by T. GormanPosted on Posted in SECActions

A Risk Alert was published by the the Office of Inspections and Examinations or OCIE, alerting Investment Advisers of managed private funds to key issues that have arisen in prior examinations. The Alert highlights a series of deficiencies, some of which have resulted in enforcement actions. Risk Alert, Office of Inspections and Examinations (June 23, 2020)(here).

The list of deficiencies identified in the Alert is divided into three sections: 1) Conflicts of interest; 2) Fees and expenses; and 3) MNPI/Code of Ethics.

Conflicts: The largest section of the Alert deals with conflicts of interest. The failure to properly disclose conflicts of interest is a violation of Section 206 of the Advisers Act as well as the pertinent Rules such as 206(4)-8. The conflicts identified include:

Allocations of investments: Certain private fund advisers did not provide adequate disclosure regarding allocations of investments among clients, including flagship funds and others that invested alongside the largest funds. Similarly, limited investment opportunities were preferentially allocated in certain instances; in others, advisers made allocations at different prices or in apparently inequitable amounts among clients.

Multiple clients/same portfolio company: In these situations, advisers caused clients to invest at different levels of a capital structure such as one client owning debt while another owned equity in a single portfolio company without adequate disclosure.

Financial relationships between investors or clients and the adviser: In select instances there was inadequate disclosure of the economic relationships involving the adviser and clients. Some clients could be, for example, seed investors while others may have provided credit facilities or similar arrangements with the adviser.

Preferential liquidity rights: In some instances, advisers entered into side letters with select investors that were given preferential treatment. In other instances, certain funds had preferential rights that were operated, for example, alongside the flagship fund without adequate disclosure.

Adviser interests: Advisers at times had interests in investments recommended to clients where there was inadequate disclosure of that fact.

Co-investments: There was inadequate disclosure of conflicts related to investments made by co-investment vehicles and other co-investors.

Service providers: There was inadequate disclosure regarding service providers and, in some instances, related incentives. For example, there was inadequate disclosure regarding arrangements among portfolio provides, private fund clients and service agreements with entities controlled by the adviser and/or its affiliates or others tied to the adviser. In some instances, private fund advisers did not have procedures to ensure that they properly implemented disclosure requirements.

Restructuring: When funds are restructured advisers did not adequately disclose the transaction and the opportunities available to all of the investors. For example, if a fund is sold there may be opportunities for the investors that are not properly disclosed to all or that are only available to certain investors in the absence of adequate disclosure of that fact.

Cross-transactions. When these types of transactions arise, advisers failed in certain instances, to adequately disclose them to all investors.

Fees and expenses: The exams revealed issues regarding the inadequate disclosure of fees and expenses.

Allocation: In a number of instances advisers incorrectly and/or inadequately allocated various fees and expenses. In some instances, the charges were not permitted and/or contrary to the agreements.

Operating partners: Some advisers failed to make full disclosure regarding those who were not employees but provided services to the private fund or portfolio companies and the related charges.

Valuation: Valuation can be a key issue. In some instances, advisers did not follow GAAP in valuing assets and/or their disclosed procedures.

Monitoring: Fund advisers at times had difficulties with the receipt of fees from portfolio companies such as monitoring fees, board fees and others which resulted in a failure to properly allocate them, account for them, apply appropriate offsets and similar matters.

MNPI/Code of Ethics

Advisers are required to establish policies and procedures with regard to material non-public information under Section 204A of the Advisers Act and to establish a Code of Ethics under Rule 205A-1. Nevertheless, OCIE observed certain deficiencies:

Section 204A: Advisers failed to establish, maintain and enforce written policies and procedures that properly addressed the risks such as employees interacting with public companies, those that may be created because of office space or those created by their employees who periodically had access to MNPI.

Code of ethics: Advisers also at times failed to establish, maintain and enforce the provisions of their code with respect to MNPI such as enforcing the terms of a restricted list, provisions regarding gifts and entertainment and sections governing the reporting of personal securities transactions.

While not every item cited above, many have been the basis of, or included in, an enforcement action. Each was identified as a deficiency. Viewed in this context, the list should be carefully reviewed by advisers not just when an inspection is scheduled but periodically to ensure adherence to proper practices.

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by T. GormanPosted on Posted in SECActions

The ruling: The Supreme Court significantly limited the SEC’s ability to seek disgorgement. Specifically, the Court held that any award must be limited to the wrongdoer’s “net profits” and be awarded “for victims.” The Court rejected the expansive concepts used by the agency for years and its repeated practice of paying the sums awarded to the Treasury. Essentially, the remedy has been returned to its historic roots, according to the opinion written by Justice Sotomayor for the Court. Liu v. Securities and Exchange Commission, No. 18-1501 (June 22, 2020).

The opinion: There is no doubt that Congress authorized the SEC to seek disgorgement as a remedy, Justice Sotomayor began for the Court. In administrative proceedings Congress specifically added the remedy in the Dodd-Frank Act in 2010. From the beginning Congress authorized the agency to seek “equitable relief” that may be appropriate “for the benefit of investors,” according to the Exchange Act. From the beginning the courts have recognized this fact, authorizing the remedy to secure the “profits” a defendant gained from “wrongful” conduct the Court’s opinion for eight Justices states, citing SEC v. Texas Gulf Sulphur Co., 446 F. 2nd 1301 (CA2 1971).

Disgorgement is a limited concept, however. It is not and should not be a penalty. In Kokesh v. SEC, 581 U.S. __(2017) the Court held that an award of what the SEC claimed in that case was disgorgement, in fact constituted a penalty. In Kokesh the Court reserved the question of whether the SEC can in fact seek disgorgement. The question is now resolved.

Liu arose from securities sold in connection with an EB-5 immigration project. There investors were solicited to finance a construction project on the promise that when completed each would be on a path to citizenship. When the construction failed to be completed the SEC brought suit claiming fraud. The agency sought remedies that included a return of all investor finds as disgorgement. Defendants – Petitioners before the Court – agued to limit the award of disgorgement. The district and circuit courts adopted the SEC’s position.

In reaching its conclusion, the Court began with the statutory language cited above. Under the securities laws there is no doubt that the SEC can seek disgorgement as a remedy. Two principles are key here. First, “equity practice long authorized courts to strip wrong doers of their ill-gotten gains . . .” although various labels may have been used for the award. Second, “to avoid transforming an equitable remedy into a punitive sanction, courts restricted the remedy to an individual wrongdoer’s net profits to be awarded for victims.” Thus, while the courts have not restricted the award to any particular type of case, it is clear that only the net profits are available after “deducting legitimate expenses.” The award is available against “culpable actors and for victims . . .”

Finally, the Court declined to parse the facts of this case and apply its ruling, noting that the parties had not specifically addressed the question. Three points should guide the lower courts in undertaking this task. First, the equitable relieve must be for the “benefit of investors,” quoting the Exchange Act. The SEC’s claim that its use of the remedy is based on a “benefit to the public” misses the mark – the award often is paid to the Treasury. While the agency argued that in some situations it may not be feasible to make such an award, the Court declined to address the issue, but suggested disapproval.

Ultimately, the determination of ill-gotten gains is personal, not one that can be imposed through joint-and-several liability on affiliates and others. The common law did, however, permit “liability for partners engaged in concerted wrongdoing.” Finally, the courts must deduct “legitimate expenses” before ordering disgorgement.

Discussion: The Court’s opinion is a significant set-back for the SEC. For years the Commission has sought and obtained large disgorgement awards based on its expansive claims about the scope of the remedy. No more. The time of refusing to deduct legitimate expenses from any claim for an award is over. Equally clear is the fact that any request for an award must be strictly limited to ill-gotten gains obtained by the particular defendant – it cannot be expanded by using concepts such as joint-and-several liability.

Now awards of disgorgement must be strictly limited the wrongful acts of a particular defendant and the net ill-gotten gain obtained by that person from that wrongful conduct, although the ruling does allow that a partnership might be liable for an award. While the Court did not define the specific types of expenses which should be deducted, Liu makes it clear that the key is the individual wrongful conduct and the individual who wrongfully obtained net profits.

Finally, while the Court declined to preclude giving the award to the U.S. Treasury as the agency has done for years, the opinion’s repeated citation to the statutory language about “investors” all but rules out this approach except perhaps in the most extreme circumstances. Indeed, at the core of the Court’s decision is an emphasis on individual, personal responsibility for wrongful conduct and the compensation of individual wronged investors. Liu is a highly personal message to the SEC about individual responsibility and accountability.

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