SEC risk alert provides compliance roadmap for investment advisors

The alert, published Tuesday, focuses on disclosure deficiencies related to conflicts of interest, fees and expenses, and policies related to the handling of material non-public information (MNPI). Compiled by the SEC’s Office of Compliance Inspections and Examinations (OCIE), the report’s findings “have resulted in a range of actions, including no comment letters, deficiency letters and, where appropriate, referrals to the Division of Enforcement.” Many advisors modified their practices to address issues brought to their attention by the OCIE, the report said.

“This alert telegraphs what they are focusing on, and any investment advisor would be wise to pay particular attention,” said Michael Saarinen, a partner at the firm Alston & Bird and a former general counsel and compliance officer.

Compliance officers would do well to refer to this risk alert for issues that may arise when their firm opens a new fund, takes on a new client, or is considering a new investment strategy, said Chris Lombardy, head of U.S. compliance consulting for the firm Duff & Phelps.

“For some of these points, people may say, ‘I know that,’” Lombardy said. “But you should be constantly monitoring for these points as your business grows and evolves. You need to keep assessing the risk.”

Here are a few particularly “sticky” points in the alert that might require a compliance department’s attention.

Handling MNPI

This is always a tricky area, because compliance departments are expected to keep tabs on employees and other people connected to the firm to determine whether they have received MNPI and whether they traded on that information.

“Your biggest risk is in connection with potential access to MNPI,” said Reed Brodsky, a partner at the firm of Gibson, Dunn & Crutcher and a former federal prosecutor. Regulators can assess a decision in hindsight and reach a different conclusion than the compliance officer assessing the situation in real time. The process used to make the determination on an MNPI issue is a firm’s best defense.

“You want to address the process for identifying MNPI, determine who might have access, how you spoke with those people,” then document how you assessed the situation, ”to show you’re making decisions in good faith,” he said.

The SEC recently announced a $1 million settlement with Ares Management, a private equity firm and registered investment adviser that failed to implement and enforce policies and procedures reasonably designed to prevent the misuse of MNPI.

In the case, Ares invested several million dollars in a public company and was able to place a senior employee on the company’s board. That senior employee obtained MNPI about the company and passed it on to Ares. Ares used the information to invest more money into the company.

Valuation during a pandemic

The OCIE’s risk assessment lists its concerns on valuation of assets under fees that could result in “overcharging management fees and carried interest because such fees were based on inappropriately overvalued holdings.” But the issue with valuation could just as easily be listed under conflicts of interest, Brodsky said.

“It’s almost certain that investigators will be looking back to see if assets were properly valued,” he said.

The task of valuing assets during a pandemic is complex. Is the change in value temporary, short-term, or long-term? Should valuation be addressed more often as a result of the distressed market?

Best practice would be to have an independent committee, outside counsel, or someone within the firm not connected with the investment to conduct the valuation, Brodsky said.

Avenues for conflicts of interest

The alert discusses risks posed by “expert network” firms used by investment firms to research a particular investment. Say a healthcare fund is examining whether to invest in a pharmaceutical company and wants to know about its latest drug, Lombardy said.

“They’ll want to talk to a doctor who is prescribing that drug,” he said. “But you don’t want to scroll through LinkedIn looking for one, right?”

So investment firms will hire these “expert network” firms to connect them with doctors familiar with the drug in question. The key is understanding how the expert network firm screens these doctors, Lombardy said, looking for potential conflicts that might pop up through past employers, drug trials they participate in, and the like.

“It might even be appropriate for compliance to chaperone some of these calls,” Lombardy said.

Who’s paying for this?

Disclosing whether the management company or the fund (ie. investors) is responsible for certain fees and expenses came up several times in the alert, for items like “broken-deal, due diligence, annual meeting, consultants, and insurance costs, among the adviser and its clients, including private fund clients, employee funds, and co-investment vehicles,” the alert said. OCIE investigators found instances where investors were overcharged because the costs were paid for by the fund in a way that was “inconsistent with disclosures to investors or policies and procedures.”

This can be especially problematic if an investment firm attempts to invest in something new, intending to set up a co-investment fund alongside the firm’s traditional fund. But when the investment falls through for whatever reason, the co-investment fund is never fully established, and so costs related to the broken deal are paid by the main fund—but investors in that main fund are not properly notified of these investment-related costs.

Another area of concern involves “operating partners” or “venture partners.” Their names and expertise look great on fund documents, but it should be clear what entity is paying them.

“In many cases, these folks are getting paid by the fund itself, not the management company,” Saarinen said.

If you say you’re doing it, follow through

Policies and procedures that take things too far can be problematic as well, Saarinen said, creating what he calls “foot faults.”

“Your compliance regime must be reasonably designed to prevent violations of the Advisers Act. Adopting policies that are unduly expansive due to concerns such as investor optics may prove to be unrealistic, creating more opportunities for you to mess up their implementation,” he said.

Take for example a policy stating the manager has committees that regularly review certain risks or how effectively the firm is investing in ESG companies, he said.

“Everyone is happy to see that sort of thing, but then you should keep in mind what could happen if one of the committees never or rarely meets,” he said. The deviation from what the firm says it does, and what it actually does, is something that regulators may seize on, he said.

Lombardy said regulators “are going to test around the risky, conflict areas in your business, so those are areas to focus efforts to revise or enhance.”