The SEC has been active in the private equity space recently after being relatively quiet for some time. A recent enforcement action serves as a reminder for fund sponsors that regulators are continuing to look at fund sponsors’ practices relating to “operating partners,” particularly in the context of disclosures to limited partners.
Coronavirus Disruption: Regulatory and Litigation Risks for Private Fund Managers
The impact of the global coronavirus (COVID-19) outbreak has been rapidly evolving, causing disruption in global commerce across a wide range of industries. Private fund managers are not immune to the disruption. According to PitchBook’s latest analysis, private equity and venture capital still have record amounts of dry powder ($2.4 trillion) to weather the storm and step in to provide liquidity to businesses. However, operations, fundraising, deal sourcing, and performance will likely be negatively affected, at least in the near-term, by the economic deterioration caused by COVID-19.
SEC clamps down on Custody Rule
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.
First Circuit Reverses District Court’s “Partnership-in-Fact” Holding and Finds Private Equity Funds Not Part of Controlled Group and Not Liable for Portfolio Company’s Pension Liabilities
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
Proskauer Private Investment Funds Group Releases 2019 Annual Review and Outlook
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.
SEC Releases FY 2019 Enforcement Results: Increases in Investment Adviser Actions and Maintained Focus on Individual Accountability
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.
SEC Announces the Formation of Asset Management Advisory Committee
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.
New York Establishes Six-Year Statute of Limitation for Prosecution of Claims under the Martin Act
On August 25, 2019, New York Governor Andrew Cuomo signed New York State Senate Bill S6536 which established a six-year statute of limitations for the prosecution of certain crimes related to fraudulent practices in respect to stocks, bonds and other securities and conducting business in the State of New York. As discussed below, the legislation overturned a New York Court of Appeals ruling last year holding that claims under the Martin Act were subject to a three-year statute of limitations.
Veil-Piercing Risks for Private Equity Managers Highlighted in Recent Court Decision
A recent case in a North Dakota district court is a reminder to private equity funds and managers that, under certain conditions, they may be held responsible for actions of a fund’s portfolio companies. Courts allow plaintiffs to pierce the corporate veil as a check against improper abuse of the corporate form. When one corporate entity is under such extensive control by another that the first is merely an alter ego of the second, a court may permit a plaintiff to reach through the corporate structure to gain recovery. This is particularly true if the first entity is undercapitalized. Through this mechanism, limited liability does not mean immunity from liability, and under certain circumstances a plaintiff can hold the ultimate shareholders or owners liable for company obligations.
Proposed Senate Bill Would Significantly Impact Certain Private Funds and Their Affiliates
Recently, a group of Congress members introduced into Congress Senate Bill 2155 named the Stop Wall Street Looting Act of 2019. Although unlikely to be enacted into law as drafted, this proposed legislation would directly and substantially affect a number of fundamental operational aspects of private equity funds and their affiliates.