May 16, 2024

Up Next in SEC Examinations? Waterfall Calculations and Investment Decisions

Over the last decade, the SEC has peeled off layers of PE industry complexity. In its enforcement actions and examinations, and through risk alerts and its annual examination priorities, the SEC has identified regulatory risks inherent to prevalent industry practices and provided guidance on increasingly intricate topics for regulatory scrutiny. For PE sponsors, however, it is insufficient to keep pace with risk areas identified in past or current SEC actions; they must also anticipate topics that may move onto the SEC’s radar in the future. In a guest article, Vinson & Elkins partner Robert Seber explores two topics that are likely to be the subject of future SEC scrutiny: waterfall calculations and investment decisions. Specifically, the article highlights common risks as to how fund managers apply impairment criteria in their carry waterfalls, calculate their funds’ preferred returns and may inadvertently violate their fiduciary duties when making investment decisions. For additional insights from Seber, see “Avoiding a Midlife Crisis: Flaws With Fund Terms After the Commitment Period and How to Improve Them” (Jan. 12, 2021); and “LPAC by Design: Six Recommendations for GPs to Define LPAC Features During Fund Formation” (Feb. 25, 2020).

SEC Enforcement Actions Targeting “AI Washing” Follow Familiar ESG Playbook for Emerging Areas of Concern

In recent remarks at the Program on Corporate Compliance and Enforcement Spring Conference 2024, the Director of the SEC’s Division of Enforcement, Gurbir S. Grewal, noted that one throughline in recent financial frauds is that “elevated investor interest in rapidly developing technology or offerings often leads to elevated investor risk.” In that spirit, the SEC has targeted artificial intelligence (AI) as a potential risk area for investors that needs to be monitored. “While perhaps not quite yet a perfect storm, there’s certainly one brewing around AI,” he said. When considering how to address the risks presented by AI, the Commission’s experience with environmental, social and governance (ESG) provides an instructive starting point. For example, companies were incentivized to exaggerate or make misleading statements about their ESG activities or products, which prompted the SEC to bring enforcement actions for “greenwashing.” Similar conduct is occurring with AI, and the SEC recently settled charges against two registered investment advisers for AI washing. “I hope these actions put the industry on notice,” he warned. This article summarizes two settlement orders that targeted alleged AI washing, along with insights on key takeaways from industry experts. For comments from Grewal on greenwashing, see “SEC’s Grewal Discusses Enforcement’s Focus on Preventing False and Misleading ESG Claims” (Apr. 18, 2024).

Second Circuit Dismisses Charges Against Former Apollo Partner for Lavish Personal Expenses Improperly Allocated to Funds

A former senior partner at Apollo Management, L.P. (Apollo) was accused of breaching his fiduciary duties by submitting his personal expenses – including travel to sporting events, a bachelor party and a wedding – as business expenses that were ultimately paid by Apollo-affiliated funds that he advised. The U.S. District Court for the Southern District of New York (District Court) found that Rashid was not liable under Section 206(1) of the Investment Advisers Act of 1940 (Advisers Act) because he was unaware that the funds – not Apollo – would pay his expenses. Instead, he was found liable under Section 206(2) of the Advisers Act, because he was “recklessly indifferent” as to which entity would pay for his expenses, and therefore negligent. On appeal, the U.S. Court of Appeals for the Second Circuit (Court) reversed the District Court’s decision on the basis that the former Apollo partner could not have reasonably foreseen that the funds would pay his expenses. This article summarizes the Court’s judgment and offers insights from industry experts interviewed by the Private Equity Law Report. For coverage of the District Court’s ruling, see “Court Fines Former Apollo Partner $240K for Misallocating Personal Expenses; Places ‘Significant Blame’ on Firm’s Internal Practices” (Jan. 19, 2021).

Preparing for the SEC’s Proposed Predictive Data Analytics Rules and Mitigating Generative AI Risks

Artificial intelligence (AI) is poised to revolutionize many industries, and asset management is no exception. The SEC has proposed new predictive data analytics rules (PDA Rules), however, that would fundamentally change how fund managers and others use new technologies, including calling into question longstanding approaches to addressing conflicts of interest. The SEC faces a looming deadline to adopt the new PDA Rules, which means the new regulations are likely to alter the way fund managers do business long before actual AI technology does. To address the potential effects of the PDA Rules, if enacted, as well as other regulatory and legislative developments related to AI, K&L Gates hosted a webinar on AI for asset managers that featured partners Jennifer L. Klass and Cheryl L. Isaac; of counsel Matthew J. Rogers; and government affairs adviser Ryan T. Carney. This article summarizes relevant takeaways from their discussion, including some of the risks and opportunities presented by AI, and compliance best practices for managing them. See our two-part series on AI in private funds: “Emerging AI Technology and Valuable Legal- and Compliance-Related Applications” (Nov. 16, 2023); and “Challenges, Best Practices for Implementation and the Road Ahead” (Nov. 30, 2023).

ACA Regulatory Outlook for 2024

“The SEC remains aggressive on rules, on exams, on enforcement,” but the pace of rulemaking has slowed somewhat due to legal challenges, said ACA Group (ACA) global advisory leader Carlo di Florio at the firm’s recent 2024 Regulatory Outlook program. Di Florio and his ACA colleagues covered top-of-mind regulatory issues for investment advisers and broker-dealers, including the new private fund rules; artificial intelligence; custody; off-channel communications; anti-money laundering compliance; Regulation Best Interest and other compliance concerns for broker-dealers; new regulatory requirements affecting registrants; cybersecurity; marketing; environmental, social and governance investment factors; U.K. developments; and compliance technology. This article synthesizes the key takeaways from the program. See “No Longer a Slap on the Wrist: SEC Penalties and Sentences on the Rise” (Mar. 23, 2023).

Kirkland & Ellis Adds Former SEC Enforcement Litigator and a Four‑Person Investment Funds Team

Kirkland & Ellis has strengthened its capabilities by adding new partners in its Dallas and Boston offices. Sarah S. Mallett, former Assistant Director in the SEC’s Division of Enforcement, has joined as a partner in the government, regulatory & internal investigations practice group in Dallas. In addition, the firm has welcomed a team of four partners – James L. Donohue, Mirela Hristova, Michelle B. Kim and Joseph R. Baron – to its investment funds group in Boston. For other recent additions to the firm, see “Kirkland & Ellis Adds Investment Funds Partner in Washington, D.C.” (Apr. 4, 2024); “Senior Investment Funds Lawyer Rejoins Kirkland & Ellis in New York” (Jan. 25, 2024); and “Kirkland & Ellis Deepens Its Investment Management Bench in Washington, D.C.” (Nov. 16, 2023).