1. whether the company was adequately capitalized for the undertaking;
2. whether the company was solvent;
3. whether corporate formalities were observed;
4. whether the controlling shareholder siphoned company funds; and
5. whether, in general, the company simply functioned as a façade for the controlling shareholder.

Due in large part to the fraud requirement, Delaware courts grant dismissal or summary judgment of alter ego claims with greater frequency than do the courts of many other jurisdictions.

What You Can Do

So, what can you do to protect a fund from piercing claims? We have put together a list of dos and don’ts to help minimize exposure to these types of claims.

Dos:

• Keep separate books and records for both companies.
• Have separate meetings of the board and keep separate minutes.
• Make the board composition of the entities different.
• Keep separate accounts, including bank accounts, for both companies.
• Require the use of separate email addresses and letterhead for any individuals with positions in both entities.
• Where possible, maintain an arm’s length relationship in business dealings between related entities.
• Adequately capitalize any corporation for its line of business.

Don’ts:

• The two companies should not use the same office or business location.
• They should not employ the same employees/attorney.
• Do not divert assets from a corporation to the detriment of creditors, or manipulate assets and liabilities between entities so as to concentrate the assets in one and the liabilities in another. This is a potential sign of the fraud element that Delaware law requires for veil piercing to apply.
• Do not have identical equitable ownership in the two entities, especially if the equitable owners have control over both entities.
• Do not have the same directors and officers responsible for supervision/management of both entities.
• Do not make the parent liable for the debts of the portfolio company.

Some of these suggestions are relatively fundamental and easy to implement. Others may be harder to accomplish, especially when managing a struggling portfolio company.  Given the risks, it is important to try to follow these guidelines.  If questions arise concerning the risk-reduction measures we’ve outlined above, it always makes sense to consult with outside counsel.

The SEC staff recently published an alert highlighting the most common deficiencies seen in investment advisers’ marketing materials.  Based on its recent examinations and initiatives, the Office of Compliance Inspections and Examinations (OCIE) issued its risk alert to highlight compliance issues relating to Rule 206(4)-1 (the “Advertising Rule”).  Here are the top six:

1. Misleading Performance Results.
2. Misleading One-on-One Presentations.
3. Misleading Claim of Compliance with Voluntary Performance Standards.
4. Cherry-Picked Profitable Stock Selections.
5. Misleading Selection of Investment Recommendations.
6. Lack of Adequate Compliance Policies and Procedures.

Earlier this year, we wrote that performance marketing was one of the top 10 regulatory risks for private funds.  And after an OCIE risk alert, we often expect to see an uptick in related enforcement activity.  At minimum, OCIE is putting the industry on notice that it will scrutinize managers’ advertising and marketing materials.

For additional guidance, please read our full client alert on this topic.

We recently posted about the risks associated with veil-piercing claims and the ways in which fund managers can protect themselves from exposure to these claims. Our first post on veil-piercing focused on Delaware standards, while this post discusses California law.

California law differs in several important respects from Delaware law on this topic. If a company is subject to suit in California, there are increased risks even if the company is incorporated elsewhere.  Courts may assert that California law should apply when the plaintiff is a California resident or when the company operates in California.

And where California law applies, courts may aggressively set aside corporate distinctions, leading to unanticipated results. For example, a Santa Clara Superior Court held in recent years held that a private fund limited partnership entity could be held responsible for the fund GP’s obligations to its former employees.

Because the alter ego inquiries are so fact-driven, if an underlying California cause of action against the portfolio company survives, it is likely the alter ego claim may survive too—beyond the dismissal stage, leading to costly litigation involving the fund. That means that a liability of the fund or even its GPs could well become entirely dependent, on a derivative basis, on that of the portfolio company.

What Law Applies?

Most states follow the internal affairs doctrine and apply the law of the state of incorporation to piercing the corporate veil claims. However, no California case has done this.  To the contrary, statements made in California cases strongly suggest that the “internal affairs doctrine” would not apply to a veil piercing claim. See, e.g., Lidow v. Superior Court, 206 Cal. App. 4th 351, 362 (2012).  And a federal district court in the Northern District of California, interpreting California law in a diversity case, concluded that the “internal affairs doctrine” does not apply to choice-of-law questions involving the alter ego/veil piercing doctrine. Oncology Therapeutics Network Connection v. Virginia Hematology Oncology PLLC, No. C 05-3033 WDB, 2006 WL 334532, at *17 (N.D. Cal. Feb. 10, 2006).

Instead, California applies the choice-of-law test it traditionally uses for all other claims: the “governmental interest” test. California’s “governmental interest” test is complicated and costly to litigate.  It involves three basic steps:

1. First, do the competing states’ laws differ?

• In other words, is the substantive law of alter ego/veil piercing different in state X than in state Y California?
• If the laws of the competing states do not differ, then either state’s law produce the same result, and it doesn’t matter which law you apply, you’ll get the same result.

1. If the laws of the competing states do differ, the court then identifies which interests of each state, if any, could be impaired if the court does not apply that state’s laws.
2. If both states have interests that would be impaired if its their laws are not applied, the California court conducts an analysis of “comparative impairment” to determine which state has the greater interest in having its laws applied.

• When the plaintiff is a California resident who claims to have been injured by the defendant, or when the defendant is doing business in California and subject to suit there, California courts tend to find that California has the greater interest.

• In either scenario, the court is validating California’s interest in policing (California defendant) or giving redress to its own citizens (California plaintiff).

In short, if a plaintiff can bring the suit in California, there is good chance California law will apply to any veil-piercing claims – even if the company and the fund are located elsewhere.

General Standards in California

California law typically does not require a plaintiff to come forward with evidence of fraud in order to apply the veil piercing doctrine.  Rather, a California plaintiff only needs to show that honoring the corporate form would “promote injustice” or “bring about inequitable results.”

California utilizes a non-exclusive, multi-factor test to make veil-piercing determinations. This long list of almost twenty factors (including one factor that points to the existence of additional factors as yet unarticulated by the courts) includes the following:

1. commingling of funds and other assets;
2. the holding out by an individual that he is personally liable for the debts of the corporation
3. failure to maintain adequate corporate records;
4. identical equitable ownership in the two entities;
5. identification of the directors and officers of the two entities in the responsible supervision and management;
6. sole ownership of all of the stock in a corporation by one individual or the members of a family;
7. the use of the same office or business location;
8. the employment of the same employees and/or attorney; and
9. failure to maintain arm’s length relationships among related entities.

Morrison Knudsen Corp. v. Hancock, Rothert & Bunshoft, LLP, 69 Cal. App. 4th 223, 249–50 (Cal. Ct. App. 1999).  California courts have made it clear that summary judgment is rarely appropriate for veil-piercing determinations.  All a plaintiff likely needs to survive summary judgment is a genuine dispute of material fact over some of these factors.

Takeaways:

What You Can Do

So, what can you do to protect a fund from piercing claims? Our prior post outlined a list of dos and don’ts to help minimize exposure to alter ego claims.  If the portfolio company is potentially subject to claims in California, these concerns are even more heightened.  A fund manager might evaluate the structure with the view of a California court:  would recognizing the corporate limitation of liability “promote injustice” or “bring about inequitable results?”  If so, the manager may want to take steps to further extend its arm’s length relationship with the investment.

The SEC’s pay-to-play rule has given advisers reason to worry about potential foot faults since its adoption. As we have noted in prior posts, the rule is filled with landmines and is therefore difficult to navigate.  As was evident from the SEC’s announcement of a series of settlements of alleged pay-to-play violations in early 2017, even a small contribution without any intent to influence an election or an official can run afoul of the rule and put two years of fees and carry at risk.

Last week, the SEC issued an order that will expand the scope of the pay-to-play rule.  The SEC approved a FINRA proposal to extend the self-regulatory organization’s Rules 2030 and 4580 (its pay-to-play and associated recordkeeping rules) to a recently established category of FINRA-registered firms known as capital acquisition brokers, or CABs.

CABs are firms that focus on a more limited set of activities than full-service broker-dealers.  Generally, an entity qualifies as a CAB if it engages solely in specific capital raising or corporate advisory activities, including corporate restructurings and acting as a private fund placement agent.  However, CABs are prohibited from maintaining customer funds and cannot trade customer securities.  Firms that carry customer accounts, produce research or chaperone non-U.S. broker-dealers under Rule 15a-6 of the Exchange Act cannot register as CABs.

The SEC order subjects CABs to the pay-to-play restrictions and recordkeeping requirements already applicable to full-service broker-dealers under FINRA CAB Rules 203 and 458.  The pay-to-play rule that applies to CABs is substantially similar to the pay-to-play rule that applies to investment advisers, with minor distinctions.

As a refresher, the SEC’s pay-to-play rule generally prohibits an adviser from providing compensated advisory services to state government or retirement plan investors for two years following an impermissible contribution – in other words, no fees or carry during the two-year “time out” period.  The rule is triggered if the adviser or one of its “covered associates” makes a “contribution” to an “official” of a “government entity” unless the “contribution” falls within one of the narrow exceptions to the rule.  An adviser could also be subject to penalties if the adviser or one of its “covered associates” coordinates or solicits a “contribution” to an “official” or “payment” to a state or local political party.  The use of “quotations” here is intentional – each is a defined term within the rule that requires independent analysis by the adviser.

While the expansion of the FINRA pay-to-play rule is somewhat narrow, it serves as a useful reminder to private fund advisers to review their compliance policies, confirm that applicable recordkeeping requirements are being met, and double-down on ensuring that personnel are well-trained on the potential implications of their political activities.  With the proper procedures in place, the potential for financial and reputational harm resulting from a violation of the pay-to-play rule can be minimized.

As we have said before, a well thought out, robust, and vigilantly enforced pay-to-play policy will pay for itself.

On October 4, 2017, U.S. Representative Sean P. Duffy [R-WI-7] introduced U.S. House of Representatives Bill H.R.3948 entitled the “Protection of Source Code Act.”

If enacted, the Bill would amend the Securities Act, the Securities Exchange Act, the Investment Company Act and the Investment Advisers Act to prohibit the SEC staff from obtaining algorithmic trading source code without a subpoena. This would prevent the SEC staff from obtaining source code through OCIE exam requests or during the early stages of an investigation before the staff has obtained authority to issue subpoenas.

Specifically, the bill would block SEC staff from compelling a person “to produce or furnish source code, including algorithmic trading source code or similar intellectual property that forms the basis for design of or provides insight to the source code, to the Commission unless the Commission first issues a subpoena.” The Bill was co-sponsored by Representatives Randy Hultgren [R-IL-14], David Scott [D-GA-13] and Luke Messer [R-IN-6].  Various industry groups have submitted a letter in support of the proposed legislation.  The Bill does not articulate Congress’ intention to extend protections to “intellectual property that forms the basis for design of or provides insight to the source code.”  The Bill also does not distinguish between algorithmic trading source code that may be deployed in live trading environments from those that are utilized in a simulated or test trading setting.

The Bill was referred to the House of Representatives Committee on Financial Services. On October 12th, by a vote of 46-14, the committee approved the Bill for consideration by the whole chamber.  However, Representative Duffy’s office has indicated that it is uncertain when the Bill will be introduced to the full House.

If enacted, the resulting revisions to the major federal securities acts would likely impose additional safeguards from the SEC staff’s investigatory process for matters involving hedge and other private fund advisers utilizing algorithmic trading programs. This follows upon the decision of then-Acting SEC Chairman Michael Piwowar to institute a policy change revoking the previously “delegated authority” to issue a formal order of investigation (a precursor to the ability to issue a subpoena in a matter).  This reported change removed authority to approve a formal order from about 20 senior SEC officials and represented a reversal of the agency’s existing policy previously authorized in 2009.

Last night, the SEC announced its enforcement results for the Fiscal Year 2017, accompanied by a report from the Co-Directors of its Division of Enforcement.  While the total number of actions was down slightly from 2016, the percentage of those cases involving investment advisers or investment companies – 18% – remained consistent, and amounted to over 80 cases. Similarly, insider trading cases remained about 9% of the actions filed.  The Annual Report specifically highlighted cases where large investment advisers allegedly charged undisclosed or inappropriate fees to clients, focusing on the fiduciary duties advisers owe to clients.  The SEC also noted a case it settled with a large fund adviser, alleging misleading performance marketing and valuation concerns. As we have previously noted, we expect continued SEC attention in the unicorn and startup field relating to valuation and performance during FY 2018.

The results indicate that individual accountability is front and center for the agency’s enforcement staff. With 73% of the Commission’s standalone actions including charges against individuals, Co-Directors of the Enforcement Division asserted that “pursuing individuals has continued to be the rule, not the exception.” Further, the SEC has highlighted its work protecting retail or “Main Street” investors. Based on our interactions with senior SEC staff, this focus on protecting Main Street extends to funds that manage pension and retirement fund investments.

A new development at the end of FY 2017 was the creation of the specialized Cyber Unit, focusing on computer hacking, distributed ledger technology and other cyber-related threats.  Fund managers with exposure to ICOs or distributed ledger technology should prepare themselves—those issuers may face increasing regulatory scrutiny which might impact the value of those investments. For example, the SEC just recently obtained an asset freeze in a case involving allegedly fraudulent ICOs. In addition, the use of alternative data sources is likely to be a focus, particularly in situations where the Enforcement Division suspects that potential material nonpublic information is being used or shared.

Yearly data from 2014 through 2017 is summarized in the table below:

For more insights into the SEC’s focus over the past year, please see our prior posts:

• SEC Chairman Identifies Guiding Principles
• SEC Flags the Top Six Advertising Rule Deficiencies for Investment Advisers
• Pay-to-Play – SEC Expands Scope of Rule to CABs
• SEC Speaks on Initial Coin Offerings: Tokens May Be Securities
• SEC Announces 2017 Compliance Outreach Program Seminars for Investment Companies and Investment Advisers
• SEC Speaks: 2017 Enforcement and Exam Trends for Private Funds

Proskauer’s Private Investment Funds Group recently released its 2017 Annual Review and Outlook for Hedge Funds, Private Equity Funds and Other Private Funds.  This yearly publication provides a summary of some of the significant changes and developments that occurred in the past year in the private equity and hedge funds space, as well as certain recommended practices that investment advisers to hedge funds, private equity funds and other private funds should consider when preparing for 2018.

Highlights from the annual review include:

• SEC examination priorities and initiatives and enforcement developments related to the private fund industry, as articulated by SEC officials and corroborated by industry participants, including a review of actions in the areas of performance marketing, valuation, conflicts of interest and investment allocation;
• A review of regulators’ continued focus on whistleblower programs, including an overview of the SEC’s continued scrutiny of separation agreements and the CFTC’s amendments to its own whistleblower program;
• An analysis of the current state of insider trading law, including an analysis of the U.S. Supreme Court’s decision in Salman v. United States, the Court’s first ruling in the area of insider trading in nearly 20 years, and the Second Circuit’s approach to the personal-benefit requirement in United States v. Martoma;
• Ongoing proposed tax changes, including an overview of the evolving tax landscape and a discussion of the recently released GOP tax plan;
• A review of Big Data, including an examination of securities, technology and privacy laws that may impact the use of Big Data;
• Regulatory developments in the area of cybersecurity, including new areas of focus for SEC enforcement initiatives and sources of industry guidance issued by the SEC staff;
• Industry developments in the areas of blockchain and bitcoin technology, including a discussion of state law developments concerning blockchain implementation and an overview of the SEC’s report on the application of the federal securities laws to initial coin offerings;
• Regulatory developments in the European Union, including an update on the Brexit process and a review of both the Alternative Investment Fund Managers Directive and the impending implementation of the General Data Protection Regulation in each of the EU Member States; and
• A comprehensive overview of required regulatory filings across the many agencies overseeing the private funds industry, including a quick reference table for monthly filings in 2018.

If a team from the SEC arrives at your office and says, “We are conducting an on-site examination and would like to talk to the CCO right now,” are you prepared? A handful of registered investment advisers have faced surprise SEC exams in recent months. These exams come in two flavors: either a “for cause” exam arising from SEC staff concerns relating to a specific ongoing issue, or a standard exam that for some reason has a surprise component.

There are several logistical items that a fund manager might consider before the SEC shows up unannounced in the lobby, regardless of the substance of the SEC’s inquiry. Thinking and planning ahead can minimize unnecessary stress and confusion in the moment. Fund managers should consider the following questions:

1. You are notified they are here: What will you do first?

• Ask who the SEC staff wishes to speak to and determine if those people are present in the office.
• Show them to a location that will not cause disruption. (Perhaps not the fishbowl conference room in the middle of the office.)
• Is it a “for cause” exam (i.e., are they investigating urgent or time-pressing issues of concern)? If you are able to determine that it is a for cause examination, call counsel before having a substantive conversation with the exam staff.

2. What if the CCO is not available?

• It may be appropriate to reschedule. Ask the staff if they would like to return when the CCO will be back in the office.
• Designate someone to handle regulatory inquiries if the CCO is out.
• Ensure the person is comfortable with both substantive knowledge and the procedural actions to be taken if the SEC were to arrive.

3. How do you determine the purpose of the exam, the SEC’s priorities, and schedule?

• It is normal to ask questions, especially in the context of a surprise visit. Ask whether the exam relates to any specific issues.
• Be prepared to ask them about their expectation for timing and next steps.

4. How should the CCO answer questions and approach requests for interviews during the conversation?

• The CCO may not be fully prepared to provide specific answers to the SEC’s questions. It is wiser to stick to general facts and offer to get back to them with specifics.
• If the SEC requests interviews with executives who are unavailable, consider expressing a willingness to schedule meetings when they are, rather than taking senior management out of preexisting obligations and meetings.

5. If they ask for documents, are you ready to turn them over?

• The SEC will likely provide a list of requested documents. Evaluate which documents can be retrieved and turned over quickly (which should include your compliance policies and procedures) and those that will take some additional time, such as those the SEC may request you create. (e.g., lists of certain transactions.)
• If necessary, explain that to the examiners that you will continue to provide documents throughout the day.
• Assign a person to keep the collection of documents up to date or who will be responsible for assisting in a collection the day of a surprise visit.
• Be sure you have first thought about whether certain documents would require consideration of privilege: for example, emails involving attorneys, memos relating to litigation, or communications with consultants working under the direction of counsel.

What is the SEC staff trying to achieve with a surprise exam? If it is a cause examination, they may be trying to determine whether client assets are at risk. Otherwise, the SEC’s main justification is that the element of surprise gives the staff a better view of the inner workings of a registered entity. They say it eliminates an opportunity for an advisor to destroy or manipulate records. However, such concern may be overblown, as cover-ups can be detected through electronic storage and metadata, forensic review, and inconsistencies between document drafts. Additionally, a surprise visit can be counterproductive, as key persons may be out of the office or not be immediately available to speak with the staff.

Nevertheless, fund advisers that consider the questions above and have a plan of action ahead of time should have a smoother time in a surprise exam. It may also be helpful for the CCO to make sure management knows what is expected of them, with the goal of imposing some level of organization on a potentially disruptive event.