Source: https://www.torys.com/insights/publications/2019/01/us-private-funds-watch-2019-regulatory-considerations
Timestamp: 2019-10-14 06:10:32
Document Index: 443959532

Matched Legal Cases: ['art 1', 'art 2', 'art 1', 'art 2', 'art 2', 'art 2']

U.S. private funds watch: 2019 regulatory considerations | Insights | Torys LLP
Venera Ziegler Christopher M. Caparelli Andrew J. Beck
Earlier than what has been typical in other years, on December 20, 2018, the SEC’s Office of Compliance Inspections and Examinations (OCIE) released its examination priorities for 2019 showing its continuing focus on the private funds industry.
Important for investors and private fund sponsors alike, below are certain highlights of OCIE 2019 examination priorities and other notable areas of SEC focus. Additionally, included below are some reminders of annual reporting obligations applicable, as indicated, to registered and exempt reporting advisers.1
In its 2019 examination priorities, OCIE stated it will continue to focus on (i) proper pre-commitment disclose of fees and expenses associated with an investment in a private fund and (ii) an adviser’s financial professionals’ adequately calculating and charging fees to investors in accordance with such disclosures. During 2018, through various speeches, enforcement actions and Risk Alerts, the SEC showed it continues to focus on pre-commitment disclosure and misallocation of fees and expenses, in particular, relating to (i) inappropriate allocation of expenses among fund clients, (ii) inappropriate allocation of distribution and marketing expenses, regulatory filing fees, back office function expenses, compensation of in-house employees and travel expenses charged to fund clients instead of the adviser, in contravention of the applicable advisory agreements, partnership agreements or other disclosures, (iii) inappropriate allocation of and failure to disclose how broken deal expenses would be allocated among funds and co-investors, (iv) failure to disclose the ability to charge accelerated monitoring fees and (v) undisclosed fees and expenses charged directly to portfolio companies, often in the form of operating partner, consulting and monitoring agreements.
Emphasizing that an investment adviser must act in accordance with its fiduciary duty and meet its contractual obligations to its clients, OCIE stated it will focus on proper disclosure and the impact of conflicts of interests to investors and properly adopted policies and procedures addressing: (i) use of services or products provided by affiliated entities, (ii) loans or lines of credit collateralized by securities and (iii) borrowing funds from clients with an emphasis on whether adequate disclosures, including that the potentially poor or failing financial condition of the investment adviser, are made to the client, and that the investment adviser has acted consistently with these disclosures. In addition to 2019 OCIE’s examination priorities, examiners continue to ask questions relating to any form of conflicts of interest, in particular, relating to cross investments, principal transactions, cross trades and conflicts with side letter provisions.
Investment advisers should review their existing practices, policies and procedures to ensure consistency with the SEC’s enforcement priorities and areas of focus. Investors should be aware and take into account these specific areas of SEC focus when conducting their diligence with respect to a potential investment.
On December 14, 2018, OCIE released a National Exam Program Risk Alert (Risk Alert).3 The Risk Alert was the result of an examination initiative it undertook of registered investment advisers to obtain an understanding of the various forms of electronic messaging (excluding email use on the investment advisers’ systems) used by advisers and their personnel, the risks of such use and the challenges in complying with the books and records and compliance rules under the U.S. Investment Advisers Act of 1940 (Advisers Act). The purpose of the Risk Alert was to remind advisers of their obligations when their personnel use electronic messaging and to help advisers improve their systems, policies and procedures. In the Risk Alert, the OCIE made a number of suggestions relating to policies and procedures, employee training and attestations, supervisory review and control over devices. The following are the suggested best practices.
Regularly reviewing popular social media sites to identify if employees are using social media in a way not permitted by the adviser’s policies and procedures.
Prior to FIRRMA, CFIUS was empowered to review, and the President entitled to block or unwind, only “covered transactions” that could result in “control” of a U.S. business by a non-U.S. person. FIRRMA broadens the scope of covered transactions to include, among others, (i) real estate acquisitions, leases and concessions involving airports, maritime ports, and property that is within close proximity to U.S. military or other sensitive facilities, and (ii) “other investments” of less than a controlling interest in U.S. businesses that involve critical technologies, critical infrastructure or sensitive personal data of U.S. citizens.
“Other investments” capture a wide range of minority investments, including through funds, limited partnerships, and LLCs, not previously subject to CFIUS review, if the investment affords the non-U.S. person: (i) access to any material non-public technical information in the possession of a U.S. business, (ii) membership or observer rights on the board of directors or equivalent governing body of a U.S. business or the right to nominate an individual to a position on the board of directors or equivalent governing body, or (iii) any involvement, other than through voting of shares, in substantive decision making of the U.S. business regarding sensitive personal data of U.S. citizens maintained or collected by the U.S. business, critical technologies or critical infrastructure.
Importantly, FIRRMA contains an exemption for indirect investments by non-U.S. persons in U.S.-managed investment funds—even if the non-U.S. person is a member of the fund's advisory board or a committee of the fund —so long as:
Annual regulatory filing obligations applicable to both registered and exempt reporting advisers
Registered investment advisers must update Part 1 and Part 2A brochure of such adviser’s Form ADV, while exempt reporting advisers must update only Part 1 of such adviser’s Form ADV. Registered investment advisers are also required to update, but are not required to file with the SEC, Part 2B brochure supplements of their Form ADV. In addition, registered investment advisers are required to provide a copy of the updated Form ADV Part 2A brochure (or a summary of changes with an offer to provide the complete brochure) and, in certain cases, Part 2B brochure supplement to each of their clients.
The Securities Exchange Act of 1934 (Exchange Act) requires investment advisers to submit a report on Schedule 13F with the SEC, within 45 days after the last day of any calendar year and within 45 days after the last day of each of the next three calendar quarters following such calendar year, if on the last day of any month of such calendar year the investment adviser exercised discretion with respect to accounts holding Section 13(f) securities (generally, publicly traded securities) having an aggregate fair market value of at least US$100 million.
Rule 13H-1 of the Exchange Act requires an investment adviser that is a “large trader” (i.e., it engages in transactions in National Market System securities equal to or in excess of two million shares or US$20 million during any calendar day, or 20 million shares or US$200 million during any calendar month) to promptly (within 10 days) file an initial Form 13H after effecting aggregate transactions equal to, or greater than, the applicable activity level. Following this initial filing, all large traders must make an amended filing to update any previously-disclosed information that becomes inaccurate no later than promptly (within 10 days) following calendar quarter end and must separately file an annual amendment within 45 days after calendar year-end unless they have filed for an inactive status.
Review of disclosure and offering documents
An investment adviser should review its disclosure documents, offering materials, pitch books and diligence questionnaires to ensure that they are consistent with the adviser’s compliance policies and procedures and that they contain all material disclosures that may be required in order for investors to be able to make an informed investment decision. An investment adviser should also ensure that such documents address all areas of SEC focus.
In order to rely on the safe harbor private placement exemption contained in Regulation D of the US Securities Act of 1933, a private fund sponsor must ensure the fund, its direct or indirect 20% beneficial owners, its placement agents and each of the sponsor’s directors, executive officers and any other personnel that are or may be involved in the fundraising efforts of the fund, have not committed bad acts that have resulted in disqualifying events. A private fund sponsor that is in the process of fundraising capital should ensure it has conducts the appropriate diligence, obtains appropriate certifications and periodic updates to ensure that such bad acts have not been committed.
A private fund sponsors that intends to solicit state or local governmental entities in the U.S. (e.g., a U.S. public employee retirement plan) or its personnel may be required to register as lobbyists in such states and comply with such states’ annual reporting requirements.
Although the adviser is not required to adopt a comprehensive compliance program, the adviser is still subject to the antifraud provisions of Section 206 under the Advisers Act which generally make it unlawful for an investment adviser to engage in fraudulent, deceptive or manipulative conduct. An investment adviser is also subject to the antifraud provisions of the other federal securities laws such as Section 17(a) of the Securities Act of 1933 and Rule 10b-5 of the Exchange Act. As such, an exempt reporting adviser should ensure that its compliance policies and procedures comply with such antifraud provisions and its fiduciary duties to clients.
Annual regulatory filing obligations applicable to registered investment advisers
Rule 206(4)-2 of the Advisers Act (Custody Rule) requires a registered investment adviser to private funds to obtain an audit by an independent public accountant, prepare annual audited financial statements in accordance with U.S. GAAP for each of its private funds and to deliver such financial statements to the fund’s investors within 120 days of the fund’s fiscal year end. Alternatively, a registered investment adviser must undergo an annual surprise examination of client assets conducted by an independent public accountant. Each private fund adviser should review its fund structures to ensure every fund and special purpose vehicle that is subject to an annual audit requirement under the Custody Rule is being audited or has been subject to a surprise audit.
Rule 206(4)-7 under the Advisers Act requires a registered investment adviser to review annually the adequacy of the adviser’s written compliance policies and procedures and the effectiveness of their implementation. Examiners routinely request copies of a register investment adviser’s annual compliance program review report and the adviser’s findings and recommendations resulting from the review. The chief compliance officer should also ensure that all relevant personnel receive annual training addressing its compliance policies and procedures.
2 OCIE’s 2019 Examination Priorities can be found at https://www.sec.gov/files/OCIE%202019%20Priorities.pdf.
3 OCIE’s Risk Alert can be found at https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Electronic%20Messaging.pdf.