October 2015 Avoiding the SEC’s Crosshairs Advice for hedge funds and private equity funds JOHN F . CANNON and KATHLEEN M. MARCUS, STRADLING YOCCA CARLSON & RAUTH, P .C. ‘‘ T he SEC is fjrst and foremost a disclosure (2) whether fjrms are changing their valuation robust valuation procedure that valued investments ” 1 Predictably, the SEC has carried methodology without additional disclosure. 4 He agency. at “current, fair and accurate market valuations,” this mantra into its expanded mission added, “While making such changes [to valuation when, according to the SEC, the fjrm valued the vast to more aggressively police private equity funds methodology] is not wrong in and of itself, the majority of their investments at face value. See SEC v. Yorkville Advisors (2012). 10 The fjrm also allegedly and hedge funds. The precision of the disclosures change in valuation methodology should be demanded by the SEC Staff, however, has caught consistent with the adviser’s valuation policy and failed to observe other requirements set forth in ” 5 even well-intentioned managers off guard. Best should be suffjciently disclosed to investors. its disclosed policies, such as regular valuation intentions, improved accuracy or even the fjnancial committee meetings and provided misleading success of a fund will not deter an enforcement To this end, the SEC has pursued enforcement information concerning its valuations to auditors. action if disclosures are incomplete, outdated or actions where valuation practices utilized by The SEC argued that the failure to adhere to the contain errors. the fund deviated from the methods the fund fjrm’s stated valuation method was a fraudulent represented to investors it would apply in marketing scheme in violation of Section 17(a) of the Securities Fortunately, funds now have increased visibility materials, Private Placement Memoranda (PPM), Act, Section 10(b) of the Exchange Act, and Rule 10b-5. 11 The complaint sought a permanent into where and how the SEC Staff will most actively diligence, or otherwise, even when the valuation reached was arguably accurate. Even for the injunction, disgorgement of unearned gains, and scrutinize statements to investors. Following two years of “presence exams” 2 by the SEC’s Offjce of most well-intentioned fund, this creates an civil monetary penalties. Litigation is still ongoing in the Southern District of New York. 12 Compliance Inspections and Examinations (OCIE), enforcement risk related to disclosures that have targeted speeches by the Commission, and an not been tailored or updated to precisely match increase in investigations and enforcement actions, current methods or practices. The SEC treats Notably, the SEC has pursued enforcement actions several topic areas have emerged as regulatory such instances as disclosure violations actionable even when a fund expressly disclosed that it may “hot spots. ” These topics include: (i) valuation under traditional anti-fraud statutes used to police utilize discretion in its valuations. Specifjcally, in methodology (i.e., inconsistencies between securities disclosures, most commonly Section In the Matter of Agamas Capital Management, LP (2013), 13 a hedge fund’s valuation policy, detailed disclosed and utilized valuation methodologies and 10(b) of the Exchange Act and Rule 10b-5. The SEC the use of selective data to infmuence valuations); (ii) also frequently brings claims under Sections 206 in its private placement memorandum, allowed the inaccuracies in marketing materials; (iii) omissions of the Investment Advisers Act of 1940 (Advisers defendant to use good faith discretion in certain and errors in disclosing the accounting or allocation Act). Sections 206(1) and (2) prohibit investment circumstances, but required documentation of its of fees and costs; and (vi) the adoption and advisers from defrauding “any client or prospective basis for such a discretionary valuation. According to implementation of regulatory compliance policies client. ” Section 206(4) more broadly forbids the SEC, the fund deviated from its stated valuation and procedures. investment advisers from any fraudulent act or procedures by failing to fully document its repeated practice, as further defjned by rules and regulations use of discretion in valuing its securities. The SEC promulgated thereunder. 6 One thing is clear: operating under the SEC’s brought claims against the hedge fund manager for disclosure-based regime requires substantial discipline violations of Section 206(4) of the Advisers Act and from fund managers on an ongoing basis. Carefully Recent enforcement actions based on disclosure of Rule 206(4)-7 thereunder for failing to implement drafted initial disclosures coupled with thoughtfully lapses are telling. For example, in In the Matter of procedures designed to prevent improper valuation Oppenheimer Asset Management Inc., et al. (2013), 7 targeted compliance efforts, using the lessons from of its assets and inaccurate disclosures to investors. the cases and investigations set forth below, may the SEC charged two investment advisers managing In its settlement, the manager agreed to pay signifjcantly reduce risk of an enforcement referral a private equity fund with misstating the value of $250,000 in civil penalties. following a visit by SEC Examiners. its investments and misrepresenting its valuation method to potential investors. In marketing These cases highlight the importance of a fjrm’s Valuation cases and investigations materials and quarterly reports given to investors, continual assessment of the accuracy of its emphasize exactitude in methodology the defendants stated that the fund’s asset values disclosures pertaining to valuation methodology for disclosures were “based on the underlying managers’ estimated each and every quarter. In addition to confjrming ” 8 However, contrary to this stated policy— Unlike a public company with an available values. that valuations were calculated pursuant to the market and liquidation value, the valuation which had been approved by the defendants’ disclosed methodology, the stated practices and of a private entity requires intensive analysis. compliance department—the portfolio manager for processes (e.g., meetings, fjle documentation) for Because a reasonable valuation for a private the fund allegedly began valuing the fund’s largest calculating a valuation range must be followed entity may be reached through a variety of investment at “par value,” resulting in a signifjcant carefully. Firms and practitioners should recognize widely accepted methods, the SEC is hesitant to markup of the investment. Although the SEC did not that the SEC is not searching for a “better” or more substitute its own valuation judgments for a fund’s suggest that the valuation methodology based on accurate valuation for the investor; rather, the calculations. Instead, the SEC looks to the details “par value” was inherently improper, it argued that SEC’s focus is whether a fund stayed consistent with of fund disclosures to assess whether a particular the defendants’ change in methodology without its disclosures and whether the fund is utilizing a description properly informed investors regarding proper disclosure was a violation of Section 17(a) valuation method exactly as promised to investors. the methodologies used to reach a valuation. of the Securities Act and of Section 206(4) of the Marketing based violations: Talent and Advisers Act and Rule 206(4)-8 thereunder. The In a speech titled “Spreading Sunshine in Private defendants settled the charges, agreeing to pay ongoing responsibilities are material Equity,” former OCIE Director Andrew Bowden 3 approximately $2.8 million in disgorgement of fees In his “Spreading Sunshine” speech, former to investors .9 emphasized that SEC examiners are specifjcally Director of OCIE Andrew Bowden noted that, in its looking for: (1) whether fjrms are “cherry-picking” investigation of marketing materials and valuation comparables or adding inappropriate items to Similarly, in 2012, the SEC charged a hedge fund disclosures, the SEC is “especially focus[ed] on their earnings without suffjcient disclosure; and advisory fjrm and two of its executives for touting a situations where key team members resign or 58
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