SEC to continue focus on managers, private funds

On track to beat last year's enforcement record and heading into a new fiscal year with possibly more staff and resources, officials at the Securities and Exchange Commission's enforcement division plan to keep focusing on investment advisers and private funds.

Some clues to future enforcement actions in fiscal 2017, or at least in the four months until the new administration takes over, come from the SEC's office of compliance inspections and examinations, where enforcement referrals often start. Exam officials have a new office for risk and strategy aimed at streamlining risk assessment, market surveillance and quantitative analysis. They also have been reassigning broker-dealer examiners and bringing in more examiners to look at investment advisers and companies both retail and institutional. That net gain of 100 more examiners by the end of this calendar year could ultimately double the current examination rate of 10% of money managers, who cover 30% of assets under management, Commissioner Kara Stein estimated at the Investment Adviser Association's compliance conference in March.

“They are being really smart about using the resources they have,” said Robert Grohowski, general counsel of the Investment Adviser Association, Washington. Both examination and enforcement divisions “have gotten more sophisticated.”

The SEC is on track to beat its fiscal year 2015 enforcement record of 807 actions, and the numbers could rise even further in fiscal year 2017, which begins Oct. 1, given the enforcement division's request for 53 new positions and a $543 million budget that is up 6% from 2016 and 12% from 2015.

Part of that money, the agency said, will go to litigating an increasing number of contested cases and to more sophisticated technology for market and data analysis. SEC enforcement officials also want to reduce the time — now averaging two years — between opening an investigation and bringing an enforcement action. They will also continue to tweak the aberrational performance data initiative that uses proprietary risk analytics to evaluate private fund returns that appear to have abnormal performance in order to help spot possible insider trading or other indicators of violations.

Discussing private equity enforcement in San Francisco in May, Enforcement Director Andrew Ceresney talked about how the OCIE's private fund unit collaborated with his division's asset management unit, leading to eight enforcement actions against private equity advisers, including Blackstone Group and KKR & Co., “with more to come,” he promised. “The message should be clear: we have the expertise and will continue to aggressively bring impactful cases in this space.”

Registered investment advisers and private funds should expect SEC enforcers to keep focusing on valuations, conflicts of interests, governance, and how fees and expenses are allocated. “They're going to continue looking hard at fees and expenses,” said Jon Eisenberg, a partner with law firm K&L Gates LLP in Washington, who expects the “overwhelming focus” to be on conflicts of interests.

“It is clear that they are continuing to make inroads on the subject of disclosure and fee management,” said Claudius Sokenu, a partner in law firm Shearman & Sterling LLP's litigation practice in New York. “The message the government is sending is: Are people managing people's money in the way they told them when they took the money? Are you doing what you said you were going to do?”

One potential new worry for private equity firms came in June, when the SEC settled with private equity firm Blackstreet Capital Management for engaging in brokerage activity related to the acquisition and disposition of portfolio companies without registering as a broker-dealer. The action surprised many observers, who think it might revive the debate over having private equity firms register as broker-dealers when transaction-based compensation is involved.

Despite the enforcement budget gains the SEC is seeking, some asset managers are bracing for the SEC to act on the idea of requiring third-party compliance reviews, to help boost examination efforts. Another possibility is amending the ADV forms money managers file, to give regulators more information about portfolio assets. ”They want to get more granular information about the holdings in separate accounts,” said Mr. Grohowski of IAA.

The SEC might get another chance at pursuing insider trading cases, after a 2015 setback when the Supreme Court declined to revisit an overturned decision against hedge fund managers Todd Newman and Anthony Chiasson. The Supreme Court will hear arguments in Salman vs. U.S., which addresses the level of proof needed for insider trading cases, on Oct. 5. In a merits brief filed in August, the federal government called for a broader standard for insider trading challenges that would enable more cases to be brought.

Another legal question that may or may not have been settled recently is the SEC's favored practice of using in-house judges instead of going through federal courts. On Aug. 9, the U.S. Court of Appeals in Washington upheld the practice on constitutional grounds, making it the first circuit court to do so. “I think it would reinforce the commission's inclination. It's not clear that the D.C. circuit will be the last word on the issue,” said Mr. Eisenberg of K&L Gates.

Despite recent amendments to in-house court rules of practice meant to address critics, legal experts like Thomas Gorman, with Dorsey & Whitney LLP law firm in Washington, think the administrative law judge challenges will continue. “Selecting an administrative forum significantly increases the prospects of a loss for anyone charged while significantly truncating their ability to defend the action. In view of the stakes, I think this will continue to be an issue.”

Bigger changes will come after the elections, when the incoming party will start with the ability to create a majority on the commission, given the two vacant commission seats and the likely departure of Chairwoman Mary Jo White, if tradition holds.

As the U.S. prepares to change administrations, more key staff changes are on the horizon, including the enforcement director who is appointed by the chair. “I think there would be a dramatic change in the direction of the commission right off the bat,” said Richard Marshall, a partner at law firm Katten Muchin Rosenman LLP in New York, and a former SEC enforcement branch chief. “I would imagine the new president putting a very strong stamp on the commission.” n