The Adviser: A Quarterly Update for Private Funds - November 2017

Bryan Cave Leighton Paisner

SEC Settles More Allegations of Misallocation of Fees and Expenses against Private Equity Fund Advisers

SEC Publishes Risk Alert on Advertising Rules

Revisions to Form ADV

Recent Developments in Cybersecurity

Proposed Changes to U.S. Tax Laws

ERISA Update: More Fiduciary Rule Changes

SEC Finds ICOs May Be Subject to Registration Requirements

SEC Enforcement Actions: Insider Trading

Selected Compliance Calendar

SEC Settles More Allegations of Misallocation of Fees and Expenses against Private Equity Fund Advisers

For several years the U.S. Securities and Exchange Commissions (“SEC”) has focused its enforcement efforts on how private fund advisers allocate fees and expenses to their fund clients and the adequacy of their disclosures to those clients regarding such practices. Consistent with this focus, the SEC recently settled two enforcement actions targeting inappropriate fee and expense allocations, one of which resulted in the fund manager paying more than $3 million in disgorgement and civil penalties.

Platinum Equity Advisers, LLC

On September 21, 2017, Platinum Equity Advisers, LLC (“Platinum”) settled the SEC’s claims that Platinum violated Sections 206(2), 206(4) and Rule 206(4)-7 of the Investment Advisers Act of 1940 (the “Advisers Act”) by charging three of its private equity fund clients approximately $1.8 million in broken deal expenses. Specifically, the SEC alleged that Platinum allocated all of its broken deal expenses to its three fund clients and allocated none of such expenses to the co-investors who intended to participate in the deals that ultimately fell through. The SEC also alleged that the funds’ governing documents did not disclose that the funds would be responsible for any expenses other than their own.

Without admitting or denying the SEC’s allegations, Platinum settled the claims, agreeing to disgorge more than $1.9 million and pay a $1.5 million civil penalty.

Potomac Asset Management Co. Inc.

Earlier in September, another investment adviser, Potomac Asset Management Co. Inc. (“Potomac”), settled claims by the SEC that it inappropriately allocated fees and overhead expenses to two of its private equity fund clients. Specifically, the SEC alleged that Potomac charged one of its fund clients $2.2 million in fees for services provided to a portfolio company, collected $726,000 in management fees that it failed to offset with other Potomac income as required under the applicable fund’s governing documents, and allocated more than $703,000 in rent, compensation and other business and regulatory expenses to two of its fund clients without authorization.

Without admitting or denying the SEC’s allegations, Potomac agreed to pay a $300,000 civil penalty, for which it is jointly and severally liable with its principal.

In both of these cases, the SEC also claimed that the investment advisers did not have or implement adequate policies and procedures to protect against the alleged misallocations.


These cases are instructive. The SEC has not relented in its enforcement efforts regarding private equity advisers’ fee and expense allocation and disclosures to their fund clients on how fees and expenses would be allocated to the funds. To avoid these issues, fund managers should (1) analyze their fund documents to determine whether they clearly disclose how and what expenses and fees will be allocated to the funds, (2) evaluate their policies and procedures regarding fee and expense allocation to ensure that the written procedures are reasonably designed to protect against fee and expense misallocation and (3) assess whether the allocation practices in the fund documents and the advisers’ allocation policies and procedures are being appropriately implemented. It is not uncommon in the industry for co-investors to not be charged for broken deal expenses, but this should be clearly disclosed in a fund’s governing documents or otherwise disclosed to limited partners.

SEC Publishes Risk Alert on Advertising Rules

In September, the SEC published a Risk Alert highlighting the most frequent violations of the “Advertising Rules” (Rule 206-4(1) of the Advisers Act that it has identified during examinations of SEC-registered investment advisers. The Advertising Rules are generally designed to prohibit advisers from publishing, circulating or otherwise distributing advertisements that contain any untrue statement of material fact or that are otherwise false or misleading. Certain advertisements, including client testimonials and past specific investment recommendations, are expressly prohibited under the Advertising Rules; other forms of advertisements have been found to violate the Advertising Rules in court opinions and SEC enforcement actions.

Some of the most common violations of the Advertising Rules the SEC identified are described below. We have observed many of these violations in the marketplace as well.

  1. Misleading Performance Results – Any advertisement of an adviser’s performance results cannot be false or misleading. Consequently, historical performance results should be presented net of fees and expenses and, if compared to an index or other benchmark, include appropriate disclosures regarding the unavoidable limitations of such a comparison. If hypothetical or back-tested performance results are presented, appropriate disclosures about how those results are calculated must be provided. It is noted that, in our experience, some state securities regulators view back-tested results as inherently misleading notwithstanding any disclosures of their limitations.
  2. Cherry Picking – Advisers are prohibited from referencing specific investment recommendations made by the adviser unless the adviser includes all investment recommendations that adviser made and appropriate information and disclosures about the recommendations. The purpose of this rule is to prevent an adviser from solely highlighting its profitable recommendations, which could lead a potential client to assume all of the adviser’s recommendations are profitable.
  3. Third-Party Rankings and Awards – Advisers who seek to include rankings or awards in their advertisements must disclose all material information about the ranking or award being described, including the number of eligible recipients, the selection criteria, and the date on which the ranking or award was received.
  4. Testimonials – Advisers are prohibited from advertising any testimonials, recommendations, or accolades about the services provided by the adviser. This includes testimonials made by current or former clients of the adviser.

For most investment advisers, advertisements and other marketing materials are an unavoidable component of growing their businesses. As noted above and in the Risk Alert, these activities are subject to numerous restrictions that are easy to violate. We strongly encourage all of our clients to have all advertisements and marketing materials reviewed by your compliance staff or outside counsel prior to distribution to potential investors.

Revisions to Form ADV

As we previously summarized in September 2016, the SEC has adopted changes to Form ADV, the filing required to be made by nearly all SEC and state-registered investment advisers. These revisions went into effect on October 1, 2017.

Among other changes, the updated Form ADV places significant additional reporting requirements on investment advisers who manage separate accounts. Separate account advisers are now required to report aggregated information about their separate account clients, including the types of assets the separate accounts hold and their exposure to derivatives and leverage. Separate account advisers with December 31 year-ends are encouraged to start compiling this information now so that it is ready for the advisers’ annual Form ADV amendment in March 2018. If an adviser needs to file an other-than-annual amendment prior to its March 2018 annual amendment and is unable to answer any of the new questions in Item 5, the SEC has advised it is acceptable for the adviser to use a placeholder of “0” and note in the Miscellaneous section of Schedule D that a placeholder was used.

Additionally, the SEC’s Form ADV FAQ has recently been updated in connection with the revised Form ADV. The updated FAQ includes additional guidance on answering Form ADV questions related to social media accounts, counting separately managed accounts, and other items. We encourage all clients to review the FAQ when completing its Form ADV.

Recent Developments in Cybersecurity

Over the past several years, the SEC has indicated that cybersecurity policies and procedures would be an area of focus during examinations. Click here for additional information about the SEC’s focus, including past guidance on cybersecurity. In an ironic twist, internal cybersecurity is now also a higher priority for the SEC itself.

In May 2017, recently appointed SEC Chairman Jay Clayton initiated an “assessment of [the SEC’s] internal cybersecurity risk profile and [its] approach to cybersecurity from a regulatory and oversight perspective.” The SEC’s self-assessment addresses many of the considerations also faced by regulated entities, from understanding the nature of data being collected and stored to identification and mitigation of cybersecurity risks. In addition, the SEC’s assessment will examine how the SEC uses its oversight and enforcement authorities in the cybersecurity context.

This internal assessment comes at a significant time for the SEC, following a 2016 breach of the EDGAR filing system and ahead of the planned launch of the Consolidated Audit Trail (“CAT”) slated for November 2017. CAT aims to improve monitoring through the use of “a comprehensive set of trading data,” by creating a centralized database to maintain records across the various stages of an order for NMS securities, including customer and related information collected from broker-dealers. The increased volume of non-public trading data and customer information will lead to an increased need to protect such data from misuse. Between the information submitted to EDGAR prior to being made publicly available and the additional data collected by CAT, potential cybersecurity intrusions pose myriad risks to issuers and investors, including the potential for hackers to trade on non-public information.

In conjunction with its increased cybersecurity self-evaluation, the SEC will continue to examine the cybersecurity procedures and controls of regulated entities, such as investment advisers, to ensure that client data is protected and, in the event of a data breach, mitigation efforts are adequate. In September 2017, the SEC’s Division of Enforcement created a new Cyber Unit to “focus the Enforcement Division’s substantial cyber-related expertise on targeting cyber-related misconduct.”
According to the SEC, examples of the misconduct to be targeted by the Cyber Unit include market manipulation schemes, violations involving distributed ledger technology and initial coin offerings, and cyber-related threats to trading platforms and other critical market infrastructure.

The SEC has made cybersecurity compliance assessments one of its exam priorities for 2017 and prior years, and the creation of the Cyber Unit and launch of CAT suggest that regulated entities such as broker-dealers and investment advisers should prepare for cybersecurity to remain a priority for the foreseeable future.

Proposed Changes to U.S. Tax Laws

The House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) on Thursday, November 2, 2017.  The proposed tax legislation covers a broad scope of topics, many of which could affect investment advisers and the funds and accounts that they manage. While it too early to make a prediction as to whether any tax reform bill will pass and what will be in the final version, we encourage clients to familiarize themselves with the proposed legislation. Additional information about the current bill can be found here

ERISA Update: More Fiduciary Rule Changes

The Department of Labor (“DOL”) has continued to re-examine the “Fiduciary Rule” that we have discussed in our two prior newsletters, which can be found here and here. As explained there, the Fiduciary Rule became effective June 9, 2017, expanded the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974 (“ERISA”) and, as a result, increased the risk that managers of investment funds selling interests to investors investing retirement plan assets, including from their personal IRAs, could be deemed to be acting as a fiduciary with respect to such investment.

On August 9, 2017, the DOL informed the court in Thrivent Financial for Lutherans v. Acosta that it would submit proposed amendments to Prohibited Transaction Exemption (“PTE”) 2016-01 (better known as the “Best Interest Contract Exemption” or “BIC Exemption”), PTE 2016-02 (the Class Exemption for Principal Transactions in Certain Assets Between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs), and PTE 84-24 concerning advisory transactions involving insurance and annuity contracts and mutual fund shares. The DOL’s proposed amendments (the “Proposed Amendments”) were subsequently published in the Federal Register on August 31, 2017. The Proposed Amendments would (i) extend the current transition period applicable to the BIC Exemption and PTE 2016-02 (during which persons who wish to rely on such PTEs must only comply with “Impartial Conduct Standards”; e.g., provide prudent advice that is in the retirement investor’s best interest, charge no more than reasonable compensation, and avoid making misleading statements) for an additional 18 months until July 1, 2019, and (ii) delay the revocation of the availability of PTE 84-24 for transactions involving fixed indexed annuities for an additional 18 months until July 1, 2019. The comment period for the Proposed Amendments closed September 15, 2017, but final amendments have not yet been issued.

Further, under the current BIC Exemption and PTE 2016-02, a financial institution is ineligible to rely on such exemptions if its contract with a retirement investor includes a waiver or qualification of the retirement investor’s right to bring or participate in a class action or other representative action in court (an “Arbitration Limitation”). On August 30, 2017, DOL announced via Field Assistance Bulletin No. 2017-03 that this restriction would not be enforced by the DOL if the sole failure of the financial institution to comply with such exemption is the inclusion of an Arbitration Limitation in the applicable contract. Although the Field Assistance Bulletin states that DOL’s non-enforcement policy will continue as long as the PTEs continue to prohibit Arbitration Limitations, we caution that in neither instance has DOL amended the PTE itself.

Each of the Proposed Amendments and the Field Assistance Bulletin simplify, but do not remove, the compliance burden on financial advisers and institutions subject to the DOL’s new Fiduciary Rule while also prolonging the uncertainty regarding the steps that such financial advisers and institutions will need to take long term to comply with the Fiduciary Rule’s (and the associated PTEs’) requirements. Notwithstanding these changes (current and proposed), the new Fiduciary Rule remains in effect and imposes real compliance obligations on investment advisers and fund managers. If you would like to market your investment fund or advisory services to retirement plan clients, including clients who investing through their personal IRA, please contact us for additional information about how to do so while complying with the new Fiduciary Rule.

SEC Finds ICOs May Be Subject to Registration Requirements

The SEC recently weighed in on Initial Coin Offerings (“ICOs”), which have enjoyed explosive growth in 2017 with little to no regulation or government oversight. An ICO is a mechanism for issuing and offering for sale a digital currency, typically in exchange for a more established digital currency such as Bitcoin. The SEC guidance on ICOs suggests that many are subject to U.S. federal securities laws. Under the Securities Act of 1933, tokens or coins sold in ICOs constitute securities, according to the SEC’s guidance, because they are an investment contract with a “reasonable expectation of profits” to be derived from the efforts of others. The SEC guidance will significantly impact digital currency entities, as well as any exchanges hosting transactions involving ICO tokens. It will be crucially important for affected entities to consult with attorneys to ensure compliance with federal securities laws in light of the SEC’s new guidance.

SEC Enforcement Actions: Insider Trading

The U.S. Court of Appeals for the Second Circuit in August closed a window it had opened three years earlier in the law of insider trading that created greater leeway for trading on inside tips from people other than close friends and family members. In United States v. Martoma, the Second Circuit affirmed the 2014 conviction of hedge fund trader Michael Martoma, who, through well-timed short sales of two drug companies’ stock, generated millions of dollars in profits and avoided losses based on tips from a doctor involved in drug trials. Martoma’s appeal was based, in essence, on the proposition that he was not a close friend of the doctor/tipper, and that he (the tippee) had to have been one in order to be liable for insider trading.  The Second Circuit rejected that argument, and thus overruled the key holding of United States v. Newman (773 F.3d 438 (2d Cir. 2014)). The court concluded that the law did not require a “meaningfully close personal relationship” between tipper and tippee, as Newman required, for a tippee like Martoma to be liable for trading on a tip provided as a gift.

This past August, the SEC reached an agreement with hedge fund advisory firm Deerfield Management for $4.6 million to settle charges that it did not have the necessary preventative measures in place to prevent insider trading. The case alleged that some Deerfield analysts traded on information from a political intelligence analyst working at the Centers for Medicare and Medicaid Services who also provided consulting services for the fund. The case underscores the need for investment fund advisory firms to adopt policies and procedures relating to the particular risks presented by their businesses.

Selected Compliance Calendar

The following compliance calendar includes selected upcoming deadlines for SEC-registered investment advisers and is not intended to be complete. State-registered investment advisers may be subject to additional or different deadlines. Please contact us to discuss which deadlines are applicable to you.



November 14, 2017

Form 13F quarterly filing is due for applicable investment advisers.

November 29, 2017

Quarterly Form PF filing is due for all “large hedge fund advisers”.

December 18, 2017

IARD Account funding deadline for amounts necessary to cover all state notice filing fees and other similar state fees applicable to investment advisers who notice file with one or more states.

December 31, 2017

Amended Form 13H due from all “large traders” within ten days after each quarter end.

March 31, 2018

Annual Form ADV amendment due.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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