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
OCIE 2019 examination priorities
Consistent with prior years and SEC enforcement actions, speeches and Risk Alerts issued during the course of 2018, the most notable 2019 examination priorities affecting the private funds industry emphasize the following topics.2
Fees and expenses
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.
Conflicts of interest
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.
OCIE will focus on proper configuration of network storage devices, information security governance and risk assessment, access rights and controls, data loss prevention, vendor management, training, incident response, and properly adopted policies and procedures. OCIE will give particular emphasis to cybersecurity practices at investment advisers with multiple branch offices, including those that have recently merged with other investment advisers.
Consistent with recent SEC statements and enforcement actions during the second part of 2018, OCIE intends to monitor the offer and sale, trading, and management of digital assets, safety of client funds and assets, pricing of client portfolios and where the products are securities, examine for regulatory compliance and internal control.
Portfolio management and training
OCIE will review advisers’ practices for executing investment transactions on behalf of clients, allocating investment opportunities among clients, ensuring consistency with disclosures, investment objectives and other legal restrictions.
Never-before or not recently examined investment advisers
OCIE will continue to conduct risk-based examinations of investment advisers that have never been examined, newly registered investment advisers and advisers that have not been examined for a number of years and have substantially grown or changed their business models.
Although not directly addressed in the 2019 examination priorities, during examinations, examiners continue to focus on valuation practices, performance presentations and calculations, presentations of internal rate of return and the effect of subscription credit facilities on such returns, pay to play practices, the testimonial rule and the custody rule.
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.
Other notable regulatory developments
OCIE Risk Alert on adviser personnel’s use of electronic messaging
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.
- Permitting only those forms of electronic communication for business purposes that can be used in compliance with the books and records requirements of the Advisers Act.
- Prohibiting business use of apps that allow employees to send messages or otherwise communicate anonymously, allow for automatic destruction of messages or prohibit third party viewing or back-up.
- If advisers permit use of social media, personal email accounts or personal websites for business purposes, adopting and implementing policies and procedures for the monitoring, review and retention of such electronic communications.
- 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.
- Providing regular reminders to employees of what is permitted and prohibited under the adviser’s policies and procedures with respect to electronic messaging.
CFIUS reform and its effect on private funds
On August 13, 2018, the Foreign Investment Risk Review Modernization Act (FIRRMA) was enacted into law, representing the first comprehensive amendments to the U.S. foreign investment review process since 2007. FIRRMA addresses the scope, procedures and timing by which transactions involving non-U.S. persons are reviewed by the Committee on Foreign Investment in the United States (CFIUS) and several features warrant particular attention for private equity investors. Final regulations for CFIUS to operate under FIRRMA are not due until early 2020, but CFIUS has already implemented a pilot program for foreign investment in businesses involved in the design or manufacture of critical technologies in several, specifically identified industries such as aircraft and semiconductor manufacturing.
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:
- the fund is managed exclusively by a U.S. general partner;
- the advisory board or committee does not have the ability to control investment decisions of the fund or decisions made by the general partner, managing member, or equivalent related entities in which the fund is invested;
- the non-U.S. person does not otherwise have the ability to control the fund; and
- the non-U.S. person does not have access to material non-public technical information as a result of their participation on the advisory board or committee.
In addition to the broader scope, certain covered transactions will, for the first time, require a mandatory filing to CFIUS (subject to substantial penalties for non-compliance) and CFIUS is authorized to impose filing fees.
Although many of FIRRMA’s details are more than a year away from coming into force, non-U.S. investors and U.S. private fund sponsors and entities in which non-U.S. investors intend to invest, should consider the concepts built into FIRRMA when making such investment and assessing whether a submission to CFIUS is warranted during the interim time period.
Annual regulatory filing obligations applicable to both registered and exempt reporting advisers
Form ADV, due March 31, 2019
Investment advisers that are registered with the SEC under the Advisers Act, and advisers filing as exempt reporting advisers with the SEC, must file an annual amendment to Form ADV within 90 days of the end of their fiscal year.
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.
De minimis exemption affirmation, due March 1, 2019
Exempt CPOs and CTAs
Many private fund sponsors are able to rely on the exemption from registration with the National Futures Association (NFA) that is available under Commodity Futures Trading Commission (CFTC) Rule 4.13(a)(3) (de minimis exemption) and have claimed such exemption. The de minimis exemption is subject to an annual affirmation which must be completed within 60 days after the end of each calendar year. Failure to affirm the exemption is deemed a withdrawal of the exemption once the 60 day period has elapsed.
Registered CPOs and CTAs
Private fund sponsors that do not qualify for the de minimis exemption may be subject to registration with the NFA as commodity pool operators (CPOs) and commodity trading advisors (CTAs), resulting in annual fees, disclosure, recordkeeping and reporting requirements. A registered CPO must file an annual report with respect to each relevant commodity pool that it operates and file Form CPO-PQR, which would need to be filed with the NFA within 60 days of the end of each calendar quarter. A registered CTA must consider file Form CTA-PR, which must be filed with the NFA within 45 days after the end of each calendar quarter.
Form 13F, due February 14, 2019
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.
Form 13H, due February 14, 2019
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.
Bad actor rule compliance
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.
Annual privacy notice
Investment advisers and private funds are subject to SEC, CFTC and Federal Trade Commission regulations governing the privacy of certain confidential information and are required to provide notice to individual investors regarding their privacy policies and procedures at the start of the relationship with such individual investor (although they are no longer required to provide an annual privacy notice to such investors unless material changes have been made to the policy).
Form D and blue sky filings
A private fund that engages in a private offering that continues for more than one year may be subject to annual renewal filing requirements under Regulation D or under state blue sky laws.
State lobbyist registration
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.
Compliance policies and procedures
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
Form PF, due April 30, 2019
Registered investment advisers to private funds with more than US$150 million of assets under management attributable to such funds are required to file Form PF with the SEC within 120 days after such adviser’s fiscal year end. Form PF requires disclosure of the adviser’s assets under management and information on each private fund it advises.
The reporting requirements for advisers whose assets under management exceed certain thresholds may be required to file a more extensive form PF and file it more frequently. In particular, a hedge fund adviser with more than US$1.5 billion of regulatory assets under management attributable to its hedge funds is required to report on Form PF on a quarterly basis within 60 days of the end of each calendar quarter and to provide specific additional information. A private liquidity fund adviser with more than US$1 billion in combined regulatory assets under management attributable to both registered money market funds and private liquidity funds is required to report on Form PF on a quarterly basis within 15 days of the end of each calendar quarter and to provide specific additional information. A private equity fund adviser with more than US$2 billion in regulatory assets under management attributable to its private equity funds is only required to file on an annual basis within 120 days of the end of its fiscal year and is also required provide specific additional.
Custody rule compliance
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.
Annual compliance program review
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.
1 This summary does not address filings required to be made under U.S. Employee Retirement Income Security Act of 1974, the Treasury International Capital, the Bureau of Economic Analysis or any tax-related filings.
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.