A recent decision by the Delaware Chancery Court suggests that a litigant might forego the ability to file a books and records request if it waits to do so until after the lawsuit is filed. Last month the Delaware Chancery Court dismissed just such an action, characterizing the request for a books and records inspection after the filing of a lawsuit as “inherently contradictory” and an improper attempt to “sue first, ask questions later.”

Section 220 of the Delaware General Corporation Law allows stockholders to inspect books and records of a Delaware corporation for any proper purpose and to compel inspection if such inspection is refused. Section 220 is typically used prior to the filing of a lawsuit as a means to develop information to support a plaintiff’s claims before it has access to discovery rules.  The corollaries to a Section 220 demand in the limited partnership and limited liability company contexts are known as a Section 17-305 demand and a Section 18-305 demand, respectively.

CHC Investment LLC brought suit against Strategic Growth Bancorp Inc. in August 2018 alleging fraud and fiduciary duty claims. In requesting a Section 220 books and records inspection, CHC sought to reconcile the differences in “diametrically opposed representations” made by Strategic Growth between 2014 and 2015. Strategic Growth challenged the books and records request, stating that it was an inappropriate pre-motion request for discovery.

Vice Chancellor Kathleen S. McCormick rejected the attempt to “sue first, ask questions later” as an arguably improper use of a books and records request. In dismissing the case, Vice Chancellor McCormick held that the use of a books and records request to investigate pending claims “undermines well-established discovery law” because once the lawsuit is filed, “discovery rules dictate what information relevant to its claims the stockholder may receive and when the stockholder may receive that information.”

According to the Vice Chancellor, in admitting that the document categories it sought were to advance its investigation of claims in the lawsuit, CHC contradicted itself – the act of filing the lawsuit presumed CHC already had the requisite information necessary to support its claims.

While there are situations where a books and records request may be used after the filing of a lawsuit, they are rare. For example, Delaware courts have allowed the use of a books and records request post-filing when there are time pressure implications or if a court has found a need to amend the complaint. There were no such special circumstances present in CHC’s case, leading to the Vice Chancellor’s dismissal.

The Chancery Court’s decision here provides practical guidance to litigants.  Delaware courts will expect a plaintiff to have performed a sufficient investigation and accumulated the information necessary to satisfy its pleading obligations before bringing a lawsuit.  Litigants therefore should not expect to succeed in bringing a books and records inspection request while the lawsuit is pending in order to acquire additional information – once a lawsuit is filed that process is governed (and limited) by the typical discovery rules and procedures.

Last week the SEC announced a settlement of fraud claims against the founder of Jumio, Inc, a private mobile payments company, for misstating the company’s financial results and using those financials to sell his company shares on the secondary market.  This case is a reminder that privately negotiated securities transactions and private, VC-funded companies are not exempt from regulatory scrutiny.  As we observed in a number of settlements last year, the SEC will pursue suspected investor fraud involving privately-held companies, whether in fundraising or sales by insiders, or even in disclosures to a company’s own employees in connection with stock options.

The SEC settlement involving Jumio alleged a variety of misconduct by the founder, such as entering into round-trip transactions designed to inflate revenue.   Interestingly, the alleged scheme was apparently designed so that the founder could sell shares on the secondary market in privately negotiated transactions, rather than in a funding round.

According to the SEC press release, Jumio’s founder agreed to a settlement ordering him to disgorge profits from the sales as well as to pay a penalty, and agreed to be barred from serving as an officer or director of a publicly traded company in the U.S.  The SEC also negotiated a settlement with Jumio’s former CFO/General Counsel for failure to exercise reasonable care in connection with the matter.  Jumio itself filed for bankruptcy in 2016 after the company restated its financial results.

Looking ahead, we see this type of case as a microcosm of what may be in store when the next economic downturn hits the current stable of unicorns.  Misconduct involving privately held companies, or even exits that are below recent valuations, may give rise to similar disputes.  Meanwhile, recent experience – most prominently with Theranos – suggests that the failure of one or more unicorns is likely to attract both regulatory scrutiny and private litigation.

There’s a new unicorn in town, and this time, it isn’t just another tech company. Rent the Runway, also known as RTR, is now officially valued at over $1 billion after its most recent funding round which raised $125 million.

The high-end rental clothing brand was launched in 2009 by female founders, including co-founder and CEO Jennifer Hyman. Rent the Runway’s third and largest round of funding took place during Hyman’s ninth month of her pregnancy term – a fact that surprises some and empowers all. The company has been sky-rocketing in value since it introduced its subscription rental service which now makes up 60% of the company’s revenues. One of the best parts – the consumer base is 100% female.

Of course, with success comes attention, and not always welcome attention.  The same week Rent the Runway reached unicorn status, LA startup FashionPass filed a lawsuit accusing Rent the Runway of monopolizing the high-end clothing rental market. In its lawsuit, FashionPass alleges that RTR conspired with other labels to demand exclusivity in the rental relationship. FashionPass’s complaint alleges in “excess of $3 million” in damages and claims it is entitled to recover treble damages.

Regardless of the merits or eventual outcome of the case, one thing is certain – by reaching unicorn status, Rent the Runway transitioned to a platform that is now being watched very closely, including by regulators and competitors.  This spotlight brings about a whole new facet of litigation risks.  As we’ve previously noted, the SEC has carefully been observing the unicorn market since 2016, keeping a particular eye out for inflated valuations and compliance issues that often come with rapidly growing startups.  And as RTR has now learned, private litigants are watching as well.

The continuously evolving events surrounding Rent the Runway, similar to those of other unicorns, serve as a useful heads-up for other rapidly growing companies.  For private funds invested in soon-to-be unicorns, and in particular those that occupy board seats, it is prudent to be proactive and recognize that with impressive performance will come an inquisitive audience.  Start early – be prepared before regulators or private litigants come knocking.  Formulate a plan – which should involve a comprehensive review of insurance policies and an understanding of what they cover (and don’t cover).  And then execute – deploy a strategy that mitigates as much as possible the effect of unwanted attention on the operational aspects of the business that drove the company to unicorn status in the first place.

The growing pains that Rent the Runway is experiencing are neither unique nor insurmountable – unwanted attention is simply one of the costs of eclipsing such a lofty milestone.  After all, unicorns are rare for a reason.

The DC Circuit recently released an opinion addressing the SEC’s administrative findings against registered investment adviser The Robare Group (TRG) for failure to disclose alleged conflicts of interest. Although the court affirmed the SEC’s finding of a violation of Section 206(2) of the Advisers Act, it held that Commission could not find willful violations under Section 207 based on the same negligent conduct.

The court’s analysis of 206(2) of the Advisers Act, the key negligence-based antifraud provision for investment advisers, is instructive. The court affirmed that, as a fiduciary to its clients, the adviser was required to make full and fair disclosure of all material facts, including conflicts of interest.However, the Commission also asserted that TRG violated Section 207 of the Advisers Act by willfully failing to disclose material conflicts of interest in its Form ADV Part 2 brochures. Yet because TRG acted negligently but not “intentionally or recklessly,” the DC Circuit disagreed that this factual basis could support a finding of willful misconduct. The holding appears to contradict the SEC’s traditional approach to alleging “willful” violations under the Wonsover analysis, which focuses on whether the actor intentionally (as opposed to involuntarily) committed the act constituting the violation.

Does the Robare decision mean that “willful” misconduct requires a finding of scienter? And does it shut the door on allegations of willful misconduct in negligence-based cases? Probably not. But it will make it more difficult for the Enforcement Division to allege willful violations in a litigated or settled context without more than negligence.

I. Facts

The Robare Group (TRG) is a registered investment adviser that used a separate financial firm for execution, custody, and clearing services for its clients. In 2004, TRG entered into a revenue sharing arrangement with the custodial firm, whereby TRG received compensation when its clients invested in certain mutual funds offered on the firm’s online platform. The Division of Enforcement at the SEC instituted an administrative proceeding in 2014 against TRG and its principals, alleging that they failed to disclose the revenue sharing agreement and the potential conflict of interest it created. Specifically, the Division alleged violations of Sections 206(1), 206(2), and 207 of the Advisers Act. Sections 206(1) and (2) govern disclosure to clients, while Section 207 addresses disclosures in filings with the Commission. A violation of Section 206(1) requires proof of scienter – an intent to defraud, but proof of simple negligence is sufficient to establish violation of Section 206(2). Section 207 proscribes willful untrue statements about, or omissions of, material facts.

In the initial administrative proceeding, the SEC’s Administrative Law Judge had dismissed all charges brought by the Enforcement Division, at which point the Division sought review by the Commission. The Commission conducted a de novo review, and concluded that TRG and its principals violated Section 206(2) by failing to adequately disclose material conflicts of interest to their clients, and Section 207 by willfully omitting material facts from TRG’s ADVs filed with the Commission.

II. Key Holdings

In appealing the Commission’s determination, TRG argued it did not violate Section 206(2) because: (1) TRG’s ADV brochures adequately disclosed the conflicts of interest arising from the revenue sharing arrangement; and (2) they were not negligent. After reviewing TRG’s Forms ADV, the DC Circuit determined the statements made in the filings did not clearly and explicitly disclose the conflicts of interest arising from the payment arrangement “in a manner that would enable [TRG’s] clients to understand the source and nature of the conflicts.” The court also deemed TRG’s arguments disputing its negligence “unpersuasive,” finding that “[b]ecause a reasonable adviser with knowledge of the conflicts would not have committed such clear, repeated breaches of its fiduciary duty, TRG and its principals acted negligently.”

In affirming the Commission’s findings with respect to Section 206(2), it is important to note that the Commission’s de novo review found that “TRG’s disclosure that it may receive selling compensation…in no way revealed that TRG actually had an arrangement with [the custodial firm], that it received fees pursuant to the arrangement, and the arrangement presented at least a potential conflict of interest” Emphasis in original. In its recent Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers, the Commission cited to its de novo review in support for the proposition that “an adviser disclosing that it ‘may’ have a conflict is not adequate disclosure when the conflict actually exists.”

The court rejected TRG’s claim that the SEC was required to call an expert to establish the relevant standard of care, finding that the fiduciary duty involved was “not so complex as to require expert testimony.” According to the court, TRG was under a duty to fully reveal potential conflicts to their clients, and for a decade their disclosures made no reference to the payment arrangement at all. The court was not swayed by TRG’s argument that their conduct conformed to that of most other investment advisers, stating “negligence is judged against a standard of reasonable prudence, whether that standard usually is complied with or not.” (internal citation omitted). The court therefore affirmed the Commission’s findings of negligent violations under Section 206(2).

TRG also disputed the Commission’s finding of a willful violation of Section 207. The court acknowledged that it had yet to address the meaning of “willfully” as applied to Section 207, and proceeded to apply the standard set out in Wonsover v. SEC, 205 F.3d 408 (D.C. Cir. 2007) (addressing the definition of willfully in connection with Section 15(b)(4) of the Exchange Act). In Wonsover, the court determined that “willfully” in the context of a securities violation means “intentionally committing the act which constitutes the violation.” 205 F.3d at 414. The DC Circuit rejected the SEC’s position that TRG acted intentionally by choosing the language contained in the Forms ADV. Section 207, in the court’s view, “does not proscribe willfully completing or filing a Form ADV that turns out to contain a material omission but instead makes it unlawful ‘willfully to omit . . . any material fact’ from a Form ADV.” Thus, the court held that Section 207 requires a finding based on substantial evidence that one of TRG’s principals subjectively intended to omit material information from TRG’s Forms ADV.

Additionally, the court reiterated that negligence and intent are mutually exclusive concepts. Therefore, the Commission can’t point to the same set of actions that it found to be negligent under 206(2) and claim they support a finding of willfulness under Section 207.

The SEC, in conjunction with the Colorado Bar Association and Colorado Society of Certified Public Accountants, recently sponsored the 51^st Annual Rocky Mountain Securities Conference featuring SEC officials and corporate experts from across the nation.  Sam Waldon, partner at Proskauer and former Assistant Chief Counsel in the SEC’s Division of Enforcement, moderated a panel of expert practitioners on developments in securities enforcement and white collar defense.  The following topics were discussed:

1. Current Commission and Division of Enforcement

The Panel generally agreed that commentators have largely overstated the extent to which the current Enforcement program has changed under the current administration.  However, they agreed that the types of cases being brought today, and the current case mix, is somewhat different than the immediately preceding Enforcement program, with a greater emphasis on cases involving retail investor harm.  And the Panel agreed that the single biggest factor impacting the Enforcement program today has been the prolonged hiring freeze.

2. Sharing results of internal investigations

The Panel discussed recent experiences with having to decide whether and how to share the results of an internal investigation with staff, highlighting the challenge of balancing the desire to gain meaningful cooperation credit, against the value of preserving privilege.  The speakers also discussed how it can often be prudent to share with staff the findings of an investigation generally, but not share memoranda memorializing witness interviews.  Such an approach reduces the risk of waiver of the attorney-client privilege and/or attorney work product immunity covering the internal investigation as a result of disclosure to the SEC.

3. Corporate penalties

With the current construct of the Commission – three Commissioners appointed by Republicans and only one appointed by Democrats – we should expect to see more settled actions with corporations with no penalties.  Most Republican Commissioners have historically embraced the 2008 Commission’s Statement on Corporate Penalties, and in particular, the idea that corporate penalties should only be imposed when a corporation has obtained a benefit from the charged misconduct and any penalty should be capped at the amount of the benefit.

4. Specialized Units

Rather than shrink the number of units, the SEC has added a new Unit, the Cyber Unit, which is the first new unit since the concept of specialized units was introduced in 2009.  The Panel discussed how the Asset Management Unit has been very active, bringing a tremendous number of Enforcement actions, most of which came out of the 12b-1 Share Class Initiative.  This lead to a discussion of the D.C. Circuit’s decision in Robare, where the court held that a finding of a willful violation is inconsistent with a finding of negligence.  This could impact future settlements generally, but in particular those that are part of the Initiative; in early settlements under the Initiative, the Commission has insisted upon willful violations (necessary to obtain a censure) and negligence charges (Section 206(2) of the Advisers Act).

5. Impact of Lucia

In Lucia, the Court held that the SEC’s administrative law judges were inferior officers who had been hired in violation of the Appointments Clause of the Constitution.  The Panel observed that while the Court’s decision answered some important questions about the SEC’s ALJs, a number of questions remain unanswered – including whether the SEC’s ratification of prior cases decided by ALJs will be effective and whether limitations on removal of ALJs remain a Constitutional flaw.  Perhaps because of these open issues, the SEC has not been litigating as many cases in administrative proceedings as it had been three or four years ago.

6. Impact of Kokesh

In Kokesh, the Court held that the SEC claims for disgorgement are penal in nature and thus subject to the five-year statute of limitations.  The Panel focused its discussion on the recently proposed legislation that would allow the SEC to obtain restitution (measured by the harm to investors, as opposed to disgorgement, which is measured as the amount of the respondent’s ill-gotten gains) and would have a ten-year statute of limitations to seek restitution.  The Panel noted the potential challenges that this could present for the SEC – while having more time to bring cases may seem beneficial, the SEC has often had difficulty prosecuting cases successfully when cases involve conduct that is over five years old.

A recent action where the SEC focused on the presumably conservative undervaluation of assets suggests that it is more than willing to use valuation as a hook to deter “smoothing” of returns. As we previously noted, while the SEC consistently announces that valuation is a “key area of focus,” it is uncommon for regulators to second guess valuation determinations in the absence of other potential violations. However, failure to adhere to stated valuation policies/procedures is one situation that may lead to heightened regulatory exposure and disputes.

Earlier this month, the SEC announced a settled action against Deer Park Road Management Company, LP, a hedge fund that focuses on distressed securities (in particular, pre-2008 residential mortgage-backed securities). The SEC’s order focused on two technical violations:

1. Failing to adopt and implement reasonably designed compliance policies and procedures relating to valuation of fund assets; and
2. Failing to implement its existing valuation policies.

First, the SEC argued that Deer Park’s valuation policies and procedures weren’t reasonably designed because they lacked procedures detailing how to use the market inputs available to Deer Park that were relevant to RMBS assets held by its flagship fund. Consequently, the SEC concluded that these procedures did not promote consistency or mitigate the potential conflict of interest from traders valuing the securities that they managed. Second, the SEC alleged that Deer Park didn’t implement the policies and procedures that required Deer Park’s traders to “maximize observable inputs such as trade information.” The SEC’s order indicates that some of the RMBS assets at issue were presumably Level 2 assets under GAAP and Accounting Standards Codification 820 (“ASC 820”), requiring the use of observable inputs. However, the SEC alleged that accessible trade information was repeatedly ignored in favor of more discretionary approaches that allowed traders to systematically undervalue the fund’s assets. Consequently, traders were able to mark up assets gradually instead of marking them to observable market inputs.

However, in this particular valuation case, the undercurrents and factual backdrop are far more interesting than the technical violations cited by the SEC. Consider the following factors:

• Traders were conservative in valuing assets;
• The fund was generating lower fees on AUM than it would have been if the traders valued the assets as the SEC required; and
• There was no disgorgement, perhaps suggesting that there was no quantifiable harm to investors (which could have hypothetically occurred if investors bought in or redeemed at artificially low prices).

Despite these mitigating factors and the manager’s subsequent remedial efforts, the SEC imposed a $5,000,000 penalty.

A closer read of the order reveals that the SEC’s real focus may not have been valuation, per se, but to discourage artificially smooth performance reporting. The SEC characterized Deer Park as “one of the most consistent performing hedge funds in the country,” and focused on the fact that from 2009 through 2014 the fund’s returns were over 20% each year, and that it hadn’t had a down month for 80 consecutive months prior to October 2015. The SEC also noted that Deer Park had managed to grow the fund’s AUM from several hundred million dollars to more than $1.5 billion during the period in question.

In addition, the SEC noted that Deer Park’s stated strategy focused on buying deeply discounted, high-yielding RMBS for its flagship fund. Although the practice of slowly marking up RMBS assets would presumably lead to lower AUM, it would also show higher yields on those assets during earlier periods.

All in all, the SEC appears to be making good on its promise to keep valuation as a key area of focus, and appears more than willing to examine in detail the valuation process and procedures hard-to-value assets as well as fund managers’ corresponding disclosures to investors.

On July 3, 2019, SEC Chairman Jay Clayton issued a “Statement Regarding Offers of Settlement” (the “Statement”), announcing important changes to how the SEC will consider future requests for waivers from disqualifications in settlements.  The Statement may have been prompted by the Bad Actor Disqualification Act of 2019 recently proposed by Representative Maxine Waters.  Regardless of the impetus, the Statement should provide settling parties with greater certainty regarding the waiver process.  Importantly, the new policy effectively allows a settling party to condition its offer of settlement on whether the SEC grants a requested waiver – if the waiver is not granted, the respondent now is able to retract its offer of settlement. 

The federal securities laws provide for a number of automatic disqualifications that prevent a respondent (or an affiliate) found to have violated certain statutes or regulations from taking advantage of certain exemptions or engaging in certain conduct otherwise permitted under the federal securities laws.  For example, an issuer subject to an SEC cease-and-desist order (even one issued as part of a settlement) prohibiting the party from violating Section 5 of the Securities Act is automatically disqualified from using the safe harbor provided by Regulation D under the Securities Act to conduct an unregistered offering of securities.  A disqualification may be (and often is) unrelated to the misconduct that forms the basis of the SEC enforcement action.

Some disqualifications can be a matter of inconvenience to a party, but others can have severe consequences.  For example, absent a waiver, a party subject to certain federal court injunctions may no longer act as an investment adviser to an investment company.  The SEC, however, has authority to grant conditional or unconditional waivers from disqualifications, and has frequently used that authority to prevent disproportionate consequences from flowing from a settled enforcement action.  The Statement deals with the process by which respondents apply for and the SEC Commissioners consider waivers.

That process grew more complicated in recent years, largely because of what became a public debate regarding the purpose behind disqualifications and whether waivers had been too easily granted.  Some within the SEC believed that disqualifications should be viewed as prophylactic only (Understanding Disqualifications, Exemptions and Waivers Under the Federal Securities Laws, Chair Mary Jo White, Mar. 12, 2015).  Under this view, the Commission should grant a waiver so long as the misconduct underlying a settlement does not relate to the conduct subject to the disqualification.  Other Commissioners argued that disqualifications should be viewed as an additional sanction for misconduct and waivers should be granted less frequently (Remarks at the “SEC Speaks” Conference, Commissioner Kara M. Stein, Feb. 20, 2015).  Under this view, the Commission should consider additional factors such as recidivism and deterrence – factors typically considered by the SEC in connection with penalties – when deciding whether to grant a waiver.

Complicating the process further was the fact that, as the Statement notes, “[a]lthough settlement offers and waiver requests have generally been made contemporaneously, and resolution of both often is critical to achieving the necessary level of certainty, in recent years, the Commission has considered these matters almost exclusively on a segregated basis.”   When a settlement of an SEC enforcement action would trigger a disqualification, separate but contemporaneous negotiations would take place between counsel for the defendants and the Division of Enforcement over the terms of the settlement and the relevant operating division (Corporation Finance or Investment Management) over the terms of the waiver.  The results of those negotiations were then separately considered by the SEC Commissioners, or in some cases by SEC Staff pursuant to delegated authority.

This bifurcated process complicated resolution of SEC enforcement actions.  For one thing, a Commissioner could vote for a settlement but against a requested waiver, as some did.  At the same time, a respondent could not make a settlement offer contingent on the granting of its waiver request.  The waiver can be, of course, a critical consideration to many industry participants considering whether to settle or to litigate the charges.  For example, for an issuer that relies on offerings under Regulation D, a waiver from a “bad actor” disqualification could be critical to its ongoing business operations.

The Statement reduces the complexity of settlement negotiations, and provides respondents with far greater certainty regarding the likely outcome of waiver requests because a settlement offer and waiver request will be considered at the same time by the full Commission.  Most importantly, the new process will effectively allow a respondent to make a settlement offer contingent upon the grant of a waiver request – if a waiver request is rejected, a respondent can pull its settlement offer.  Also, each Commissioner must now make a determination whether to grant a waiver in the context of considering the settlement as a whole.  A Commissioner who wishes to reject a waiver request will run the risk that doing so will cause the proposed settlement to collapse.

The changes described in the Chairman’s Statement thus will alter settlement negotiations of Commission enforcement actions between respondents as well as the internal dynamics of Commission consideration of settlements.  Both should have the effect of creating a more stable process with greater certainty for respondents.

Today, we are launching a proprietary database tracking all SEC enforcement actions involving private equity advisers. The tracker contains key information from the actions, including summaries of key issues, settlement terms, and relevant statutory provisions. The tracker will be an important resource for us and our clients, providing us with quick access to comparable cases and allowing us to identify important enforcement trends impacting private equity advisers as they develop. We are also making available summary information from the database for all SEC enforcement actions against private equity advisers over the last 6 years.

Click here to view the tracker.

Contact us for additional information.

The Third Circuit recently issued an important decision for private fund advisors who serve on corporate boards.  In a precedential decision on a matter of first impression, the Third Circuit distinguished the role of nonvoting board observers from the function of formal corporate directors.  And while the decision was issued in the context of liability for alleged violations of the securities laws, the Third Circuit suggested the analysis may apply more broadly to other situations involving board observers.

The case, Obasi Investment Ltd. v. Tibet Pharmaceuticals, Inc. et al, began in New Jersey federal court as a class action lawsuit alleging Tibet Pharmaceuticals failed to disclose certain information about its financial health prior to its IPO.  Two of the defendants, Downs and Zou, claimed they were merely observers to Tibet’s board and therefore should not be found liable for any misconduct of the company board.  The trial court judge granted summary judgment in the duo’s favor on all counts except a violation of Section 11 of the 1933 Securities Act, stating that the question presented a novel issue ripe for an appellate court.

On appeal, the Third Circuit threw out the last remaining Section 11 claim against the two defendants stating that board observers are not the same as directors.  A claim under Section 11 can be brought against any person “named in the registration statement as being or about to become a director, person performing similar functions, or partner.”  The issue before the Third Circuit was whether the board observers were “person[s] performing similar functions” to directors.

As board observers, Downs and Zou were unable to vote on company matters but, according to the registration statement, “may nevertheless significantly influence the outcome of the matters submitted to the Board of Directors for approval.”  Nevertheless, the Third Circuit pointed to three features that distinguished the board observers from directors:

1. The observers could not vote on board matters;
2. The observers were loyal to the placement agent rather than the shareholders; and
3. The tenure of the observers was not subject to shareholder vote.

In rejecting the plaintiffs’ primary argument, the Third Circuit held their interpretation of the word “similar” to be too narrow, determining that even if a person is named as performing similar functions to a director, that person still may not “possess the directors’ ‘formal power to direct and manage a corporation, and the responsibilities and duties that accompany those powers.’”  After comparing the responsibilities of Downs and Zou to those of a director, the Third Circuit held that the role of the board observers was not sufficiently “similar” to that of a director to find liability under Section 11.

The Third Circuit’s opinion provides some helpful guidance on the distinction between nonvoting board observers and formal corporate directors.  In connection with their investments in companies, private fund advisors often are given the right to hold one or more of the board of director seats or, alternatively, appoint a nonvoting board observer with informational rights.  There are several significant differences between the two.  For example, directors have voting – and sometimes veto – rights, but also owe certain fiduciary duties to the company and its shareholders and must be careful not to engage in activities that could be viewed as self-interested or not in the best interest of the company and its shareholders.  In addition, a member of the private fund advisor who also sits on the company’s board of directors must navigate potential conflicts of interest between their duties to the company and the private fund.  Board observers, on the other hand, have access to important and timely information, and while they do not have voting rights, board observers, unlike directors, do not owe fiduciary duties.  The Third Circuit’s decision – distinguishing board observers from formal directors for purposes of liability in at least some contexts – is another data point for private fund advisors to consider when weighing the pros and cons of appointing one of its members as a formal director or a nonvoting board observer.

Recently, a group of Congress members introduced into Congress Senate Bill 2155 named the Stop Wall Street Looting Act of 2019. Although unlikely to be enacted into law as drafted, this proposed legislation would directly and substantially affect a number of fundamental operational aspects of private equity funds and their affiliates. The proposal, co-sponsored by a number of Democratic members of Congress, is the latest iteration of periodic legislative efforts to “rein in” perceived abuses in the private equity industry.

To summarize several key areas of Senate Bill 2155:

• Sections 101 and 102 would hold private funds that are control persons of a portfolio company jointly and severally liable for all debt incurred by the portfolio company;
• Section 103 would provide that any indemnification of a private fund that is a control person, or an affiliate thereof (defined to include 20% or greater beneficial owners), for the liabilities of a portfolio company and its affiliates is void against public policy;
• Section 201 would prohibit portfolio companies from making a capital distribution during the 24 months following a leveraged buyout transaction;
• Section 203 would apply a 100% tax on fees paid by portfolio companies to private fund managers, such as “monitoring” or “transaction” fees;
• Section 403 would tax carried interest, currently taxed at the preferential capital gains rates at the higher earned income rates;
• Section 501 would require the SEC to issue rules requiring each private fund to make certain annual public disclosures including the identities of those with interests in the fund and their ownership interests, the debt held by the fund (disaggregated by both domestic versus offshore and financial institution verses non-financial institution creditors) its portfolio companies (including portfolio company debt categorized as liabilities, long-term liabilities, and payment in kind or zero coupon debt), the performance of the portfolio companies, and fees and payments collected by the firm; and
• Section 502 would prohibit investment advisers, including private fund managers, from requiring investors (including pension plans) to waive the fund managers’ fiduciary duty under ERISA or under the Investment Advisers Act of 1940.

Additionally, for purposes of Senate Bill 2155, Section 3 defines a “private fund” as a company or partnership relying on either section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (but expressly excluding venture capital funds) that directly, or through an affiliate, acts as a control person of an entity that is acquired in a change in control transaction (e.g. a portfolio company). Section 3 further defines the term “control person” as someone who owns or controls, including through coordination with other persons, at least 20% of voting securities of a company, but excludes limited partners of a private fund organized as a partnership.

Reactions from the private fund industry to date have understandingly varied. On July 18^th, American Investment Council President and CEO Drew Maloney issued a statement characterizing Senate Bill 2155 as both “harmful” and “extreme.” Subsequently, a Pensions & Investments article dated August 5^th reported that the Institutional Limited Partners Association “support[ed] some of the legislation’s ideas but it also look[ed] forward to House hearings and more bipartisan legislation later this year.

A recent case in a North Dakota district court is a reminder to private equity funds and managers that, under certain conditions, they may be held responsible for actions of a fund’s portfolio companies.  Courts allow plaintiffs to pierce the corporate veil as a check against improper abuse of the corporate form.  When one corporate entity is under such extensive control by another that the first is merely an alter ego of the second, a court may permit a plaintiff to reach through the corporate structure to gain recovery.  This is particularly true if the first entity is undercapitalized.  Through this mechanism, limited liability does not mean immunity from liability, and under certain circumstances a plaintiff can hold the ultimate shareholders or owners liable for company obligations.

The plaintiffs in Marchan, et al. v. John Miller, et al. brought such a veil piercing claim against private equity firm KRG Capital Partners, LLC in a products liability action.  A major point of contention was how closely connected KRG Capital was to the portfolio companies that made and sold a defective product.  KRG Capital had an agreement to manage TerraMarc Industries, Inc., an entity that KRG’s principals originally created to make investments in the agricultural industry.  KRG Capital itself was not a shareholder in TerraMarc, although its principals remained TerraMarc’s shareholders and board members throughout its existence.  TerraMarc had been liquidated prior to the lawsuit, but it had previously acquired and operated a portfolio companies that manufactured and sold farm equipment.  The plaintiffs were injured by equipment manufactured and sold by those portfolio companies, and sued KRG Capital and TerraMarc, as well as the portfolio companies.

Despite KRG’s position that it lacked unity of ownership and unity of interest with TerraMarc, the court denied its motion for summary judgment and determined that under federal law, veil-piercing was a question for the jury to decide.  The court went so far as to include a diagram labeling KRG Capital as the owner and operator of TerraMarc in its decision.  This case demonstrates courts’ concerns about safeguarding plaintiffs’ ability to recover from those entities and people that controlled the tortfeasor.  The case ultimately settled this spring with the last of the cross claims being dismissed this past summer.

Different courts have developed various factors to determine whether to pierce the corporate veil.  Delaware has a high standard which considers the following: (1) whether the entity was adequately capitalized; (2) whether the entity was solvent; (3) whether corporate formalities were observed; (4) whether the controlling shareholder siphoned company funds; and (5) whether the company generally functioned as a façade for the controlling shareholder. California has a less rigid set of criteria which does not require a finding of fraud or a “sham” entity.  Rather, California has a long non-exhaustive list of factors that courts can look to such as whether the entities comingled funds, employed the same employees, or failed to maintain arm’s-length relationships.  Overall, California uses the doctrine when the separate existence of the corporation would promote injustice or bring about inequitable results.

While courts may go about assessing veil piercing claims differently, at its core the doctrine is about fairness and holding accountable those in control of an entity’s actions.  To minimize exposure to such claims funds should:

• 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.

Funds should avoid:

• Two companies using the same office or business location.
• Diverting assets from a corporation to the detriment of creditors, or manipulating 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.
• Having identical equitable ownership in the two entities, especially if the equitable owners have control over both entities.
• The same directors and officers responsible for supervision/management of both entities.
• Employing the same employees/attorney.
• Making the parent liable for the debts of the portfolio company.

If questions arise, it always makes sense to consult with outside counsel.

A settlement last week involving a private equity fund sponsor is a reminder that compliance with fee calculation provisions and valuation policies and procedures are crucially important for fund managers.  Even when an error is the result of simple negligence, the SEC will take enforcement action when fee calculations do not strictly comply with the governing documents, especially where investments are overvalued. 

ECP Manager LP is a private equity fund adviser that served as the manager of ECP Africa Fund PCC (the “Fund”), among other private equity funds.  The manager collected management fees from the Fund based on its total invested capital contributions, but under the Fund’s Shareholders Agreement, could not take fees for investments that had been written down or written off. In 2010, the Fund obtained warrants on the common stock of an African mining company, attributing $3.41 million of invested capital contributions to the warrants. However, by March 2014, the Fund had valued these warrants at zero, and shortly thereafter the warrants expired with no value. Nonetheless, in 2014 and 2015, ECP Manager included the full $3.41 million when calculating its management fees on invested capital. The SEC did not identify any individuals responsible for the error, and did not explain how the error occurred.  The SEC estimated the Fund’s shareholders overpaid $102,304 in management fees due to ECP Manager’s mistaken fee calculations attributable to the warrants.

On September 27, 2019, the SEC issued a Cease-and-Desist Order and imposed sanctions based on ECP Manager’s violation of the Advisers Act Section 206(2) and Section 206(4) and Rule 206(4)-8 for fraudulent or deceptive conduct (these provisions only require negligent conduct).  The SEC ordered ECP Manager to disgorge approximately 122,000 in fees and prejudgment interest, and imposed a $75,000 penalty.

We have added this settlement to our Private Equity SEC Enforcement database, which can be accessed here.

On August 25, 2019, New York Governor Andrew Cuomo signed New York State Senate Bill S6536 which established a six-year statute of limitations for the prosecution of certain crimes related to fraudulent practices in respect to stocks, bonds and other securities and conducting business in the State of New York. As discussed below, the legislation overturned a New York Court of Appeals ruling last year holding that claims under the Martin Act were subject to a three-year statute of limitations.

Background

First enacted in 1921, the Martin Act “authorizes the [New York] Attorney General to investigate and enjoin fraudulent practices in the marketing of stocks, bonds and other securities within or from New York State.” Kerusa Co. LLC v. W10Z/515 Real Estate Ltd. Partnership, 12 N.Y.3d 236, 242, 906 N.E.2d 1049 (2009). Unlike claims of fraud under common law, the Martin Act does not require proof of scienter and reliance, making it an extremely powerful enforcement tool for the New York Attorney General (“NYAG”).

People v. Credit Suisse Securities USA LLC, et al.

Despite the lengthy history of the Martin Act, before 2018 the New York Court of Appeals had never judicially determined the applicable statute of limitations. A recent appeal brought the issue to the forefront. On November 20, 2012, the NYAG commenced an action against Credit Suisse Securities USA LLC, et al. (“Credit Suisse”) alleging violations of the Martin Act in connection with the offer and sale of residential mortgage-backed securities in 2006 and 2007.

Credit Suisse moved to dismiss the Martin Act claims on the basis that the three-year statute of limitations under Section 214(2) of the New York Civil Practice Law and Rules (“New York CPLR”) applied to the action and thus, despite a tolling agreement Credit Suisse entered into with the NYAG in March of 2012, the claims were time-barred. The NYAG countered that the timeliness of the claims were instead governed by the six-year statute of limitations under Section 213(8) of the New York CPLR.

Comparing the relevant provisions in the New York CPLR, the six-year statute of limitations under Section 213(8) applies to actions “based on fraud,” while three-year statute of limitations under Section 214(2) applies to fraudulent practices beyond those recognized under common law (i.e. those causes of action created by statute). Credit Suisse argued that because fraud claims brought under the Martin Act do not require proof of scienter or reliance, such claims were statutory creations and therefore subject to the three-year statute of limitations under Section 214(2).

In 2014, the New York state trial court denied Credit Suisse’s motion dismiss, which Credit Suisse appealed. In 2016, the New York Appellate Division (First Department) affirmed the trial court’s ruling in a 3-2 decision. Credit Suisse subsequently petitioned the New York Court of Appeals for further review.

On June 12, 2018, the New York Court of Appeals issued a 4-1 ruling reversing the Appellate Division and holding that claims brought under the Martin Act were subject to the three-year statute of limitations under Section 214(2) of the New York CPLR. The court reached its decision on the grounds that the Martin Act expanded liability for “fraudulent practices” beyond those recognized under the common law. Perhaps in a foreshadowing of future events, dissenting Judge Jenny Rivera called on the New York state legislature to put forth legislation expressly codifying a six-year limitations period for claims brought under the Martin Act.

Following the New York Court of Appeals ruling, a spokeswoman for the NYAG stated that the ruling would “have no impact” on the activities of the NYAG. However, practitioners predicted a rise in requests by the NYAG for tolling agreements, as well as an acceleration of investigations brought by the NYAG. Some practitioners also predicted that the NYAG could start to pursue claims under common law theories of fraud, to take advantage of a longer six-year statute of limitations period.

The Legislative Fix

On June 15, 2019, Senate Bill S6536 was proposed to amend Section 213 of the New York Rules to expressly include claims brought under the Martin Act within a six-year statute of limitations. According to its own press release, the NYAG submitted the legislation as a program bill and vigorously advocated for its passage. On August 25, 2019, New York Governor Andrew Cuomo signed the bill into law.

Takeaways

While the legislation is effective immediately, it does not clearly address whether it applies retroactively. Nonetheless, any defendant would likely have strong policy-based arguments that previously time-barred claims should be precluded from prosecution. At the same time, the NYAG may seek to include conduct from earlier time periods in connection with ongoing investigations, which would have previously been time-barred under the 2018 New York Court of Appeals ruling.

In the ever-evolving and complex world of economic sanctions, voluntary self-disclosure is frequently the best long-term strategy for any company that discovers a violation of a sanctions regime. The more difficult task is to assess the costs and benefits of self-disclosure in cases where the conduct falls into a gray area. We explain the complex relationship between voluntary self-disclosure and the Office of Foreign Assets Control’s enforcement response in a chapter recently published in the International Comparative Legal Guide.

Read the chapter here.

As a further indication of the SEC’s focus on the asset management industry, on November 1, 2019 the Commission formally established an Asset Management Advisory Committee. This follows the SEC’s recent announcement of its intent to establish the committee. According to the published notice, the committee’s objectives and scope of its activities are to provide the Commission with diverse perspectives on asset management – including (i) trends and developments affecting investors and market participants, (ii) the effects of globalization, including as it relates to operations, risks and regulation, and (iii) changes in the role of technology and service providers – as well as related advice and recommendations.

The committee has an initial two-year term, which can be renewed by the Commission, and will meet at such intervals as are necessary to carry out its functions. A maximum of 21 voting members will be appointed to the committee – a press release issued by the SEC identified the initial members of the committee. The announcement also referenced a committee charter which, though not made publicly available as of this date, contemplates that the full committee will meet four times annually.

As the Commission will use the committee to ensure regulations meet the needs of investors and market participants, investors and market participants should look to the committee’s advice and recommendations as guidance with respect to trends in the asset management space.

Yesterday the SEC announced its enforcement results for FY 2019, accompanied by a report from the Co-Directors of its Division of Enforcement.  While the total number of actions increased slightly from 2018, the percentage of cases involving investment advisers or investment companies increased more dramatically, growing from 22% in 2018 to 36% in 2019, with a significant portion of the increase attributable to the SEC’s Share Class Selection Disclosure Initiative. Investment advisory issues accounted for 191 standalone actions in the past year. Insider trading cases decreased slightly from 10% of the actions filed in 2018 (51 actions) to 6% of the 2019 actions (30 actions).  Total penalties and disgorgement were also up, reaching $4.35 billion, notwithstanding Kokesh v. SEC, a Supreme Court decision holding that Commission claims for disgorgement are subject to a five-year statute of limitations. This year’s report described Kokesh as an ongoing challenge for the Commission’s efforts to seek disgorgement.

The increase in actions, though small, was notable in light of this year’s month-long government shutdown and the SEC hiring freeze, which extended through the first several months of FY 2019. The freeze, which may have been the single biggest factor impacting the current Enforcement program, was lifted on April 1, 2019. The 862 total actions and the 526 stand-alone actions brought by the SEC represent the second highest totals ever.

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 failure to adopt appropriate valuation policies. As we have previously noted, we expect continued SEC attention to valuation issues, especially with respect to unicorns and start-ups, during FY 2020.

The results also indicate that individual accountability continues to be a priority for the agency’s enforcement staff. Excluding Share Class Initiative actions (which, as part of the Initiative, did not charge individuals), 69% of the Commission’s standalone actions included charges against individuals. The Co-Directors of the Enforcement Division asserted that the Division “remained focused on individual accountability by pursuing charges, where appropriate, against executives at all levels of the corporate hierarchy.” Further, the SEC also continues to highlight 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.

The report additionally focused on cases from the Cyber Unit, a unit focusing on computer hacking, distributed ledger technology and other cyber-related threats. Several cases focused on ICOs and digital assets, and the Co-Directors described the Division’s evolving focus as capturing not only fraud matters, but also compliance with securities laws.

Yearly data from 2014 through 2019 is summarized in the table below:

We will continue to examine the report and provide further updates and analysis.

To view Proskauer’s Private Equity SEC Enforcement Tracker, click here.

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

SEC Announces the Formation of Asset Management Advisory Committee

Fund Sponsor’s Fee Calculation Mistake Leads to SEC Enforcement

SEC Announces New Approach to Disqualification Waivers

SEC Fines Fund Manager $5 Million Over Undervaluation of Assets

Rocky Mountain Securities Conference: A Review of Enforcement

DC Circuit Opinion Reaffirms Fiduciary and Disclosure Obligations of Advisers While Rejecting SEC Finding of “Willful” Violations

Fraud Claims Against Startup Founder Involving Secondary Market Sales Demonstrate SEC Focus on Privately-Held Companies

The Top Ten Regulatory and Litigation Risks for Private Funds in 2019

SEC Staff Announces 2019 OCIE Examination Priorities

Valuation of Illiquid Securities as a Focus of Recent Enforcement Actions

In a series of enforcement cases over the past few months, the SEC has continued to bring actions focused on undisclosed fees charged to clients. Many of these cases have charged firms with fraud and other violations based on fees that were not adequately disclosed. While some attention has focused on retail wealth managers, institutional advisers to private funds have attracted scrutiny for undisclosed fees, leading to the following enforcement actions:

• In August of 2019, the SEC charged a private venture capital fund adviser, Frost Management Company, LLC, with fraud and breach of fiduciary duties based on over $14 million in undisclosed incubator fees to start-up companies in which their fund clients invested. The complaint alleges that Frost offered incubation services to the start-ups in which it invested, and that these incubation services were provided through an affiliated entity. However, the SEC alleged that the fees paid to the affiliate, which were supposed to be used for “operational support,” were in fact used to fund the principal’s personal expenses. Furthermore, the SEC alleged that, contrary to representations to investors, the fees that its portfolio companies were paying to the affiliate were not below market rate. The case is currently ongoing, and the SEC is seeking injunctions, disgorgement and prejudgment interest, and civil penalties.
• Also in August of 2019, the SEC settled charges against MVP Manager LLC based on allegations regarding undisclosed brokerage commissions for acquisitions of pre-IPO shares. MVP’s clients were private funds that invested in the securities of pre-IPO venture-backed companies. The order alleged that MVP personnel arranged to receive an undisclosed brokerage commission on the sale of pre-IPO securities to MVP’s client funds on three separate occasions. The order further alleged that this undisclosed commission created a conflict of interest, as MVP and its personnel had an economic incentive to cause the private funds to purchase the securities. MVP agreed to violations of the antifraud provisions of the Advisers Act, and repaid $170,000 worth of undisclosed fees along with an $80,000 penalty.
• Earlier in July of 2019, the SEC settled another conflicts of interest case against the principal of Genesis Capital LLC based on undisclosed fees. The order alleged that Genesis failed to disclose certain conflicts of interest that resulted from investments in, and fees paid to, companies that were affiliates of the adviser. The settlement involved violations of the antifraud provisions of the Adviser’s Act, disgorgement, and a $75,000 civil penalty.
• In September 2019, the SEC brought an action against a fund-of-funds manager for an undisclosed fee sharing agreement. The order alleged that the manager’s principal had arranged a separate fee-sharing arrangement with the manager of one of the underlying fund investments, but did not disclose the agreement to the fund-of-funds investors. This undisclosed fee arrangement resulted in an conflict of interest as to fund investors, and a settlement involving the antifraud provisions of the Advisers Act.

Retail wealth managers have also faced scrutiny, often in connection with more complex alternative investments. For instance:

• An undisclosed 7% commission charge for alternative investments where an alternative share class (without embedded commissions) was available;
• An undisclosed 5% commission that an adviser received when his clients invested in certain promissory notes;
• Approximately $254,000 in undisclosed fees that were generated in exchange for recommending investments in certain private real estate funds; and
• A revenue sharing agreement leading to undisclosed conflicts in recommending mutual fund share class investments that resulted in over $100 million being paid to the adviser.

From the SEC’s perspective, fund advisers are fiduciaries to their clients including the funds they advise and, in the context of that relationship, any ambiguities in fee disclosure are likely to be examined closely and create risk. Given the SEC’s continuing focus in the area, all advisors should focus on all fees, in whatever form, from all sources and ensure that they are adequately disclosed to investors and clients.

Proskauer’s Private Investment Funds Group recently released its 2019 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 advisers should consider when preparing for 2020.

Highlights from the annual review include:

• A summary of SEC examination priorities and enforcement developments impacting the private funds industry, including a review of recent staff-level guidance, allocation of fees and expenses and conflicts of interest;
• A review of SEC policy and rulemaking initiatives, including the recent proposal to amend the Advisers Act’s advertising and cash solicitation rules and also the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers;
• An analysis of the current state of insider trading law, including analysis of both the “close personal relationship” requirement for tippee liability and a Second Circuit decision which held that forfeiture penalties for insider trading can include appreciation on trading funds;
• U.S. and UK tax updates, including an overview of the U.S. qualified opportunity zone program and an analysis of the ways in which the Organisation for Economic Co-operation and Development’s base erosion and profit shifting project is continuing to change the international tax landscape;
• An extensive review of employment law developments at the federal and state level potentially impacting advisers, including relevant sexual harassment and pay equity laws;
• A review of alternative data, including a review of the Ninth Circuit’s opinion in hiQ Labs, Inc. v. LinkedIn Corp., a ruling that is being hailed as a victory for web scrapers and the open nature of publicly available website data;
• Developments relating to cybersecurity and privacy law, including a review of the New York SHIELD Act and the California Consumer Privacy Act;
• Regulatory developments in the European Union, including an update on the still uncertain Brexit process and a review of the recently published changes to the rules relating to the pre-marketing of funds in the EU; and
• A comprehensive overview of required U.S. regulatory filings across the many agencies overseeing the private funds industry, including a quick reference table for monthly filings in 2020.

Last Friday, the U.S. Court of Appeals for the First Circuit ruled that two co-investing Sun Capital private equity funds had not created an implied “partnership-in-fact” for purposes of determining whether the Sun Funds were under “common control” with their portfolio company, Scott Brass, Inc. (SBI) – resulting in a ruling that the Sun Funds were not under “common control” with SBI or a part of SBI’s “controlled group” and, therefore, that the Sun Funds could not be held liable for SBI’s multiemployer pension fund withdrawal liability.

This ruling marks the end (for now) to the seven-year Sun Capital dispute.  The ruling has significant implications for both multiemployer pension funds and private equity funds.  Among other things, the ruling may hamper the efforts of multiemployer pension plans and the PBGC to collect plan termination and withdrawal liability from private investment funds (and their other portfolio companies) based on a “partnership-in-fact” analysis; on the other hand, private equity fund sponsors should be aware that (i) acquiring an 80% (or more) interest in a portfolio company, whether within one private equity fund or pursuant to a “joint venture” between related (and maybe even unrelated) funds, may trigger joint and several liability for the portfolio company’s underfunded pension or withdrawal liabilities, and (ii) even a smaller ownership interest percentage could possibly trigger the ERISA “controlled group” rules based on complicated “common control” determinations.

See our fuller analysis here.

Under rule 206(4)-2 of the Advisers Act, otherwise known as the Custody Rule, it is a fraudulent practice for a registered investment adviser to have custody of client funds or securities, unless the adviser takes certain required steps to protect the assets.  Over the past year the SEC’s Enforcement division has been relatively active investigating and enforcing the rule – which, at most, requires a showing of negligence – with a number of complicated provisions that can trip up the uninformed.

Recently, the SEC brought enforcement actions that highlight two key areas under the Custody Rule that can result in liability. First, in addition to maintaining client funds and securities with a “qualified custodian,” advisers with custody of the funds and securities must obtain either (i) a “surprise examination” of those assets annually from an independent public accountant or (ii)  an annual audit of its financial statements by an independent public accounting firm that is registered with (and is subject to regular inspection by) the PCAOB and distribute the financial statements prepared in accordance with GAAP to each investor in the fund within 120 days of the fund’s fiscal year end (180 days for fund of funds).  Most registered private fund advisers rely on the annual audit approach.

Sometimes the 120-day deadline can be difficult to meet for a variety of reasons, including when the auditor is unable to provide an unqualified opinion required to accompany the statements.  The SEC staff has stated that it would not recommend enforcement action if the adviser relying on the audit approach “reasonably believed” that the 120-day deadline would be met but the deadline is missed due to “unforeseeable circumstances”.  But the Commission’s flexibility is limited, as illustrated in a recent enforcement action.  In September, the SEC charged hedge fund advisory firm ED Capital Management and its principal with violations of the Custody Rule (among other violations).  In that case, the adviser was unable to timely obtain unqualified opinions from the audit firm it engaged, and failed to deliver GAAP-compliant fund financial statements to fund investors, over four consecutive years.  Compounding the error, the adviser incorrectly stated in its Form ADV that it had distributed audited financial statements prepared in accordance with GAAP, leading to the SEC alleging willful violations of Section 207 of the Advisers Act, which prohibits advisers from making false statements in reports the SEC.

Second, the Custody Rule requires the accounting firm performing either a surprise examination or financial statement audit to meet the auditor independence standards set forth in Regulation S-X.   Provision of non-audit services by the auditor to either the adviser or one of its affiliates can jeopardize the auditor’s independence and cause the adviser to fail to meet the requirements of the audited financials alternative or the surprise exam.

As but one example, the SEC recently settled an order with RSM US LLP for, among other things, violating the auditor independence rules and thereby causing Custody Rule violations by eight registered advisers, although it did not charge the advisers for the Custody Rule violations.  The SEC alleged that RSM repeatedly misrepresented that it was “independent” in its clients’ audit reports while providing non-audit services to affiliates of RSM’s audit clients.  The non-audit services included corporate secretarial services, payment facilitation, payroll outsourcing, loaned staff, financial information system design or implementation, bookkeeping, internal audit outsourcing, and investment adviser services.  The auditor ultimately agreed to violations of the auditor independence rules and improper professional conduct.

Registered advisers with custody of client assets should be careful when maintaining such assets with qualified custodians and engaging auditors in order to avoid inadvertently violating the Custody Rule.  Although an adviser may view the auditor’s independence as the auditor’s responsibility, the SEC views the adviser as responsible for compliance with the Custody Rule, and it has brought enforcement actions against advisers as a result of the auditor’s breach of its independence requirements.  See Katz, Sapper & Miller, LLP and Total Wealth Mgmt., Inc.  Thus it is risky for advisers to ignore the need for the auditor to maintain its independence, and many advisers require auditors to provide periodic representations that the auditors meet audit independence requirements with respect to the adviser and its affiliates.  The SEC is most likely to bring an action against the adviser when it believes that the adviser had reason to know of the auditor firm’s lack of independence.  It’s best to be careful.