Conference Speaker Warns Private Companies: The SEC Has Not Forgotten You

Chris Gaetano
Published Date:
Nov 19, 2020
Richard D. Marshall, a partner at Katten Muchin Rosenman LLP, who spoke at the Foundation for Accounting Eduation's Alternative Investment Conference on Thursday, warned private fund managers that the Securities and Exchange Commission (SEC) is paying them very close attention.

"We all know, a few years ago, there was an enforcement case almost every day involving a private fund, and it looked like the SEC was just obsessed. Some people say it's been reduced. It has not," he said.

Marshall said that the SEC still has all the infrastructure in place to inspect private funds, pointing to the enforcement group dedicated specifically to them, which itself boasts subgroups on private equity and hedge funds.

"So that structure has not changed," he said. "It continues from the prior administration, and I don't see any chance it will disappear. ... This structure remains, the interest remains, and this is something that is a big priority." 

One risk area the SEC is focused on is possible conflicts of interest. Take, for example, the allocation of investment opportunities. Say, Marshall posited, someone has two funds, one for private equity and another for hedge funds. The question is which fund gets access to which investment opportunity, he said, and "you better not prefer one fund over another," especially if the difference in opportunity is accompanied by a difference in prices too.

Another possible trouble zone here would be financial relationships between the adviser and the client, for example seed investors. Does this first investor in a private fund get preferential treatment? One example would be liquidation rights that allow someone to be "the first out the door" in the event of liquidity or valuation problems, while "the people at back are disadvantaged."

The SEC is also looking hard at whether the adviser has a personal interest in the investment, the selection of service providers (especially affiliated ones) and fund restructurings.

Fees and expenses are another possible risk area. Marshall said the SEC is very exacting when it comes to this area, even in cases where an accountant might not think it's material. He brought up an example of a $500 million fund allocating $30,000 for "certain employees of the advisers where a portion of their time can be allocated to the fund." The SEC, he said, requires very exacting documentation in cases like this.

"For a $500 million fund, you may think it's not material. The SEC doesn't want to hear that; it doesn't want to hear it's not worth bothering with that," he said, and added "they also really don't want to hear you basically made a guess."

Instead, Marshall said, the SEC wants to see documents with time records, with "studies done saying these people spent 57 percent of their time on the advising business, and 43 percent of their time on the fund business." The fees and expenses must be allocated exactly in the way the organization's documents say they are. The SEC has complained before about charging the fund for certain office expenses like a new photocopier, for example, because the fund is not meant to be paying for them. Again, while an accountant might not think this amount is material, that does not matter in the regulators' view. Travel expenses, he said, are the same way.

"The SEC is very, very tough on this," he said. "They really allocate this down to the penny. The SEC says, 'You've got rules, you better follow it, you better audit it.'"

Insider trading is perhaps the biggest focus, and Marshall said that there are several recent court cases that promise to greatly expand liability for this crime. One, United States v. Blaszczak, involved a government worker tipping off a friend about upcoming changes to the Medicare reimbursement rates. Prior case law held that the person who gives the tip must derive a personal benefit from passing on the inside information (e.g. selling the tip to a hedge fund) in order to be charged, but in this case, the government worker did not personally benefit. While the jury acquitted the defendants on the securities fraud charges because that would have required a personal benefit to the tipper, it found them guilty on the mail fraud and wire fraud charges. Marshall said that the case has been appealed twice, and the Supreme Court is currently deciding whether to take on the matter.

"The argument was, accepted on trial and on appeal, mail and wire fraud is not bound by the restrictions that apply in a securities prosecution, so the tipper does not have to derive a personal benefit. There might not even have to be materiality! So that's very troubling. It's creating a kind of new area of insider trading that rewrites the whole law," he said.

Another recent case he called troubling was Securities and Exchange Commission v. Edward Kosinski which involves a doctor who was running a clinical trial. The doctor, despite signing a confidentiality agreement, traded on this information. So far, he said, it's a pretty straightforward insider trading case.

"What's more controversial is that the doctor was also found by the Second Circuit to be an insider of the company making the drug; that means even if the doctor had not signed the confidentiality agreement, he'd still be liable for insider trading, as an officer of the company doesn't need to sign an agreement when trading in the company's own securities [to be charged with insider trading], there's a duty created by law. [It's a] very aggressive, and very expansive view on who's an insider," he said.

He also noted that there have been two court cases this year in which the SEC did not technically charge someone with insider trading, but did charge the company for having inadequate policies to prevent insider trading, both of which created heavy fines.

"The SEC has not forgotten about private funds, they have not forgotten about insider trading." he said. "So be very, very vigilant in terms of monitoring procedures. ... The SEC is not forgetting about any of these issues." 

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