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Last month the SEC brought an enforcement action illustrating how cross trades can trip up a manager of a private fund.  The SEC’s settlement with investment manager Lone Star Value Management LLC was based on allegations that the manager carried out a series of cross trades among funds it managed without disclosing to the client in writing that it was acting as a principal and obtaining the client’s consent. In addition to Lone Star, the SEC also sanctioned its founder, sole managing member, CEO, and portfolio manager for violations of Section 206(3) under the Advisers Act and Rule 206(4)-7 thereunder relating to principal transactions.

An increasingly sophisticated and active OCIE division, innovative market disruptors, a maturing credit cycle, and a philosophical change in how the private fund industry views and utilizes litigation are likely to lead to increased regulatory scrutiny and litigation risk for advisers (and their funds) in 2019.  With that backdrop, we are pleased to present our Top Ten Regulatory and Litigation Risks for Private Funds in 2019.

On Friday, the WSJ published an article detailing how companies are monetizing smartphone location data by selling it to hedge fund clients.  The data vendor featured in the WSJ article obtains geolocation data from about 1,000 apps that fund managers use to predict trends involving public companies.  However, as we’ve noted, the use of alternative data collection for investment research purposes may give rise to a host of potential issues under relevant laws.

According to recent news reports, the DOJ and the SEC are investigating the possible improper use of third-party broker quotes by hedge fund managers to value illiquid debt securities in their portfolios. Prosecutors are reportedly focused on possible instances where fund managers allegedly solicited predetermined or improper quotes from brokers, and used those estimates to inflate their own valuations of thinly-traded mortgage bonds.

In addition, the co-head of the SEC’s Asset Management Unit recently highlighted that unit’s focus on valuation, particularly where registered advisers failed to follow their own internal procedures when valuing illiquid positions. The SEC’s focus is further demonstrated by a recent action against a fund manager for improperly valuing municipal bonds inconsistently with GAAP.

At the recent SEC Speaks program, sponsored by PLI, senior SEC staff members provided valuable insight into the SEC’s 2017 priorities for private funds.  While the tenor of this year’s discussion seemed to focus more on retail investors, the staff discussed several topics that private fund advisers should keep in mind from both an enforcement and exam standpoint.

Enforcement

The SEC’s Asset Management Unit (AMU) Co-Chief Dabney O’Riordan outlined several areas that the AMU will focus on this year.  As a general matter, O’Riordan underscored that the structure of private funds can impair transparency for investors, which compounds risks in all of the areas that she discussed.  In particular, she noted the following areas of focus for private funds:

Top-10-2017_v2Private investment funds and advisers are likely to face new regulatory challenges and increased litigation risks in 2017, not only because of a change in the administration, but also because many advisers have not corrected and aligned past practices with current regulatory guidance.  In this post, we have highlighted ten areas that should be on the top of every private fund adviser’s list for 2017 – and how to assess and manage the associated risks.

SECThe Securities and Exchange Commission today announced its enforcement results for fiscal year 2016, reaching new highs in the number of actions filed and money ordered forfeited through disgorgement and penalties.  The SEC noted that it brought the most ever cases involving investment advisers or investment companies, including 8 enforcement actions related to private equity advisers, an area that has clearly been a priority for the Commission over the past year, and a record 21 cases under the Foreign Corrupt Practices Act, an area of increasing importance to the SEC. 

SECValuation is typically near the top of the list when the SEC’s enforcement division and exam staff disclose their priority topics for private funds.  We expect that trend to continue and, if anything, the focus on valuation is likely to increase, especially as the market for unicorns shakes out.

That said, the SEC rarely challenges valuations per se, given the significant judgment required to determine the fair value of Level 3 assets.  Instead, the SEC focuses on issues “around” valuation practices, including: (1) breakdowns in controls/policies/procedures; (2) violations of Generally Accepted Accounting Principles (GAAP); and (3) disclosures to investors and auditors.

Is your organization equipped to stay on top of regulator demands?  Join Proskauer’s Tim Mungovan, co-head of the Private Equity & Hedge Fund Litigation Group, and Marsh’s FINPRO U.S. Chief Innovation Officer Machua Millett on June 15 at 2:00 p.m. ET for a webinar on the new regulatory landscape for…