SEC Enforcement in Private Equity and Hedge Funds.

SEC enforcement matters in the private fund world can target anyone. This includes executives, principals, traders, and compliance personnel. In many cases, these matters start as routine examinations or informal requests to produce documents.

In many cases, matters involving the SEC or the CFTC also involve parallel criminal investigations by the U.S. Department of Justice (DOJ). This means that the same conduct that prompts an SEC matter or CFTC matter may also prompt a grand jury investigation.

Along with SEC or DOJ (and, in some cases, CFTC) proceedings, private fund managers and executives may also face civil litigation from investors. This is particularly true when an SEC matter becomes public, triggering disclosures in private placement memoranda and reports to investors.

Private equity and hedge funds are among several types of private funds. This includes, but is not limited to:

• Hedge funds
• Private equity funds
• Venture capital funds
• Commodity pool funds
• Real estate investment trusts (REITs)

We represent hedge-fund and private-equity advisers in SEC examinations and investigations.

One key aspect of private-fund enforcement is its focus on advisers. SEC private-fund enforcement matters are usually directed at the adviser. The SEC often uses the Investment Advisers Act of 1940 to pursue its allegations, but it may also rely on the Securities Act of 1933 or the Securities Exchange Act of 1934.

In addition to the SEC, the Commodity Futures Trading Commission (CFTC) may get involved as well. This typically happens in matters involving the Commodity Exchange Act (CEA), including matters involving commodities, futures, derivatives, and swaps.

What Conduct Most Often Triggers Private-Fund SEC Scrutiny?

Conflicts of interest present an ongoing focus of private-fund enforcement. The SEC is increasingly pursuing claims that private fund managers violate the Investment Advisers Act’s anti-fraud provisions by failing to adequately disclose these conflicts to investors and in offering documents.

SEC scrutiny frequently concentrates on the following specific topics:

• Allocation of investment fund fees and expenses
• Portfolio valuation
• Accuracy of fund performance
• Marketing statements and offering material
• Books-and-records and other administrative compliance
• Control of material nonpublic information (especially with hedge-fund advisers)
• Fiduciary duty in relation to conflicts of interest
• Inadequate conflict disclosures
• Undisclosed compensation

Examples of Fiduciary Duty and Conflict of Interest Allegations

The SEC aggressively pursues allegations involving a private-fund adviser’s alleged fiduciary duty. As the SEC has noted:

• “The fundamental principle underlying the Investment Advisers Act is the fiduciary duty that investment advisers owe to their clients.”
• “Many investment advisers use private placements to raise capital from investors, and it is in the interest of the investing public and of investors that these advisers adhere to the disclosure obligations imposed by the Federal securities laws.”

These are the primary (though by no means exclusive) bases for the SEC’s fiduciary duty allegations:

• Improper allocation of investment fund fees and expenses
• Improper or flawed portfolio valuation
• Improper or flawed fund performance reporting
• Materially false or misleading marketing and offering materials
• Materially false or misleading advertising material
• Failures of books-and-records controls
• Failures of trading or other other compliance controls
• Use or disclosure of material nonpublic information (MNPI)
• Improper use of fund assets
• Related-party transactions

Examples of Investment Advisers Act Anti-Fraud Allegations

The SEC investigates private-fund advisers for various violations of the Investment Advisers Act. Violations may include:

• Investment fee and expense allocation
• Portfolio valuation
• Fund performance representation
• Marketing, advertising, and offering disclosures
• Books-and-records failures
• Use or disclosure of material nonpublic information
• Investment performance misrepresentations
• Insider trading
• Fraudulent solicitation
• Conflict of interest disclosure and mitigation
• Conflicts arising from private-equity fund managers’ ownership interest in portfolio companies
• Undisclosed compensation
• Third-party placement fees
• Private investment advisor (PIA) and third-party placement agency compensation
• Third-party compensation related to fund formation, fund management, and investment advisory services

Must My Private-Fund Adviser Register with the SEC?

Generally, U.S. investment advisers must register federally with the SEC unless they qualify for a state-registration exemption. However, state-registered investment advisers must register federally if they meet certain thresholds. Generally, state-registered advisers must register federally if their regulatory assets under management (RAUM) equal or exceed $110 million.

Private-fund advisers have additional options for avoiding federal registration. Under Section 203(m) of the Investment Advisers Act of 1940 (“Advisers Act”), private-fund advisers with less than $150 million in RAUM-1) are not required to register federally. (Note: Section 203(m) only applies to advisers that “advise only private funds,” and while this applies to many private-fund advisers, it does not apply to all).

Section 203(l) of the Advisers Act exempts advisers that advise solely “qualifying venture capital funds.” An adviser qualifying as an “exempt reporting adviser” under Section 203(l) or Section 203(m) of the Advisers Act (i.e., that is otherwise exempt from registration as an investment adviser) does not need to file the regular annual Form ADV report. However, under Rule 204-4, exempt reporting advisers must still submit “a limited number of reports” annually to the SEC, including “aggregate regulatory assets under management.”

Compliance Obligations of Registered Private-Fund Advisers

Registered private-fund advisers have an extensive list of compliance obligations. This includes filing annual Form ADV amendments with the SEC within 90 days after the end of the adviser’s fiscal year (as required by Rule 204-1 under the Advisers Act). Registered private-fund advisers with $150 million or more in private-fund assets may also need to file “Form PF” on a quarterly, annual, or other periodic basis.

Compliance Obligations of Exempt Reporting Advisers

Exempt reporting advisers must file limited annual reports. However, even though an exempt reporting adviser is exempt from registration, the SEC notes:

• “Exempt reporting advisers remain subject to the antifraud and books and records obligations of the Investment Advisers Act.”
• “The SEC may examine the records of exempt reporting advisers, such as those required to be maintained under Section 204(a) of the Investment Advisers Act.”
• “The SEC is also required to enforce the compliance obligations that apply to exempt reporting advisers.”
• “The SEC enforcement staff pursues the same broad range of enforcement cases against exempt reporting advisers as it pursues against other advisers.”

Compliance Obligations of Qualified Parallel Private-Fund Investment Advisers

In certain cases, hedge-fund and private-equity advisers are subject to the regulatory authority of multiple agencies. For example, Section 202(a)(11) of the Advisers Act defines “investment adviser” and sets out the exclusions from that definition in clauses (A) through (H), none of which turns on whether an adviser manages parallel private funds. An adviser that manages private equity funds, venture capital funds, and hedge funds is an investment adviser under that definition, and it must look to the exemptions from registration in Sections 203(l) and 203(m) of the Advisers Act rather than to any exclusion from the definition itself.

How Does an SEC Examination Become an Enforcement Case?

Q: How does the SEC select companies to examine?

A: As the SEC Division of Examinations explains, selection is based on several factors, including:

• Analysis of information gathered on prior examinations
• Information gathered via tips and referrals
• Targeted initiatives and industry-wide sweeps
• Referrals from other agencies (including, but not limited to, the U.S. Department of Justice, U.S. Department of Labor, and FinCEN)
• Filing analysis
• Other information and risk analysis

Q: What authority does the SEC have to conduct an examination?

A: Section 204(a) of the Advisers Act authorizes the SEC to conduct examinations and review required books and records in order to ensure compliance with the Act and other applicable securities laws and regulations.

Q: How often does the SEC refer a private-fund examination to the SEC’s Division of Enforcement?

A: Findings that suggest violations of the Securities Act, Advisers Act, or other relevant laws can be referred to the Division of Enforcement. However, it is important to note that not every SEC examination triggers a referral, and not every referral leads to enforcement proceedings.

Q: Does the SEC have the power to issue subpoenas during an investigation?

A: Yes, generally speaking. In many cases, the issuance of a formal investigation order enables the SEC to issue subpoenas for documents and testimony.

Q: When will the SEC take investigative testimony?

A: In many cases, investigative testimony is also authorized through the same formal investigation order. Investigative testimony is essentially a “deposition-style” questioning session, and the testimony is taken under oath with the witness’s legal counsel present.

Q: What is a “Wells submission”?

A: A Wells submission provides target company and target individual(s) an opportunity to present their side of the story before taking enforcement action. With a Wells submission, the company or individual can use this advocacy stage to argue against filing the proposed charges with the Commission.

Q: Is an enforcement action authorized by the SEC’s Division of Enforcement staff or the Commission?

A: While the Division of Enforcement staff conducts the investigation, this is not where authorization to commence an SEC enforcement action comes from. All decisions regarding authorization to commence civil and administrative proceedings are made by the Commission.

Q: What type of enforcement action can the SEC take in an investigation against a hedge fund or private equity fund?

A: The SEC has two primary enforcement avenues:

• Civil action: The SEC can file a civil complaint in U.S. District Court. This can include allegations of both securities fraud and various securities law violations.
• Administrative proceeding: In an administrative proceeding, the SEC can also pursue allegations of securities fraud and other securities law violations.

If you are facing this situation, Spodek Law Group handles federal criminal defense matters nationwide, from offices in New York and Los Angeles.

What Must the SEC Prove Against Advisers and Executives?

The SEC clarified in a private-fund enforcement letter that a pooled investment vehicle, such as a hedge fund or private equity fund, rather than its investors, is generally the advisory client.

While this suggests that fund investors are not the advisory client, Rule 206(4)-8 of the Advisers Act expressly protects current and prospective pooled-fund investors from “fraud, deceptive practices, or material misrepresentations or omissions.” This rule is often seen in the SEC’s private-fund enforcement complaints, and it frequently appears alongside allegations under Section 206(1) and Section 206(2) of the Advisers Act.

The primary difference between these sections is the elements the SEC must prove. Allegations under Section 206(1) require proof of “scienter,” or intent to defraud, while allegations under Section 206(2) can potentially be based on simple negligence.

Unlike Section 206(1), Rule 206(4)-8 does not require proof of scienter. This means that, in some cases, the SEC can prevail against a private-fund adviser or executive without proving that the individual or entity intended to defraud investors.

Like all civil proceedings, enforcement cases involving the SEC are tried to the “preponderance-of-the-evidence” standard. This is a lower burden of proof than the “beyond a reasonable doubt” standard required in criminal proceedings.

The SEC often includes allegations of supervisory liability in its private-fund enforcement cases. These allegations target individual executives and compliance personnel for allegedly failing to implement adequate supervisory controls, books-and-records procedures, policies and procedures, and other requisite compliance safeguards.

In these cases, the SEC will often argue that, because an individual had the title of “Chief Compliance Officer” or “CCO,” this per se establishes his or her responsibility for the private-fund adviser’s compliance failures. However, in many situations, this is not the case, and individual executives should not be held personally responsible for a firm’s compliance failures simply based on their job title.

Moreover, Section 203(e)(6) of the Advisers Act provides a defense for executives and compliance officers:

“For the purposes of this paragraph no person shall be deemed to have failed reasonably to supervise any person, if, (A) there have been established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, insofar as practicable, any such violation by such other person, and (B) such person has reasonably discharged the duties and obligations incumbent upon him by reason of such procedures and system without reasonable cause to believe that such procedures and system were not being complied with.”

We use this defense strategy aggressively on behalf of the private-fund executives and compliance personnel we represent in SEC enforcement matters.

How Should a Private-Fund Adviser Investigate Violations without Waiving Privilege?

In many situations, the first step toward resolution is an internal investigation. Conducting an internal investigation allows a firm to determine:

• The nature and scope of any employee misconduct, or failure of internal controls or other compliance matters,
• Whether remedial efforts are warranted,
• Whether and when to self-report, and,
• Whether an request for cooperation credit is warranted.

In each of these situations, addressing the underlying issue promptly and, when necessary, voluntarily disclosing the issue to the government can provide significant benefits. However, private-fund advisers must take particular care to avoid inadvertently waiving the lawyer-client privilege and work product privilege.

What Is the Lawyer-Client Privilege, and How Can Private-Fund Advisers Avoid Waiving the Privilege?

While it is important for private-fund advisers to address issues promptly and, when necessary, disclose their findings to regulators, this presents unique challenges. The attorney-client privilege protects confidential legal communications between the attorney and the client. The privilege does not protect the underlying facts of the investigation; but if it becomes necessary to report an internal investigation to the SEC, private-fund advisers must be careful to disclose the factual information without waiving their privilege. This generally requires carefully crafting the reported information to ensure that it does not constitute a disclosure of protected information. The work-product privilege provides protection for communications and documents generated during an internal investigation as well.

While the lawyer-client privilege cannot be used to withhold information pertaining to the underlying facts of a suspected violation of the securities laws or other applicable federal statutes and regulations, any voluntary disclosures made to the SEC and other federal authorities are subject to an analysis of whether they waiver the privilege.

What Is an Upjohn Warning?

An Upjohn warning is a statement made by investigating counsel to a witness at the start of an interview. The warning informs the witness that counsel represents the organization and not the individual witness. This is essential for protecting the privilege, and it is also critical for explaining the scope of a target individual’s privilege and potential for protection when the individual makes a decision to seek representation.

How Can Private-Fund Advisers Avoid a Whistleblower Complaint?

The SEC’s Whistleblower Program encourages current and former employees to report the Securities and Exchange Commission’s alleged statutory and regulatory violations to the SEC. To avoid unnecessary exposure, companies and individuals need to be proactive, and this means knowing when it is necessary to investigate potential violations, when the results of an investigation should be disclosed to the SEC and other relevant agencies, and when a request for cooperation credit is warranted. These are all factors under the SEC’s Seaboard Report that are used to assess the amount of cooperation credit to which a target company or target individual may be entitled.

What Deadlines and Penalties Shape a Private-Fund SEC Defense?

I. Deadlines: Limitations Periods and Tolling Agreements

The SEC faces different limitation periods for seeking civil penalties, disgorgement, and other types of enforcement proceedings. Generally, 28 U.S.C. 2462 imposes a five-year limitation period for the SEC to seek civil penalties.

For disgorgement claims, however, the deadline depends on the nature of the allegations. Under 15 U.S.C. 78u(d)(8), claims alleging scienter-based violations of the Securities Act, Securities Exchange Act, Investment Company Act, Investment Advisers Act, Trust Indenture Act, Investment Company Accounting Reform and Transparency Act, or Dodd-Frank Act have a ten-year limitation period. Otherwise, the SEC is generally limited to five years to seek disgorgement.

In these cases, the deadline runs from the date of the violation unless an appropriate exception or tolling agreement applies. Parties may execute agreements tolling otherwise-applicable SEC limitation periods; and if such an agreement does not include a term and condition regarding future tolling, the limitation period will resume to run after the expiration of the existing tolling period.

II. Penalties

The SEC has substantial authority to seek various types of monetary and non-monetary penalties against private-fund advisers and their executives in civil and administrative proceedings. These include:

• Disgorgement and Restitution: The U.S. Supreme Court in Liu v. SEC determined that equitable disgorgement is limited to net profits and may only be awarded for benefits obtained by the wrongdoer in a scheme or practice that is used to harm investors ( victims ). For SEC disgorgement claims to qualify as “equitable,” the remedy must be “designed to target illicit profits from wrongful conduct.”
• Civil Penalties: Section 209(e) of the Advisers Act establishes three tiers of civil penalties for violations of the Securities Act, Advisers Act, or other applicable federal securities laws. A tier-three violation involves substantial losses or significant risk of substantial losses to investors. The penalties are calculated based on either “the gross amount of pecuniary gain” or “the amount of the losses” the target company’s alleged violation incurred. This may lead to astronomical penalties and enforcement outcomes that can exceed the amount that private-fund advisers and executives can realistically face, creating the need to negotiate with the SEC.
• Administrative Penalties: Along with monetary penalties, the SEC also has authority to seek “a range of other non-monetary penalties” against private-fund advisers and their executives. These include:
• Industry bars: Section 203(f) of the Advisers Act authorizes the SEC to seek an “industry bar” against “any associated person” who violates or attempts to violate the SEC’s provisions, regulations, or rules. An industry bar prohibits any associations with the securities industry on the SEC’s terms.
• Private-offering disqualification: Certain SEC orders can trigger a private-offering disqualification. Rule 506(d) of Regulation D (17 C.F.R. 230.506(d)) states:
• “A person shall be deemed a ‘bad actor’ with respect to a private offering if the person is… the subject of a final order by the Securities and Exchange Commission … which (i) created a substantive, cease-and-desist order; (ii) imposed a supervisory-compliance or civil money penalty or temporary license or registration revocation, suspension, or limitation; or (iii) provided for other remedies including, but not limited to, the imposition of the terms and conditions of a consent decree.”

Speak With a Federal Defense Lawyer

If you are dealing with any part of what this article describes, the next step is a conversation with a lawyer who handles these cases. Spodek Law Group is a second generation criminal defense firm practicing since 1976, representing clients nationwide from offices in New York, Brooklyn, Queens and Los Angeles. Call 212-300-5196 to speak with our team.