OCIE Warns Private Fund Advisers About Common Compliance Issues

On June 23rd, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert for private fund advisers, including those that manage hedge funds or private equity funds. The report cautioned about common compliance issues that increase fees for investors and put them at risk. OCIE broke these issues down into three categories.

1 – Conflicts of Interest

Private fund advisers are required to disclose potential conflicts of interest to clients and prospective clients so they can make an informed decision about their investments. Throughout their examinations, the OCIE found multiple situations where advisers failed to do so. Some of the common missed disclosures involved:

· Allocations of investments – Some advisers allocated securities or investment opportunities in a preferential or inequitable manner to some clients, without properly disclosing the process to others, or in a manner inconsistent with their disclosures. Similarly, disclosures about the terms of co-investment arrangements were often lacking clarity.

· Financial relationships – Advisers who had economic relationships with some of their investors, like those who offered seed capital or credit facilities, failed to disclose those relationships to the rest of their investors.

· Preferential liquidity rights – Funds did not disclose that they had agreements for preferential liquidity terms with some of their investors.

· Adviser interests in recommended investments – Pre-existing ownership or other financial relationships such as referral fee arrangements were not adequately disclosed.

· Fund restructurings – During fund restructurings, some advisers did not disclose key information that could have impacted investors’ decisions, like the value of the fund interests and investor options.

· Service providers – Disclosures related to the fund’s service providers, including the structure of financial relationships and common ownership were often missing or incomplete.

· Cross-transactions – When organizing cross-transactions between clients, required disclosures, including price advantages or disadvantages between the parties, fell short of full transparency.

2 – Fees and Expenses

OCIE also found that private fund advisers ran into issues with fees and expenses. Common problems in this category involved:

· Allocation of fees and expenses – OCIE found private fund advisers inaccurately calculating fees in ways such as: allocating shared expenses and charging clients for fees that were not allowed (e.g., travel and entertainment) in manners inconsistent with the relevant operating agreements.

· Operating partners – Some advisers failed to properly disclose compensation for operating partners, who were not adviser employees, which could have misled investors about the fund’s expenses.

· Fee offsets – Advisers failed to calculate, disclose or track appropriate fee offsets resulting in overcharged fees.

· Valuation – Certain advisers failed to value assets according to their agreed valuation process, resulting in overcharges of management fees.

3 – Code of Ethics for Material Nonpublic Information (MNPI)

Private fund advisers are required to maintain a code of ethics and have written procedures to prevent the misuse of Material Nonpublic Information (MNPI) and avoid undue influence on investment decisions. Again OCIE found compliance violations in this area.

First, they found that private fund advisers failed to establish and maintain written procedures to prevent the misuse of MNPI. This led to issues such as advisers not addressing the risk of their employees obtaining MNPI by interacting with “insiders” at publicly-traded companies or by access to adviser office systems that held MNPI.

Second, private fund advisers did not have provisions in their codes of ethics to prevent misuse of MNPI. Thus, advisers did not follow trading restrictions for securities on an adviser’s “restricted list”.

Similarly, they did not enforce requirements in their codes of ethics preventing employees from receiving gifts from third parties which may have resulted in inappropriate investments.

OCIE recommends that private fund advisers review their compliance in these areas as they could be a priority for future examinations. For more information, please visit the OCIE’s Risk Report.

It is critical that advisers have the right procedures and monitoring of their compliance. If you have questions about OCIE’s Risk Alert, please contact your Anchin Relationship Partner or Jeffrey Rosenthal at 212-840-3456.