Legislative Priorities

The SEC’s Year of Enforcement

By: John Sikora Jr., Partner, Latham & Watkins, LLP   

What Is a Private Equity Fund Manager to Make of the SEC’s Year in Enforcement?

In reviewing the results of SEC Enforcement’s fiscal year that ended on September 30, 2014, the agency congratulated itself on its comprehensive approach to enforcement and its “first-ever” cases.1 Private equity fund managers should consider a number of important takeaways:

The SEC Wants to Make a Mark In The Private Equity Space

The SEC spent a considerable amount of time talking about private equity in its most recent fiscal year.  Notably, Andrew Bowden, the head of the SEC’s National Exam Program, delivered a speech titled “Spreading Sunshine in Private Equity” in May 2014.2  In this speech, Bowden chided the private equity industry for a lack of transparency, particularly as to fees earned by managers and charged to investors and portfolio companies.  Furthermore, Bowden stated that more than half of the presence exams of PE fund managers revealed “violations of law or material weaknesses in controls.”

In enforcement, the SEC touted two private equity cases it brought in the past fiscal year as “first-ever” cases.  E.g. In the Matter of TL Ventures (the SEC’s first-ever action under the Advisers Act “pay to play” rule (Rule 206-4(5)), charging a private equity fund manager with violating the Rule based on two separate political contributions by a management company employee totaling $4,500);3 In the Matter of Clean Energy Capital, LLC (described as the SEC’s “first action arising from a focus on fees and expenses charged by private equity firms,”) the SEC alleged that the management company and its president improperly charged $3 million in expenses to their funds.4 During the past fiscal year the SEC also brought the Lincolnshire case, in which the agency again brought fraud charges based on a private equity fund manager’s misallocation of expenses.5

What Is Around the Corner for The SEC and Private Equity?

It is important to heed the messages that the SEC has been sending about its view of private equity as SEC enforcement actions often follow warnings by SEC staff members in public speeches.  For example, months after a 2013 speech by the Chief of the SEC’s Asset Management Unit warning against using inflated interim valuations while raising a few fund, the agency brought two related cases alleging the use of inflated valuations in fund marketing materials.6-8

In 2014, the SEC followed Bowden’s “Spreading Sunshine” speech with the Lincolnshire action.  The relationship between staff speeches and enforcement actions is not surprising.  Before a senior official of the SEC gives a major policy speech, they generally canvass staff members to see what sorts of investigations in the pipeline are likely to lead to “message cases” in the area that is the subject of the speech.  As a result, statements in SEC speeches often foretell future enforcement actions.

Most recently, the SEC has been signaling that it is looking carefully at performance advertising and reporting by private equity fund managers.  Bowden identified marketing and valuation as key risk areas in his “Spreading Sunshine” speech.  Further, Reuters recently reported that SEC examiners are probing the IRR’s included in fund marketing materials.

Private equity managers can expect the SEC exam staff to scrutinize performance claims in fund marketing materials.  As a result, it is important for managers to re-evaluate their performance disclosures, in particular as to the transparency of performance calculations.  Given the SEC’s aggressive posture and willingness to pursue enforcement investigations and actions in the private equity space, proactive steps by fund managers are appropriate.

John Sikora Jr. is a Partner at Latham & Watkins, LLP, where he focuses on enforcement matters covering all aspects of the U.S. federal securities laws.