With one current vacancy and a second upcoming vacancy, the Securities and Exchange Commission needs some new blood. President Biden nominated two new commissioners to help the agency regain its full population.
Jaime Lizárraga has been nominated to fill a Democratic seat currently occupied by commissioner Allison Lee. She has stated that she is resigning, but will serve until her successor is in place. Lizárraga has worked for Speaker Pelosi for 14 years, and spent eight years before that on the House Financial Services Committee. He was the deputy director of legislative affairs at the SEC, briefly in the 1990s.
Mark Uyeda has been tapped to replace the vacancy created by former Republican commissioner Elad Roisman. Mr. Uyeda is a career attorney with the Securities and Exchange Commission. He is currently on detail from the SEC to the U.S. Senate Committee on Banking, Housing, and Urban Affairs, where he serves as Securities Counsel on the Committee’s Minority Staff.
Alumni Ventures Group is New Hampshire-based venture capital fund manager. It raised dozens of funds to pool capital and invest it in small companies. From 2016 through 2020, in marketing the funds the manager said its management fee was the “industry standard ‘2 and 20’.” The funds had a 10-year life.
Most of us realize there is no industry standard and it’s not as simple as 2 and 20.
Instead of charging 2% per year, the firm charged 20% up front, taking the 10 years’ worth of fees at the time of the initial capital contribution. The Securities and Exchange Commission found that this practice was inconsistent with what a reasonable investor would understand without additional disclosure.
In a statement the firm thinks its 20% up front fee is “far better for investors than chasing down small management fees every year for a decade and imperiling the investors’ ownership if the fees are not received.”
I think that is a stretch. A fund manager can pull the fees from the capital held by the fund. By taking the fees up front, the firm is taking payment before rendering its services.
The firm could have stated that it was taking the 20% fee up front and disclosed that payment in the fund documents and marketing materials. Would that have deterred potential investors from making the investment? The SEC certainly thinks so.
FINRA released regulatory notice 22-10 that said it generally considers the role of compliance chief an advisory position rather than a supervisory one.
Rule 3110 (Supervision) imposes specific supervisory obligations on member firms. The responsibility to meet these obligations rests with a firm’s business management, not its compliance officials. The CCO’s role, in and of itself, is advisory, not supervisory. Accordingly, FINRA will look first to a member firm’s senior business management and supervisors to determine responsibility for a failure to reasonably supervise. FINRA will not bring an action against a CCO under Rule 3110 for failure to supervise except when the firm conferred upon the CCO supervisory responsibilities and the CCO then failed to discharge those responsibilities in a reasonable manner.
This concern has grown as the SEC has continued to bring cases against compliance officers without using its own informally stated framework.
Participating in the wrongdoing
Hindering the SEC examination or investigation
Wholesale failure
One and two are usually fairly obvious. Typically with one, the CCO is also wearing another hat.
It’s the wholesale failure that lacks definition and is commonly used without adding any framework to when something is a foot-fault and when it is a “wholesale failure.” Time for the SEC to take the next step and establish a formal framework for CCO liability
I’m a cyclist. I like cycling for my commute, fast rides, rides in the suburbs, fat biking in the snow. I like watching competitive cycling: men’s and women’s races. I watch more women’s racing because of Kathryn Bertine.
Kathryn Bertine details her activism for equality with women’s cycling in Stand. It’s a memoir detailing the ups and down in her professional life, and the ups and down in her personal life. All those ups and downs are framed in the story of her efforts to get a women’s version of the Tour de France and move towards equality between women’s professional cycling and men’s professional cycling.
My first request is that you pay more attention to women’s cycling. The women’s races are as exciting as the men’s races. There is a chicken and egg problem with women’s cycling. Fewer people are watching it because there is less coverage and inferior coverage. There is less coverage and inferior coverage because the producers think fewer people are watching.
I picked up GCN+ this year to watch cycling races. I tried to watch as many women’s races as men’s races. When I click on a story about men’s racing, I make sure to click on a story about women’s racing. I usually buy a watercolor from Greig Leach each cycling season. This year I bought all women’s races, realizing that my shelf was just art from the men’s races. My favorite was this example of the results of Karthyn’s efforts for equality in cycling. Lizzie Deignan winning the first Paris Roubaix Femmes:
Equality. Once you know the teams and the riders, it’s more enjoyable. Whether it’s the men or the women on the bikes.
Kathryn is a bad ass athlete and a fantastic writer. I first came across her writing in As Good as Gold. She worked for ESPN documenting her quest to make the 2008 summer Olympics in Beijing. She tried lots of sports: triathlon, modern pentathlon, team handball, luge, rowing, open water swimming, racewalking, track cycling, and road cycling. She was unsuccessful in most of those. She was a competitive triathlete, but not at an Olympic level. Turns out she was excellent at cycling and that experience led to her pro career.
It was the vast difference in treatment of the men’s and women’s professional cycling that lead to Stand. She encountered clear discrimination and dismissive treatment by those running the professional cycling organizations. Sponsors were not there for women’s cycling because there was so much less coverage of women’s cycling. There was so much less coverage because the cycling organizations were not promoting the races and therefore there were fewer sponsors. I view it as a terrible circle of passing the blame.
It took someone like Kathryn to stand up and push for equality. Stand is her story in this push for equality.
I’m going to spoil part of the ending. Kathryn established The Homestretch Foundation to provide temporary housing and other resources to professional or elite athletes—primarily female athletes—who face financial and economic discrepancies. If you’ve gotten this far down the page and aren’t a book reader, please consider sending a donation to The Homestretch Foundation.
At its open meeting on February 9, the Securities and Exchange Commission offered up a buffet of proposed regulations of private funds. It’s really an all-you-can eat buffet with six proposed changes across a variety of areas.
The SEC wants private funds to send out quarterly statements to private fund investors. It doesn’t seem that the SEC would require them to be audited. It would have to provide a detailed accounting of all fees and expenses. It sounds like it would some form of standardized reporting. The quarterly reports would have to provide information on fund performance. For “liquid funds, the quarterly statement would provide annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year. For “illiquid funds,” the statement would provide the gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter. Not sure what is going to draw lines between “liquid” and “illiquid” funds.
The SEC is proposing that private funds have an annual audit. This seems odd to me. Private funds largely have to do this already under the Custody Rule. Not sure what this regulation would do beyond the Custody Rule, unless it will replace the Custody Rule for private funds.
Adviser-Led Secondaries Rule would require a fairness opinion in connection with an adviser led secondary transaction. This requirement would provide a check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors. Not sure how much this rule would help in already complex transactions
The preferential treatment rule would prohibit private fund advisers from providing preferential terms for redemptions and providing additional information about fund holdings. The proposed rule would go further and prohibit private fund advisers from providing “other preferential treatment” unless disclosed to current and prospective investors. This proposed rule is designed to protect investors by prohibiting specific types of preferential treatment that have a material, negative effect on other investors. Is the SEC trying to kill side letters? This proposal could be a mess.
The prohibited activities rule is side table full of dishes cooked up by the SEC under the umbrella that these practices are contrary to the public interest and the protection of investors
Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser;
Seeking reimbursement, indemnification, exculpation, or limitation of its liability for certain activity;
Reducing the amount of an adviser clawback by the amount of certain taxes;
Charging fees or expenses related to a portfolio investment on a non-pro rata basis; and
Borrowing or receiving an extension of credit from a private fund client.
The desert is that all registered investment advisers, not just private funds, have to document their annual review in writing.
Commissioner Peirce, as expected, was against the rule. She sees it as a diversion of resources by the SEC away from retail investor protection. Further she says that maybe the SEC needs to re-think whether there is any reason to keep private placements away from retail investors if the SEC is going to impose retail-like requirements on private investments.
Chair Gensler along with Commissioner Lee and Crenshaw were all in favor of the proposed rule. They all piled on the idea that private funds are a large and growing segment of the investment industry. Of course if investors were unhappy with private funds they would not be investing in private funds and they would not be a large and growing segment of the investment industry.
Calculating fund fees during the commitment period is usually easy for most private equity funds. Take the committed capital and multiply it by the applicable fee percentage. After the commitment period, the calculation often gets more complicated. Most funds have some reduction to actual capital deployed with deductions for write-downs and partial realizations.
Global Infrastructure Management got the calculation wrong for its funds. Part of the problem was an inconsistency between the funds’ PPMs and the funds’ partnership agreement in how to treat partial realizations. The PPMs stated the post-commitment management fee would be based on the capital contributions relating to the retained portion of investments. The partnership agreements said the fee would be calculated based on each limited partner’s capital contribution that was used to acquire an investment, and thus a partial disposition of the investment would not reduce management fees.
Global followed the partnership agreement and didn’t reduce the fee for partial dispositions. Unfortunately, Global employees appeared to have also told some investors that it would reduce and others that it wouldn’t.
It seems clear that the SEC view is that inconsistency works against the fund manager. The SEC made Global rebate fees back to investors based on the partial realization language in the PPMs. Fund managers need to prove that they are entitled to the fees and are may be cut short by inconsistent language.
I assume some compliance officers often get involved in their firm’s retirement plans. If so, you may want to take a look at a decision last week by the US Supreme Court: Hughes v. Northwestern University. The case is a lawsuit by employees of Northwestern against the school and trustees of the school’s retirement plans. This is one of hundreds of lawsuits against big retirement plans for being mis-managed. Since it’s a non-profit, Northwestern’s plans are not traditional 401ks, but the same standards apply to its plans as to Beacon’s 401k.
The employees claimed that Northwestern and the plan fiduciaries violated their duty of prudence by, among other things, offering needlessly expensive investment options and paying excessive recordkeeping fees.
The Northwestern plans have many options for employees to chose among. Many, many, many options. The plans had over 400 investment options during the time period. Some of those 400 investment options were low-cost index funds. Some were high-cost retail class funds.
The plan used revenue-sharing to plan expense, a completely acceptable way to pay record-keeping expenses and other costs. The funds pay some of the management fee back to the plan and the plan pays the fund administration costs with those fees. As you might expect, low cost index funds usually don’t pay a fee back to the plan and the higher cost funds pay more back to the plan.
Northwestern’s defense was that it “had provided an adequate array of choices, including the types of funds plaintiffs wanted (low-cost index funds).”
The Supreme Court ruled for the employees
“[E]ven in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan’s menu of options. If the fiduciaries fail to remove an imprudent investment from the plan within a reasonable time, they breach their duty.”
The case makes it clear that retirement plan sponsors have a duty to protect employees from making poor investment choices by monitoring and removing those poor choices from the plan menu. Just adding more good options does not make up for leaving bad options in the plan.
The EXAMS staff breaks their problematic observations into four broad categories:
failure to act consistently with disclosures;
use of misleading disclosures regarding performance and marketing;
due diligence failures relating to investments or service providers; and
use of potentially misleading “hedge clauses
Disclosures
The staff found fund managers not getting consent from their LPACs when required by the fund documents. That seems like a poor choice by those fund managers.
Fund managers were not getting the management fee calculations right during the post-commitment period. Sure, commitment period is easy, just the percentage against the commitment. Post-commitment you typically have to deal with equity invested calculations, impairments and partial sales.
Some funds were diverting from their designated strategy. I see this issue pop up during long term funds. The world ends up in a different place than when the fund originated. You still need to stay within the guard rails.
Marketing Performance
Fund managers like to think they are a unique flower and benchmarks don’t apply to them and their performance needs to be shown in a special way. (That is true.) The problem is stepping over the line and showing it in a misleading way. The Risk Alert points out failures in calculations by using the wrong dates, cherry picking, omitting information on leverage, and not including fees. This is a continuing problem with private funds. It’s been raised by the SEC many times and the SEC is raising the issue again. I don’t think the new Marketing Rule went into enough detail on what the SEC wants.
Due Diligence
“A reasonable belief that investment advice is in the best interest of a client also requires that an adviser conduct a reasonable investigation into the investment that is sufficient to ensure that the adviser is not basing its advice on materially inaccurate or incomplete information.”
Hedge Clauses
The EXAMS staff observed private fund advisers that had included hedge clauses in fund documents that waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud. That could violate Section 206(1) and section 206(2) of the Advisers Act. You can’t contract away your fiduciary obligations.
On Wednesday February 9 the SEC has a full agenda for its meeting and fund managers should pay attention. Here are the matters to be considered:
The Commission will consider whether to propose rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) for private fund advisers and whether to propose amendments to the compliance rule under the Advisers Act.
The Commission will consider whether to propose new rules to address cybersecurity risk management for investment advisers and investment companies as well as related amendments to certain rules regarding adviser and fund disclosures under the Investment Advisers Act of 1940 and the Investment Company Act of 1940.
The Commission will consider whether to propose rules and rule amendments under the Securities Exchange Act of 1934 to shorten the standard settlement cycle for most securities transactions. The proposed rules and rule amendments would be applicable to broker-dealers and certain clearing agencies. The Commission also will consider whether to propose rule amendments under the Investment Advisers Act of 1940 to require investment advisers to maintain certain related records.
The Commission will consider whether to propose amendments to its whistleblower rules.
I wonder whether fund investors have enough transparency with respect to these fees. I wonder whether limited partners have the consistent, comparable information they need to make informed investment decisions. … That’s why I have asked the staff to consider what recommendations they could make to bring greater transparency to fee arrangements.
I’m going to guess that the SEC is going to propose some kind of standard fee disclosure table for private funds like there is in registered funds.
Next, I’d like to discuss the broader group of financial sector registrants, like investment companies, investment advisers, and broker-dealers, beyond those covered by Reg SCI.
As I mentioned earlier, this group has to comply with various rules that may implicate their cybersecurity practices, such as books-and-records, compliance, and business continuity regulations. Building upon that, I’ve asked staff to make recommendations for the Commission’s consideration around how to strengthen financial sector registrants’ cybersecurity hygiene and incident reporting, taking into consideration guidance issued by CISA [Cybersecurity and Infrastructure Security Agency] and others.
I’m guessing we will see an expansion of cybersecurity requirements and reporting of cyber incidents to clients and investors.
It’s been a decade since the SEC and FSOC pushed Form PF on to private funds. The SEC has decided it wants more data and has proposed an amendment to Form PF.
The big change is next day reporting for key events by Large Hedge Fund Advisers and Private Equity Funds
For large Hedge Funds:
certain extraordinary investment losses
significant margin and counterparty default events,
material changes in prime broker relationships,
changes in unencumbered cash,
operations events, and
events associated with withdrawals and redemptions
For Private Equity Funds:
execution of adviser-led secondary transactions,
implementation of general partner or limited partner clawbacks,
removal of a fund’s general partner,
termination of a fund’s investment period, or
termination of a fund.
The purpose is provide more timely information to the SEC and FSOC and presumably signal distress in the markets quicker than the current delayed reporting.
Commissioner Pierce opposed the changes. She does not think it will actually provide useful information for FSOC. She thinks it’s just a grab by the SEC to enhance enforcement activity and twist the form into micro-management by the SEC. In particular, the one-day period is an incredibly short term for a firm that will likely be focused on trying to resolve issues rather than regulatory reporting.
Chair Gensler raised the specter of Long Term Capital Management in 1998. He used this as the boogeyman for why the SEC needs such intensive and quick reporting.
Net assets managed by private funds rose to $11.7 trillion in the first quarter of last year from $5.3 trillion in 2013, SEC data show. There were 6,910 private equity funds with $1.60 trillion in gross assets in first quarter of 2013 and 15,584 funds with $4.71 trillion in gross assets in the fourth quarter of 2020.
The proposal would reduce the threshold that triggers reporting as a large private-equity adviser to $1.5 billion from $2 billion in assets under management. That would pull approximately 75% of private equity funds into the reporting regime.
The Form PF still has that clunky definition of a “hedge fund” that leaves fund managers with subscription credit facilities wondering if they might considered a hedge fund.
