Since the Second Circuit’s 2014 decision in United States v. Newman triggered a debate about the personal benefit requirement, several bills have been introduced in Congress to define insider trading. The most recent effort is H.R. 2534, the Insider Trading Prohibition Act, which the House of Representatives passed overwhelmingly last week. The bill would codify certain aspects of the judicially created body of insider trading law. Although we understand that the Senate is unlikely to consider this legislation at least in the near term, the bill’s provisions – if ever enacted – could make it easier for the government to prove insider trading cases, at least against individuals. Continue Reading
Under rule 206(4)-2 of the Advisers Act, otherwise known as the Custody Rule, it is a fraudulent practice for a registered investment adviser to have custody of client funds or securities, unless the adviser takes certain required steps to protect the assets. Over the past year the SEC’s Enforcement division has been relatively active investigating and enforcing the rule – which, at most, requires a showing of negligence – with a number of complicated provisions that can trip up the uninformed.
Recently, the SEC brought enforcement actions that highlight two key areas under the Custody Rule that can result in liability. First, in addition to maintaining client funds and securities with a “qualified custodian,” advisers with custody of the funds and securities must obtain either (i) a “surprise examination” of those assets annually from an independent public accountant or (ii) an annual audit of its financial statements by an independent public accounting firm that is registered with (and is subject to regular inspection by) the PCAOB and distribute the financial statements prepared in accordance with GAAP to each investor in the fund within 120 days of the fund’s fiscal year end (180 days for fund of funds). Most registered private fund advisers rely on the annual audit approach. Continue Reading
Last Friday, the U.S. Court of Appeals for the First Circuit ruled that two co-investing Sun Capital private equity funds had not created an implied “partnership-in-fact” for purposes of determining whether the Sun Funds were under “common control” with their portfolio company, Scott Brass, Inc. (SBI) – resulting in a ruling that the Sun Funds were not under “common control” with SBI or a part of SBI’s “controlled group” and, therefore, that the Sun Funds could not be held liable for SBI’s multiemployer pension fund withdrawal liability.
This ruling marks the end (for now) to the seven-year Sun Capital dispute. The ruling has significant implications for both multiemployer pension funds and private equity funds. Among other things, the ruling may hamper the efforts of multiemployer pension plans and the PBGC to collect plan termination and withdrawal liability from private investment funds (and their other portfolio companies) based on a “partnership-in-fact” analysis; on the other hand, private equity fund sponsors should be aware that (i) acquiring an 80% (or more) interest in a portfolio company, whether within one private equity fund or pursuant to a “joint venture” between related (and maybe even unrelated) funds, may trigger joint and several liability for the portfolio company’s underfunded pension or withdrawal liabilities, and (ii) even a smaller ownership interest percentage could possibly trigger the ERISA “controlled group” rules based on complicated “common control” determinations.
See our fuller analysis here.
Proskauer’s Private Investment Funds Group recently released its 2019 Annual Review and Outlook for Hedge Funds, Private Equity Funds and Other Private Funds. This yearly publication provides a summary of some of the significant changes and developments that occurred in the past year in the private equity and hedge funds space, as well as certain recommended practices that advisers should consider when preparing for 2020. Continue Reading
In a series of enforcement cases over the past few months, the SEC has continued to bring actions focused on undisclosed fees charged to clients. Many of these cases have charged firms with fraud and other violations based on fees that were not adequately disclosed. While some attention has focused on retail wealth managers, institutional advisers to private funds have attracted scrutiny for undisclosed fees, leading to the following enforcement actions:
- In August of 2019, the SEC charged a private venture capital fund adviser, Frost Management Company, LLC, with fraud and breach of fiduciary duties based on over $14 million in undisclosed incubator fees to start-up companies in which their fund clients invested. The complaint alleges that Frost offered incubation services to the start-ups in which it invested, and that these incubation services were provided through an affiliated entity. However, the SEC alleged that the fees paid to the affiliate, which were supposed to be used for “operational support,” were in fact used to fund the principal’s personal expenses. Furthermore, the SEC alleged that, contrary to representations to investors, the fees that its portfolio companies were paying to the affiliate were not below market rate. The case is currently ongoing, and the SEC is seeking injunctions, disgorgement and prejudgment interest, and civil penalties.
- Also in August of 2019, the SEC settled charges against MVP Manager LLC based on allegations regarding undisclosed brokerage commissions for acquisitions of pre-IPO shares. MVP’s clients were private funds that invested in the securities of pre-IPO venture-backed companies. The order alleged that MVP personnel arranged to receive an undisclosed brokerage commission on the sale of pre-IPO securities to MVP’s client funds on three separate occasions. The order further alleged that this undisclosed commission created a conflict of interest, as MVP and its personnel had an economic incentive to cause the private funds to purchase the securities. MVP agreed to violations of the antifraud provisions of the Advisers Act, and repaid $170,000 worth of undisclosed fees along with an $80,000 penalty.
- Earlier in July of 2019, the SEC settled another conflicts of interest case against the principal of Genesis Capital LLC based on undisclosed fees. The order alleged that Genesis failed to disclose certain conflicts of interest that resulted from investments in, and fees paid to, companies that were affiliates of the adviser. The settlement involved violations of the antifraud provisions of the Adviser’s Act, disgorgement, and a $75,000 civil penalty.
- In September 2019, the SEC brought an action against a fund-of-funds manager for an undisclosed fee sharing agreement. The order alleged that the manager’s principal had arranged a separate fee-sharing arrangement with the manager of one of the underlying fund investments, but did not disclose the agreement to the fund-of-funds investors. This undisclosed fee arrangement resulted in an conflict of interest as to fund investors, and a settlement involving the antifraud provisions of the Advisers Act.
Retail wealth managers have also faced scrutiny, often in connection with more complex alternative investments. For instance:
- An undisclosed 7% commission charge for alternative investments where an alternative share class (without embedded commissions) was available;
- An undisclosed 5% commission that an adviser received when his clients invested in certain promissory notes;
- Approximately $254,000 in undisclosed fees that were generated in exchange for recommending investments in certain private real estate funds; and
- A revenue sharing agreement leading to undisclosed conflicts in recommending mutual fund share class investments that resulted in over $100 million being paid to the adviser.
From the SEC’s perspective, fund advisers are fiduciaries to their clients including the funds they advise and, in the context of that relationship, any ambiguities in fee disclosure are likely to be examined closely and create risk. Given the SEC’s continuing focus in the area, all advisors should focus on all fees, in whatever form, from all sources and ensure that they are adequately disclosed to investors and clients.
Yesterday the SEC announced its enforcement results for FY 2019, accompanied by a report from the Co-Directors of its Division of Enforcement. While the total number of actions increased slightly from 2018, the percentage of cases involving investment advisers or investment companies increased more dramatically, growing from 22% in 2018 to 36% in 2019, with a significant portion of the increase attributable to the SEC’s Share Class Selection Disclosure Initiative. Investment advisory issues accounted for 191 standalone actions in the past year. Continue Reading
As a further indication of the SEC’s focus on the asset management industry, on November 1, 2019 the Commission formally established an Asset Management Advisory Committee. This follows the SEC’s recent announcement of its intent to establish the committee. Continue Reading