UPDATE. Sec presence exams Field Observations. Sec presence exam Background

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1 WAShINgTON UPDATE nabil Sabki Stephen p. wink nicholas m. look Sec presence exams Field Observations By eliminating the fewer-than-15-client exemption from registration under the Investment Advisers Act of 1940, as amended, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 caused many previously unregistered private fund advisers to register with the Securities and Exchange Commission. 1 It has now been more than a year since the initial registration deadline March 30, 2012 for these newly registered private fund advisers, and the SEC staff has been carrying out a program of focused Presence Exams of these advisers. This article describes the SEC Presence Exam Program and summarizes some of our observations regarding the SEC staff s findings, comments, and focus during these exams. Sec presence exam Background Every registered investment adviser is subject to examination by the SEC through the Office of Compliance Inspections and Examinations and its National Exam Program. Typically, an investment adviser will receive only one to two weeks notice before the SEC staff arrives on-site to begin the examination process. As part of these examinations, the SEC staff requests and reviews the books and records of the adviser, interviews various personnel, and attempts to determine if the adviser is complying with the numerous rules and regulations of the Advisers Act. For routine SEC examinations, the SEC staff is commonly onsite at the adviser s offices between two and six weeks or longer, depending on the size of the adviser and complexity of its operations. On October 9, 2012, the OCIE issued a letter to senior executives or principals of newly registered advisers describing a new Presence Exam initiative by the SEC. 2 This initiative is intended to (1) familiarize newly registered investment advisers with the NEP and the OCIE, as well as the advisers duties under the Advisers Act; (2) examine these advisers to promote compliance with the Advisers Act and certain areas the SEC deems of particular importance for newly registered advisers; and (3) upon completion of the Presence Exam initiative, report to the SEC and the public on observations made during these examinations. The initiative is expected to last approximately two years. The SEC noted five areas of particular focus for its Presence Examinations: marketing, portfolio management, conflicts of interest, safety of client assets, and valuation. In our experience, the SEC staff has indeed focused on these areas, spending, on average, two to five days on-site at each adviser s office. By conducting quicker high-level exams, the SEC staff is able to visit many newly registered advisers in shorter periods of time. 3 According to the SEC, the Presence Exam initiative also seeks to help newly registered investment advisers comply with a new and unfamiliar area of the law. To this end, the SEC publicize[s] best practices and [offers] staff guidance in a number of areas. 4 In particular, advisers should be on the lookout for risk alerts, 5 as well as general compliance outreach materials. 6 Stefan paulovic 1. See US Securities and Exchange Commission, SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act, press release , June 22, 2011, 2. See US Securities and Exchange Commission Office of Compliance Inspections and Examinations, Letter to Senior Executives or Principals of Newly Registered Investment Advisers, Oct. 9, 2012, 3. See US Securities and Exchange Commission, Testimony on SEC Budget, by Chair Mary Jo White, May 7, 2013, see also Where the SEC Action Will Be, June 23, 2013, online.wsj.com/article/sb html. 4. See US Securities and Exchange Commission, Doing the Right Thing: Compliance That Works for Investors, speech by Commissioner Luis A. Aguilar, April 18, 2013, 5. See US Securities and Exchange Commission, Office of Compliance Inspections and Examinations, Public Alerts, Reports, and Letters, 6. See US Securities and Exchange Commission, Investor Alerts and Bulletins, see also ibid; US Securities and Exchange Commission, Doing the Right Thing: Compliance That Works for Investors, speech by Commissioner Luis A. Aguilar, April 18, 2013, 12 PREA Quarterly, Summer 2013

2 WAShIngTon UPDATE Learning from Experience and Looking Forward Since the SEC announced the Presence Exam Program, many advisers have undergone Presence Exams, and notable points have emerged. Drawing on firsthand experience and public statements of the SEC staff, we summarize below some of the SEC staff s findings, comments, observations, and focus during these Presence Exams. Transaction-Based Compensation. The SEC staff has observed that some private fund advisers (and/or their affiliates or personnel) receive transaction-based compensation for purported investment banking or other broker activities relating to one or more of the fund s portfolio companies. 7 The SEC staff has requested advisers receiving these transaction fees to provide a detailed legal analysis as to why they do not fall within the definition of a broker under the Securities Exchange Act of 1934, as amended. 8 We understand that advisers have provided a range of responses, including that (1) the management/advisory fee otherwise payable by the fund to the adviser is offset or otherwise reduced by such transaction fees, (2) the adviser is effectively con- ducting these transactions for its own account rather than for the account of others because the fund whose portfolio companies are generating these fees is under common control with the adviser, and (3) the policy reasons for registration as a broker do not apply where the recipient of the transaction fees is already subject to fiduciary duties. At the time of this writing, it is not clear to what extent such arguments will be persuasive to the SEC staff. 9 It should also be borne in mind that broker status determinations will also turn on the specific facts of given arrangements. The stakes are high, as acting as an unregistered broker may not only subject an adviser to sanctions by the SEC but also could grant counterparties a potential right to rescission. 10 Thus, until the SEC staff provides more clarity as to the scope of permitted activities, or the SEC provides exemptive relief for certain limited broker activities at some point in the future, advisers should carefully consider their portfolio company transaction fee arrangements in light of currently applicable regulatory requirements. Custody. Approximately one-third of all recent SEC examinations have noted some form of custody-related 7. See US Securities and Exchange Commission, A Few observations in the Private Fund Space, speech by David W. Blass, April 5, 2013, Among the fees observed by the SEC staff were fees the manager directs a portfolio company of the fund to pay directly or indirectly to the fund s adviser or one of its affiliates in connection with the acquisition or disposition (including an initial public offering) of a portfolio company or a recapitalization of the portfolio company. Such fees, according to Blass, were described as compensating the private fund adviser or its affiliates or personnel for investment banking activity, including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions. 8. Section 15(a) of the Exchange Act requires that persons engaged in broker activity must register with the SEC pursuant to Section 15(b) of the Exchange Act unless an applicable exemption is available. In general, a broker is any person engaged in the business of effecting transactions in securities for the account of others. Although the Exchange Act and the rules promulgated thereunder do not specifically define effecting transactions or engaged in the business, the SEC and the SEC staff have taken a very expansive view of the scope of those terms. In his speech, Blass reiterated that the SEC and the SEC staff have consistently viewed transactionbased compensation as the hallmark of broker activity and cautioned that the receipt of transaction-based compensation coupled with the types of activities being performed may trigger the requirement to register with the SEC as a broker under the Exchange Act. 9. See US Securities and Exchange Commission, A Few observations in the Private Fund Space, speech by David W. Blass, April 5, 2013, Blass acknowledges that no broker registration requirement appears to be triggered where the advisory fee is wholly reduced or offset by the amount of the transaction fee but calls into question the argument that these transactions are not conducted for the account of others as the fund and the recipient of the transaction fee are distinct entities with distinct interests. 10. Section 29(b) of the Exchange Act provides that contracts made in violation of the Exchange Act shall be void in respect of the rights of any person who, in violation of any such provision, rule, or regulation, shall have made or engaged in the performance of any such contract. 11. See US Securities and Exchange Commission office of Compliance and Inspections, national Exam Program Risk Alert: Significant Deficiencies Involving Adviser Custody and Safety of Client Assets, Vol. III, Issue 1, March 4, 2013, See Advisers Act Rule 206(4)-2(d)(2). 13. See Advisers Act Rule 206(4)-2(a)(4). 14. See Advisers Act Rule 206(4)-2(a)(1). 15. See Advisers Act Rule 206(4)-2(b)(4). 14 PREA Quarterly, Summer 2013

3 issue or written comment. 11 The deficiencies generally fall into four categories: (1) failure by an adviser to recognize that it has custody as defined under the custody rule, 12 (2) failure to comply with the rule s surprise exam requirement, 13 (3) failure to comply with the qualified custodian requirement, 14 and (4) failure to comply with the audit approach for pooled investment vehicles (the Private Fund Audit Exception). 15 The Risk Alert issued by the SEC highlights specific deficiencies found, which should help advisers identify and address these issues. For most advisers of real estate, private equity, hedge, and other private funds, many of the deficiencies stemmed from the adviser s failure to comply with the Private Fund Audit Exception or surprise audit requirement for co-invest funds or employee, friends and family funds that are smaller in size. Historically, such vehicles have generally not required audits, on the assumption that if investors in these smaller vehicles did not want to incur the cost of an audit or a surprise audit, the SEC staff would not object. The SEC staff has since made it very clear that if an adviser has custody over a private fund s assets (e.g., by virtue of being a general partner or managing member of the private fund), the adviser must comply with the custody rule requirements regardless of the size of the fund or the desire of the underlying fund investors. allocating expenses fairly and equitably among their funds and consider if any fund is bearing a disproportionate share of expenses. For private fund advisers, the allocation of broken-deal expenses merits particular attention. Many advisers make a practice of rolling broken-deal expenses into the next consummated deal. This may be appropriate so long as Expenses and Allocation of Expenses. Presence Exams have focused on fund and adviser expenses. A primary inquiry has been whether expenses are being allocated fairly and equitably among the adviser s funds (including its sponsored or managed funds). Advisers should carefully consider whether they are PREA Quarterly, Summer

4 WASHInGTOn UPdATE the series of deals is made for the same fund. However, rolling broken-deal expenses from one fund into another fund is generally problematic because a different set of investors would bear such expenses. The SEC staff has also expressed concern over whether expenses are appropriately allocated to a given fund. For example, an adviser should not attempt to push down management company overhead expenses to a fund. Expenses should be charged to a fund only if the fund s organizational documents clearly permit the fund to bear such expenses. As a result of SEC staff findings in Presence Exams, some advisers have been required to reimburse expenses considered by the SEC staff to have been inappropriately charged or allocated to the fund. Portfolio Company Expenses. In most Presence Exams for private fund advisers, the SEC staff has specifically asked advisers to provide a schedule of all expenses the adviser or its affiliates charge to portfolio companies (e.g., monitoring fees, transaction fees, and early termination fees), as well as the percentage of such fees that offset management fees. The SEC staff is very focused on confirming that such fees have been clearly disclosed to investors. General Partner Givebacks. In a few recent exams, the SEC staff has closely scrutinized the operation of general partner giveback provisions. A general partner giveback obligation is generally a mechanism whereby, at the end of a fund s life (or at certain interim points), a private equity fund manager is contractually bound to return to fund investors any excess carried interest that was previously distributed to the manager. Such giveback obligations are typically backed up by personal guaranties of the principals of the fund s general partner. In cases where a significant giveback obligation has built up (based on the performance of the overall fund portfolio) and not enough capital remains on the general partner s balance sheet to cover the giveback obligation, the SEC staff has specifically inquired how the general partner intends to meet the obligations. 16 Requests. Advisers are required to keep certain books and records under the Advisers Act, and the SEC staff has indicated that it expects advisers to retain all communications that relate to such books and records. Given the SEC staff s position, many advisers have implemented policies and procedures to retain all s. 17 On several recent occasions, the SEC staff has requested that an adviser produce all s for certain senior personnel for a two- to three-month period. The SEC staff will generally allow advisers to withhold s that are attorney-client privileged as long as a log of such s not produced is provided to the SEC. Most advisers that have been subjected to production have commented that such production can be very time-consuming and expensive. Advisers should advise all employees that s are subject to SEC examination and that employees should treat as a formal and recorded method of communication. Scope of Review. Many advisers were surprised when the SEC staff requested books and records that predated the date of the adviser s initial registration. While in most instances the SEC staff has acknowledged that books and records that predate the registration date of the adviser are not expected to comply with specific Advisers Act rules (e.g., the advertising rules), the SEC staff has 16. We are aware that many private fund managers voluntarily escrow certain amounts to cover future potential giveback obligations. In such situations, the SEC staff has generally not raised any concerns. 17. See The Association of the Bar of the City of new York, Committee on Investment Management Regulation, letters to the Securities and Exchange Commission, May 11, 2005, and nov. 15, 2005, 16 PREA Quarterly, Summer 2013

5 Washington Update generally insisted on reviewing such documents. to date, we are not aware of any adviser receiving a deficiency letter from the sec staff relating to noncompliance with the advisers act rules that stemmed from records that predated the adviser s registration with the sec. nonetheless, many advisers found it disconcerting to be asked to produce offering memorandums, pitch books, and other materials that predated registration dates. Tone at the Top. a common theme during sec exams is a focus on the tone at the top. 18 it is not necessarily just the senior compliance personnel in the spotlight; [a] firm s senior leadership must be visible and vocal advocates for a strong culture of compliance. 19 accordingly, all senior principals should be prepared to answer questions during sec examinations, including questions about how they help promote a culture of compliance at the firm and provide adequate resources for the compliance function. a culture of compliance, particularly at the top, is an important quality that every adviser should embrace. as presence examinations continue, advisers should expect the sec staff to become even more familiar with and focused on the private fund industry. this may well lead to additional issues and areas of concern that were not previously raised by the sec staff. similarly, the sec staff s current focus on broker-dealer registration concerns in connection with the receipt of transaction-based fees has been considered a sea change, given how prevalent such arrangements have long been in the industry. Conclusion the sec continues to perform presence exams and most likely will continue to provide guidance to newly registered investment advisers, either through public speeches or writings, as the sec uncovers new areas of general concern (e.g., transactionbased fees). Based on our experience during the first phase of presence exams, we have found that the sec staff has been helpful and encouraging to advisers that have been open and cooperative with the sec staff. our sense is that, in general, the first round of presence exams has been productive for both the sec staff (as they learn more about the private fund industry) as well as the newly registered advisers (as they learn to operate under the advisers act). however, advisers should not get complacent on the basis of a smooth presence exam (nor indeed at any time). Routine sec examinations are much more thorough and time-consuming than presence exams. advisers should maintain a thoughtful focus on compliance, both in anticipation of eventually receiving a full routine sec examination and as a matter of sound practice. Nabil Sabki is a Partner in the Chicago office, Stephen P. Wink is a Partner in the New York office, Nicholas M. Look is an Associate in the Orange County office, and Stefan Paulovic is an Associate in the New York office of. 18. see Us securities and exchange Commission, national exam program director Carlo V. di Florio to Leave sec, press release , May 2, 2013, Us securities and exchange Commission, national exam program office of Compliance inspections and examinations, examination priorities for 2013, Feb. 21, 2013, Us securities and exchange Commission, examinations by the securities and exchange Commission s office of Compliance inspections and examinations, Feb. 2012, pg. 25, Us securities and exchange Commission, speech by sec staff, speech by Carlo V. di Florio, Jan. 31, 2012, see ibid; see also Us securities and exchange Commission, doing the Right thing: Compliance that Works for investors, speech by Commissioner Luis a. aguilar, april 18, 2013, 18 PREA Quarterly, Summer 2013