October 2015

Avoiding the SECs Crosshairs

Advice for hedge funds and private equity funds
JOHN F. CANNON and KATHLEEN M. MARCUS, STRADLING YOCCA CARLSON & RAUTH, P.C.

he SEC is first and foremost a disclosure

agency.1 Predictably, the SEC has carried
this mantra into its expanded mission
to more aggressively police private equity funds
and hedge funds. The precision of the disclosures
demanded by the SEC Staff, however, has caught
even well-intentioned managers off guard. Best
intentions, improved accuracy or even the financial
success of a fund will not deter an enforcement
action if disclosures are incomplete, outdated or
contain errors.
Fortunately, funds now have increased visibility
into where and how the SEC Staff will most actively
scrutinize statements to investors. Following two
years of presence exams2 by the SECs Office of
Compliance Inspections and Examinations (OCIE),
targeted speeches by the Commission, and an
increase in investigations and enforcement actions,
several topic areas have emerged as regulatory
hot spots. These topics include: (i) valuation
methodology (i.e., inconsistencies between
disclosed and utilized valuation methodologies and
the use of selective data to influence valuations); (ii)
inaccuracies in marketing materials; (iii) omissions
and errors in disclosing the accounting or allocation
of fees and costs; and (vi) the adoption and
implementation of regulatory compliance policies
and procedures.
One thing is clear: operating under the SECs
disclosure-based regime requires substantial discipline
from fund managers on an ongoing basis. Carefully
drafted initial disclosures coupled with thoughtfully
targeted compliance efforts, using the lessons from
the cases and investigations set forth below, may
significantly reduce risk of an enforcement referral
following a visit by SEC Examiners.

Valuation cases and investigations

emphasize exactitude in methodology
disclosures
Unlike a public company with an available
market and liquidation value, the valuation
of a private entity requires intensive analysis.
Because a reasonable valuation for a private
entity may be reached through a variety of
widely accepted methods, the SEC is hesitant to
substitute its own valuation judgments for a funds
calculations. Instead, the SEC looks to the details
of fund disclosures to assess whether a particular
description properly informed investors regarding
the methodologies used to reach a valuation.
In a speech titled Spreading Sunshine in Private
Equity, former OCIE Director Andrew Bowden3
emphasized that SEC examiners are specifically
looking for: (1) whether firms are cherry-picking
comparables or adding inappropriate items to
their earnings without sufficient disclosure; and

1 58

(2) whether firms are changing their valuation

methodology without additional disclosure.4 He
added, While making such changes [to valuation
methodology] is not wrong in and of itself, the
change in valuation methodology should be
consistent with the advisers valuation policy and
should be sufficiently disclosed to investors.5
To this end, the SEC has pursued enforcement
actions where valuation practices utilized by
the fund deviated from the methods the fund
represented to investors it would apply in marketing
materials, Private Placement Memoranda (PPM),
diligence, or otherwise, even when the valuation
reached was arguably accurate. Even for the
most well-intentioned fund, this creates an
enforcement risk related to disclosures that have
not been tailored or updated to precisely match
current methods or practices. The SEC treats
such instances as disclosure violations actionable
under traditional anti-fraud statutes used to police
securities disclosures, most commonly Section
10(b) of the Exchange Act and Rule 10b-5. The SEC
also frequently brings claims under Sections 206
of the Investment Advisers Act of 1940 (Advisers
Act). Sections 206(1) and (2) prohibit investment
advisers from defrauding any client or prospective
client. Section 206(4) more broadly forbids
investment advisers from any fraudulent act or
practice, as further defined by rules and regulations
promulgated thereunder.6
Recent enforcement actions based on disclosure
lapses are telling. For example, in In the Matter of
Oppenheimer Asset Management Inc., et al. (2013),7
the SEC charged two investment advisers managing
a private equity fund with misstating the value of
its investments and misrepresenting its valuation
method to potential investors. In marketing
materials and quarterly reports given to investors,
the defendants stated that the funds asset values
were based on the underlying managers estimated
values.8 However, contrary to this stated policy
which had been approved by the defendants
compliance departmentthe portfolio manager for
the fund allegedly began valuing the funds largest
investment at par value, resulting in a significant
markup of the investment. Although the SEC did not
suggest that the valuation methodology based on
par value was inherently improper, it argued that
the defendants change in methodology without
proper disclosure was a violation of Section 17(a)
of the Securities Act and of Section 206(4) of the
Advisers Act and Rule 206(4)-8 thereunder. The
defendants settled the charges, agreeing to pay
approximately $2.8 million in disgorgement of fees
to investors.9
Similarly, in 2012, the SEC charged a hedge fund
advisory firm and two of its executives for touting a

robust valuation procedure that valued investments

at current, fair and accurate market valuations,
when, according to the SEC, the firm valued the vast
majority of their investments at face value. See SEC
v. Yorkville Advisors (2012).10 The firm also allegedly
failed to observe other requirements set forth in
its disclosed policies, such as regular valuation
committee meetings and provided misleading
information concerning its valuations to auditors.
The SEC argued that the failure to adhere to the
firms stated valuation method was a fraudulent
scheme in violation of Section 17(a) of the Securities
Act, Section 10(b) of the Exchange Act, and Rule
10b-5.11 The complaint sought a permanent
injunction, disgorgement of unearned gains, and
civil monetary penalties. Litigation is still ongoing in
the Southern District of New York.12
Notably, the SEC has pursued enforcement actions
even when a fund expressly disclosed that it may
utilize discretion in its valuations. Specifically, in
In the Matter of Agamas Capital Management, LP
(2013),13 a hedge funds valuation policy, detailed
in its private placement memorandum, allowed the
defendant to use good faith discretion in certain
circumstances, but required documentation of its
basis for such a discretionary valuation. According to
the SEC, the fund deviated from its stated valuation
procedures by failing to fully document its repeated
use of discretion in valuing its securities. The SEC
brought claims against the hedge fund manager for
violations of Section 206(4) of the Advisers Act and
of Rule 206(4)-7 thereunder for failing to implement
procedures designed to prevent improper valuation
of its assets and inaccurate disclosures to investors.
In its settlement, the manager agreed to pay
$250,000 in civil penalties.
These cases highlight the importance of a firms
continual assessment of the accuracy of its
disclosures pertaining to valuation methodology for
each and every quarter. In addition to confirming
that valuations were calculated pursuant to the
disclosed methodology, the stated practices and
processes (e.g., meetings, file documentation) for
calculating a valuation range must be followed
carefully. Firms and practitioners should recognize
that the SEC is not searching for a better or more
accurate valuation for the investor; rather, the
SECs focus is whether a fund stayed consistent with
its disclosures and whether the fund is utilizing a
valuation method exactly as promised to investors.

Marketing based violations: Talent and

ongoing responsibilities are material
In his Spreading the
Sunshine
speech,
former
Sunshine
speech,
former
Director of OCIE Andrew Bowden noted that, in its
investigation of marketing materials and valuation
disclosures, the SEC is especially focus[ed] on
situations where key team members resign or

October 2015

Avoiding the SECs Crosshairs

Advice for hedge funds and private equity funds
JOHN F. CANNON and KATHLEEN M. MARCUS, STRADLING YOCCA CARLSON & RAUTH, P.C.

heaSEC
is firstrole
andsoon
foremost
disclosure
announce
reduced
after aa fundraising
1 Predictably, the SEC has carried
agency.
is completed,
raising
suspicions that the adviser
thischanges
mantrawere
into its
expanded but
mission
knew such
forthcoming
never
tocommunicated
more aggressively
private investors
equity funds
thempolice
to potential
before
and
hedge14funds.
The precision
of theisdisclosures
This disclosure
omission
relatively
closing.
demanded
by the SEC
caught are
straightforward:
key Staff,
talenthowever,
and teamhas
members
even
well-intentioned
managers
guard.
a material
reason that
investorsoff
chose
oneBest
private
intentions,
improved
accuracy
or even the of
financial
equity fund
over another.
Nondisclosure
the
success
of athose
fundteam
will not
deter an
enforcement
fact that
members
plan
on leaving or
action
if disclosures
are incomplete,inoutdated
or can
will have
reduced responsibilities
the future
contain
violateerrors.
securities laws.
Fortunately,
funds
now have
increased
visibility
Additionally,
the former
Director
of OCIE
also took
into
where
how the SECwhere
Staff will
most
actively
issue
withand
circumstances
a team
member
scrutinize
statements
investors.
Following
two
is transitioned
from atomanager
working
for the
2 by the SECs Office of
years
of presence
general
partner toexams
a so-called
operating partner.15
Compliance
Whereas a Inspections
manager is and
paidExaminations
by the general(OCIE),
targeted
thefrom
Commission,
andpartners
an
partner,speeches
and thusby
paid
the general
increase
in investigations
and enforcement
management
fees, an operating
partner isactions,
hired as
several
topic areas
have
emerged
regulatory
a consultant
to the
fund
and paidasout
of the funds
hot
spots.
These operating
topics include:
(i) valuation
assets.
Utilizing
partners
as consultants
methodology
(i.e.,
is not unlawful
byinconsistencies
itself. However,between
the SEC appears
disclosed
and utilized
valuation
methodologies
and
to be particularly
critical
of circumstances
where
the
use of selective
data
to influence
valuations);
a manager
is moved
from
the general
partners (ii)
inaccuracies
marketing
materials;
payroll andin
put
on the funds
payroll(iii)
asomissions
a consultant
and
errorsany
in disclosing
theinaccounting
or allocation
without
real change
the individuals
ofresponsibilities.
fees and costs; and
the adoption
and
Such(vi)
a transfer
can implicate
implementation
of regulatory
compliance
disclosure and conflict
of interest
issues. policies
On the
and
procedures.
cost
side, the SEC expects complete transparency
about which costs are incurred by the fund and
One
thing
clear: operating
under the SECs
which
areis allocated
to management.
On the conflict
disclosure-based
regimeinterest
requiresinsubstantial
side, managements
balancing discipline
its yearly
from
fund managers
on an
ongoing its
basis.
Carefullyfees
operating
budget and
increasing
take-home
drafted
disclosures
coupled with
can beinitial
potentially
antagonistic
to thethoughtfully
investors
targeted
efforts,growth
using the
lessons from
interestcompliance
in the long-term
of investments.
the cases and investigations set forth below, may
significantly
reduce risk
an enforcementrelating
referral to
In sum, disclosures
(orofnondisclosures)
following
visit
SEC Examiners.
the rolesa of
keybyemployees,
payroll allocation, and
potential conflicts of interest will likely be reflected
Valuation
and investigations
in the samecases
marketing
materials and company
emphasize
exactitude
methodology
records as those
that are in
pertinent
to a valuation
disclosures
investigation.
Unlike a public company with an available
market
and liquidation
valuation
SEC closely
reviewsvalue,
howthe
funds
disclose
ofallocation
a private entity
intensive
andrequires
accounting
for analysis.
fees and costs
Because
reasonable
valuation
a private
The SECahas
taken aim
at whatfor
it terms
excess
entity
may be reached
through
variety ofcomponents
mostacommon
management
fees.16 The
widely
accepted
methods,
the SEC is hesitant
of such
excess fees
are undisclosed
expensestoand
substitute
its own
valuationabove,
judgments
a funds
hidden fees.
As described
one offorthe
largest
calculations.
SEC looks tosalaries.
the details
undisclosedInstead,
expensesthe
is consultant
The SEC
ofhas
fund
disclosures
assess whether
particular
also
observedto
improper
charges afor
undisclosed
description
properly
investors
regarding
administrative
feesinformed
or other fees
not contemplated
the
used to reach
a valuation.
in methodologies
the LLC or LLP operating
agreement,
transaction
fees in excess of the fees contemplated by the
Inagreement,
a speech titled
in Private
and Spreading
the hiring ofSunshine
related-party
service
3
17
Equity,
former
Director of
Andrew
Bowdenvalue.
providers
withOCIE
deliverables
questionable
emphasized that SEC examiners are specifically
looking
for: (1)ofwhether
firms are
cherry-picking
Automation
management
functions
has also
comparables
or adding of
inappropriate
items
caught the attention
regulators. The
SECtohas
their
earnings
sufficient
disclosure;
andsuch
observed
thatwithout
traditional
management
tasks,

(2)aswhether
are changing
valuation
investorfirms
reporting,
may be their
shifted
to software
4 He
methodology
without
additional
disclosure.
programs. Once
again,
the SEC does
not take
added,
While
such
changes
[to valuation
issue with
themaking
business
decision
to implement
methodology]
is not wrong
in and
of itself, the
automation. Rather,
the SEC
has questioned
change
in valuation
methodology
should be a
whether
an expense
for what is traditionally
consistent
with task
the advisers
valuation
policyon
and
management
is being covertly
passed
to
5
should
be sufficiently
disclosed
to without
investors.
the fund.
The SEC believes
that,
contrary
disclosure, the funds limited partners have a
Toreasonable
this end, the
SEC has pursued
enforcement
expectation
that expenses
for
actions
where
valuation practices
utilized
bypaid for
traditional
management
functions
will be
the
deviated from
theby
methods
the fund
byfund
management
and not
the fund.
represented to investors it would apply in marketing
materials,
Placement
Memoranda
Finally, inPrivate
the widely
publicized
June 29, (PPM),
2015
diligence,
or otherwise,
even
whenRoberts
the valuation
settlement
with Kohlberg
Kravis
& Co.
reached
wasthe
arguably
accurate.
Even 18forSpecifically,
the
L.P. (KKR),
SEC took
aim at fees.
most
well-intentioned
fund,ofthis
creates
following
an examination
KKR
whichan
commenced
enforcement
disclosures
that
have
in 2013, therisk
SECrelated
allegedtothat
more than
$17
million
not
tailored
updated to its
precisely
match equity
in been
expenses
wereorallocated
main private
current
methods
Theduty.
SEC KKR
treats
funds in
breach or
of practices.
its fiduciary
agreed
such
instances
to pay
nearly as
$30disclosure
million toviolations
settle theactionable
charges,
under
traditional
anti-fraud
statutes used to police
including
a $10 million
penalty.
securities disclosures, most commonly Section
10(b)
of the
Exchange
and
Rule
The SEC
alleged
that Act
from
2006
to10b-5.
2011, The
KKR SEC
also
frequently
under
Sections
206
allocated
80%brings
of $338claims
million
in what
the SEC
ofcharacterized
the Investment
Act expenses
of 1940 (Advisers
as Advisers
broken deal
related to
Act).
Sections 206(1)
(2) prohibit to
investment
unsuccessful
buyoutand
opportunities
its flagship
advisers
defrauding
any
client orthe
prospective
privatefrom
equity
funds (and,
indirectly,
limited
client.
Section
206(4)
more
broadly many
forbidspension
partners
in those
funds,
including
investment
from
any fraudulent
act or During
funds and advisers
other large
institutional
investors).
practice,
asperiod,
further except
definedfor
byarules
and
regulations
the same
partial
allocation
promulgated
thereunder.in6 2011, KKR allegedly
to certain co-investors
did not allocate broken deal expenses to KKRs
Recent
enforcement
actions
based on
disclosure
co-investors
(including
dedicated
co-investment
lapses
are for
telling.
For example,
in Inconsultants
the Matter of
vehicles
its executives,
certain
and
Oppenheimer
Asset Management
al. (2013),7
other co-investors),
even thoughInc.,
KKRsetco-investors
the
SEC
chargedparticipated
two investment
advisers
managing
had
allegedly
in and
benefitted
from
a KKRs
privatesourcing
equity fund
with misstating
the value
of transactions
(investing
$4.6 of
itsbillion
investments
andthe
misrepresenting
its valuation
alongside
$30.2 billion invested
by KKRs
method
potential
investors.
marketing the
flagshiptoprivate
equity
funds).InImportantly,
materials
andthat
quarterly
reports
given partnership
to investors,
SEC alleged
neither
the limited
the
defendants
that the
fundsmaterials
asset values
agreement
norstated
the related
offering
for the
were
based
on the
underlying
funds
expressly
disclosed
thatmanagers
KKR did notestimated
allocate
However,
contrary
this stated policy
values.
broken8 deal
expenses
to itstoco-investors.
which had been approved by the defendants
compliance
portfolio
manager
In anotherdepartmentthe
recent announcement,
three
private for
the
fundfund
allegedly
began
valuing
funds largest
equity
advisers
within
The the
Blackstone
investment
at par
value,
resulting
in a significant
Group agreed
to pay
nearly
$39 million
to settle
markup
the investment.
the investors
SEC did not
chargesofthat
they failed toAlthough
fully inform
suggest
that the that
valuation
methodology
based
about benefits
the advisers
obtained
fromon
par
value was
inherently
improper,
it argued
accelerated
monitoring
fees
and discounts
on that
the
defendants
change inManagement
methodologyPartners,
without
legal
fees.19 Blackstone
proper
disclosure
was a violation
of Section
17(a)
Blackstone
Management
Partners
III, and Blackstone
ofManagement
the SecuritiesPartners
Act and IV
of allegedly
Section 206(4)
failedof
tothe
Advisers
Act and
Rule the
206(4)-8
thereunder.
The
adequately
disclose
acceleration
of monitoring
defendants
settled
the charges,
agreeing
to payprior
fees paid by
fund-owned
portfolio
companies
approximately
$2.8 million
disgorgement
of fees
to the companies
sale or in
initial
public offering.
The
topayments
investors.9to Blackstone, the Commission alleged,
reduced the value of the portfolio companies
Similarly,
in 2012,
thedetriment
SEC charged
a hedge
prior to sale,
to the
of the
fundsfund
and
advisory
firm andThe
twoSEC
of its
executives
for touting
their investors.
also
alleged that
fund a

robust
valuation
procedure
that
valued
investments
investors
were not
informed
about
a separate
fee
atarrangement
current, fairthat
andprovided
accurateBlackstone
market valuations,
with a larger
when,
according
to thebySEC,
the firmlaw
valued
vast
discount
on services
an outside
firmthe
than
the
majority
theirthe
investments
at face value.
SEC
discountofthat
law firm provided
to the See
funds.
v. Yorkville Advisors (2012).10 The firm also allegedly
failed
observedemonstrate
other requirements
forth in
Thesetomatters
that SECset
Examiners
itsactively
disclosed
policies,
such
as regular
valuation
trace
fees and
costs
to the relevant
committee
and
provided misleading
disclosuresmeetings
and make
enforcement
referrals when
information
valuations Where
to auditors.
disclosures concerning
are deemedits
insufficient.
the SEC
The
argued problems
that the failure
to adhere
to the
hasSEC
identified
with the
allocation
of fees
firms
statedinvaluation
methodthe
was
a fraudulent
and costs,
each instance,
funds
could have
scheme
in violation
of Section
17(a) of theaction
Securities
insulated
themselves
from enforcement
with
Act,
Section transparent
10(b) of the Exchange
Act,
and Rule
enhanced,
disclosures.
A well-drafted
11 The complaint sought a permanent
10b-5.
agreement
and thorough and thoughtful marketing
injunction,
disgorgement
unearned
gains,
and
materials and
disclosuresofcan
avoid these
pitfalls.
civil monetary penalties. Litigation is still ongoing in
12
the
Southern for
District
of New York.
Necessity
attention
to internal
controls,

compliance policies and procedures

Notably,
SEC above
has pursued
enforcement
actions
In manythe
of the
investigations
and cases,
the
even
a fund
expressly
disclosed
that
it may
SEC when
took issue
with
the funds
internal
controls,
utilize
discretion
in its valuations.
including
compliance
policies andSpecifically,
procedures.in
InIndeed,
the Matter
of Agamaslaws
Capital
LP
the securities
offerManagement,
multiple causes
13 a hedge funds valuation policy, detailed
(2013),
of action
by which the SEC can pursue firms for
infailing
its private
placement
memorandum,
allowed the
to maintain
sufficient
internal controls.
In
defendant
to use
good
faith discretion
in has
certain
the context
of fund
valuations,
the SEC
asserted
circumstances,
required
documentation
of itsRule
some of these but
causes
of action
most notably,
basis
for such
a discretionary
According
to
206(4)-7
when
it finds that valuation.
a firms internal
controls
the
SEC, the
fund deviated
fromtoitsensure
statedthat
valuation
provide
insufficient
oversight
its
procedures
by failing methodology
to fully document
its repeated
disclosed valuation
is being
followed.
use of discretion in valuing its securities. The SEC
brought
claims againstenforcement
the hedge fund
manager
In the Oppenheimer
action,
for for
violations
Section
206(4)that
of the
Act and
instance,ofthe
SEC alleged
theAdvisers
defendants
20 when
ofviolated
Rule 206(4)-7
thereunder
for failing
to implement
they failed
to
Rule 206(4)-7
procedures
to written
prevent policies
improper
valuation
adopt and designed
implement
reasonably
ofdesigned
its assetstoand
inaccurate
disclosures
investors.
ensure
that the
valuationstoprovided
Intoitsinvestors
settlement,
managerwith
agreed
pay
werethe
consistent
the to
valuation
$250,000
civildisclosed
penalties.
methodsinthey
in marketing materials.
Similarly, in the KKR matter, the SEC contended
These
casesdid
highlight
theand
importance
of a firms
that KKR
not adopt
implement
written
continual
assessment
the accuracy
of its its fund
compliance
policy or of
procedure
governing
disclosures
pertaining
to valuation
methodology
expense allocation
practices
in a timely
matter. for
each
quarter.
In addition
to confirming
The and
SEC every
took this
position
even though
KKR had
that
valuations
were calculated
pursuant
improved
its procedures
over time
(e.g., to
in the
2011,
disclosed
methodology,
the
stated
practices
KKR revised
its practices
and
allocated
someand
share of
processes
(e.g.,
meetings,
file documentation)
for
broken deal
expenses
to several
committed capital
calculating
a valuation
range
be followed
co-investment
vehicles,
and must
in 2012,
KKR further
carefully.
Firms
and practitioners
should
recognize
revised its
methodology
and began
to allocate
a
that
theofSEC
is not
searching
forco-investors).
a better orThe
more
share
those
expenses
to its
SEC
accurate
valuation
for the
investor;
rather,
considered
the failure
to timely
adopt
suchthe
a policy
SECs
is whether
a fund206(4)
stayedofconsistent
withAct
to befocus
a violation
of Section
the Advisers
itsand
disclosures
and whether the fund is utilizing a
Rule 206(4)-7.
valuation method exactly as promised to investors.
Relatedly, in In the Matter of GLG Partners, Inc.,
21 the SEC
Marketing
violations:
and
charged aTalent
hedge fund
et al. (2013),based
ongoing
responsibilities
are
material
with internal
controls failures
even
though the
Infund
his Spreading
the Sunshine
speech,
former to
properly valued
the investment
pursuant
Director
of OCIE
Andrew policies.
Bowden According
noted that,tointhe
its
its disclosed
valuation
investigation
of marketing
materials
valuation
SEC, hedge fund
employees
receivedand
information
disclosures,
SEC is especially
focus[ed]
on
calling intothe
question
the valuation
on numerous
situations
keyfund
teamhad
members
resign
or
occasions,where
and the
inadequate
policies
and

59

October 2015

Avoiding the SECs Crosshairs

Advice for hedge funds and private equity funds
JOHN F. CANNON and KATHLEEN M. MARCUS, STRADLING YOCCA CARLSON & RAUTH, P.C.

is first
and
foremost
a disclosure
procedureshetoSEC
ensure
that
such
information
was
1 Predictably, the SEC has carried
agency.
communicated
to the
funds pricing committee.
this mantra
into its expanded
mission for
The SEC believed
this compliance
failure allowed
to
aggressively
policeand
private
equity
funds in
an more
overvaluation
of assets
nearly
$8 million
and
hedgemanagement
funds. The precision
thealleged
disclosures
unearned
fees. TheofSEC
that
demanded
by the
SEC Staff,
however,
has caught
the hedge fund
violated
Sections
13(b)(2)(A)
and (B)
even
managers
offpublic
guard.companies
Best
of thewell-intentioned
Exchange Act, which
require
intentions,
improved
or internal
even theaccounting
financial
to devise and
maintainaccuracy
sufficient
success
a fund
will not deter
an enforcement
controlsof
and
bookkeeping
to maintain
accountability
22 The hedge
action
if disclosures
are incomplete,
outdated
or
fund settled
the claims,
for its assets.
contain
agreeingerrors.
to disgorge approximately $9 million of its
unearned management and administrative fees plus
Fortunately,
now have increased visibility
prejudgmentfunds
interest.
into where and how the SEC Staff will most actively
scrutinize
statements to
investors.
Following
two
Design procedures
that
navigate
SEC risk
years
areasof presence exams2 by the SECs Office of
Compliance
and Examinations
(OCIE),
Although theInspections
two year presence
exam period
has
targeted
speeches
the Commission,
an
concluded,
the OCIEbynoted
a high rate ofand
deficiencies
increase
in investigations
and22enforcement
Accordingly, actions,
the OCIE
it found during
this initiative.
several
topic
havetoemerged
has stated
itsareas
intention
continueastoregulatory
concentrate
hot
spots.
topics examinations
include: (i) valuation
resources
onThese
compliance
of private
methodology
(i.e.,funds.
inconsistencies
between
equity and hedge
Fortunately,
the last few
disclosed
utilized
valuationamethodologies
and
years haveand
begun
to illuminate
pathway for the
the
use of selective data to influence valuations); (ii)
industry.
inaccuracies in marketing materials; (iii) omissions
and
errors in
accountingchallenging
or allocation
Regulation
bydisclosing
disclosurethe
is particularly
of
andPublic
costs;companies
and (vi) the
adoption
and
forfees
funds.
may
make disclosures
implementation
regulatory
compliance
policies
at any time, and of
upon
receiving
the information,
and
theirprocedures.
investors are free to sell shares in a liquid
market. To the contrary, fund investors often commit
One
thing
clear:and
operating
capital
forisyears
cannot under
readilythe
sellSECs
or transfer
disclosure-based
regime
requires
substantial
discipline
their interests upon
receipt
of new
information.
from
fund managers
on must
an ongoing
basis.
Carefully
Accordingly,
great care
be used
when
drafting
drafted
initial
disclosures
coupled
with thoughtfully
the initial
offering
materials
to provide
wide latitude
targeted
compliancetoefforts,
using
thevaluation
lessons from
for fund managers
make the
best
and
the
casesdecisions
and investigations
setthe
forth
may
staffing
throughout
lifebelow,
of the fund
significantly
reduce
riskofofthe
an enforcement
referral
without running
afoul
existing disclosures.
following a visit by SEC Examiners.
Recent SEC precedent clearly provides that funds
Valuation
cases disclose
and investigations
must meticulously
and follow stated
emphasize
exactitude Improvements
in methodology
valuation methodologies.
in valuation
disclosures
techniques or data, as well as accounting for costs
Unlike
a public
company
withcarefully
an available
and fees,
must be
considered
in the context
market
and liquidation
the valuation
of the funds
disclosures.value,
Justification
for any
of
a private
entity
analysis. and
changes
over
time requires
must be intensive
well documented,
Because
a reasonable
valuation
for a private
where possible,
disclosed
to investors.
entity may be reached through a variety of
widely
accepted
methods,
is hesitant
to
Moreover,
the SEC
expects the
thatSEC
funds
will adopt
substitute
own valuation
forthan
a funds
policies anditsprocedures
that judgments
contain more
calculations.
Instead, the
SEC looks
to the
principled statements
regarding
ethics
anddetails
of
fund disclosures
to assess
whether aprocedures
particular
governance.
For example,
compliance
description
properly
informed
investors regarding
must be tailored
to the
funds operations
and provide
the
methodologies
to reach
valuation.
express
directives toused
ensure
propera accounting,
disclosure protocols, governance structure, and
In
a speech
titledinformation
Spreadingdisclosure.
Sunshine in
ensure
accurate
InPrivate
this new
Equity,
former OCIE Director
Andrew
Bowden
era, well-intentioned
managers
must not
only 3work
emphasized
that
SEC
examiners
are specifically
to achieve the
best
solution
or provide
the greatest
looking
for:
whether
firmswork
are cherry-picking
accuracy,
but(1)they
must also
within their
comparables
or adding
inappropriate
items
to
THFJ
historic disclosures
to avoid
SEC scrutiny.
their earnings without sufficient disclosure; and

1 60

robust valuation procedure that valued investments

(2) whether firms are changing their valuation
NOTES without additional disclosure.4 He
at current, fair and accurate market valuations,
methodology
added, While making such changes [to valuation
when, according to the SEC, the firm valued the vast
methodology] is not wrong in and of itself, the
majority of their investments at face value. See SEC
10 The
[1] Daniel
M. Gallagher,
Commissioner,
Sec.
Society of(2012).
Corporate
Secretaries
& allegedly
firm also
change
in valuation
methodology
should
be& Exch. Commn,
v. Remarks
YorkvilleatAdvisors
Governance
Professionals
(11
July
2013),
http://www.sec.gov/News/Speech/Detail/Speech/1370539700301.
failed to observe other requirements set forth in
consistent with the advisers valuation policy and
5
Furthermore,
as noted
on the Commissions
website:
all investors,
whether
large institutions
or private
its disclosed
policies,
such as regular
valuation
should
be sufficiently
disclosed
to investors.
individuals, should have access to certain basic facts about an
investmentmeetings
prior to buying
it, and so long
as they
committee
and provided
misleading
To this
theInvestors
SEC hasAdvocate:
pursued How
enforcement
information
its valuations
to auditors.
holdend,
it. The
the SEC Protects Investors,
Maintainsconcerning
Market Integrity,
and Facilitates
Capital
actions
where http://www.sec.gov/about/whatwedo.shtml
valuation practices utilized by
The SEC10argued
that the failure to adhere to the
Formation,
(modified
June 2013).
the [2]
fund
from the
methods the
fund and Examinations
firms stated
valuation method
wastoaconduct
fraudulent
In deviated
2012, the Office
of Compliance
Inspections
(OCIE) announced
an initiative
represented
to investors
it would (labeled
apply inpresence
marketing
in violation
17(a) that
of the
Securities
focused, risk-based
examinations
exams)scheme
of investment
advisorsoftoSection
private funds
recently
materials,
Private
Placement
Memoranda
(PPM),
Act,
Section
10(b)
of
the
Exchange
Act,
and
Rule
registered with the Commission.
11 The complaint sought a permanent
diligence,
or
otherwise,
even
when
the
valuation
10b-5.
[3] In April 2015, the SEC announced that Andrew Bowden would be leaving the agency at the end of the month
injunction,
unearned
gains,
reached
wastoarguably
accurate.
EvenRelease,
for theSec. & Exch. Commn,
to return
the private
sector. Press
OCIE disgorgement
Director Andrew of
Bowden
to Leave
SEC and
(7
civil
monetary
penalties.
Litigation
is
still
ongoing in
mostApril
well-intentioned
fund,
this
creates
an
2015), http://www.sec.gov/news/pressrelease/2015-59.html.
Southern
District
of New
York.(612May 2014).
enforcement
relatedDirector,
to disclosures
that
haveCommn,the
[4] Andrewrisk
J. Bowden,
OCIE, Sec.
& Exch.
Spreading
Sunshine
in Private
Equity
not been tailored or updated to precisely match
[5] Id.
Notably, the SEC has pursued enforcement actions
current methods or practices. The SEC treats
[6] A further discussion of the relevant statutes and causes of action is provided below.
even when a fund expressly disclosed that it may
such instances as disclosure violations actionable
[7] In the Matter of Oppenheimer Asset Management Inc., et. al., File No. 3-15238 (11 March 2013), available at:
utilize discretion in its valuations. Specifically, in
under traditional anti-fraud statutes used to police
https://www.sec.gov/litigation/admin/2013/33-9390.pdf.
In the Matter of Agamas Capital Management, LP
securities disclosures, most commonly Section
[8] The underlying managers were the managers of the real estate13funds that the private equity fund had
(2013), a hedge funds valuation policy, detailed
10(b) of the Exchange Act and Rule 10b-5. The SEC
invested in.
in its private placement memorandum, allowed the
also frequently brings claims under Sections 206
[9] Notably, in a separate action, the SEC also charged the former portfolio manager of the fund with misleading
defendant to use good faith discretion in certain
of the
Investment Advisers Act of 1940 (Advisers
about
the and
valuation
and performance
of the fundscircumstances,
investments through
marketingdocumentation
materials and other
but required
of its
Act).investors
Sections
206(1)
(2) prohibit
investment
communications.
In
its
settlement,
the
SEC
barred
the
portfolio
manager
from
the
securities
andAccording
ordered to
basis for such a discretionary industry
valuation.
advisers from defrauding any client or prospective
him Section
to pay $100,000
in civilbroadly
penalties.forbids
the SEC, the fund deviated from its stated valuation
client.
206(4) more
[10] SEC advisers
v. Yorkvillefrom
Advisors,
No. 12 Civ.
complaint
available
http://www.sec.gov/
procedures
by failing
to at:
fully
document its repeated
investment
any LLC,
fraudulent
act7728
or (S.D.N.Y. 2012),
litigation/complaints/2012/comp22510.pdf.
use of discretion in valuing its securities. The SEC
practice,
as further defined by rules and regulations
6 that the defendants were investment advisers defrauding the clients the hedge funds
[11] The SEC
also claimed
brought claims against the hedge fund manager for
promulgated
thereunder.
in violation of Sections 206(1), (2) and (4) of the Advisers Actviolations
and Rule 206(4)-8
thereunder.
of Section
206(4) of the Advisers Act and
[12]enforcement
All of the SECsactions
claims survived
thedisclosure
defendants motion of
to dismiss
in the district
court for
Southern
Recent
based on
Rule 206(4)-7
thereunder
forthe
failing
to implement
lapses
are telling.
For example,
in InAdvisors,
the Matter
of 12 Civ.procedures
to prevent
improper
valuation
District
of New York.
SEC v. Yorkville
LLC, No.
7728 (GBD),designed
2013 U.S. Dist.
LEXIS 110624,
at *14
7
Oppenheimer
Asset
Management
Inc., raised
et al. several
(2013),defenses:
of its
and inaccurate
disclosures
investors.
(S.D.N.Y. Aug.
1, 2013).
The defendants
(1) assets
the valuations
were neither
objectivelytofalse
the nor
SECdisbelieved
charged two
investment
advisers
managing
its material;
settlement,
thevaluations
managerwere
agreed
to pay
when
communicated;
(2) the
valuations wereInnot
(3) the
not made
with
a private
equityscienter.
fund with
misstating
therejected
value ofthese arguments,
$250,000
in civilthe
penalties.
the requisite
Although
the court
it found
SECs allegations minimally
its investments
and misrepresenting
its valuation
sufficient in stating
a violation after the
SEC failed to demonstrate with facts that the overvaluations were
method
to potential
investors.
material
or made with
scienterIn
ormarketing
negligence. Id. at *11-12. These cases highlight the importance of a firms
materials
quarterly
reports
givenManagement,
to investors,LP, File No.
continual
the accuracy
[13] In and
the Matter
of Agamas
Capital
3-15616assessment
(19 Novemberof2013),
available of
at:its
http://
the www.sec.gov/litigation/admin/2013/ia-3719.pdf.
defendants stated that the funds asset values
disclosures pertaining to valuation methodology for
were[14]
based
on the underlying managers estimated
each and every quarter. In addition to confirming
Bowden, supra note 4.
values.8 However, contrary to this stated policy
that valuations were calculated pursuant to the
[15] Id.
which had been approved by the defendants
disclosed methodology, the stated practices and
[16] Id.
compliance departmentthe portfolio manager for
processes (e.g., meetings, file documentation) for
[17] Press Release, Sec. & Exch. Commn, SEC Charges KKR with Misallocating Broken Deal Expenses (29 June
the fund allegedly began valuing the funds largest
calculating a valuation range must be followed
2015), http://www.sec.gov/news/pressrelease/2015-131.html.
investment at par value, resulting in a significant
carefully. Firms and practitioners should recognize
[18] In the Matter of Blackstone Management Partners, L.L.C., File No. 3-16887 (7 October 2015), available at:
markup of the investment. Although the SEC did not
that the SEC is not searching for a better or more
http://www.sec.gov/litigation/admin/2015/ia-4219.pdf ; see also Press Release, Sec. & Exch. Commn, Blackstone
suggest that the valuation methodology based on
accurate valuation for the investor; rather, the
(Oct. 7,
2015), http://www.sec.gov/news/pressrelease/2015-235.html.
parCharged
value with
was Disclosure
inherentlyFailures
improper,
it argued
that
SECs focus is whether a fund stayed consistent with
Rule 206(4)-7
requires
implementation
of written policies
procedures
reasonably
to is
prevent
the [19]
defendants
change
in methodology
without
itsand
disclosures
and
whetherdesigned
the fund
utilizing a
violations
of thewas
Advisers
Act.
proper
disclosure
a violation
of Section 17(a)
valuation method exactly as promised to investors.
[20]
In the Matter
GLG
et al.,
File No. 3-15641 (12 December 2013), available at: https://www.
of the
Securities
Act of
and
ofPartners,
Section Inc.,
206(4)
of the
sec.gov/litigation/admin/2013/34-71050.pdf.
Marketing based violations: Talent and
Advisers
Act and Rule 206(4)-8 thereunder. The
[21] The SEC
also the
brought
claimsagreeing
under Section
13(a) of the ongoing
Exchange Act
and Rules 13a-1, 13a-11,
13a-13, and
responsibilities
are material
defendants
settled
charges,
to pay
12b-20 thereunder
which list
requirements
for issuers of
securities.
Inregistered
his Spreading
the Sunshine speech, former
approximately
$2.8 million
in filing
disgorgement
of fees
.9 the presence exam initiative, examiners identified violations of law or material weaknesses in controls
[22] During
Director of OCIE Andrew Bowden noted that, in its
to investors
over 50% of the time. Bowden, supra note 4.
investigation of marketing materials and valuation
Similarly, in 2012, the SEC charged a hedge fund
disclosures, the SEC is especially focus[ed] on
advisory firm and two of its executives for touting a
situations where key team members resign or