Author: Doug Cornelius

You can find out more about Doug on the About Doug page

Changing the Definition of “Covered Funds” under the Volker Rule

The rule that the late Paul Volker wanted to impose on banks was to stop them from engaging in proprietary trading. If the government was going to provide a back stop, then the banks should not be engaged in risky trading behavior with the protection of the federal government.

Although the Volker Rule sounds easy in concept, it’s been tough to implement and prove compliance. Even harder now that the line between investment bank and commercial bank largely does not exist.

One aspect of the Volker was to also get banks out of the business of sponsoring investment funds. Section 13 of the Bank Holding Company Act of 1956 generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring, or having certain relationships with covered funds.

The definition of “covered fund” covered fund covered a hedge fund or private equity fund. For compliance, you need to dive into the definition:

“The terms “hedge fund” and “private equity fund” mean an issuer that would be an investment company, as defined in the Investment Company Act of 1940 (15 U.S.C. 80a–1 et seq.), but for section 3(c)(1) or 3(c)(7) of that Act “

So it’s the same definition of private fund from the Investment Advisers Act.

What’s proposed to be changed?

  1. Revise certain restrictions in the foreign public funds exclusion to more closely align the provision with the exclusion for similarly situated U.S. registered investment companies.
  2. Permit loan securitizations excluded from the rule to hold a small amount of non-loan assets, consistent with past industry practice, and codify existing staff-level guidance regarding this exclusion.
  3. Be able to invest in and have certain relationships with credit funds that extend the type of credit that a banking entity may provide directly
  4. Exclude venture capital funds from the definition of covered fund
  5. Exclude an entity created and used to facilitate a customer’s exposures to a transaction, investment strategy, or other service.
  6. Exclude wealth management vehicles that manage the investment portfolio of a family, and certain other persons, allowing a banking entity to provide integrated private wealth management services.
  7. Make clear that an “ownership interest” in a fund does not include bona fide senior loans or senior debt instruments interests in the fund

The proposal to exclude venture capital funds sticks out from the others. It may even be the riskiest of these.

The argument for venture capital funds is that they “promote growth, capital formation, and competitiveness.” (See page 60) With the lack of leverage and reliance on other securities, venture capital funds are less interconnected with the broader markets. ” Banking entity investments in qualifying venture capital funds may benefit the broader financial system by improving the flow of financing to small businesses and start-ups and thus may promote and protect the financial stability of the United States.” (see page 60)

For the definition of “venture capital fund” the proposal refers to the SEC’s definition in 203(l)-1, with the limitations on holdings and debt.

This seems like good lobbying by venture capital. Comment period is open for the proposals. Let’s see if sticks.

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SEC Cybersecurity Update

The Securities and Exchange Commission Commission’s Office of Compliance Inspections and Examinations issued examination observations related to cybersecurity and operational resiliency practices taken by SEC registrants.

This compilation of observations is based on OCIE’s observations of broker-dealer, investment advisers, clearing agencies, national securities exchanges and other firms that OCIE has taken a look at. It’s not clear if these observations are from cyber sweeps or the full body of exams.

But it doesn’t matter. The report is full of good things and acts as a roadmap for good practices.

If you noted that the types of firms covered has a lot of variety, you are correct. The Report acknowledges that there is no “one-size fits all” approach to cybersecurity.

[A]ll of these practices may not be appropriate for all organizations, we are providing these observations to assist market participants in their consideration of how to enhance cybersecurity preparedness and operational resiliency.

The report is very concise so I’m not going to list all of the items. Matt Kelly highlights a few of his favorites on cybersecurity. I think the report can be used as a roadmap to review your firm’s cybersecurity.

The SEC is taking things a step further and talking about resiliency. It’s ridiculous to think that any firm can make itself immune to an attack or failure.

[If] an incident were to occur, how quickly can the organization recover and again safely serve clients?

You need a plan. You need an inventory of your services and systems. You need to know how to substitute a system so that you can still deliver services to your clients.

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The One with the Missing Solar Generators

Jeff and Paulette Carpoff had what sounds like a great idea to me: mobile solar generator units. These are solar generators that would be mounted on trailers that could provide emergency power to cellphone towers and lighting at sporting events. Plus there were generous federal tax credits due to the solar nature of the generators.

I’m willing to hand over a check just hearing the idea. Others agreed and gave Carpoff almost $1 billion in investments to create over 17,000 of the generators.

“A million dollars isn’t cool. You know what’s cool? A billion dollars.”

Sean Parker – The Social Network

What’s not cool is that the Carpoffs only had about 6,571 of the generators.

The conspirators pulled off their scheme by selling solar generators that did not exist to investors, making it appear that solar generators existed in locations that they did not, creating false financial statements, and obtaining false lease contracts, among other efforts to conceal the fraud. 

There is a “What is a Security?” twist to the charges. Some of the fake generator investments were structured as sale-leaseback arrangements. The investors paid to purchase generators from DC Solutions, while simultaneously leasing them to DC Distribution. DC Distribution would then sub-lease the Generators to end-users. The investors would profit from the investments due to tax credits, depreciation on the generators, and lease payments. If the purchase of the generator is tied to the lease and exclusive, then there is a line of cases finding that to be an investment contract. Just like the orange grove in Howey. However a bulk of the investments were made to a fund, pooling money for a bulk purchase and lease of generators.

As interesting as I may find this topic in the charges, the conspirators are going to jail and probably have less interest in the arcane corners or securities law.

I’m going to assume that the Carpoffs started the business with good intentions. They did create thousands of these generators and leased at least some of those for legitimate purposes. They seem to have made at least $18 million in revenue. It seems that the business just did not scale. They could find enough end users to satisfy the investment demand.

As with many Ponzi schemes, they weren’t willing to be honest with their investors about the failure and engaged in false and misleading. There was much more money to be made in collect cash from investors than from leasing the generators.

As with any good fraud fraud charges they list out the extravagant items bought by the fraudsters. This comes up short on the itemization.

  • 150 cars
  • dozens of properties
  • 1978 Firebird previously owned by actor Burt Reynolds
  • a minor-league professional baseball team
  • share in a jet service
  • Nascar sponsorship

Jeff and Paulette Carpoff are scheduled to be sentenced by U.S. District Judge John A. Mendez on May 19. Jeff Carpoff faces a maximum statutory penalty of 30 years in prison. Paulette Carpoff faces a maximum statutory penalty of 15 years in prison. The actual sentences, however, will be determined at the discretion of the court after consideration of any applicable statutory factors and the Federal Sentencing Guidelines, which take into account a number of variables.

Four defendants have previously pleaded guilty to federal criminal charges related to the fraud scheme since October. Joseph W. Bayliss, 44, of Martinez, and Ronald J. Roach, of Walnut Creek, each pleaded guilty to related charges on Oct. 22, 2019. Robert A. Karmann, 53, of Clayton, pleaded guilty to related charges on Dec. 17, 2019. Ryan Guidry, 53, of Pleasant Hill, pleaded guilty to related charges on Jan. 14, 2020. A seventh co-conspirator is scheduled to plead guilty on Feb. 11. The investigation into the fraud remains ongoing.

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The One with the Fake Pot Ownership

With the growth of marijuana businesses across several states, many see it at a sector ripe for investment with the possibility of big returns. While states approve the sale of marijuana, it’s not entirely legal. Federal law still lists it as a controlled substance. That makes banking difficult and oversight difficult for investors. It also makes it a target for less than scrupulous middlemen.

That’s where we find Guy Griffitthe and Robert Russell. Mr. Russell and his wife had created a company in Washington that held a license to grow marijuana under the state’s recreational cannabis laws.

According to the SEC complaint, Russell cut a deal with Griffithe to offer a stake in his marijuana growing business. That was the first problem.

Under the Washington law for marijuana businesses, ownership is tightly controlled and regulated. Russell couldn’t sell an ownership interest without approval from the state Liquor and Cannabis Board. According to the complaint, Russell and Griffithe tried to structure it as a right to receive profits and not an ownership interest. I don’t think it worked.

That didn’t seem to stop Griffithe from selling interests in the company that bought the interest in the marijuana growing company. The pitch was that the investment would help the marijuana grower to expand by providing capital for equipment, land and physical facilities.

The next problem is that Griffithe didn’t register the securities for sale and didn’t make sure the sale was happening within an exemption. He used a website and openly advertised the sale of the securities.

The third problem was that they spent most of the $4.85 million they raised on non-business purchases. The SEC loves to list out the extravagant purchases made by fraudsters with their ill-gotten cash. This was no exception.

  • 2008 Bentley Continental
  • 2012 Mercedes Benz C Class
  • 2013 Ford Mustang (I’ll assume this was a Boss 302 or Shelby GT500 model)
  • 2015 Porsche Panamera
  • $250,000 towards a 65-foot Pacific Mariner yacht

The final straw was that the marijuana growing business was not actually profitable. According to the SEC, it never made a profit. Meanwhile Griffithe’s marketing material proclaimed a 40% profit margin. They faked the profitability by using some of the investor paid-in capital to make distributions. That turned it into a Ponzi scheme.

Fraudulent investment activity in marijuana business has become so widespread that the SEC has published an Investment Alert: Marijuana Investments and Fraud.

This case points out one of the shortcomings in that SEC alert. It fails to point out the very common limitation on changes of ownership in marijuana businesses. Even if the investment is legitimate, the likely requirement of approvals for the acquisition and later sale will have a big impact on the investment.

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Compliance Bricks and Mortar for January 24

These are some of the compliance-related stories that caught my attention.

Two Anti-Corruption Items of Note
Matt Kelly
Radical Compliance

Good news for anti-corruption enthusiasts looking for something to read — we have two fresh pieces of literature this week that you can study and shoehorn into your compliance programs. First, Transparency International just released its 2019 Corruption Perceptions Index, which is one of the go-to benchmarks to help compliance officers perform a corruption risk assessment. The short version: lots of countries are backsliding into more corruption. Second, Britain’s Serious Fraud Office has quietly released its in-house guidance for how investigators should assess corporate compliance programs, akin to the U.S. Justice Department’s own guidance on how to evaluate compliance programs. The SFO material is much shorter and probably less informative, but still, it’s now available to the public.

http://www.radicalcompliance.com/2020/01/23/two-anti-corruption-items-note/

New Year Brings New Responsibilities for Some Asset Managers Who Are Exempt from Registration with the CFTC
Ropes & Gray

With the New Year comes new responsibilities for certain asset managers who are exempt from registration with the U.S. Commodity Futures Trading Commission (“CFTC”) as commodity pool operators (“CPOs”) or commodity trading advisors (“CTAs”). Following recent amendments to CFTC rules applicable to asset managers (discussed further here), family offices, operators of business development companies (“BDCs”) and certain operators of registered investment companies (“RICs”) should reevaluate their CPO registration exemptions and, with respect to family offices, CTA registration exemptions. Asset managers affected by the rule amendments may be required to take additional action. In addition, as in years past, certain CPO and CTA registration exemptions, including those claimed under CFTC Rule 4.5, 4.13(a)(3) and 4.14(a)(8), must be renewed by March 2, 2020.

https://www.ropesgray.com/en/newsroom/alerts/2020/01/New-Year-Brings-New-Responsibilities-for-Some-Asset-Managers-who-are-Exempt-from-Registration?

So Maybe The SEC Does Need Whistleblowers’ Help?
Jon Shazar
DealBreaker

Ah, right, those whistleblowers the SEC has made as clear as possible it neither needs nor wants nor intends to compensate. Surely, then, Jay Clayton’s boys can’t have missed too much, right?

https://dealbreaker.com/2020/01/tca-hedge-fund-shuts

Preventing Phishing Attacks
Michele R. O’Brien
The Compliance & Ethics Blog

Your organization’s staff should always be considered the first line of defense against cyber threats. Unfortunately, they can also be the biggest risk factor when it comes to phishing. It takes just one employee to take the bait and that’s enough for attackers to steal intellectual data. 

https://complianceandethics.org/preventing-phishing-attacks/

Fried Frank Discusses Delaware Chancery’s Latest Decision on Material Adverse Change Clauses
By Gail Weinstein, Warren S. de Wied, David L. Shaw, Steven Epstein and Andrew J. Colosimo
The CLS Blue Sky Blog

Channel Medsystems, Inc. v. Boston Scientific Corporation (Dec. 18, 2019) is the Delaware Court of Chancery’s first decision issued since the Delaware Supreme Court’s 2018 Akorn decision to evaluate whether an acquiror had a right, under a merger agreement, to terminate a pending acquisition on the grounds that there was a “Material Adverse Effect” or “Material Adverse Change” in the target company. (We use “MAE” and “MAC” interchangeably in this memorandum.) Akorn was the first case in which the Court of Chancery, post-trial, found the existence of an MAE and the first post-trial Delaware decision to find that an acquiror had the right to terminate a merger agreement based on an MAE. In Channel, by contrast, Chancellor Bouchard ruled, after trial, that there was not an MAE and that the acquiror was required to close the merger.

https://clsbluesky.law.columbia.edu/2020/01/21/fried-frank-discusses-delaware-chancerys-latest-decision-on-material-adverse-change-clauses/

SEC/Telegram Litigation Commentary & Compendium (A Must Read for FinTech Players)
John Reed Stark

[T]he SEC Telegram matter is more than just the typical SEC emergency enforcement action. The SEC Telegram docket does not just provide a rapid-fire presentation of just about every issue facing cryptocurrency market participants today. The matter also offers a rare and vivid glimpse into the dramatic disparity between on the one hand, how the SEC enforcement division views digital token offerings (they should all be registered!) and on the other hand, how the so-called fintech bar views digital token offerings (they are not always securities!). 

https://www.linkedin.com/pulse/sectelegram-litigation-commentary-compendium-must-read-stark

The One with the Fake ComplianceGuard

Compliance; solve it with the blockchain. Operational due diligence; solve it with the blockchain. Shortcomings of separately managed accounts; solve it with the blockchain. Financial audits; solve it with the blockchain.

Shaun MacDonald, managed to squeeze $30 million in ICO funding from investors for his idea to create ComplianceGuard, a blockchain based tool for funds, and a blockchain terminal, crypto-focused version of the ubiquitous Bloomberg Terminal. According to the SEC complaint, the tools were not in production. That and other materially false and misleading statements were made in the illegal sale of securities that was the ICO.

The first problem is that Shaun MacDonald is really Boaz Manor. In 2010, Mr. Manor pleaded guilty in Ontario, Canada to the crimes of laundering the proceeds of a crime and disobeying an order of a court. Both charges related to the 2005 collapse of the hedge fund firm Portus Group. Mr. Manor darkened his hair, grew a beard, and used aliases to hide his identity and conceal the fact that he had served a year in prison.

It started with ComplianceGuard. A box-shaped device that was supposed to do something compliance-y. It was enough to convince people to give him $775,000 through a token offering. It looked something like this. The whitepaper is full of great compliance-related themes. But I don’t see any actual description of a solution to those compliance requirements

Mr. Manor managed to put the device in the hands of a few hedge funds. But according to the SEC complaint, none of them actually used it. It basically functioned as an extra electronic hard drive for the storage of manually entered transaction data. None of the funds paid for the devices.

Then the company pivoted harder to blockchain with the blockchain terminal. That caught the attention of token purchasers and the company raised $30 million.

Clearly, it was more sexy than compliance.

The company actually made a product and sent it to to funds for use. It’s not clear than anyone actually used those terminals or even if they did anything useful.

I’m going to guess that the ICO fundraising was better than the terminals.

In the end, the SEC has all of the alleged fraud. But it also has the fraud of the disguised Mr. Moran.

On top of that, it has a claim for the unregistered sale of securities. The company did file a for Form D for 506(c) offering. But that form of offering requires you to take reasonable steps to verify that the purchaser is an accredited investor. The SEC claims that those steps were not taken.

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The Economic Effects of Private Equity: Good or Bad?

It depends.

But it’s certainly not the scourge portrayed by the Stop Wall Street Looting Act. That bill is clearly myopic in equating private equity with leveraged buyouts. Even with that subset of private equity, the results of leveraged buyouts are not bad for the underlying companies.

In a recent paper a group of economists looked at the data. They jumped in data from CapitalIQ and collected a sample of 9,794 private equity led leveraged buyouts. They divided those deals into four groups: the buyout of an independent, privately held firm (private-to-private), the buyout of a publicly listed firm (public-to-private), the buyout of part of a firm (divisional), and the sale of portfolio firms from one PE firm to another (secondary).

Does a PE buyout result in job losses. According to the paper, relative to control firms:

  • In private-to-private buyouts employment at targets rises 13 percent
  • In secondary buyouts, employment rises 10 percent
  • In public-to-private deals employment falls by 13 percent
  • In divisional buyouts, employments falls by 16 percent

That’s a push. One would assume that one of the reasons a public company ends up under-valued and in the sights of PE firms is that its underperforming.

To support that, the research shows a rise in labor productivity of eight percent at target firms. The researchers note that as striking given that the target firms tend to be mature firms in mature industries.

I think the problem is the public perception of private equity caused by poor results in public-to-private deals, like Toys ‘R Us, catch all the headlines, while the run of the mill deals with good success or great success don;t make the headlines.

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Compliance Bricks and Mortar for January 17

These are some of the compliance-related stories that have caught my attention.

Investment Funds – Year-end Compendium of Our 2019 Client Updates
Sidley Austin

As the developments affecting the investment management industry continue to unfold, we have once again prepared our semiannual compendium of relevant Sidley Updates for our investment fund and adviser clients and friends. The compendium includes a summary of each Sidley Update year-to-date, in reverse chronological order, along with a link to its full text. We have included all of the updates, making the compendium repetitive in instances where we revisited a topic to report on emerging information and breaking news in the industry.

https://www.sidley.com/en/insights/newsupdates/2020/01/year-end-compendium-2019

Samsung Signs on the Compliance Line
Matt Kelly
Radical Compliance

Quite the compliance moment was witnessed in Korea this week, when the executive team at Samsung Electronics made a public display of signing a pledge to obey anti-corruption laws and build a new culture of compliance at the firm. The firm’s top three executives — president Kim Hyun-seok, vice chairman Kim Ki-nam, and mobile communications head Koh Dong-jin — signed the pledge at a publicity event at Samsung headquarters on Monday. Like, in front of the cameras. With reporters around and publicity photos issued.

http://www.radicalcompliance.com/2020/01/14/samsung-signs-compliance-line-pledge/

The Astros Cheating Scandal and Compliance
Tom Fox
FCPA Compliance & Ethics

Over the next few blogs, I will be exploring the MLB Report in detail, how it demonstrates that culture must be on the forefront of every Chief Compliance Officer (CCO) and corporation, what it means for the compliance community and how the MLB Report informs enforcement of anti-corruption laws such as the Foreign Corrupt Practices Act (FCPA).

Part 1 – The Cheating Scheme
Part 2 – Hinch and Luhnow

Private equity firms fear a Democrat topping Trump in 2020
Dan Primack
Axios

What’s happening: The result is that private equity investors are talking about clearing the portfolio decks this year, locking in profits under the current taxation scheme.

The big picture: This is different than the decades-long debate over carried interest, which was about if PE investment profits should be taxed as capital gains or as ordinary income. If you no longer have a difference between the two rates, it no longer matters how carried interest is classified.

https://www.axios.com/private-equity-fears-democrats-2020-presidential-election-79b046d3-78a7-44ed-ade6-be93d02528cb.html?

Into the Mainstream: ESG at the Tipping Point
 Rakhi Kumar, Nathalie Wallace, and Carlo Funk
Harvard Law School Forum on Corporate Governance

In 2017, we conducted a major global survey to give deeper insight into the increasingly important Environmental, Social and Governance (ESG) market. Performing for the Future revealed a picture of ESG investment driven by performance beliefs, coupled with challenges and evolving pathways to adoption. …

Our latest research uncovers the views of more than 300 institutional investors and world-leading institutions, revealing what is driving organizations to adopt ESG, how this is influencing adoption, and the barriers that must be overcome to deliver the best outcomes.

https://corpgov.law.harvard.edu/2020/01/13/into-the-mainstream-esg-at-the-tipping-point/

Compliance Alert: Expensive watches raise red flags
Harry Cassin
The FCPA Blog

One luxury item is showing up more often in alleged graft-related asset seizures: wrist watches, especially the high-end variety with eye-watering price tags. In November 2018, Venezuela’s former national treasurer Alejandro Andrade was sentenced in the United States to ten years in prison for his role in a plot to launder $1 billion in bribes. He also forfeited $1 billion in personal assets, including bank accounts, aircraft, real estate, vehicles, horses, and watches. Andrade used watches to pay some of the bribes.

https://fcpablog.com/2020/01/08/compliance-alert-expensive-watches-raise-red-flags/

Marginalization of counsel … and compliance officers
Jeff Kaplan
Conflict of Interest Blog

Years ago, a firm I knew moved its chief compliance officer from a relatively nice office to a decidedly not nice one. The move was intended to send a message and it was received that way. I noted at the time that this would not end well for the firm. Sadly, I turned out to be right. In a recent post on the Harvard Corporate Governance Blog, “Bernie Ebbers and Board Oversight of the Office of Legal Affairs,” Michael W. Peregrine, McDermott Will & Emery LLP revisits the once-famous World Com accounting fraud scandal from the early 2000s and particularly the aspect of it that entailed the CEO (Ebbers) marginalizing corporate counsel. The details of this matter are less important (to me) than are the author’s very useful recommendations for mitigating this sort of risk.

http://conflictofinterestblog.com/2020/01/marginalization-of-counsel-and-compliance-officers.html

OCIE’s 2020 Exam Priorities — Key Takeaways for Private Fund Managers
Proskauer

Last week, the SEC’s Office of Compliance Inspections and Examinations released its 2020 Exam Priorities with a number of areas of interest to private fund managers. OCIE reported that it examined 15% of registered investment advisers (RIAs) during fiscal year 2019, down from approximately 17% of RIAs during FY 2018 but consistent with FY 2017’s 15% coverage rate. The four-week government shutdown in January 2019 reduced exam activity last year, but we expect the numbers to trend upward in 2020.

https://www.proskauer.com/alert/ocies-2020-exam-priorities-key-takeaways-for-private-fund-managers

OCIE’s 2020 Examination Priorities

The Securities and Exchange Commission’s Office of Compliance Inspections and Examinations announced its 2020 examination priorities. OCIE has been publishing its examination priorities annually in an effort to enhance the transparency of its examination program and to provide insights into its approach to examination. With its current risk-based approach, the exam priorities highlight areas that OCIE thinks present greater potential risks to investors and the integrity of the U.S. capital markets.

OCIE identified eight overarching priority areas

1. Retail Investors, Including Seniors and Those Saving for Retirement – OCIE again will focus on the protection of retail investors, including the various intermediaries that serve and interact with retail investors and the investments marketed to, or designed for, retail investors. Examinations in these areas will include reviews of disclosures relating to fees, expenses, and conflicts of interest.

2. Information Security – OCIE will continue to prioritize cyber and other information security risks across the entire examination program.

3. Financial Technology and Innovation, Including Digital Assets and Electronic Investment Advice – OCIE will keep a close eye on those in the digital asset space, as well as RIAs that provide services to clients through automated investment tools and platforms, often referred to as “robo-advisers.”

4. Focus Areas Relating to Investment Advisers, Investment Companies  – OCIE will continue its risk-based examinations for each type of these registered entities. In particular, examinations of registered investment advisers will focus on RIAs that have never been examined, including new RIAs and RIAs registered for several years that have yet to be examined. These examinations will include RIAs advising retail investors as well as private funds.  Investment company examinations will focus on mutual funds and exchange-traded funds, the activities of their RIAs, and the oversight practices of their boards of directors. 

5. Focus Areas Relating to Broker-Dealers, and Municipal Advisors – OCIE will continue its risk-based examinations for each type of these registered entities. Broker-dealer examinations will focus on issues relating to the preparation for and implementation of recent rulemaking, along with trading practices. Municipal advisor examinations will include review of registration and continuing education requirements and municipal advisor fiduciary duty obligations to municipal entity clients.

6. Anti-Money Laundering Programs – OCIE will continue to review for compliance with applicable anti-money laundering requirements, including whether entities are appropriately adapting their AML programs to address their regulatory obligations.

7. Market Infrastructure – OCIE will continue its focus on entities that provide services critical to the functioning of our capital markets, including clearing agencies, national securities exchanges, alternative trading systems, and transfer agents. Particular attention will be focused on the security and resiliency of entities’ systems.

8. FINRA and MSRB – OCIE will continue its oversight of the Financial Industry Regulatory Authority by focusing examinations on FINRA’s operations, regulatory programs, and the quality of FINRA’s examinations of broker-dealers and municipal advisors. OCIE will also continue to examine the Municipal Securities Rulemaking Board to evaluate the effectiveness of its operations and internal policies, procedures, and controls.

As for private funds, on page 16 of the Priorities:

“OCIE will continue to focus on RIAs to private funds that have a greater impact on retail investors, such as firms that provide management to separately managed accounts sideby-side with private funds. Moreover, OCIE will review RIAs to private funds to assess compliance risks, including controls to prevent the misuse of material, non-public information and conflicts of interest, such as undisclosed or inadequately disclosed fees and expenses, and the use of RIA affiliates to provide services to clients.”

As for examination coverage:

“OCIE has increased its examination coverage of RIAs over the past several years from 10 percent in FY 2014 to a high of 17 percent in FY 2018. OCIE’s coverage of RIAs in FY 2019, a year in which the RIA population continued to increase and the SEC experienced a 35-day lapse in appropriations, was 15 percent.”

If these priorities sound familiar, they are not very different from the 2019 priorities. I think that’s because it’s the right set of priorities using a risk-based approach.

The 2021 priorities may change with the regulatory pipeline. The changes in marketing and Regulation BI will alter the compliance landscape.

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Modernization of Auditor Independence Rules

For private funds to comply with the Custody Rule, they usually rely on the annual, independent audit prong for compliance. That rule requires an audit from an auditor that is subject to audit as defined in Regulation S-X. The SEC has proposed some changes to Regulation S-X that affect the auditor independent framework.

“Many of the current independence requirements have not been updated since their initial adoption in 2000 and amendments in 2003.  Since that time, the Commission and our staff have, through several consultations per year, continued to learn about the application of our independence rule set and the efficiency and effectiveness of our independence requirements as market conditions and industry practices have changed.  The proposed amendments to Rule 2-01 are designed to respond to these changes, reflect the SEC staff’s experience administering the independence requirements, and incorporate consideration of the recent and longer term feedback received from the public. “

The changes look like they will mostly be at the edges of compliance and not have a significant impact on auditor independence for fund managers.

I had some questions about auditor independence a few years ago and found the decision-making about independence to be very opaque with almost no public guidance. This modernization may help improve this process.

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