This newsletter discusses recent key SEC guidance releases, regulatory changes, and noteworthy news for private fund advisers.
SEC Sanctions Private Fund Adviser and Chief Investment Officer for Valuation Policy Failures
Fiduciary Duty Standards Clarified for Private Fund Advisers
New ILPA Principles For Private Fund Advisers
The SEC’s New Guidance on Proxy Voting Impacts Advisers of Funds That Hold Publicly Traded Securities
On June 4, 2019, the SEC announced that Deer Park Road Management Company, LP (“Deer Park”) agreed to pay a $5 million penalty, and its Chief Investment Officer (“CIO”) a $250,000 penalty, to settle charges stemming from compliance deficiencies that contributed to Deer Park’s failure to ensure that certain securities in its flagship hedge fund were valued property. A link to the settlement order can be found here.
The SEC alleged that Deer Park’s valuation policies failed to address sufficiently how to conform the firm’s valuations with GAAP. While Deer Park’s policies required the firm to value securities at a “fair value,” in accordance with GAAP pronouncement Accounting Standard Codification 820 (“ASC 820”), the policies lacked any procedures regarding how Deer Park should ensure consistency with the requirements of ASC 820, including the requirement that the valuation method maximize the use of relevant observable inputs and minimize the use of unobservable inputs. The SEC also alleged that Deer Park’s valuation policies were not reasonably designed for its business practices, given its use of valuation models and pricing vendors, and the potential conflicts of interest arising from traders’ ability to determine the fair value assessment of a portion of the positions they managed.
The SEC further alleged that Deer Park had failed to implement its existing valuation policies. While Deer Park’s valuation policies required traders to maximize the use of relevant observable inputs, Deer Park’s traders regularly failed to account for recent trade information in valuing fund securities. The SEC’s order stated, for example, that the valuation spreadsheets submitted by Deer Park traders to the CIO would at times note that a security was “undervalued,” “can trade much higher,” and “can sell it for a profit if needed.”
As a result of this alleged conduct, the SEC alleged that Deer Park and its CIO had willfully violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, which require investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules. Without admitting or denying the allegations, Deer Park and its CIO agreed to cease and desist from committing or causing any future violations of Section 206(4) of the Advisers Act or Rule 206(4)-7 thereunder, Deer Park agreed to pay a monetary penalty of $5 million, and the CIO agreed to pay a monetary penalty of $250,000.
Valuation remains a key focus of the SEC, including during staff examinations of advisers. Note that the Deer Park action involved members of the SEC’s Office of Compliance Inspections and Examinations. Compliance professionals therefore must remain vigilant in discussing valuation issues raised by SEC staff members during exams.
Key Take-Away: Advisers, particularly those trading difficult to value securities, must develop effective valuation policies and procedures that are reasonably designed to meet applicable compliance standards, and periodically test these procedures. The Deer Park action is notable because Deer Park’s valuation failures caused it to undervalue investments. The result: a decrease in the fund’s net asset value and a corresponding decrease in the fees paid by investors. Indeed, Deer Park was not penalized for harming investors, but rather for failing to adopt and implement appropriate valuation policies and procedures.
The SEC released an Interpretation (the “Interpretation”), effective July 12, 2019, on the standard of conduct for investment advisers under the Investment Advisers Act of 1940 (the "Advisers Act"). The SEC released the Interpretation in an effort to reaffirm and clarify certain aspects of the fiduciary duty an investment adviser owes its clients under section 206 of the Advisers Act.2 For purposes of this update we will analyze the Interpretation as it relates to fund sponsors and their fiduciary duties to private funds. Importantly, the SEC noted the Interpretation does not expand upon the existing fiduciary duties an investment adviser owes to its clients, which is enforceable under the antifraud provisions of the Advisers Act and is applicable to both registered and unregistered investment advisers, including exempt reporting advisers.
Generally speaking, this fiduciary duty materializes in two prongs: the duty of care and the duty of loyalty, which together require an investment adviser to act in the best interests of clients at all times. Many investment advisers, in today’s world of complex transactions and investment management fees, may find this a tall order to unfailingly meet. The SEC acknowledged this point, and recognized several market practices as meeting the fiduciary duty standards, stating, “this [Interpretation] generally reaffirms the current practices of investment advisers.” More specifically, the SEC acknowledged market practices often found in fund offering documents (or restructuring documents) allowing investment advisers to limit the best interest requirement by “shape[ing] [a] relationship [with a client] by agreement, provided that there is full and fair disclosure and informed consent.”
Such “shaping,” the SEC explained, should be detailed and take into account the specifics of the adviser-client relationship (i.e., not relying on general provisions, such as (i) statements that the adviser will not act as a fiduciary; (ii) blanket waivers of all conflicts of interest; or (iii) waivers of obligations under the Advisers Act).
The Interpretation laid out a number of elements necessary to meet the full and fair disclosure and informed consent requirements, including: (i) the disclosure of all material facts relating to the advisory relationship; (ii) the exposure of all conflicts of interest which might incline investment advisers (consciously or unconsciously) to render anything but advice in the best interests of its clients; and (iii) that any disclosure must be sufficiently specific such that a client (taking into account the level of sophistication of an investment adviser’s actual clients) is able to understand such disclosure and make an informed decision.
The Interpretation specifically noted two additional points. First, advisers’ use of the word “may” when disclosing conflicts of interest should only be used when no such conflict exists (i.e., if such a conflict does (or will) exist the disclosure should be clear and not use the word “may”). The second, and perhaps more important of the two, is “where an investment adviser cannot fully and fairly disclose a conflict of interest to a client such that the client can provide informed consent, the adviser should either eliminate the conflict or adequately mitigate (i.e., modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.”
The SEC noted a number of other points in the Interpretation that are more applicable to broker dealers than private fund advisers. That being said, these points are generally applicable to private fund advisers and can be summarized as follows: (i) an investment adviser must perform a reasonable inquiry into the client’s objectives, which are generally shaped by the specific investment mandates for private funds; (ii) an investment adviser has a general duty to seek the best execution of its clients’ transactions; and (iii) the investment adviser has a duty to monitor its clients’ investments.
Key Take-Away: While the Interpretation should not cause alarm, we recommend that registered advisers consider updating their Form ADV disclosures and fund offering materials to replace blanket waivers of unspecified conflicts with more detailed disclosures of actual or potential conflicts. For example, the typical advanced waiver of “any and all conflicts currently existing or that could arise in the future” likely would be viewed by the SEC staff as contrary to an adviser’s fiduciary standard and thus, unenforceable. We also recommend clear disclose of any arrangements where fund assets are used to potentially benefit the adviser over the fund, such as charging performance fees on gross assets (rather than net of expenses), charging fees to portfolio companies without a corresponding waiver of fees at the fund level, charging the fund for salaries or benefits of advisers’ employees for providing services to the fund, or charging the fund for the fund manager’s regulatory, legal or compliance expenses primarily related to the adviser (e.g., costs of preparing SEC Form PF or responding to an onsite examination of the fund’s adviser by the SEC staff).
The Institution of Limited Partners Association (“ILPA”) is a trade association for institutional limited partners in the private equity context. ILPA produces principles (the “ILPA Principles”) to align the interests of limited and general partners as well as improving transparency and governance within the private equity fund space. ILPA published its first edition of principles in September 2009. The ILPA Principles are intended to provide a common set of terms for institutional limited partners to use in negotiations with fund managers similar to what the National Venture Capital Association does for the venture capital space.
The third edition of the ILPA Principles (click here) (“Principles 3.0”), published in June 2019, states its goal is to improve the private equity industry for the long-term benefit of all its participants. Principles 3.0 addresses new and emerging issues (subscription lines of credit, non-financial disclosures, co-investments and GP-led secondary transactions) and provides additional guidance on common matters (fund economics and LPAC responsibilities).
We have selected a handful of the main elements of Principles 3.0 we believe will be of interest to private fund managers, as well as their general partners (“GPs”) and limited partners (“LPs”).
Subscription Lines of Credit. GPs should use subscription lines to benefit their funds as a whole, rather than to pay out early redemptions. For carried interest calculations where a credit facility is in place, the preferred return should accrue from the date that capital is at risk, i.e., when the credit facility is drawn instead of when the capital is ultimately called from the LPs. This is likely to be an area which may be challenging for GPs to support; ILPA suggests GPs will understand there’s a need to mitigate what might be behavior-altering effects of the use of these facilities.
Co-investment allocations. GPs should consider employing a pre-qualifying assessment during fundraising, and at intervals during the investment period, to confirm LP interest in and ability to execute on co-invest opportunities. Further, GPs should give prospective investors the strategic rationale for co-investments to explain why the entire amount is not being allocated to the fund itself.
Governance. Principles 3.0 provides that an indemnity clause protecting the GP from third party claims should exclude protection in the event of the GP’s contractual breach of the fund documents or behavior that constitutes “gross negligence, fraud or willful misconduct”, even if the governing law would permit it. Further, these exclusions should not be qualified with respect to the GP’s “prior knowledge” or “material and adverse effect” on the fund or its LPs.
Recycling of distributions. ILPA’s framework on the ability for the GP to recycle capital (which is then added back to the LPs’ undrawn commitments and available for further drawdowns) empowers LPs to establish some boundaries. For example, Principles 3.0 suggests the amount of total distributions subject to recycling provisions should either have an agreed cap, or a monitoring threshold (based on factors such as the GP’s track record and the strategy of the fund).
GP and fund economics. Principles 3.0 is more explicit in approaches to waterfall structures, carried interest calculations, clawback and fees and expenses. For example, Principles 3.0 suggests carried interest should be calculated based on net (not gross) profits and the impact of fund level expenses should be factored into the calculation. Whole fund carried interest calculations (i.e., the "European style" all-contributions-plus-preferred-return-back-first) are still preferred to the "American style" deal-by-deal model.
Principles 3.0 recommends that the industry move to a gross-of-tax clawback model, paid back within two years after the liability is recognized.
Reflecting a rise in third party investment in GPs, a new Principle indicates GPs should proactively disclose the ownership of the management company and notify all LPs if this changes over the life of the fund.
Management Fees. GP should absorb both the costs and expenses associated with the results of an SEC investment adviser regulatory examination (conversely, regulatory approval for a transaction should be a fund expense), as well as for a technology implementation that chiefly benefits the GP.
No additional management fees should be charged to portfolio companies, or they should be 100% offset against the fund management fee and subject to standard disclosure.
Key Take-Away: ILPA Principles are guidelines for sophisticated investor negotiations with fund managers. Even if fund managers do not consider ILPA Principles as “market standards”, they should be prepared to discuss why their fund documents may deviate from ILPA Principles.
Fund advisers typically exercise proxy voting authority over publicly traded securities held by the fund. Two recent SEC releases show the SEC will exercise greater oversight to ensure that investment advisers – including advisers to investment funds – manage their proxy voting in a manner consistent with their fiduciary obligations. Links to the releases can be found here (the “Guidance”).1
An adviser’s fiduciary duties of care and loyalty extend to its proxy voting practices, whether the adviser directly votes proxies or relies on voting research, advice or services of independent proxy voting firms (“Proxy Firms”). The Guidance is largely presented in the format of answers to a series of hypothetical questions posed by the SEC. Summarized below are the SEC’s responses to questions we believe most relevant to fund advisers:
Question 1 relates to how an adviser and its clients can determine the scope of the adviser’s proxy voting authority and responsibility, and the impact of that decision on the adviser’s fiduciary duties. It is generally impractical to limit the proxy voting authority of fund advisers. This article therefore assumes that fund managers have unlimited proxy voting authority.
Question 2 relates to steps advisers should take to ensure they vote proxies in a manner that is in the best interests of the client (e.g., the fund) and in accordance with the adviser’s own proxy voting policies and procedures. Here, advisers should:
Questions 3-5 clarify how advisers satisfy their fiduciary duties when utilizing Proxy Firms either for research and recommendations or actual voting responsibility, or both. The key points include:
Question 6 clarifies that advisers who have proxy voting authority are not required to exercise every opportunity to vote a proxy. For example, the adviser and its client may have agreed to limit the adviser’s proxy voting authority in particular instances. Or, the adviser may determine that it is in a client’s best interests not to vote a proxy (for example, if the costs of voting the proxy outweigh the expected benefit to that client).
Key Take-Away: Advisers of funds that hold publicly traded securities should periodically review and assess their proxy voting policies and procedures to determine if any changes are merited in light of the new Guidance and the SEC’s intention to exercise greater oversight of advisers’ proxy voting practices.
1. This article examines the Guidance that applies directly to fund advisers who vote proxies or select Proxy Firms for research or voting services. This article does not address the portions of the Guidance that relates to the applicability of federal proxy rules to proxy solicitations by Proxy Firms.
2. 15 U.S.C. 80b, and unless otherwise noted all references to the Advisers Act or any rules promulgated thereunder are to 15 U.S.C. 80b and 17 CFR 275, respectively.