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July 6, 2020

Key Take-Aways from OCIE's Recent Alert on Compliance Issues Observed in Examinations of Private Fund Managers


On June 23rd, the Office of Compliance Inspections and Examinations (OCIE) of the Securities and Exchange Commission (the SEC or Commission) released its findings of frequent compliance issues observed by OCIE staff in its regular examinations of registered investment advisers that serve as managers to private funds, including private equity and hedge funds (the Alert).1 OCIE staff highlighted that the issues identified in their examinations of private funds have broad implications for investors, given that more than 36% of SEC-registered investment advisers act as managers to one or more private funds.2 These issues, if not proactively considered and addressed, can lead to enforcement referrals stemming from an OCIE exam. Consequently, registered investment advisers should consider their compliance and surveillance processes and procedures in light of these issues, and take affirmative steps to determine whether enhancements should be implemented.

The Alert indicates that OCIE has found that some managers of private funds still fail to have (i) adequately detailed policies and procedures relating to material non-public information (MNPI), (ii) policies and disclosures that, while adequate on their face, accurately correspond to the private fund manager's practices, or (iii) adequate disclosures that provide investors in private funds with knowledge of potential conflicts (such as potential capital stacking or preferential liquidity rights conflicts). OCIE has routinely focused on these areas, which have been previously cited as deficiencies in prior SEC guidance and statements.3 Many of these areas have also been the subject of enforcement actions.4Indeed, almost a third of all of the SEC's enforcement actions with monetary settlements in 2019 were from its Share Class Selection Initiative, a program that began in February 2018, under which investment advisers were encouraged to self-report failures to disclose fees received from certain classes of mutual funds and the resulting conflicts of interest when these funds were recommended by the investment advisers.5

While the Share Class Selection Initiative focused on retail investors, here, the emphasis is on private fund investors. This group typically includes family offices, high-net-worth investors and government and private pension plans (and their beneficiaries).6 The themes, though, remain the same, and so does the focus on deficiencies that could result in the overcharging of fees and expenses and the failure to make pre-commitment disclosures of conflicts of interest, which could negatively impact private fund investors, given the long lock-ups and illiquidity that characterize most private equity funds and certain illiquid hedge fund "side-pockets."

These issues warrant attention. In 2019, OCIE made more than 150 enforcement referrals, and enforcement actions resulting from OCIE referrals included, among other things, settled actions against advisers to private funds.7

Adequacy of Policies and Procedures Related to MNPI

One area of noncompliance highlighted by OCIE was the failure by some managers to have written policies and procedures in place to prevent the misuse of MNPI, which is required by Section 204A under the Investment Advisers Act of 1940, as amended (the Advisers Act). The SEC generally interprets Section 204A to require that managers have written policies and procedures in place to detect and isolate instances where the manager comes into possession of MNPI by virtue of its employees' access to MNPI (for instance, through a board or observer seat of a public company) or as a result of such firm's diligence activities (for example, through expert networks or value-added investors).8 Firms are required to have these policies in place in order to ensure that they are not trading in public securities on the basis of potential MNPI.

Even though these requirements are not new, the Commission has signaled that they remain a high enforcement priority. For example, the Commission recently charged Ares Management LLC (Ares) for failing to implement and enforce its policies and procedures designed to prevent the misuse of MNPI.9 Specifically, without admitting or denying the Commission's findings, Ares consented to a settled order in which the Commission found, among other things, that Ares failed to enforce its policies and procedures governing employees who served as directors of portfolio companies and had access to MNPI at a time when Ares was actively purchasing common stock of those same companies in the open market.

The Commission's order charging a failure to enforce information controls is significant, including because the Commission made no finding of an underlying violation of law. For example, the Commission made no finding that Ares actually misused MNPI or engaged in insider trading. Indeed, the Commission seemed to recognize that Ares' written policies and procedures related to the handling of MNPI were reasonably designed. The Commission, however, faulted Ares for not adequately implementing and enforcing those policies and procedures. According to the SEC, Ares' compliance officers failed to perform a sufficient investigation into whether the investment committee's decision to purchase common stock in the open market was based on MNPI.

The Ares consent order appears to be a "message" case addressed to the market. Particularly in the private equity and hedge fund spaces, service on a board of directors is a regular occurrence. These firms are thus at heightened risk that OCIE examiners could question whether, notwithstanding the existence of reasonably designed policies and procedures, the firm's process for determining whether MNPI was misused was deficient. The Ares settlement demonstrates that even managers with well-developed and established compliance programs and policies may encounter difficulties in meeting the SEC's expectations related to the thoroughness with which such conflicts and other concerns are investigated and documented. For example, in the Ares matter, the SEC deemed confirmations by key executives that they did not have any MNPI to be insufficient to evidence that the firm was not in possession of MNPI.10

Adequacy of Other Documentation

Similarly, the Alert cites to other deficiencies that include both a substantive conflict and an inadequate documentation component. For example, OCIE cited frequent failures by private fund advisers fairly and equitably to allocate investment opportunities. OCIE identified substantive failures–for instance, private fund advisers allocating investment opportunities to higher fee-paying clients or to proprietary accounts rather than to other clients. Moreover, in addition to those substantive failures, OCIE also identified corresponding documentation failures–for example, the failure to document that such allocations were consistent with existing allocations policies or disclosure or otherwise conducted equitably or with client consent. Among other missteps, documentation failures can also arise where advisers fail to maintain restricted lists for employee and firm transactions under Advisers Act Rule 204A-1 (the Code of Ethics Rule) and where advisers fail to maintain proper lists of access persons of their firms.

Coordination of Disclosures and Business Practices

The Alert also reminds advisers that they should regularly review and, as needed, synch their disclosures to prospective and existing investors with their current business practices. The Alert notes a significant number of substantive conflicts areas where advisers failed to have adequate disclosure or where advisers may have had existing disclosure but such disclosure failed to match their existing business practices. OCIE found examples of inadequate disclosure in areas ranging from failures to disclose that multiple clients (i.e., funds) invested in different portions of the same portfolio company's capital stack (which created the potential for conflict among such clients in how the portfolio investment was managed) to instances where the adviser had favorable financial relationships with certain investors that might create incentives to provide such investors with favorable treatment (such as to seed investors of the adviser) or had inadequate disclosures related to favorable liquidity rights (including rights granted pursuant to private fund side letters with investors) that were not disclosed to existing investors without such rights.

Disclosures Related to Conflicts of Interest

OCIE also identified inadequate disclosure related to fund restructurings, valuation of the fund interests being sold or transferred pursuant to "stapled secondaries," and co-investment opportunities. Given the economic uncertainty that seems likely to continue in light of COVID-19, OCIE's identification of inadequate disclosures related to those matters should provide managers with a heads-up to the extent they seek to utilize restructuring or capital-raising techniques with respect to or alongside their existing private funds. It appears that OCIE staff will look vigilantly to ensure that managers treat their existing private fund investors fairly and in-line with existing disclosures when restructuring an end-of-life fund or seeking to raise additional capital through one or more co-investment vehicles.

OCIE also highlighted, in particular, instances where managers may have failed to make any, or adequate, disclosures where they had a financial interest that created a conflict with existing clients. The Alert notes that advisers often have trouble matching their expense practices with their existing disclosure, as well as identifying situations where broken-deal, due diligence and other shared expenses were over-allocated to certain funds. The Alert also raises concerns over funds bearing expenses that should have been borne by the manager, including because such expenses were not fairly disclosed as fund expenses or because such expenses exceeded caps in the relevant fund's offering documents. OCIE also stated that some managers failed to comply with their disclosures regarding certain fee offsets related to monitoring and directors fees. These failures resulted in those managers providing credits to certain clients not entitled to credits (e.g., non-fee-paying accounts) or in managers' failures to properly credit clients with reductions of management fees for fee offsets altogether.

Finally, OCIE noted that some advisers continue to fail to adequately disclose certain proprietary financial interests or relationships with third parties. These failures include situations where managers fail to fully disclose arrangements involving private fund portfolio companies and service providers in which the adviser has financial interests distinct from the investing fund or situations involving an adviser's use of operating partners with respect to services provided to private funds or their portfolio companies, which may have the effect of causing the private fund or portfolio company to bear the expense of such operating partner in a manner that benefits the adviser. Full and adequate disclosure of any financial conflict involving the adviser and its clients will continue to be imperative for the SEC staff.

Some Lessons Learned

The frequency and varied nature of these policy and disclosure deficiencies identified by OCIE should serve as a reminder to private fund advisers that they should evaluate or establish a periodic process in which they regularly review their business practices in light of their existing disclosures and policies. Annual compliance testing under Rule 206(4)-7 (the Compliance Rule) also remains a key opportunity for advisers to make sure that their policies and control processes for addressing frequently reviewed areas for conflicts, such as valuations, investment allocations and allocations of fees and expenses, are functioning as envisioned.

The SEC will charge violations of the information controls provisions of the Advisers Act and violations of the Compliance Rule even where it finds no underlying violations of law. This should motivate advisers to review their policies and procedures regarding compliance with Rule 204A (regarding misuse of information) and the Compliance Rule, in particular. Demonstrating that they have appropriate control frameworks in these areas will help to ensure that private fund managers can be sufficiently responsive not only to OCIE examinations but also to limited partner questions regarding operational processes for dealing with conflicts of interest.

While not necessarily breaking new ground, the Alert continues to put private fund managers on notice that OCIE will continue to focus on these evergreen areas of conflicts, and related disclosures, as they continue their examination focus on private funds. As private funds continue to comprise a significant segment of the alternatives market, the SEC's scrutiny of private fund managers and their practices is likely to grow in intensity.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.

  1. Office of Compliance Inspections and Examinations, Risk Alert: Observations from Examinations of Investment Advisers Managing Private Funds (June 23, 2020) (Alert).

  2. Id. at 1.

  3. Speech, Andrew J. Bowden, Office of Compliance Inspections and Examinations, Spreading Sunshine in Private Equity (May 6, 2014).

  4. In the Matter of Kohlberg Kravis Roberts & Co., L.P., Advisers Act Release No. 4131 (June 29, 2015); In the Matter of First Reserve Mgmt., L.P., Advisers Act Release No. 4529 (Sept. 14, 2016).

  5. Division of Enforcement, 2019 Annual Report (Nov. 6, 2019).

  6. Office of Compliance Inspections and Examinations, 2020 Examination Priorities (Jan. 7, 2020) at 16.

  7. Id.

  8. Alert at 6.

  9. In the Matter of Ares Mgmt. LLC, Advisers Act Release No. 5510 (May 26, 2020).

  10. Id. at 7.