Taking Stock: How the SEC’s Enforcement Priorities and Headwinds May Affect Private Equity in 2018 and Beyond (Cleary Gottlieb Steen & Hamilton LLP)
Under Chair Mary Jo White, the Securities and Exchange Commission took a number of public steps to make it clear that the SEC’s enforcement program had the private equity industry squarely in its sights. From speeches, to the creation of a private equity-oriented taskforce in the Office of Compliance Inspections and Examinations (“OCIE”), to a raft of well-publicized and aggressive enforcement actions, the Chair White-led Commission devoted significant time and resources to policing the industry. During Chair White’s tenure, the SEC filed around a dozen actions against private equity fund managers, including cases alleging that managers had insufficiently disclosed expense allocations, the receipt of certain fees and other alleged conflicts of interest. These actions—the vast majority of which focused on allegedly negligent conduct as opposed to outright fraud—demonstrated that the SEC was focused on ensuring that fund managers disclosed even potential conflicts of interest, even where investors were not clearly harmed, or, indeed, where it was not at all evident that those funds’ LPACs found the conduct at issue particularly troubling.1
Following the 2016 presidential election and the appointment of SEC Chairman Walter “Jay” Clayton, one open question was whether the SEC would shift its focus away from private equity towards other parts of the financial industry with a closer nexus to so-called “mom and pop” investors. While the SEC is unlikely to turn its back entirely on private equity fund managers, the SEC’s priorities combined with a number of headwinds—including two significant legal decisions and resource constraints at the agency—may result in a reduced focus on the sector, at least in the short term.
To be clear, the SEC has by no means abandoned its enforcement efforts in the private equity space. To the contrary, the Commission continues to pursue cases in which private equity fund advisers’ allegedly inadequate disclosures presented potential conflicts of interest.2 Additionally, in June 2018, the SEC announced it had reached settlements with 13 registered investment advisers, some of whom are private equity advisors, who the Commission alleged repeatedly failed to file annual reports on Form PF.3
That said, a number of developments over the last year and a half may serve to blunt somewhat the vigilance with which the SEC polices the private equity industry. In Kokesh v. SEC, a case involving a registered investment adviser, the Supreme Court held unanimously that SEC actions for disgorgement are subject to a five-year statute of limitations.4 Some lower federal courts have expanded this holding to encompass injunctions and industry bars, potentially subjecting all of the most potent relief the SEC can seek to the five-year limitations period. 5 If this expansion is adopted more widely, it will curtail the SEC’s remedial powers in a significant way. Indeed, Steven Peikin, the Co-Director of the SEC’s Enforcement Division, has already commented on the measurable impact that Kokesh has had on the SEC’s enforcement efforts: in terms of lost disgorgement, “the latest numbers are over $800 million, just in the last year or so alone . . . .” 6 It is worth noting that a number of the major private equity enforcement actions of the recent past have alleged violative conduct reaching much further back in time—conduct for which the SEC would no longer be able to obtain disgorgement or potentially other forms of equitable relief. 7
In addition, earlier this year, the Supreme Court ruled in Lucia v. SEC that the SEC’s process for appointing administrative law judges (“ALJs”) was unconstitutional.8 Uncertainty over the constitutionality of the SEC’s ALJs has existed for some years, since Lucia-like challenges first began to make their way through the courts. The upshot is that, for now, the administrative proceedings forum remains largely unused by the Enforcement Division in litigated matters. As a result, most enforcement litigation has been pushed into federal courts, where it is more difficult for the SEC to prosecute nuanced and complex cases (such as many of the settled private equity matters of the past few years) that do not present obvious investor harm.9 Federal litigation affords extensive discovery and requires adherence to strict evidentiary rules as well as the right to a jury trial, each of which is absent (or highly curtailed) in administrative proceedings. It is conceivable that, given the complexities of many of the SEC’s past private equity cases, the Commission would prefer not to pursue such actions in federal court, and therefore would be less likely to pursue investigations of marginal cases that might force its hand in litigation.
Finally, two developments within the Commission are worth noting. First, the Commission’s currently-announced enforcement priorities are heavily weighted toward detecting and stopping fraud that affects “Main Street” retail investors—this includes, for example, failures to fully disclose mutual fund fees and affinity cases such as schemes targeting vulnerable groups of investors like the elderly. Thus, it is likely that the Enforcement Division (and, in particular, the specialized Asset Management Unit, which spearheaded the spate of private equity cases in the 2014-16 timeframe), will be focusing on areas that may not as frequently implicate the private equity space and its sophisticated investor base. Second, the SEC is facing significant resource constraints. The Enforcement Division, like the rest of the Commission, remains subject to a hiring freeze and has experienced significant attrition over the last year and a half.10 To be sure, it is unlikely that the Commission will ever bring enforcement against private equity managers back down to pre-2010 numbers. Not only did most fund managers register with the Commission in the wake of Dodd-Frank,11 but the Commission has set up specialized units— OCIE’s private equity task force and the Asset Management Unit within the Enforcement Division—to develop expertise and to focus on the advisory space, which creates structural incentives to investigate and bring enforcement actions. That said, the past year has demonstrated a real shift from the enforcement priorities of the recent past; and when combined with recent Supreme Court decisions making it more difficult to bring old and complex cases and resource constraints at the agency, these trends probably mean that, at least in the short term, fewer such actions will be investigated and brought in the PE space. A word of caution, however: enforcement priorities change – particularly with economic dislocation – and such changes often happen faster than the statute of limitations. As such, it remains critical for advisers to have in place robust compliance procedures both to deter and detect wrongdoing and to make it clear—should the SEC come knocking—that scrupulous compliance with law is a priority.
1 For example, the SEC’s settlement order against certain funds affiliated with Blackstone found that the “LPAC of each Fund could have objected and arbitrated over the accelerated monitoring fees after they had been taken, but never did.” In the Matter of Blackstone Management Partners L.L.C., et al., File No. 3-16887, at 5 (Oct. 7, 2015).
2 See, e.g., In the Matter of WCAS Management Corporation, File No. 3-18449 (Apr. 24, 2018) (failure to adequately disclose its contractual arrangement with group purchasing organization); In the Matter of THL Managers V, et al., File No. 3-18565 (June 29, 2018) (failure to adequately disclose that it may receive accelerated fees upon the termination of portfolio company monitoring agreements); In the Matter of TPG Capital Advisers, LLC, File No. 3-18317 (Dec. 21, 2017) (same).
3 See Press Release, U.S. Securities and Exchange Commission, SEC Charges 13 Private Fund Advisers for Repeated Filing Failures (June 1, 2018), https://www.sec.gov/news/press-release/2018-100.
4 581 U.S. __ (2017).
5 See, e.g., SEC v. Cohen, No. 17-cv-430 (NGG) (LB), 2018 WL 3455403, at *14 (E.D.N.Y. July 12, 2018) (concluding that, because the injunction sought by the SEC “would function at least partly as a penalty, and thus is subject to § 2462, . . . the SEC’s claims are just as time-barred insofar as they seek injunctive relief as they are insofar as they seek penalties or disgorgement”); SEC v. Gentile, No. 16-1619 (JLL), 2017 WL 6371301, at *4 (D.N.J. Dec. 13, 2017) (deeming certain equitable remedies—an “obey-the-law” injunction and a “penny stock bar”—penalties under Kokesh).
6 See Oversight of the SEC’s Division of Enforcement: Hearing Before the Subcomm. on Capital Mkts., Secs., and Inv. of the H. Fin. Servs. Comm. (May 16, 2018), available at https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=403383; Dave Michaels, Supreme Court 2017 Decision Has Cost Investors Over $800 Million, SEC Says, Wall Street J. (May 16, 2018), available at https://www.wsj.com/articles/supreme-court-2017-decision-has-cost-investors-over-800-million-sec-says1526487555.
7 See, e.g., In the Matter of Apollo Management V, L.P., et al., File No. 3-17409 (Aug. 23, 2016) (failure to adequately disclose accrued interest, dating back to 2008); In the Matter of Blackstone Management Partners L.L.C., File No. 3-16887 (Oct. 7, 2015) (failure to adequately disclose receipt of legal fee discounts greater than discounts received by the funds, dating back to 2008); In the Matter of Kohlberg Kravis Roberts & Co. L.P., File No. 3-16656 (June 29, 2015) (failure to adequately disclose that it did not allocate broken deal expenses to coinvestors and failure to adopt a written compliance policy governing such allocation practices, dating from 2006 to 2011).
8 585 U.S. __ (2018).
9 For a fuller discussion of the Lucia case, see Supreme Court Holds that SEC Administrative Law Judges Are Unconstitutionally Appointed, Cleary Enforcement Watch (June 26, 2018), available at https://www.clearygottlieb.com/-/media/files/alert-memos-2018/2018_06_26-sec-administrative-law-judges-areunconstitutionally-appointed-pdf.
10 In its recent FY 2019 budget request, the SEC sought funding to restore 100 positions, which “represents approximately one-quarter of the positions lost in the hiring freeze.” U.S. SECURITIES AND EXCHANGE COMMISSION, FISCAL YEAR 2019 CONGRESSIONAL BUDGET JUSTIFICATION ANNUAL PERFORMANCE PLAN AND FISCAL YEAR 2017 ANNUAL PERFORMANCE REPORT (2018), available at https://www.sec.gov/files/secfy19congbudgjust.pdf. Specifically, as relevant here, the Commission’s FY 2019 budget requested funding for “17 restored positions” for the Division of Enforcement and 24 positions for OCIE, including “13 restored positions to focus on examinations of investment advisers and investment companies.” Id. at 25, 28.
11 Investment Advisers Act of 1940 (“Advisers Act”), Section 203(a). Dodd-Frank eliminated the commonly-reliedupon “private adviser exemption,” located previously in Section 203(b)(3) of the Advisers Act.