Keeping Up with Recent Changes and Trends in Private Fund Regulation

This Ropes & Gray podcast series, which we expect to update periodically, will highlight developments in Washington, D.C. that affect private funds and their legal, regulatory and compliance obligations. In the first episode of the series, hedge fund partner Joel Wattenbarger is joined by investment management counsel David Tittsworth to discuss relevant SEC rulemakings, enforcement and inspection issues, as well as developments on Capitol Hill, including impacts of the partial government shutdown.

Transcript:

Joel Wattenbarger: Hello, and thank you for joining us today on this Ropes & Gray private fund regulatory update podcast. My name is Joel Wattenbarger, I'm a hedge fund partner based in our New York office, and I'm joined today by David Tittsworth, investment management counsel based in our Washington D.C. office. This is the first in what we expect will be a periodic series of podcasts updating listeners on notable U.S. regulatory developments that we think are of interest to hedge fund, private equity fund and other private fund managers. This is really a continuation of a series of conversations and regular conference calls that we’ve held internally over the last year at Ropes & Gray and we thought that our clients and other interested listeners may find value in these as well.

We're starting at an interesting time in this series of podcasts – a time when as we record, the federal government is not in fact open for business. So David, I wanted to start by getting your perspective as our resident expert in D.C. on the government shutdown. The government shutdown with any luck will be resolved by the time listeners are listening to this podcast, but would love to get your perspective in terms of the shutdown, the impact it's having on clients who have business before the SEC, and if you want to put on your prognosticator's hat and give us maybe some sense of where you think this is all headed.

David Tittsworth: Well, thank you, Joel. And it certainly is interesting – other people might find other choice words to describe the shutdown. The partial government shutdown began midnight Saturday, December 22nd. If it goes another for another week or so, it will become the longest shutdown in history. I know I was working on Capitol Hill in 1995-1996 when the longest shutdown in U.S. government history occurred – that one lasted 22 days. The SEC is certainly one of the agencies that's affected. The reason it is affected is very simple: there is no appropriations bill that funds the agency.

So the SEC website is one source of information you can go to right now. The website, on its home page, says the SEC is operating with "a very limited number of staff members available." There's actually a 20-page operations plan you can take a look at if you really want to look at the details. Something like 280 of the 4,400 total SEC employees are actually working. The others are actually prevented from working and are on furlough until the shutdown ends. Also on the investment management website, there are statements like the staff "will not be able to respond to any questions about pending matters." I know that I've actually made phone calls over to the SEC during the last few days. If you do the same thing, you're going to get a voice message and it'll say something like, "This is Joel Wattenbarger. I am not in the office because of a lapse in appropriations for the Securities and Exchange Commission. I will not be working until the shutdown ends and I will not be checking my voicemail during that period of time." So when will the shutdown end? The answer is that it'll end when the SEC's appropriation bill, that's a bill required to be passed by Congress, is approved. Unfortunately we don't know what date that will be. Obviously the President plays a big role in this – he can veto any bill that might be passed by both the House and the Senate. If he were to veto a bill, it would require two-thirds majority in both Houses to override the veto. So there are a lot of options that are being discussed. I imagine a lot of you out there are watching television or listening to the radio and listening to both the Democrats and the Republicans and the President talk about different options, but the bottom line is no one knows when or how this partial shutdown is going to end. So things are uncertain at this time. We certainly have clients that are affected by the shutdown. I would advise everybody to stay tuned for the latest developments, including finding out how the SEC is going to deal with the backlog of filings after the shutdown ends.

Joel Wattenbarger: Great. Thank you, David. We will keep our fingers crossed for a resolution sooner rather than later to the government shutdown. The one other thing I wanted to ask in terms of your perspective on developments in D.C. is there's been a recent change, not one I think that got a lot of press attention, but in the composition of the commissioners at the Securities and Exchange Commission, and specifically, Kara Stein is no longer a Commissioner at the SEC. Can you just give listeners a little background in terms of her departure and what the future may hold in terms of a replacement?

David Tittsworth: That's exactly right. The statute that authorizes the SEC passed by Congress in 1933 says there will be five Commissioners, no more than three of whom will be of the same political party. For the last year, we've had five Commissioners: two Democrats, two Republicans and the Chairman Jay Clayton deems himself as an Independent. But Kara Stein, one of the Democrats, and I think it's fair to characterize her as the most liberal member of the SEC, had to leave her position as a Commissioner at the end of the 115th Congress, which just ended last week, early in January of 2019. Her term actually expired in the summer of 2017, but the way the law is written, a Commissioner can stay over until the end of the Congress, which is what she did, or until another person is appointed and confirmed by the Senate, which never happened. So currently we have four Commissioners: Jay Clayton, the Chairman of the Commission, as I said is in an Independent, two Republicans, Hester Peirce and Elad Roisman, as well as one Democrat, Robert Jackson. So we don't really have an idea, Joel, of when Senator Schumer, the Democratic Leader in the House, will provide a name of a potential nominee to the White House. We assume that that will happen some time in 2019, but I think the bottom line is that for the next several months, folks should assume that the SEC's going to be operating with four Commissioners. So with that, Joel, let me turn things back to you. I know that there's been a lot of activity by the Office of Compliance Inspections and Examinations, commonly known as OCIE, and if you could bring us up to date, I'd appreciate that.

Joel Wattenbarger: Sure. Thank you, David. So the first thing I wanted to mention was a risk alert that was issued by OCIE last month in December of 2018 on the topic of electronic messaging. The reason this is coming out of OCIE is because they recently conducted an exam initiative that focused on the use of electronic messaging for business purposes by registered investment advisers and other SEC regulated entities. The alert shared observations from that exam initiative and really was a bit of a double-edged sword I think from the perspective of practitioners in this area and their clients. The good news was that the alert acknowledged the ability of investment adviser personnel to use personal devices, social media, texting and other forms of instant messaging for business purposes provided that the investment adviser in question has adopted appropriate policies and procedures to comply with applicable Advisers Act requirements. The other edge of the sword is that in fact it's quite difficult to adopt and implement policies and procedures with respect to at least some of the uses we see of electronic messaging in the registered investment adviser space. So this risk alert identified various best practices that the SEC would encourage advisers to adopt if they are permitting in particular their personnel to use mobile devices or personally-owned devices for business communications. And those include prohibiting the business use of apps and other technologies that allow an employee to send messages or otherwise communicate anonymously, delete messages automatically, or prohibit third-party viewing or backup of messages as well as requiring employees who do nevertheless receive a message in a prohibited form to move that message to another system and to adopt policies for monitoring review and retention of all electronic communications that are made for business purposes.

I think the experience that I've had, the experience that many of my clients have had, is that again, adopting and implementing these policies can be a challenge in the modern world where the use of personal devices and the use of texting and other forms of direct messaging have just become pretty pervasive as a means of communicating. And to adopt policies that feel to personnel sort of unnatural or that sort of restrict them from using what are otherwise very common means of communication can be a challenge – it can be a challenge here in the U.S. and it can be a particular challenge in some non-U.S. countries. I know that China is a place where many clients have found that the most common means of communications are in fact direct messaging applications that aren't really set up to comply with all of the conditions that are set forth in the best practices in this risk alert from OCIE. So, not an easy nut to crack in terms of how to manage the use of personal devices and the use of electronic messaging for business purposes, but as you're considering your own policies or as you may be considering these issues in your own business, very important to be aware that this alert is out there and refer to it in connection with giving advice or adopting and implementing policies in this area.

The other recent development out of OCIE, sort of a little bit bigger picture, is they've recently released their exam priorities for 2019. This is an annual report that they issue at the beginning of each year identifying what they anticipate their exam priorities will be for that year. I think it's important to sound, even at the outset a note of caution, our experience and I think if you even attend conferences or other settings in which you hear representatives of OCIE about their own experience, this is not the sum total of the issues that they're going to be looking at on exam. And in fact, priorities can and do change over the course of a year, and they very much will engage in examinations over the course of the year where they'll hone in on certain issues that don't show up anywhere in the exam priority document. So you shouldn't assume that the sort of list of priorities and the information in this annual report will necessarily be reflective of your own experience if you're subject to an SEC exam during 2019. That having been said, it's interesting to look at what they have identified as priorities – and the six big picture priorities are critical market infrastructure, protection of retail investors, oversight of FINRA and the MSRB, digital assets (so cryptocurrency and other forms of digital assets), cybersecurity and anti-money laundering programs.

I think from a private fund manager perspective, probably the good news about this list of priorities is that none of these items are directed specifically towards private funds and I think that's consistent with our experience in 2018 – that overall, OCIE, while it is absolutely continuing to conduct a large number of exams of private fund managers, they are not fixated on private fund managers probably in the same way that they were in the several years immediately following the implementation of the Dodd-Frank registration rules that affected so many private equity and other private fund managers. That having been said, if I look at the protection of retail investor section of this report and I look at the specific sort of sub-items under that section of the report, it's a lot of stuff that sounds very familiar to those of us in the private fund space, including a focus on fee and expense disclosure, conflicts of interests generally, conflicts associated with the use of affiliated service providers, and oversight of portfolio management and trading from a compliance perspective. All of those things are things that we have seen and I anticipate will continue to see, not just in exams of advisers that have more of a retail client base, but also advisers that are managing primarily private funds.

The other thing I thought was notable in this report was just some of the statistics that appeared at the beginning of the report. The one that jumped out to me was that OCIE examined 17% of all registered investment advisers in Fiscal Year 2018 – that would have been the fiscal year that ended actually in September of 2018. That's an increase from 15% of all registered investment advisers in the previous year and represents a continuation of a trend. I think if you look back several years, that number was more in the range of 11-12% per year. So there's clearly been a concerted effort by OCIE and we saw it in practice over the last year of conducting more exams, going out to see registered investment advisers more frequently. But with at least a subset of those exams, in particular exams involving smaller or in the SEC's view less risky advisers, we're seeing some exams that are much shorter in time and sort of narrower in scope than what we've seen traditionally. So more exams, but in at least some cases, sort of lighter touch exams than what's been the case in prior years.

David Tittsworth: I'll go out on a limb, Joel, and predict that in 2019 Federal Fiscal Year, the SEC will get to 20% of all the SEC registered advisers. We'll find out if that comes true or not. And I know you've been following a number of recent enforcement cases – so the Division of Enforcement at the SEC has been quite busy in the private fund space and maybe you could highlight a couple of the cases that have come to your attention.

Joel Wattenbarger: Sure, I will. Just a brief recap, but maybe to set the stage, I think for much of 2018, things were relatively quiet in terms of enforcement cases, specifically in the private fund arena. And I think relative to what we had seen in prior years, there was a sense that the enforcement division's focus had moved to some extent away from private funds, especially private closed-end funds. But at the end of the year, there's been a little flurry of cases in this space, so I think folks in the industry would be well advised not to sort of breathe too easily in terms of enforcement focus. The cases I wanted to mention, the first was Yucaipa, really dealing with expense issues – the specific issues in that case involved in-house tax personnel. Expenses associated with those in-house tax personnel were being charged to a private fund managed by Yucaipa without clear disclosure to fund investors. There were also expenses that had been allocated solely to the fund that per the settlement order, benefited both the fund and the adviser, and so in the SEC's view, should have been allocated in part to the adviser rather than solely to the fund. There were other undisclosed conflicts arising from the use of third-party service providers in the Yucaipa case. I think nothing in that case struck me as especially new or notable relative to some of the other fee and expense cases we've seen, but a reminder of the importance of having clear disclosure of any expense that's ultimately going to be borne by your fund investors rather than by the adviser itself.

The next case I wanted to highlight was NB Alternatives. Here was an interesting case in that the adviser in this case had what they called a “business services platform.” That platform consisted of personnel who were providing services at the level of portfolio companies of a private fund manager. There was clear disclosure in the fund documents that this platform existed, that the expenses associated with the services being provided to portfolio companies would in fact be borne by the funds and fund investors that this adviser managed. And so on the face of it you'd say, "Gee, this is exactly what the SEC wants managers to be doing, making clear disclosures so investors understand the expenses they would be bearing." The problem was that the members of the business services platform team were apparently engaged in providing services other than services directly to portfolio companies, so they were doing some pre-investment diligence, they were doing potentially some fundraising activities, and they were doing other things that didn't relate to the mandate that had been disclosed to investors in the offering documents and the managers' Form ADV. So I think the takeaway here is that the SEC is not just looking to say, "Have you made disclosures of expenses that may be borne by fund investors? But have you implemented policies and procedures, and are you really overseeing the allocation of expenses to insure that you're implementing your expense policies and procedures consistent with the disclosures that you have made to investors?" It seems like maybe a relatively obvious point, but the SEC is really drilling down now, not just looking at sort of general categories of expenses and disclosures, but drilling down to specific expenses that are being borne by funds and saying, "Is 100% of this an expense that has been adequately disclosed to investors, or should a portion of this be borne by the adviser?"

And the last and in some ways I think most interesting case is the Fifth Street Management case. And Fifth Street Management, there were several different issues in the case. The first two were really an expense allocation issue, an evaluation issue, both of which were I would say not particularly again new or notable, but consistent with those sorts of issues that we've seen –undisclosed expenses or an evaluation that was being conducted in a manner that wasn't consistent with the adviser's policies and disclosures to investors. But the last issue in the case, one that really only took up a couple of paragraphs in the order, so unfortunately we don't have a great deal to go on, but it was the most interesting aspect of the settlement order in my opinion – and the issue was that the adviser in question advised both BDCs (Business Development Companies) as well as a hedge fund, and the hedge fund's marketing materials apparently touted the hedge fund group's access to material non-public information about portfolio companies of the BDCs. And what the SEC found was that the adviser had failed to maintain and enforce written policies and procedures reasonably designed to prevent the misuse of material non-public information. It's an interesting case in that there are a number of managers who manage different types of products across their platform, don't have firm information barriers between the teams managing those different types of clients and don't necessarily have disclosure or policies and procedures that may govern all of the aspects of information sharing across those teams. And in light of this SEC enforcement action, although unfortunately the settlement order itself doesn't make entirely clear what the nature of any policies and disclosures were, I think it's well worth the while for any manager that is sort of managing different products, some of which invest on the private side, some on the public side, that you really take a hard look at the disclosures you're making to your investors with respect to both products, about the use of information that may be derived from managing one product and then is ultimately used for the benefit of another product, and that you also take a look at your policies and procedures regarding the use and misuse of material non-public information and insure that those policies and procedures do address the use of information across different clients and risks that may arise and that you have procedures in place to guard against those risks. So with that, David, let me turn it back to you for the end of this podcast and just ask that you share with us a little bit about the broader SEC agenda for the year 2019 as reflected in some recent remarks from Chairman Clayton.

David Tittsworth: Sure, and I'll be very brief. There are three things that I think people should look at if they're interested in trying to figure out what the agenda is for the SEC in 2019. One is the Reg-Flex Agenda that was published or released late in October by the Office of Management and Budget. Clayton, the chair of the SEC, has said that he wants these agendas to be more accurate and shorter, and I think that he's actually lived up to that promise. So looking at that agenda at the end of October, there are a lot of potential rule makings under the asset management umbrella. He also made a speech early in December, December 6th, that talks about the rule making record during the past year and also looking ahead. And then he testified before the Senate Banking Committee on December 11th. All those, his speeches on the SEC website, the Senate Banking Committee written testimony is available on the Senate Banking Committee website, and it might be worth a look for those who are trying to figure out where the SEC is going. I'll mention just a couple of items that might be of interest.

Clayton's highest priority seems to be completing of rulemaking that has eluded other chairmen for nearly 20 years at the SEC relating to standards of conduct for broker dealers and investment advisers. And there are actually three parts of proposed rules and interpretations that were approved by the Commission back in April. Again, I would guess that Clayton will try to take those very controversial proposals and get a final vote on those some time in the first half of 2019. There's also he's mentioned that he wants the staff to release a concept paper on how to harmonize exempt offerings. So for private funds, that could be a very interesting document that will deal with Reg D and related issues. There almost certainly will be something recommended to the Commission on improving the current proxy process. There was an all-day round table held at the SEC's headquarters here in Washington D.C. in November and I would be very surprised if there wasn't some follow-up activity on that in 2019. As well there are proposed amendments expected to the Investment Advisers Act advertising rules that prohibit testimonials and past specific recommendations that also were written before social media even existed, so that will be a very interesting proposal to look at. And while it doesn't fall in the rule making category per se, the full Commission is reconsidering several applications that were denied by the staff to establish cryptocurrency ETFs and it'll be very interesting to see what the Commission does with those.

So I'll end by talking very briefly. At his December 6th speech, Chairman Clayton talked about emerging market risks and trends, and he emphasized three areas that people should be aware of. Number one is cybersecurity. And of course cybersecurity I think is an evergreen risk that all registrants, anybody in financial services should be acutely aware of. The SEC has issued guidance to registrants during the past year, it's made cybersecurity a priority in inspections and I think you can expect a continued focus on cybersecurity going forward. Chairman Clayton also mentioned Brexit as an emerging market risk. Again, we're not going to go into the details today, but just in terms of the uncertainty and the potential market risks, people should be very well aware and watch the developments of the Brexit as it occurs in the next few months. And then finally, he mentioned the transition away from LIBOR as a reference for short-term interest rates as being an emerging market risk that the SEC was going to monitor. So I'll send it back to you, Joel, to close this out.

Joel Wattenbarger: Thank you, David, and thank you for joining me today. I hope listeners found this to be an insightful and informative discussion. For more information, please visit our website, www.ropesgray.com. And of course, if we can help you navigate any of these developments, please don't hesitate to get in touch. By the same token, if you have topics you would like to hear us address on future podcasts, we'd love to hear from you. Stay tuned for future podcasts on the latest developments in this space. And thank you for listening.