By Jennifer Dickinson, Senior Managing Director, U.S.
2022 will go down as a record year in the world of investment adviser compliance in the U.S.
- Civil penalties in 2022 were the highest in SEC history, at $4.194 billion
- Total money ordered (including civil penalties, disgorgement and pre-judgment interest), too, was the highest on record, totaling $6.439 billion (almost double the total in fiscal year 2021)
- 2022 was also the second biggest on record in terms of whistleblower awards, both in terms of the number of individuals and the total dollars awarded
Of the 760 enforcement actions and 20+ rules proposed in 2022, much of it was aimed at investment advisers – particularly those that manage private funds.
This article serves as a digest of key regulatory takeaways from 2022, which advisers can glean from to improve their compliance programs.
Recordkeeping and electronic communication
Few enforcement cases shook the industry as much as the SEC’s actions against a big-name broker-dealer, 15 other broker-dealers and one investment adviser. These firms were charged with failing to maintain business-related text and/or instant messages that were transmitted on employees’ personal devices. In total, the firms paid $1.235 billion in penalties.
None of these cases involved underlying violations or investor harm, highlighting the importance of these records to the SEC’s regulatory mission.
However, financial firms are left to wonder how they can effectively ensure that their employees never use unarchived messaging platforms. And in the venture capital and private equity spaces in particular, frustration is high as some portfolio company founders and savvy investors simply refuse to use traditional email and prefer the latest in instant messaging platforms.
Given the high stakes, it is important to educate employees on the firm’s recordkeeping and communication policies. Compliance teams also need to keep up with new messaging technologies and inquire as to what employees are using.
Compliance teams can issue certification forms for employees to acknowledge their understanding of the firm’s recordkeeping and electronic communications policies.
Some firms are also implementing sanctions, such as fines that are donated to charity, to address violations.
Pay to play
The SEC’s “pay to play” rule is intended to ensure that public entities select investment advisers on their merits, not under the influence of political contributions. Since the rule was adopted in 2010, there have been multiple enforcement cases, but the four in 2022 were particularly notable, given that:
- In all cases, the contributions were $1,000 or less
- Two of the cases were connected to public university systems’ board of regents
- Three of the firms were exempt reporting advisers, which are specifically scoped into the rule
- The connection between the officials to whom contributions were made and the group responsible for selecting the investment advisers was tenuous. For example, in one of the cases, an employee made a contribution to an unsuccessful candidate running for governor of Massachusetts. The governor sits on the board of the state pension system and appoints other board members. Collectively, this board selects investment advisers and fund managers
- Most of the violations were connected to existing clients or fund investors and did not involve soliciting new or additional business from public entities
One SEC commissioner, noting that the rule is a “blunt instrument,” also questioned the pursuit of these cases, given that there was no actual quid pro quo (i.e. political contributions in exchange for advisory services or investing in a fund). The statement concluded that pursuing such cases “does more harm than good.”
These cases highlight the “strict liability” nature of the rule. We encourage firms to revisit their policies and procedures to make sure they are tracking employees’ contributions and monitoring connections to clients and fund investors.
ESG and greenwashing
As environmental, social and governance (ESG) concerns continue to trend, the SEC has focused on investment products and strategies that claim to have an ESG component. In particular, concern is over the materiality of ESG considerations to the product(s) in question, accuracy of disclosures, and fulfillment of fiduciary duty.
- In May 2022, the SEC charged an adviser to mutual funds for making materially misleading statements and omissions about its consideration of ESG factors. Representations and implications were made to the effect that all investments in the funds had gone through an ESG quality review and received a score. However, the SEC found that this wasn’t the case. The firm agreed to pay a $1.5 million penalty
- In February 2022, the SEC charged a robo-adviser that marketed its advisory services as compliant with Shari’ah law. Among other things, the firm touted its income purification process on its website, but did not actually implement written policies and procedures to assess Shari’ah compliance on an ongoing basis
Whether a firm actively markets an ESG strategy, or otherwise factors in ESG-like considerations when managing portfolios, they should revisit their marketing materials, disclosures and policies to ensure that all are aligned.
Firms need to remember that the onus is on them to prove to the SEC that they are following their policies and adhering to their stated investment strategies.
Firms should also monitor the SEC’s rule proposal, which will codify its expectations in this area.
The Custody Rule
The SEC continues to actively enforce the Custody Rule. In 2022, charges were filed against nine registered private fund advisers, eight of which substantively violated the rule by failing to issue audited financial statements within the required timeframe. Of these firms, six did not change their “report not yet received” response in Form ADV, Part 1A, Schedule D, Section 7.B.23.(h) once the audits were complete.
Of note, one case did not involve any substantive custody rule violation and was solely about the failure to update Form ADV.
While fund managers should diligently proceed with their audits in a timely manner, it is also important to make sure the ADV is completely accurate with respect to the custody-related questions. Firms that are filing before audits are received should conduct calendar check-ins with their finance teams to ensure that audits are received and the ADV is updated.
Another development to watch is the component of the proposed private fund reforms that would close off the surprise verification route to compliance with the Custody Rule. If adopted, it will impact firms that rely on this as a more efficient and cost-effective alternative to auditing their SPVs.
Enforcement of Reg BI
In the SEC’s first action enforcing Regulation Best Interest (Reg BI), a broker-dealer and five of its representatives were charged with violating their obligations under the regulation that took effect in June 2020. They recommended and sold unrated, high-risk debt instruments (known as L Bonds) to retail investors, many of whom were retirees on fixed incomes. The SEC alleged that the respondents did not conduct appropriate due diligence, suitability inquiries or adequately factor in their clients’ risk tolerances. The case is pending in a Southern California federal court.
Advisers should ensure they are considering all of a client’s circumstances when making investment recommendations and decisions. In particular, the SEC will examine firms on each of the three components of fiduciary duty: care, good faith and loyalty.
Firms should also revisit the SEC’s August 2, 2022 Staff Bulletin: Standards of Conduct for Broker-Dealers and Investment Advisers Conflicts of Interest. It highlights the importance of periodic review and testing of policies from a conflicts of interest perspective.
Fees and expenses
Fees and expenses continue to be an active enforcement area, with violations ranging from the overcharging of management fees, to the now-classic scenario of disproportionate allocation of expenses to the main fund for the benefit of co-investors.
In one action, the SEC charged a registered investment adviser for failing to properly offset management fees charged to three private equity funds it managed, and for making misleading statements to investors in those funds.
In this case, all three funds had provisions in their governing documents stating that certain portfolio company fees paid to the adviser were subject to a fund-level offset against management fees. Moreover, two of the funds had inconsistencies in their documents relating to the management fee calculation. In both cases, the private placement memorandums stated that a partial disposition of a portfolio company would reduce the management fee, while the amended and restated limited partnership agreements (LPAs) said that such a transaction would not reduce the management fee.
Firms must ensure that their funds’ governing documents reflect their desired terms, and that a given fund’s documents are internally consistent. And, in addition to the unique lessons of each enforcement case, there is a clear need for firms, whether registered or not, to periodically review and test their financial controls
Conflicts of interest
The SEC charged a real estate fund manager and its principals for failing to disclose conflicts of interest associated with certain of the funds’ investments. The fund manager was part of a larger organization that included other real estate-related businesses, all of which were owned by the same parent company. For nearly two years, the respondents caused the funds to invest in projects involving some of these affiliates. While the affiliated projects were technically within the funds’ investable universe, the SEC found that they invested almost exclusively in these affiliated projects and conflicts of interest were not disclosed to the funds’ investors. For example, some of the deals had questionable valuations, off-market terms or otherwise benefitted the affiliate more than they did the fund. Finally, these deals resulted in undisclosed compensation to the participating affiliates.
Another notable case was against a pair of exempt reporting advisers. For more than three years, the advisers and their principal caused some of their venture capital funds to make loans, totaling over $4.4 million, to affiliated entities and other funds that the firms managed. The SEC determined that the loans were not authorized by the funds’ governing documents, no disclosures were made to the lending funds’ investors and the respondents failed to conduct any assessment of whether the loans were in the funds’ best interest.
Whether registered or exempt, the SEC expects advisers to strictly adhere to fiduciary principles when making investment decisions. In the first case, the fact that the projects were within the funds’ strategies did not matter much since the conflicts were overwhelming. The latter case shows that firms should be wary of any related-party loans. Compliance and finance teams need to scrutinize and proposed loans, and conduct regular reviews of these activities.
This year will inevitably bring more regulatory excitement as proposed rules become final, exams on the amended Marketing Rule unfold (and updates are made to the FAQ), investment trends evolve and market conditions play out.