In a panel discussion during the Stout Summit: Investment Funds and Alternative Assets 2023, Joel Cohen, Managing Director in Stout’s Disputes, Claims, & Investigations group and New York Regional Leader, led a discussion on the current state of regulation, enforcement, and litigation as it relates to private funds. The panelists included:

• Jaclyn Grodin, Counsel, Goulston & Storrs
• Carmen Lawrence, Partner, King & Spalding
• Colleen Kilfoyle, Managing Director and Head of Litigation, Sculptor Capital

This discussion has been edited for length and clarity.

Jaclyn: Many may not be accustomed to the level of oversight that the SEC is about to impose on private funds. The risk alert and examination priorities are all-encompassing. It’s crucial for everyone to get on board, even if it’s different from how things used to be done when launching and managing private equity funds or other investment vehicles.

The reality is that the SEC is here, it’s coming, and there will be more rule making, exam activity, and enforcement proceedings. A robust compliance program, including mock exams and internal audits, is essential. While there might be cost constraints, firms should be creative in finding effective solutions for their specific needs. This reality is likely to intensify over the next couple of years unless there’s a change in administration.

Joel: What are major enforcement matters from the past year?

Carmen: Regarding enforcement, we haven’t seen the year-end results yet, but we can anticipate some high-profile issues based on the SEC’s focus. These include fees and expenses, conflicts of interest, and valuation. Enforcement sweeps have also been a notable trend, such as the off-channel communication sweep and the marketing rule sweeps.

Let’s briefly discuss a couple of cases. The first one is the Energy Capital Partners matter, which involved undisclosed and disproportionate expenses allocated to a private equity fund. Energy Capital failed to have reasonable policies and procedures in place to prevent such an occurrence. They agreed that a third-party co-investor didn’t have to cover expenses associated with a specific transaction, but instead of absorbing the cost, they allocated an unfair share of those expenses to the private equity fund without disclosure or consent. This violation resulted in a cease-and-desist order, a million-dollar penalty, and a $3.3 million repayment to the fund—a straightforward case commonly seen.

The second case involves Inside Venture Management and excessive management fees. They lacked written policies and procedures for determining impairment of a portfolio. The partnership agreement allowed the advisor to charge management fees based on the fund’s investment capital and individual portfolio investments, but it required fee reductions when impairment was identified. The issue arose because there were no clear written guidelines for determining impairment, relying on subjective criteria. Given the conflict of interest—fee reduction upon impairment discovery—the SEC found them motivated not to recognize impairment when it occurred.

As a result, they found that there needed to be more objective criteria in place. There should have been written policies around the determination and disclosure of the impairment policy to investors. In this case, there was a Cease-and-Desist order, an $865,000 disgorgement, and a $1.5 million penalty. When they conducted a revised impairment review, the advisor had to repay $3.8 million to the portfolio company.

Whenever there’s impairment tied to a reduction of fees, examiners are delving into the basis for those decisions. Document those decisions when they’re made because if it’s not in writing, according to the SEC, it didn’t happen. While there’s always an element of judgment involved, try to include objective criteria in your determinations.

There’s a case related to conflicts of interest, American Infrastructure Funds. This case emerged toward the end of the fiscal year and is about the failure to disclose accelerated monitoring fees received by the advisor upon the sale of a portfolio company. Once again, conflicts of interest are at the forefront.

Joel: How do you handle enforcement actions?

Colleen: If we find ourselves in a challenging situation, our primary focus is on transparency with our investor base. We ensure they are aware of what’s happening and maintain clarity in our communications, which can help prevent future litigation. While it may lead to redemptions, avoiding lawsuits from our own investors is the priority.

We have a disciplined approach in communicating enforcement actions to the world and our investor base. Our communications are handled by the legal department, and we prepare talking points with mock Q&A sessions. If there are questions from investors, they are routed through our sales team to the legal department for review and drafting before being sent back to investors.

Jaclyn: Being transparent is essential, but the new rules might limit firms’ discretion regarding transparency. When exam-related or investigation-related costs are charged to the fund, the Restricted Activity Rules imposes a new requirement requiring disclosure of the expense to investors within 45 days of the end of the fiscal quarter in which the expense is incurred. From an exam perspective, firms may decide to absorb the cost of the exam if they don’t want to disclose it to investors to prevent raising unnecessary concerns for routine exams. However, from an investigatory perspective, firms might have fewer options and be more constrained in their disclosures. This is something to keep in mind going forward, especially if you historically haven’t disclosed exams to your investors; you may have no choice but to do so in the future.