Hedge and Private Equity Funds

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The SEC’s Division of Investment Management issued updated guidance regarding the definition of “knowledgeable employees” under Rule 3c-5 of the Investment Company Act of 1940.  See Managed Funds Ass’n, SEC No-Action Letter, avail. 2/6/14, https://www.managedfunds.org/wp-content/uploads/2014/02/Staff-Response-to-MFA-3c-5-Letter-Final-Outgoing-2-6-14-no-sigs.pdf

The SEC staff explained that “private funds” include private equity funds, hedge funds, and other pooled investment vehicles, excluded from the definition of an “investment company.”  Investment Company Act Rule 3c-5 permits a knowledgeable employee of a private fund – “covered fund”- or a knowledgeable employee of an affiliated person managing the investments of a covered fund – “affiliated management person”- to invest in a covered fund, without being subject to certain conditions under Investment Company Act Section 3 that otherwise apply.

The SEC staff clarified the definition of a knowledgeable employee by analyzing the various categories of the term under Rule 3c-5.  The staff confirmed that it will not recommend enforcement action against covered funds if they treat certain employees of covered separate accounts as knowledgeable employees.  The staff further explained that other employees may also qualify as knowledgeable employees, depending on the facts and circumstances.

The letter recommended that investment managers maintain a written record of employees that have been “permitted to invest in a Covered Fund as knowledgeable employees” and should be able to explain why a particular employee qualifies as a knowledgeable employee.

This guidance provides a road map for those employees acting in this type of fund sphere.

The SEC’s Division of Investment Management said it will not object if an investment adviser pays a cash fee for the solicitation of advisory clients, although a federal district court injunctive order precluded it.  RBS Sec. Inc., SEC No-Action Letter, avail. 11/26/13, http://www.sec.gov/divisions/investment/noaction/2013/rbssecurities-11252013-section 206.htm.

In granting relief, the staff noted especially that the firm otherwise will conduct any such cash solicitation arrangement in compliance with Investment Advisers Act of 1940 Rule 206(4)-3.  Rule 206(4)-3 prohibits an investment adviser from paying a cash fee to any solicitor subject to a court injunction related to the purchase or sale of a security.  The staff especially noted counsel’s representations that:

  • It will conduct any cash solicitation arrangement with an investment adviser registered or required to be registered under Section 203 of the act in compliance with the terms of Rule 206(4)-3, except for the investment adviser’s payment of cash solicitation fees to it;
  • The judgment does not bar or suspend it from acting in any capacity under the federal securities laws;
  • It will comply with the terms of the judgment; and
  • For 10 years from the date the judgment was entered, it and any investment adviser with which it has a solicitation arrangement will disclose the judgment to each person whom it solicits at least 48 hours before the person enters into an advisory contract, or at the time the person enters into such a contract, provided the person may terminate the contract without penalty within five business days.

In short, the SEC has opened the door on these cash solicitations.

The SEC’s push to conduct narrowly focused examinations of newly registered investment advisers is ahead of schedule and providing it with insights about compliance weaknesses, hedge fund advisers, and private equity companies.

To date, the SEC has completed 210 presence exams while 42 are currently open.  Exam teams are focused on compliance associated with marketing practices, portfolio management, conflicts of interest, safety of client assets, and valuation.

Data from presence exams conducted to date reveals the most commonly cited deficiency for hedge fund managers involves marketing practices, including, but not limited to, misleading statements or weak disclosures contained in marketing and advertising materials, such as misleading performance statistics and data on past recommendations.  The exams also showed hedge fund adviser deficiencies involved internal compliance, control procedures and inadequate maintenance of books and records as well as conflicts of interest, including offering co-investment opportunities to some favored clients but not to others and a failure to make certain disclosures.

Enforcement actions will likely follow.

The SEC has launched an investment adviser examination initiative to review those who have never been examined including advisers domiciled outside the United States.

If an adviser has been registered for more than three years and never been the subject of an SEC exam or is domiciled outside the U.S., an exam probably will take place.  The envisioned exams will conduct narrowly focused examinations of the targets.

Similar to the SEC’s “presence” exam program, the envisioned exams will conduct narrowly focused examinations of the targeted population, probably with an emphasis on a limited number of issues and the exams likely will take less time than a traditional risk-based examination.

About 11,000 investment advisers are registered with the SEC, 4,500 report they advise one or more private funds, such as hedge funds or private equity companies.  The Dodd-Frank Act required about 1,500 advisers to register with the SEC.

A word of caution, start preparing now.

Tis the season for the regulators to announce their examination priorities.  No less than the SEC’s Office of Compliance Inspections and Examinations released its 2014 Examination Priorities for its National Examination Program (“NEP”).

In particular, the SEC identified several new issues for registered investment advisers, primarily for those RIAs, who are at least three years old and have never been examined; as well as continued presence exams for hedge and private equity managers; wrap fee programs; quantitative trading models; and disguised distribution payments.  OCIE will also continue to examine for failure to comply with the custody rule; conflicts of interest, including, but not limited to, undisclosed compensation and allocation of investment opportunities, and performance marketing; alternative investment strategies for registered funds; money market fund stress testing; securities lending; senior management meetings concerning risk management; IT systems’ supervision; dual registrants and suitability; private placement solicitations; and IRA rollovers.  OCIE stated that these priorities also apply to  broker-dealers, clearing agencies, and transfer agents.  See http://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2014.pdf.

In short, given these priorities, it looks to be an interesting year for securities entities subject to the SEC’s jurisdiction.

Now that 2014 is here, it is a good idea to understand what the Enforcement Division might focus on this year.  In a recent article that appeared in the BNA, David Marder, a partner with Robins, Kaplan, Miller & Ciresi identified fifteen things to expect in the coming year. 

The fifteen things he noted to expect include: 

  1.             Increased use of whistle-blowers;
  2.             Increase requiring defendants admit guilt in settlements;
  3.             Increasing the use of available technology;
  4.             Increase the number of easier to prove cases;
  5.             Push self-reporting of securities violations;
  6.             Increased focus on microcaps;
  7.             Continued focus on gatekeepers;
  8.             An emphasis on financial reporting;
  9.             Protection of market structure and integrity;
  10.             Increase the activity of specialized SEC units;
  11.             Continue attacking insider trading;
  12.             Investigate misconduct at hedge funds, private equity funds and mutual funds;
  13.             Increase the size of the trial unit to avoid losing at trial;
  14.             To further leverage the exam program; and
  15.             Increase administrative proceedings.

 Although this certainly seems like a robust agenda, expect the SEC under the leadership of Chair Mary Jo White to pursue it with particular vigor.   

It seems like the SEC has a lot to prove; in part, to justify it budget.  The question is whether the industry is adequately prepared to deal with a bulked up and more aggressive SEC.  Time will tell . . . .

Former shareholders may pursue narrowed claims against some large private equity firms who allegedly conspired with one another minimizing competition for target companies.  See Dahl v. Bain Capital Partners LLC, D. Mass., 07-12388, 3/13/13), http://www.bloomberglaw.com/public/document/Klein_et_a_v_Bain_Capital_Partners_LLC_et_at_Docket_No_107cv1238.

The plaintiffs previously held shares in various public companies that were, ultimately, acquired by private equity firms.  The complaint alleged that, between 2003 and 2007, the private equity firms engaged in an conspiracy to fix the prices in certain transactions. The court found that the evidence supported an inference that some of the defendants may have colluded.

In short, private equity firms should monitor this case, and avoid potential coordinated activities.

FINRA issued an investor alert regarding the “unique characteristics and risks” presented by “alternative funds.”  See  http://op.bna.com/srlr.nsf/r?Open=rhil-98ktb8.

In a release, FINRA explained that “alt” mutual funds are United States Securities and Exchange Commission-registered and publicly offered, and hold “more non-traditional in-vestments and employ more complex trading strategies than traditional mutual funds.”  Alt funds, according to FINRA, invest in anything ranging from global real estate, commodities, and leveraged loans, to start-up companies and unlisted securities that offer exposure beyond traditional stocks, bonds and cash.  These funds also might hold derivatives and employ a short- selling strategy, while some alt funds are structured to hold other alternative funds.  This alert was to hopefully inform investors regarding these risks.  Moreover, FINRA said those interested in investing in an alt fund should consider its investment structure, strategy risk factors, investment objectives, operating expenses, fund manager, and performance history.

These funds present risks unlike other fund investments, and FINRA is seeking to head off the problem.

In its scrutiny of newly registered private fund advisers, the SEC Staff has observed two practices that might implicate broker-dealer registration requirements.

The first practice involves fund advisers that pay their personnel transaction-based compensation for selling interests in their funds or that have personnel whose primary purpose is selling interests in the funds. The second practice involves private fund advisers, their personnel, or their affiliates receiving transaction-based compensation for purported investment banking or other broker activities relating to one or more of the funds’ portfolio companies.

The receipt of transaction-based compensation has long irritated the SEC, and it believes it is the quintessential aspect of being a broker.  The failure to properly register as a broker-dealer may have serious consequences, including, but not limited to, being sanctioned by the SEC, or having the securities transaction in question rescinded.  When private fund advisers are selling interests in their funds, they should consider certain questions when they obtain new investors and retain existing investors.  The advisers also should consider if employees, who solicit investors, have other responsibilities, and the method of payment.  These are the same factors that the SEC Staff considers when trying to determine if a person or entity is a broker-dealer.

As to the second type of practice, it is common for advisers of certain types of funds—such as private equity funds that execute a leveraged buyout strategy—to collect others fees in addition to advisory fees.  Some of those other fees call into question if the advisers are engaging in broker-dealer activities.

As such, private fund advisers must be aware of the SEC’s concerns.

The U.S. District Court for the District of New Jersey ruled that New Jersey fraud and misrepresentation claims by a venture capital firm over an unsuccessful investment in a telecom concern could proceed. See Edelson V LP v. Encore Networks Inc., D.N.J., Civ. No. 2:11-5802(KM), 5/9/13.  www.blomberglaw.com/public/document/EDELSON_V-LP-v_ENCORE -NETWORKS-INC-et_al_Docket_No_211cv05802_DNJ.

The plaintiff made an investment in a failed private communications technology company that went bankrupt, but then was re-started by the defendants.  The allegations related to the defendants’ failure to disclose their history, exaggerated sales and financials, and statements that various firms had contracted with them when, in fact, they had not.  The company then allegedly diverted business opportunities and assets into another venture where the defendants were shareholders.   The court also said that various projections had no valid basis in fact and the defendants knew it.

Essentially, this fund will be able to pursue its fraud claims.