Why Building and Maintaining Robust Compliance Programs Has Become Increasingly Important for ERAs
Overview of SEC Regulatory Regime
While the Investment Advisers Act of 1940 (the Advisers Act) does not exclude Exempt Reporting Advisers (ERAs) from the U.S. Securities and Exchange Commission (SEC) examination process, the SEC has historically affirmed that it does not “anticipate that [it’s] staff will conduct compliance examination of these advisers on regular basis,” and, instead, would conduct exams based only on indications or suspicions of wrongdoing (so-called “for cause” examinations),1 which could lead (and has led) to enforcement action in appropriate circumstances. While the SEC may change course in the future and commence subjecting ERAs to routine exams (as its staff has hinted at least on one occasion in the past), “for cause” exams continue to remain the norm in the ERA space for the time being.
ERAs (unlike Registered Investment Advisers (RIAs)) are subject to only a handful of provisions under the Advisers Act. The chart below illustrates this concept.
While at first glance this may suggest that ERAs’ fiduciary duty and other GRC obligations may be very light, this is anything but true. As noted in greater detail below, the overwhelming majority of the SEC’s allegations in enforcement actions brought against illiquid fund managers (RIAs and ERAs) over the past few years have focused on allegations of breaches of long-established fiduciary duty concepts applicable to all investment advisers in their dealings with their respective investors (as further codified in the broad anti-fraud provisions set forth in Section 206 of the Advisers Act and Rule 206(4)-82 thereunder). As a result, virtually all of the thematic lessons from SEC enforcement actions brought over the years against RIAs employing illiquid investment strategies are broadly relevant to ERAs in the illiquid fund manager space.
Lessons From an SEC Enforcement Action
The SEC brought an enforcement action against a state-level venture capital ERA with approximately $13.5 million in investor capital commitments for failure to adequately disclose and manage various conflicts-of-interest (including the related failure to implement the controls set forth in the governing documents of a venture capital fund managed by the ERA that are designed to mitigate these very conflicts). Such a tacking of allegations for failure to operationally comply with conflicts resolution provisions in fund governing documents (and/or internal policies and procedures) onto allegations of anti-fraud rule violations arising out of a mishandling of these very same conflicts, has become a staple feature of SEC enforcement actions in the private markets space.
Additionally, the very fact that the SEC was willing to expend resources to take enforcement action against a state-level ERA should signal to all ERAs how serious the SEC is about vigorously taking punitive action against unregistered private markets investment advisers for activities (or lack thereof) that could have a materially detrimental impact on investors’ interests.
The allegations and takeaways from this enforcement action, which should be of wide interest to private markets managers (ERAs and RIAs), are:
- Failure to establish a limited partner advisory committee in accordance with Fund governing documents: The governing and offering documents of the Fund managed by the venture capital (VC) ERA required the fund’s general partner (an affiliate of the VC ERA) to set up a limited partner advisory committee designed to weigh in on transactions involving the fund and/or portfolio companies on the one hand and the VC ERA and its affiliates on the other hand. However, per the SEC’s allegation, this independent committee was not organized for several years into the fund’s lifecycle.
Takeaway: The SEC has repeatedly sanctioned private markets managers (SEC-registered and ERAs) for failure to timely organize and/or adequately involve limited partner advisory committees where required under fund governing documents as the SEC (in line with the industry) views such committees as playing a crucial role, on behalf of investors, in overseeing managers’ handling of conflicts. Also, as noted above, both in SEC exams and enforcement actions, the SEC has taken an increasingly keen interest in ensuring that private markets firms are adequately complying with the economic, conflicts-of-interest resolution, corporate governance, and other key terms set forth in fund governing documents and side letters that impact investors’ interests. As such, to effectively manage, monitor, and document compliance with such contractual obligations, managers should seriously consider using practice-oriented tools (e.g., spreadsheets or software-based tools) designed to assist in this endeavour. In certain SEC exams and enforcement actions, private markets firms have been required to implement such tools.
- Failure to provide investors with audited Fund financial statements as required by Fund governing documents: The governing documents of the fund managed by the VC ERA required the fund’s general partner to provide investors with audited financial statements of the fund on an annual basis. However, as alleged by the SEC, the fund’s general partner never complied with this requirement, thereby denying investors the protections that come with having a fund’s financial statements audited by an independent third-party.
Takeaway: ERAs are not subject to the SEC custody rule that requires RIAs to undertake independent audits of private fund financial statements and deliver the resulting audited financial statements to fund investors. However, given the important protections that come with such independent fund audits, especially in the illiquid fund space, it is very common for investors in such funds to contractually obtain these protections from their investment managers. As evidenced by this enforcement action, the SEC is ready to step in and protector investors where managers fail to comply with such important contractual obligations.
- Failure to disclose conflicts arising from defaults by the founders: In an interesting set of facts, a significant portion of investors in the fund managed by the VC ERA defaulted on capital calls issued by the fund’s general partner. Of particular note, the VC ERA’s founders also partially defaulted on their “skin-in the-game” commitments to the fund. The fund’s governing documents provided the fund’s general partner with “absolute” discretion to protect the fund’s interests by, among other things, demanding payment of the balance due as an interest-bearing loan or forfeiting the defaulting limited partner’s distribution rights. However, as alleged by the SEC, the fund’s general partner chose not to enforce any remedies against any of the defaulting limited partners, which comprised a majority of the investors and included the founders. The SEC’s order found that the decision concerning whether to deem the founders in default presented a conflict of interest that required disclosure to the fund, whether through the non-existent limited partner advisory committee or otherwise. Per the SEC, the conflict “pitted the fund’s interest in receiving its committed capital against [the founders’] interest in avoiding being deemed in default and becoming subject to one or more of the punitive actions enumerated in the fund’s governing documents.
Takeaway: Given the long-term and captive nature of investments in illiquid close-end funds, virtually all outside investors in closed-end funds expect and demand their fund sponsors have adequate “skin-in-the-game” to ensure the economic and other interests of the investment managers and their key persons on the one hand, and those of the outside investors on the other hand, are appropriately aligned. As such, if a fund sponsor (or its key persons) default on one or more of their capital commitments to a closed-end fund, this is an extremely material development for all outside investors in the fund and failure to disclose such a default would be viewed as a fundamental breach of the fund sponsor’s fiduciary duties and a dereliction of its obligations under the Advisers Act’s anti-fraud rules. This enforcement action is a reminder that where fund managers neglect such key duties and obligations, the SEC is willing, from an investor protection standpoint, to vigorously take punitive action against such managers to disincentivize such behavior in the future.
- Failure to adequately disclose and manage conflicts arising from the use of affiliated service provider services: The offering documents of the fund managed by the VC ERA disclosed that the VC ERA, or its affiliates, may provide services to fund portfolio companies for which they will receive compensation at “competitive market rates charged by first-class unaffiliated service providers,” and such services will be disclosed to the fund’s limited partner advisory committee. However, as alleged by the SEC, neither the provision of such services to certain fund portfolio companies by the VC ERA’s controlling persons through a service provider controlled by such persons, nor the fact that such control persons caused the fund to invest in such affiliated service provider were disclosed to the fund’s investors or the fund’s limited partner advisory committee for several years.
Takeaway: The SEC has, on numerous occasions, sanctioned RIAs and ERAs in the private markets space for failure to adequately disclose and implement controls around the use of affiliated service providers, even when no damage to investors may have occurred – either privately via the examination process or publicly via the enforcement process. This is a reflection of the SEC’s view that such arrangements inherently involve material conflicts (i.e., self-dealing risks). To effectively manage regulatory risks, firms should disclose such arrangements to all investors as early as possible. Given the long-term and captive nature of investments in closed-end funds (where investors may be at the mercy of their managers for over a decade), the SEC seems to strongly prefer that conflicts be disclosed to investors prior to their investment in the applicable fund(s) whenever feasible.
Additionally, to the extent an affiliated service provider arrangement was not contemplated prior to the launch of a closed-end fund, based on ACA’s SEC examination experience, seeking the informed consent of the fund’s limited partner advisory committee, and meaningfully disclosing key aspects of such an arrangement (including, but not limited to, proposed fees) to all fund investors prior to implementation, will be especially important.
Further, prior to retaining an affiliated service provider and periodically thereafter, managers should conduct surveys in the relevant markets to determine what comparable quality independent third-party vendors charge for similar services and factor the results of such surveys in setting and periodically adjusting the compensation to be received by their affiliated service providers. Such survey results should, at a minimum, be disclosed to the applicable fund’s LP advisory committee to ensure their consent to/review of affiliated service provider usage is meaningful and informed. Evidence of undertaking such surveys is frequently requested in SEC exams to verify that affiliated service arrangements are being undertaken on an arms-length basis. Additionally, even where firms appear to have, as a matter of practice, undertaken all the right steps to effectively manage conflicts relating to the use of an affiliated service provider, in numerous exams, the SEC has pushed such managers to formally adopt policies and procedures to ensure consistency in approach over the duration of the conflict as well as to facilitate testing adherence to such policies and procedures on a retroactive basis.
Finally, to the extent a manager’s affiliated service provider seeks to receive higher than market rates under the argument the affiliate is seeking to provide white glove services and/or services that are not fully available in the relevant markets (such that a pure apples to apples comparison is not possible), the justification for such premium pricing should be adequately documented and disclosed.
As fiduciaries that may be subject to SEC inspection (and that are being increasingly subject to SEC enforcement action), ERAs should consider adopting compliance policies and procedures relevant to their operations to mitigate regulatory risks. Similar to compliance programs for comparable SEC-registered advisers, these policies and procedures should be designed to prevent violations from occurring, detect and document violations that have occurred, and promptly address any violations that have occurred.
How we help
Whether operating as an ERA or an RIA, ACA has a range of services that can help a venture capital firm develop and maintain an effective compliance program.
- Compliance Program Development and Enhancement
- Compliance Program Reviews, Mock Exams, and Gap Analysis
- SEC Registration, FCA Authorization, and Initial Filing Services
- Compliance Training and Education
If you have any questions about the SEC focus areas, or would like to speak with someone about developing and implementing an effective compliance program, please reach out to your ACA consultant or contact us here.
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