On May 12, 2016, SEC Director of Enforcement Andrew Ceresney gave a keynote address on Private Equity Enforcement. Ceresney reiterated the SEC’s view that private equity is a key area for enforcement, and that recent actions show that it is particularly focused on undisclosed fees and expenses and increasing transparency in the industry. Ceresney also provided guidance on arguments that the SEC staff has typically found unavailing.
Ceresney noted that the unique nature of private equity investments were a concern, asserting that the “investment structure of private equity and the nature of private equity investments can lend themselves to some of the misconduct that we’ve observed.” However, recent enforcement actions show that problems typically arise when fee and expense allocations are not appropriately managed, giving rise to undisclosed conflicts of interest. Ceresney further stated that as fiduciaries, private equity advisers are expected to eliminate or disclose such conflicts.
Ceresney highlighted the three primary categories of actions against private equity fund advisers:
- Undisclosed fees and expenses (for example, undisclosed conflicts of interest related to accelerated monitoring fee payments);
- Impermissibly shifting and misallocating expenses (for example, misallocation of “broken deal” expenses to certain funds, misallocating expenses among portfolio companies, or misallocating adviser expenses to funds it managed);
- Failure to adequately disclose conflicts of interests, including conflicts arising from fee and expense issues (for example, failing to disclose certain material consulting agreements, fees and payments from portfolio companies to affiliates of the adviser).
Sensing a trend? A focus on undisclosed fees and expenses is the primary thread in these actions.
Ceresney also emphasized repeatedly that where actual or potential conflicts exist pre-capital commitment, they should be disclosed to investors before their commitments. Where conflicts arise post-capital commitment and are presented to a fund’s limited partner advisory committee (LPAC) for review, advisers need to ensure that they provide the LPAC members with sufficient disclosures of the conflict to make an informed determination on behalf of a fund. Implicit in this comment is that the limited partnership agreement provides the LPAC with the authority to consent to such a conflict.
Ceresney also provided guidance to practitioners. He specified certain arguments that the enforcement staff has rejected during the course of private equity investigations (a “do not argue” list for practitioners).
First, some advisers have argued that it is unfair to charge them for disclosure failures resulting from organizational documents that were drafted long before advisers were required to register with the SEC and the SEC began its focus on private equity. Ceresney advised against making those kinds of arguments. As we have noted here before, unregistered does not mean unregulated. Even before Dodd-Frank was enacted, private equity fund advisers have always been investment advisers. And whether registered or not, they are fiduciaries and are subject to the antifraud provisions of the Investment Advisers Act.
Second, Ceresney stated that it is not a relevant defense to liability to argue that, even if a conflict of interest was undisclosed, the investors benefited from the services provided by the adviser. Although this fact may be relevant to the appropriate remedy, it is not a defense to liability. Because their fiduciary duties as advisers require them to disclose all material conflicts of interest, whether or not the investments ultimately benefited investors “does not relieve an adviser of its duty to inform and obtain consent.”
Finally, advice of counsel will be considered (assuming the adviser waives the privilege and discloses the advice completely), but an adviser “cannot escape liability simply by pointing to the actions of counsel.” Ceresney stated that the adviser is ultimately responsible for disclosure of conflicts to clients, although advice may be considered in evaluating remedies or whether an action is appropriate.
We assume that, after three years of increasing scrutiny of the private equity industry, the SEC staff has repeatedly heard these arguments. Practitioners should be aware that the staff is not-so-subtly telegraphing that these arguments will not gain traction.
Private equity advisers should bear in mind the following:
- Over the past three years, the Enforcement Division has gained a better understanding of the industry and is scrutinizing previously-unregistered advisers.
- Advisers fund formation documents (for new funds) should be updated to conform with current industry practice and recent enforcement trends.
- Fee and expense allocations should be examined and confirmed for accuracy, and analyzed in the context of conflicts of interest.
- Potential conflicts of interest (such as arrangements between portfolio companies and affiliates of the adviser) should be examined and disclosed to LPs.
There is no question that the SEC’s enforcement resources will continue to target the private equity industry. As Ceresney noted, the SEC is sending “a clear signal to industry participants that their practices must comport with their fiduciary duty and disclosures in their fund organizational documents.”