The decision by the U.S. Court of Appeals for the Fifth Circuit (Fifth Circuit) striking down the private fund adviser rules (PFAR) – along with ubiquitous predictions of a softer, gentler SEC under Paul S. Atkins – have understandably led many private fund advisers to breathe a sigh of relief. But even without specific and prescriptive rules, private fund advisers’ activities will continue to be scrutinized by today’s SEC and subject to examination and enforcement efforts long after the current administration.

As Stephen Cutler, former Director of the SEC’s Division of Enforcement, presciently noted, the “pendulum” of securities law enforcement and reform swings both ways over time. Although struck down and overly prescriptive in many of its particulars, the PFAR largely codified positions and principles the SEC has taken and expressed over the years about the need for proper disclosures to avoid or mitigate conflicts of interest. Thus, the PFAR offers a helpful roadmap for steps to consider and action items to execute, particularly as private fund advisers launch new fund products and prepare to update their Form ADV disclosures for 2025.

This article outlines some practical and proactive action items that private fund advisers should consider going forward, based on the requirements in the PFAR, to position themselves effectively for ongoing regulatory scrutiny and to offer best-in-class fund documents and transparency for their investors.

See “Potential Areas of Scrutiny in Future SEC Examinations of PE Sponsors” (Jan. 9, 2025).

Regulatory Next Steps

Although the SEC has declined to litigate the PFAR further, the agency will likely still focus on the topics and themes that were the subject of the PFAR. In particular, the SEC’s Division of Examinations will continue to scrutinize the types of conflicts of interest targeted by the PFAR.

As the SEC continues its examination efforts, advisers may consider ways to proactively address certain thematic concerns expressed by the SEC in its recent enforcement actions and throughout the PFAR rulemaking process – i.e., the PFAR, the SEC’s adopting release, the proposed rules, debate and discussion by and among SEC commissioners and staff, etc. (collectively, PFAR Rulemaking). In particular, advisers might devote extra attention to the following topics, each of which fall within the SEC’s purview as they examine advisers and assess, among other things, potential violations of the general antifraud provisions of the Investment Advisers Act of 1940 (Advisers Act):

• pre-commitment disclosures to investors;
• contractual arrangements;
• ongoing disclosures; and
• policies and procedures.

Beyond helping advisers navigate future SEC examinations, focusing on those key areas could confer other benefits. Most private fund advisers actively endeavour to “do right” by their investors by enhancing their transparency, clarity and other avenues. Improving compliance efforts and disclosure practices in those areas can help advisers identify new and better ways to clearly document the contours of their bargain with investors, as well as provide efficient and transparent disclosure on topics of interest to investors – separate and apart from any legal obligations.

See “PE Industry in 2024: Emerging Trends in GP‑LP Negotiations, Fund Structures and Compliance Focuses (Part Two of Two)” (Jan. 25, 2024).

Pre‑Commitment Disclosures

The PFAR Rulemaking covered a variety of topics that advisers might consider addressing in pre-commitment disclosures to investors. Although certain topics will feature into longstanding and prominent disclosures for many advisers – even for advisers that have historically included disclosure on a given item – it may be worth re-underwriting and potentially enhancing applicable language.

In particular, many advisers will find it helpful to review the specific conflict of interest concerns identified by the SEC in PFAR Rulemaking to ensure their disclosures appropriately consider those concerns and contain the level of specificity that the SEC expects. A few examples of areas addressed by the PFAR that advisers may find ripe for re-underwriting include:

• disclosure of clawback constructs;
• adviser and related person compensation frameworks at both the fund and portfolio company levels;
• performance information; and
• differential liquidity and/or portfolio-level information rights across other sponsor funds or accounts.

Similarly, advisers may want to consider the level of specificity with which their pre-commitment disclosures anticipate preferential terms expected to be provided to other fund investors, particularly when those terms could have a more direct impact on other investors (e.g., investment excusal or “opt-out” rights).

See “Current Scope of PE-Specific Side Letter Provisions: Industry Trends, Excusal Rights and Placement Agent Representations (Part One of Three)” (Mar. 19, 2019).

Other potential disclosure topics or enhancements are teed up less by the PFAR itself than by the commentary throughout the PFAR Rulemaking. For example, the SEC’s skepticism of the role of LP advisory committees (LPACs) was made clear by language in the adopting release. Regardless of whether the Commission’s concerns about LPACs are shared or warranted, advisers may consider enhancing pre-commitment (and/or ongoing) disclosures to investors about LPACs and their roles, decision-making processes, etc.

See “LPAC by Design: Six Recommendations for GPs to Define LPAC Features During Fund Formation” (Feb. 25, 2020).

Further, advisers should ensure that their pre-commitment disclosures generally tie to applicable policies and procedures, particularly in light of continued SEC enforcement in that area.

Contractual Arrangements

Advisers may consider improvements or clarifications to their limited partnership agreements (LPAs) or other operating agreements governing their funds.

Waivers of Fiduciary Duties

Among the lowest hanging fruits – and among the highest risk-adjusted return fruits in terms of minimizing deficiency risk – is the SEC’s focus on the waiver of U.S. federal fiduciary duties.

Although the SEC declined to adopt a prohibition on limitation of liability and indemnification for simple negligence in the PFAR, some of the commentary in the adopting release seemed to expand on positions expressed by the SEC in the Interpretation Regarding Standard of Conduct for Investment Advisers that was issued in 2019 (Interpretation). The SEC also brought several enforcement actions throughout 2024 targeting the issue, including its recent settlement with ClearPath Capital Partners, LLC.

Therefore, advisers should review their LPAs – which, for many advisers, will include language outside of specific exculpation and indemnification provisions – to ensure their language is clear that the adviser is not purporting to waive its U.S. federal fiduciary duties, whether directly or indirectly.

See “SEC Sanctions Fund Manager for Misleading Hedge Clauses Despite Accompanying Savings Clauses” (Oct. 17, 2024); and this three-part series on navigating the Interpretation: “What It Means to Be a Fiduciary” (Dec. 3, 2019); “Six Tools to Systemically Identify Conflicts of Interest” (Dec. 10, 2019); and “Three Tools to Systemically Monitor Conflicts of Interest” (Dec. 17, 2019).

Other Focus Areas

Although the SEC has long been focused on the specificity of expense provisions more generally, there will likely be greater scrutiny around operative LPA language (and corresponding disclosures) where advisers look to charge their funds for categories of expenses that were targeted in the PFAR, such as:

• investigations by governmental or regulatory authorities;
• examination-related costs; and
• compliance-related expenses.

Further, advisers may want to focus on other LPA provisions addressed in the PFAR Rulemaking relating to investor withdrawal and information rights, clawbacks and LPACs.

Similarly, advisers can expect continued scrutiny of other long-standing SEC focus areas, such as the provision of services to funds and/or portfolio companies by employees, related personnel, or affiliated or quasi-affiliated entities of the private fund adviser.

Ongoing Disclosures

Advisers should also consider incorporating learnings from the PFAR Rulemaking across a variety of forums for ongoing disclosures.

Third-Party Relationships

The PFAR contained what would have been a new Rule 211(f)(2)‑2 under the Advisers Act, which would have required advisers to distribute to investors a written summary of any material business relationships with the provider of the – under the PFAR, required – fairness or valuation opinion relating to a proposed adviser-led secondaries transaction. Although the adopting release states that materiality would require a facts and circumstances analysis, it also notes that “for purposes of this rule, audit, consulting, capital raising, investment banking, and other similar services would typically meet this standard.”

It is easy to contemplate the SEC taking the view in the context of an examination that consent to an adviser-led secondary transaction was defective where, as always viewed in hindsight, material relationship matters bearing upon the independence of the opinion provider were not disclosed. That view is likely to also be applied to a range of other transactions when consent is solicited from an LPAC or investors generally, as the SEC could take the view that steps or processes purporting to offer a level of third-party validation or independent protection either did not do so at all or were inconsistent with the manner presented to investors.

See “The Merits and Shortcomings of the Diligence‑Lite Approach to GP‑Led Transactions” (Oct. 25, 2022).

Supplemental Disclosures

Although the PFAR Rulemaking offers many other topical opportunities for ongoing disclosures, most likely fall within the purview of the Fifth Circuit’s statement that “[t]he Commission conflates a ‘lack of disclosure’ with ‘fraud’ or ‘deception’ . . . but a failure to disclose ‘cannot be deceptive’ without a ‘duty to disclose.’”

Regardless of any duty or other requirement, there are certain topics where advisers may simply elect to provide supplemental disclosure (i.e., not required by a fund’s LPA or other governing documents) to their investors and/or LPACs. Those disclosures, in turn, may become assets to the adviser in the course of navigating an SEC exam. Those sorts of supplemental disclosures are common and may be delivered by advisers for a variety of reasons, including when they believe disclosing information will help investors or where standardized disclosure to a broader group of investors may more efficiently preempt questions that investors would otherwise ask.

For example, advisers might provide additional information about the calculation of a clawback liability. Clawback scenarios set forth in LPAs typically contain a preexisting written forum (e.g., a reporting framework to LPACs or investors) that advisers may find easy to supplement. Rather than looking to satisfy a prescriptive reporting regime, supplemental disclosures may contain data points or other information that the adviser believes will be of the highest value to investors.

Regardless of any such supplemental disclosures, advisers should remain mindful of contractual disclosure requirements applicable to LPACs or investors generally, particularly on topics where the SEC has demonstrated a historical focus.

Policies and Procedures

Advisers should take advantage of the breathing room afforded by the vacatur of the PFAR and the likely shift in SEC enforcement priorities under the Trump administration to review certain aspects of their policies and procedures and incorporate learnings from the PFAR Rulemaking.

For example, advisers may look to what would have been Rule 211(h)(2)‑1 under the Advisers Act on restricted activities and re-underwrite the appropriateness of certain expense allocations. Or advisers may look to what would have been Rule 211(h)(2)‑3 under the Advisers Act on preferential treatment to ensure their non-disclosure agreement templates sufficiently protect against investors using information provided by the adviser for trading or other activities outside of the fund itself.

See “How ILPA’s Model NDA Could Change Preliminary Due Diligence Practices” (Feb. 16, 2021).

In addition to bolstering their policies and procedures, advisers should also ensure their operational processes – both internally by the adviser, as well as externally through their service providers – match those revised compliance policies (i.e., “do what you say”).

Concluding Thoughts

Although the SEC’s near-term enforcement priorities will likely return to a focus on the sorts of “core” topic areas pursued in the years before Chair Gary S. Gensler, the Commission will continue to provide oversight of private fund advisers. Ordinary course adviser examinations conducted by SEC staff under Atkins are likely to look and feel similar to those conducted under Gensler. Further, private fund governing documents and disclosures that are drafted and negotiated today will remain subject to SEC scrutiny and potential enforcement, not only today or over the next four years, but also as the pendulum shifts over time.

Certainly, advisers can breathe a sigh of relief at avoiding the requirement to comply with the time-consuming, costly and burdensome new obligations that would have been imposed under the PFAR, as well as a less aggressive – or at least less novel – near-term enforcement environment. That means advisers can get back to the business of continuously re-underwriting what really matters to their investors and deciding how to most clearly and effectively document and disclose the bargain with their investors.

As part of that process, the SEC’s views expressed throughout the PFAR Rulemaking provide a helpful “checklist” of terms and conduct the SEC may view as objectionable, or at least suspect, for advisers to consider alongside their fund documents and compliance and operating processes. In line with the adage that “the best defense is a good offense,” advisers can position themselves most effectively for ongoing regulatory scrutiny by taking a proactive approach to topics addressed by the PFAR Rulemaking and more generally scrutinized by the SEC under Gensler.

See this two-part series on Gensler’s tenure at the SEC: “Examination Practices, Enforcement Efforts and Industry Guidance” (Feb. 6, 2025); and “Rulemaking, Culture and Operational Proficiency, and Relationship With Private Funds Industry” (Feb. 20, 2025).

 

Zachary J. Moore is a partner in Finn Dixon & Herling’s private investment funds practice. He advises sponsor clients on the formation and operation of a wide range of fund products, including closed-end, open-end, contingent, evergreen and hybrid structures investing across investment strategies, including private credit, special situations, PE buyout and growth products. He was previously in-house counsel at Sixth Street Partners, where he led the fund formation legal function responsible for capital formation.

Andrew M. Calamari is a partner in Finn Dixon & Herling’s litigation practice. He advises sponsor clients on all manner of SEC examination, enforcement and regulatory compliance matters, including counseling clients on SEC examination preparation and navigating post-examination investigation and enforcement matters. He was previously the Director of the SEC’s New York Regional Office, where he led its examination, investigation and enforcement initiatives.

As Paul S. Atkins takes the helm at the SEC, the beginning of the Trump administration offers a prime opportunity to benchmark the Commission’s performance by evaluating the tenure of former Chair Gary S. Gensler. With that evaluation in place, it will be easier to mark any shift in tactics and conduct by the Commission as to the private funds industry over the course of Atkins’ tenure.

To assist with those efforts, the Private Equity Law Report spoke with several former SEC staff members about Gensler’s efforts in several key areas and asked them to grade those efforts on a five-point scale (poor, below average, average, above average and excellent). The experts supplemented their grades with analysis about positive and negative aspects of Gensler’s performance as to each key area, and offered forecasts about the SEC’s likely approach under the Trump administration.

This second article in a two-part series addresses the Commission’s rulemaking efforts; culture and operational proficiency; and relationship with the private funds industry during Gensler’s tenure. The first article considered the efforts of the SEC’s Division of Examinations (Examinations) and Division of Enforcement (Enforcement), respectively, as well as the quality of industry guidance (e.g., FAQs, risk alerts, etc.) under Gensler.

See our two-part series on Dechert and Mergermarket’s 2024 PE Outlook: “Navigating Fundraising and Regulatory Headwinds” (Jan. 25, 2024); and “Parsing the Ongoing Growth of GP‑Led Transactions and Other Sectors” (Feb. 8, 2024).

Rulemaking

Overall Grade: Poor

Split: Below Average (1); Below Average/Poor (1); Poor (2)

Positives

Rulemaking under Gensler was well-intentioned, ambitious and purposeful, but suffered some significant setbacks, noted Amy Lynch, president of FrontLine Compliance and former staff member in Examinations. It is curious that some rules were not finalized – e.g., the proposed cybersecurity rule for advisers and funds seems straightforward in that the industry is already meeting its requirements and there was no real pushback on the proposal, she said.

See “A Practical Approach to Navigating the New Cybersecurity Legal and Regulatory Landscape” (Aug. 24, 2023); and “SEC Proposes Cyber Risk Management Rules for Advisers” (Apr. 12, 2022).

Negatives

Limited Final Rules

Despite a robust rulemaking process, the final results from those efforts under Gensler are largely lacking. For the asset management industry, the headline piece of rulemaking under Gensler was the private fund adviser rules (PFAR), which became a complete loss after they were vacated by the U.S. Court of Appeals for the Fifth Circuit (Fifth Circuit) in June 2024, said Adam S. Aderton, partner at Willkie Farr and former Co‑Chief of the Asset Management Unit in Enforcement (AMU).

Given the amount of effort and political capital that went into finalizing the PFAR, the SEC suffered a severe blow to its overall efforts and agenda when the rules were vacated. “The PFAR was huge and all encompassing, and now it is gone,” emphasized C. Dabney O’Riordan, partner at Quinn Emanuel and former Chief of the AMU.

Notably, the PFAR was not the only final rule that was vacated by the courts after being litigated by the industry. The finalized rules broadening the definitions of “dealer” and “government securities dealer” under the Securities Exchange Act of 1934 were also vacated by the U.S. District Court for the Northern District of Texas in November 2024, Aderton continued. “Although the published rules that have been struck down may potentially provide guidance on the SEC’s expectations, they are ultimately impermanent.”

Poor Rulemaking Process

One issue is that rulemaking during Gensler’s tenure probably spread the SEC’s resources too thin and, by prioritizing so many issues, effectively decreased the importance of each issue, O’Riordan reasoned. “It is very difficult to move so many rules forward at the same time with the same policy divisions writing them, as it increases the potential that the staff will burn out.”

Also, rather than pursuing versions of rules that could garner a consensus among the ideologically divided SEC Commissioners, rules with broad implications – such as the PFAR – were passed with just a three-two majority vote, which is not ideal, O’Riordan observed. “Commissioners Hester Peirce and Mark Uyeda will vote for things; they are not always a ‘no.’ In prior administrations, we’ve seen rulemaking that is not based on three-two voting including, most notably, amendments to the Marketing Rule.”

See our two-part series: “SEC Commissioners Peirce and Roisman Argue Against Prescriptive ESG Disclosures” (Aug. 24, 2021); and “SEC Commissioners Gensler and Lee Advocate Further SEC Oversight of ESG Efforts” (Aug. 31, 2021).

Another part of the problem is that SEC rulemaking under Gensler was hard-charging but not always well thought through, opined Igor Rozenblit, managing partner and founder of Iron Road Partners and former Co‑Chief of the Private Funds Unit. “Gensler seemed quite involved in rulemaking and the proposed rules sometimes prioritized progressive ideology at the expense of practical regulatory solutions,” he asserted. “There also seems to have been a missed opportunity to rely on experienced SEC staff and to engage with industry participants to identify what was really needed in the market,” O’Riordan added.

“The hardline regulatory approach sometimes backfired,” Rozenblit posited. “For example, the proposed version of the PFAR was so unworkable that the industry was driven to prepare to challenge the final rule. Although the final version of the PFAR was significantly pared back from the proposal, litigation was already inevitable by the time it was released.”

Future Challenges

Another complication is that the SEC’s position may be compromised going forward because the Fifth Circuit decision vacating the PFAR calls into question rulemaking under Section 206(4) of the Investment Advisers Act of 1940 (Advisers Act), which is the basis for most rules under the Advisers Act, Aderton noted. “That could make future rulemaking more difficult and potentially give rise to issues about the validity of existing rules promulgated under Section 206(4).”

See “Fallout From the Fifth Circuit’s Bombshell Ruling Vacating the Private Fund Adviser Rules” (Jun. 27, 2024).

“For better or worse, having lost some of these challenges, future courts may be more skeptical of SEC rulemaking given the outcomes of so many of the rules that were promulgated during Gensler’s tenure,” Aderton added.

Potential Changes Under Trump Administration

Reduced Rulemaking

Rulemaking is an area that will likely change dramatically with Gensler’s resignation, as it may cease almost entirely under the Trump administration, Lynch suggested. “During his previous tenure, Trump said one rule needed to be repealed if another was created. Now, he said you must repeal 10 rules to get one rule passed. Therefore, I think rulemaking is going to be very hard unless it’s about something the administration values, which may include crypto regulations.”

See “What’s Next for the SEC? A Look at the Latest Reg Flex Agenda” (Oct. 3, 2024).

Instead, the Commission will likely seek to effectuate change through exemptive relief and guidance in lieu of rulemaking, which can make the SEC more of a partner with the private funds industry, O’Riordan speculated. “The new Commission can make a quick impact by giving clear and decisive guidance on how certain rules work in different contexts.”

To the extent the SEC moves forward with rulemaking under Atkins’ tenure, it is likely to take a different form. Generally, rulemaking under the Gensler administration was quite prescriptive, which was a stark contrast to the principles-based rules that broadly govern investment advisers, Aderton observed. Therefore, there will probably be a shift back to more principle-based rules under Atkins, such as Regulation Best Interest on the retail broker-dealer side.

“When I was at the SEC, the Division of Investment Management primarily led rulemaking when it identified a problem that needed fixing. I hope we return to that approach, as it generates more deliberate and thoughtful rules,” Rozenblit said.

Alternative Areas of Focus

The subject matter of rulemaking efforts will probably pivot from making it more difficult to access investment opportunities to an approach that tries to expand investors’ ability to participate and advisers’ ability to innovate, Aderton opined. It will also be interesting to see whether new rules are designed to encourage new entrants to the market, which many commenters suggested was discouraged by the prescriptive rulemaking of the past few years.

One approach could be to revise the accredited investor definition to make it more inclusive, or simply changing the income and asset thresholds to qualify, Rozenblit said. There may also be rulemaking activity to improve capital access for retail investors to private funds, unless the desired outcomes can only be achieved through legislation, he noted. “For example, the SEC could pass rules making it easier to package private fund strategies in more retail-friendly wrappers,” Aderton added.

See “SEC Adopts Incremental Expansion of Accredited Investor Definition Despite Divide Among Commissioners” (Nov. 10, 2020).

As mentioned, another likely area of focus for the Trump administration is regulations to support crypto, which may lead to the proposed Custody Rule being repurposed and redesigned from the version put forth by Gensler, Rozenblit suggested. It is difficult to custody crypto, so one solution would be to exempt it from the Custody Rule, he reasoned. “I think we’re going to get a custody rule that relaxes a lot of the custody requirements.”

See our two-part series on the proposed Custody Rule: “Parameters and Requirements of the Long Overdue Update to the Custody Rule” (Mar. 23, 2023); and “Concerns About the Scope and Specific Items for Closed‑End Fund Managers to Monitor” (Apr. 6, 2023).

Culture and Operational Proficiency

Overall Grade: Below Average/Poor

Split: Average/Below Average (1); Below Average (1); Poor (2)

Positives

Gensler faced a significant managerial challenge in 2021 during the coronavirus pandemic, with SEC staff working almost exclusively out of the office as the pandemic continued, Aderton acknowledged. The Democrats also had reduced congressional power following the 2022 midterm elections, which led to budget issues. Nonetheless, the Commission managed to overcome those obstacles to produce an incredible amount of work during Gensler’s tenure. “Whatever ultimately became of the rules, many were promulgated and just getting through chopping that much wood is a feat unto itself,” he conceded.

SEC staff should also be credited for being quite flexible and diligent in pivoting to a new way of working; for example, the staff continued to advance the regulatory mission through remote exams and remote testimony for several years, Aderton continued. “The building kept moving – they processed a tremendous number of enforcement cases and kept their exam numbers up despite the pandemic and the dispersed workforce.”

See “How Fund Managers Can Prepare for SEC Remote Examinations During the Coronavirus Pandemic” (Sep. 1, 2020).

Negatives

Generally, morale within regulators is good during Democratic administrations, but morale under Gensler was significantly worse than in the previous Republican administration, Rozenblit observed. There may have been several reasons why the culture and morale at the SEC suffered during Gensler’s tenure.

Every SEC Chair coming in during a change of administration needs some time to hire staff and get the Commission back up to full speed, Lynch said. Gensler pushed hard during that period, which may have been tough when morale was already low. “Gensler had good management techniques, but maybe his execution could have been better,” she suggested.

In addition, there seems to have been higher staff attrition – especially of senior staff – during Gensler’s tenure, including longtime staff that many probably expected to spend their entire careers at the Commission, O’Riordan noted. Those departures may have been exacerbated by some of his hiring choices while at the agency. Gensler appointed academics to lead divisions, but they seemed to have limited industry experience, which can be discouraging for seasoned staff with deeper practical knowledge, Rozenblit mentioned. That reflects a general failure by Gensler to take full advantage of the knowledge and expertise available from longstanding SEC staff.

Finally, morale may have been negatively affected by the array of instances when the SEC’s efforts were stymied by the courts. For example, the PFAR, revised dealer definitions and other rules were overturned by courts after the substantial time and dedication that staff devoted to them, Aderton noted.

Potential Changes Under Trump Administration

Morale at the Commission may be in a challenging place in the near term given some of the court and industry pushback against the efforts of the past administration, the expected hiring freeze and the Trump administration suggesting belt tightening will continue at administrative agencies, Aderton reasoned. “Morale was at its highest during former SEC Chair Mary Jo White’s tenure in the Obama administration and remained steady under Chairman Jay Clayton. However, it has declined rapidly since then, with no clear signs of improvement,” Rozenblit added.

Specifically, there has been some suggestion that the Trump administration will introduce new pay caps and change how people are promoted at the SEC, which would be extremely harmful to the agency and result in more attrition in favor of better compensation in the private sector, Lynch speculated. “If they don’t have certain pay scales and known increases each year, that will lead staff to want to leave sooner and make staffing much more difficult. Without the right people, they’re really going to have their hands tied.”

With that said, there may be some ways to elevate staff morale in the new administration. “The SEC is filled with dedicated professionals. Leadership that engages with the staff and shows how much they are valued can be positive for morale,” Aderton posited.

Relationship With the Private Funds Industry

Overall Grade: Below Average

Split: Average (1); Below Average (2); Poor (1)

Positives

The private funds industry has always had a somewhat adversarial relationship with the SEC, and it likely hasn’t worsened significantly, even amid the heightened scrutiny under Gensler, Rozenblit opined.

Despite the PFAR being vacated, private fund investors have looked to that rule for guidance, and it has in some ways empowered them to take some matters into their own hands, Rozenblit asserted. “You can see [Institutional Limited Partners Association] taking up the mantle and enhancing their reporting template.”

See “ILPA Guidance Promotes Equitable Framework for Continuation Fund Transactions” (Jul. 27, 2023).

In addition, the private funds industry was well-examined during Gensler’s tenure and at least received guidance on what their compliance programs should look like through that process, Lynch noted. “I think some CCOs quietly appreciated the amount of noise Gensler made about the private funds industry because it reinforced the importance of compliance in their organizations,” Rozenblit added.

Negatives

Gensler made it clear from the outset that the private funds industry was in his sights, and that was reflected in the SEC’s rulemaking, examination efforts and enforcement actions, Lynch said. That stance engendered some backlash from the private funds industry, including numerous court challenges of enforcement actions and rulemaking, which ultimately culminated in the PFAR being vacated, she stated. “By the end of Gensler’s tenure, his relationship with the industry was somewhat sour.”

The antagonistic relationship between the SEC under Gensler and the private funds industry seemed to largely stem from the premise that private fund managers “are in it for themselves and not in it for their investors,” Aderton observed. “The SEC’s pursuit of the private fund industry has not been balanced with an acknowledgment that so many pension funds and other institutional investors turn to the private funds industry because they’re looking for better returns for their ultimate beneficiaries, and they feel like they can find it there.”

During Gensler’s tenure, there was a feeling within the private funds industry that it was viewed as the enemy by the Commission despite the incredible value the industry provides to investors, O’Riordan agreed. That undercurrent narrowed the lines of communication, and those in the private funds industry may have been reluctant to raise any issues they were seeing with the SEC, even quietly during information meetings. “I think the private funds industry felt alienated by the Commission because their voices were not being heard,” Lynch added.

In addition, the SEC’s posture did not seem to acknowledge that many LPs are well-advised, sophisticated players that can protect their own interests, Aderton said. “Much is lost in the desire to look through the pension plan to underlying beneficiaries, as opposed to recognizing that for many private funds significant market power resides with the LP, as the customer, rather than the private fund manager.”

See “Practical Insights on Five Problematic GP/LP Dynamics Identified by SEC Chair Gensler” (Feb. 1, 2022).

Potential Changes Under Trump Administration

The experts interviewed by the Private Equity Law Report agreed that the private funds industry’s relationship with the SEC is likely to improve under the Trump administration. “I think the private funds industry is going to believe, and appreciate, that they have a better audience to talk to under the next administration,” O’Riordan said. “The industry may be more willing to communicate with the regulator if they do not feel there will be a knee-jerk reaction and rulemaking.”

A major impetus for the likely improved relationship between the private funds industry and the Commission is the latter’s expected focus on matters directly affecting retail investors, as opposed to indirect protection of those investors via regulating private funds. However, that shifting focus is unlikely to completely take the private funds industry out of the SEC’s gaze. Although there may be more focus on protecting retail investors, private funds may come within that sphere because they are becoming more creative with their product offerings to reach the retail market, Lynch noted. “Also, Examinations’ priorities – including as to private funds – remain current and it may take some time for that ship to change course.”

See “SEC 2025 Examination Priorities Feature Essential Compliance Concerns, Emerging Technologies and Several Notable Omissions” (Dec. 12, 2024).

Conclusion: Gensler’s Legacy

When considered across various criteria, the experts interviewed by the Private Equity Law Report struck a pretty negative tone as to Gensler’s legacy as Chair of the SEC – both in general and specifically with regard to oversight of the private funds industry. “With respect to the private funds industry, the past administration may be viewed as an unsuccessful effort to expand the regulatory remit as to that industry that also may have created challenges going forward as to future regulations,” Aderton summarized.

Another prominent element of Gensler’s legacy may be what he failed to focus on during his tenure. Gensler’s background put him in a strong position to address cryptocurrencies and digital assets, which he talked about coming into the role but then failed to deliver, Lynch observed. In fact, as opposed to charting a regulatory path forward for the burgeoning class of digital assets, he expended significant resources of Examinations and Enforcement staff to actively take a strong stance against them. “Although Gensler said Congress had not given him authority over digital assets, Commissioner Peirce seems to have a plan for regulating them and it remains to be seen who is correct,” she noted.

With that said, Gensler’s legacy may be dictated by what happens next and reactions to, or repercussions from, what has occurred during his tenure, O’Riordan suggested. If there is a significant market event related to the private funds industry or the crypto industry, then Gensler may be credited for attempting to address those areas in more depth through his robust rulemaking and enforcement efforts. “It is notable, however, that Gensler emphasized in speeches that the SEC’s role was not to weigh in on whether an investment was good or bad, but that is exactly what he seemed to do,” she clarified.

See “PE Industry in 2025: Trump Administration’s Likely Impact on Rulemaking, Examinations and Enforcement (Part One of Two)” (Jan. 9, 2025).

PE sponsors’ practices have become more complicated over the years as firms seek an edge when valuing Level‑3 assets and as investment strategies have become increasingly complex. That has trickled down to firms’ financial statements and the opinions provided by auditors, particularly as auditors deploy sophisticated methodologies to probe valuations; fee and expense allocations; and other critical financial reviews. Ideally, a sponsor would receive an unqualified opinion from their auditor, but it is quite common for material misstatements or other discrepancies to lead to a qualified opinion or, in the worst-case scenario, an adverse opinion.

Although, institutional investors have become more sophisticated at scrutinizing PE sponsors’ practices during their operational due diligence, it can still be daunting to parse the nuances and significance of issues raised in a sponsor’s audit report or valuation policy. To help PE investors understand and navigate sponsors’ financials, the Investment Management Due Diligence Association (IMDDA) hosted a webinar that was moderated by its co‑founder, Daniel Strachman, and featured Jennifer Cuello and Thomas Murdoch, who are both audit partners in EisnerAmper’s financial services group.

This article summarizes key takeaways from the webinar, including an overview of the audit process; recommendations on what investors should look for or ask about when reviewing a fund’s financial statements; and practical tips about how to confront key issues that can arise in audits of PE sponsors.

For more on the audit process, see “The Importance of Exercising Due Diligence When Hiring Auditors and Other Vendors” (Jun. 21, 2018).

What an Audit Entails

The audit process can be broken down into three phases: planning, field work and wrap-up, Cuello summarized. It is critical to begin the process as early as possible, with most firms initiating their annual audit in August or September. “We use that time to get ahead of things,” she explained. “The planning process is very robust, so it’s absolutely necessary that we start on time so that we can do a quality audit and balance that with efficiency.”

In many cases, the audit will run straight through the third fiscal quarter of a given year. When possible, Cuello and her colleagues seek to review investment purchases and sales, and other capital activity, well before January, she stated. “For investments in particular, we’re not only confirming the existence of that investment but also getting the tax table as of the balance sheet date and confirming any metrics that we can.”

Scope of Audit

Besides conducting a thorough examination of a firm’s financial reporting and who oversees it, Cuello and her colleagues look into a firm’s IT controls – with a particular focus on any points of intersection between the firm and a third party. That is absolutely critical for ensuring the privacy and integrity of information at the firm, she stressed.

It is important to note, however, that testing IT systems for faults falls beyond the scope of most audits, Cuello clarified. “I think some people assume we are also testing IT controls along with the audit,” she explained. “We gain an understanding of controls – e.g., we walk through them – but in the private funds industry it’s really unlikely that we’re actually going to test controls.”

With that said, auditors will examine the control framework for financial reporting and conduct a preliminary analytical review of the fund’s finances and operational risks, Cuello noted. They also will scrutinize the numbers on a firm’s books and compare the figures to the year before, probing for anything that stands out. That process is useful for rooting out irregularities, she said. “For example, we’ve seen negative expenses that are really income, or we’ve seen the investment balance changed considerably when we weren’t really expecting it.”

Sorting Investments

As part of the audit process, Cuello described the following classification scheme that auditors use to sort a firm’s investments based on their transparency:

• Level‑1 Investments: An asset with observable inputs, such as an investment in a stock with an easily available public price (e.g., Apple stock).
• Level‑2 Investments: An asset with at least some level of unobservable input, such as stock that has a public market price but is not traded at a high enough volume for there to be much data available on its performance.
• Level‑3 Investments: An investment in a private company for which no pricing data is publicly available, which requires auditors to construct a model based on data for comparable companies.

See “SEC Enforcement Action Scrutinizes Substantive Details of Level‑3 Valuation Policies and Procedures” (Jun. 29, 2023).

This phase of the audit can be more time-consuming than many fund managers anticipate, Cuello cautioned. “Some people, especially first-time managers, think we just come in, we get bank statements and documents, and then we go,” she said. “In a lot of cases, that’s not true. We have a really robust process that starts early,” she recounted. “So much goes on behind the scenes, including many interactions with the client and third-party providers.”

Determining Accurate Valuations

Valuation Methodologies and Teams

Auditors pay close attention to a firm’s valuations of its investments and portfolio companies, and any related disclosures, Murdoch said. Specifically, auditors look beyond public stock prices and examine a manager’s valuation methodology on a granular level. Of particular concern to auditors is whether managers assign fair value to their assets, which is a value that accurately reflects what the manager would receive from the sale of the asset, or would pay to acquire it, in an orderly transaction between market participants, he explained.

Warning against the manipulation of metrics to make a firm’s financials look better than they really are, Murdoch gave a cautionary example. One client used generally accepted accounting principles in its financial reporting and culled data from the 12 months prior to the valuation date stated in its official figures. The underlying company was performing so poorly, however, that the client decided to flip the time frame by presenting a financial statement based on the 12 months ahead. “In essence, the client issued a projection rather than a traditional financial report,” he explained. “Needless to say, we did not agree with that change,” he quipped. “Be aware of the methodology, and just inquire if something does not feel right.”

Further, it should be highly important for investors to know that experienced and well-informed financial professionals are performing the valuations, Murdoch continued. “For example, is the responsibility left to a handful of third-year investment associates? We hope not. Or is it two of the managing partners and a subcommittee of three deal team members that make up a formal investment committee?”

See “What Role Should the GC or CCO Play in the Audit of a Fund’s Financial Statements?” (Feb. 4, 2020).

Critical Valuation Documents

When reviewing valuations and assessing their accuracy and transparency, auditors may prepare an unobservable input table, or request one from the fund manager, Murdoch stated. “That is where the fund manager discloses significant valuation approaches, techniques and inputs, such as whether they are using the income approach or the market approach,” he explained.

The unobservable input table is of paramount importance to investors as it enables them to see whether the fund manager is making investments and pursuing investment strategies in accordance with the terms to which the investors originally agreed. For example, the table would indicate whether a venture capital (VC) manager is using EBITDA (earnings before interest, taxes, depreciation and amortization) multiples in its financial reporting, which would be highly irregular given that VC funds make investments in early-stage companies with little or no revenue – rendering EBITDA metrics irrelevant.

Given the prevalence of investment strategies that involve real estate assets, auditors will also seek profit-and-loss statements (P&Ls) that give an accurate sense of the net operating income of a given asset, Murdoch noted. In addition to asking the fund manager for such documentation, auditors will obtain P&Ls from a third party to ensure an independent and accurate valuation of the asset in question, he said.

Another section of the auditor’s opinion of overriding importance to investors is the equity section, setting forth how the fund allocates various elements of its profits and losses, Murdoch continued. This section is crucial for establishing:

• whether a given allocation is consistent with the terms to which investors agreed;
• whether the carry percentage and hurdle rates are as agreed;
• the existence of any side letters between managers and investors; and
• any other factors that may affect allocations and the equitable treatment of investors in a given fund or group of funds.

Of course, side letters are common and do not necessarily raise any flags, Murdoch acknowledged. At the end of the day, the appropriateness of such arrangements depends on what managers and investors have agreed.

Addressing Fund Expenses

Management Fee Offsets

Management fees are a fund’s most significant expense. A fund’s limited partnership agreement or limited liability partnership agreement must clearly set forth what the manager’s compensation will be, and also ensure that any related party agreements are also crystal clear, Murdoch noted.

See “Recent Survey Shows Market Adversity Is Tempering LPs’ Ability to Negotiate Key PE Fund Terms” (Sep. 5, 2024).

In many cases, management fees are clearly established when a fund is launched and do not lead to any operational or reporting irregularities. It is important to be aware of management fee offsets, however, which come into play when employees of a management company or their partners provide services for portfolio companies, Murdoch cautioned. “Usually, based on the fund agreements, payments for those services are an offset to the management fee that investors have to pay, and should be disclosed in the financial statements.” If financial statements do not clearly specify those management fee offsets, then that should be noted in auditors’ opinions, he advised.

When management fee offsets are in place, the possibility of duplicative payments, or what Murdoch called “double-dipping,” is a danger. That happens when a fund manager’s employees or their partners receive compensation from the management company for a service they have provided to a portfolio company, and attempt to pass on a consulting fee to the investor. “Those persons are already being paid a quarterly management fee by the investor to manage that portfolio,” he noted, “so why would they be getting additional consulting fees? Well, the answer is they should not get paid twice for doing one job.”

See “What to Expect From Today’s SEC Examinations and Enforcement Relating to PE Management Fees and Expenses (Part One of Two)” (Sep. 21, 2023).

Hidden Expenses

Partnership agreements between investors and fund managers must make a clear and accurate reckoning of all allowable expenses, Murdoch asserted. It is common for those agreements to make explicit allowances for tax, legal and accounting fees, but there are other types of expenses that they should include. For example, when a manager of several funds participates in an annual investor meeting, which part of the portfolio will cover that expense? The agreement should clearly spell out how that expense will be allocated among the funds the manager oversees, he advised.

It would be a mistake for fund managers and investors to overlook the allocation procedures of operational expenses and other fund-related expenses just because they are for relatively minor amounts, Murdoch argued. “They’re usually a small percentage of the net asset value, but are highly scrutinized by regulatory authorities and very important to investors.” In fact, the SEC’s 2025 examination priorities identified fund fee expenses, as well as related waivers and reimbursements, as one of the regulator’s primary areas of focus in the new year, he added.

See “SEC 2025 Examination Priorities Feature Essential Compliance Concerns, Emerging Technologies and Several Notable Omissions” (Dec. 12, 2024).

Independent Confirmation

Portfolio Company Verifications

Often, a fund manager incurs myriad consulting, advisory and other fees that it does not report in its financial statements. Auditors would never know of such expenses – or be able to factor them into the opinions they issue – without making certain inquiries during the audit, Murdoch noted.

Specifically, auditors often independently verify with any portfolio companies how much they have paid the fund manager in the way of fees, Murdoch continued. That is a crucial way of ferreting out any expenses that may not be consistent with investors’ understanding. “We hope the portfolio companies respond, and respond accurately, and when they do, if we see that it agrees with what the client has offset, great,” he explained. “If it doesn’t, it’s usually a discussion, because sometimes whoever’s responding may not know exactly what we’re asking and there could be some confusion.”

Commitment and Contingency Footnotes

Investors must also be aware of whether their fund documents contain all proper and necessary footnotes setting forth a manager’s commitment of a certain amount of money to guarantee a portfolio company’s debt or other liability, Murdoch stated. Those disclosures are vitally important to any assessment of a fund’s operational strategies, its solvency, its general performance and the commitments it has made to its portfolio companies. “Can the fund satisfy the guarantee and commitments it has promised its portfolio companies, continue to pay expenses through the life of the fund and also make new investments and follow-ons?”

Oftentimes the commitment and guarantee footnotes are fine because fund managers’ interests are aligned with their investors as to portfolio companies in that they want to manage them, help them avoid filing for bankruptcy and get them to the next stage of financing, Murdoch assured. “Sometimes those disclosures can constitute a red flag, however, so investors should be sure not to just walk over that commitment footnote – especially if there’s something in there other than just general terms.”

Possible Outcomes

Types of Deliverables

An audit is a “robust process” that, according to Cuello, results in up to three primary deliverables for the end user:

• financial statement;
• governance letter; and
• management letter.

A governance letter is often “very boilerplate, very simple,” she clarified. It typically does not address highly serious operational or reporting problems, although Level‑3 investments will show up in the governance letter. Alternatively, the auditor will issue a management letter if serious omissions or misstatements of a firm’s financials come to light that exceed the auditors’ materiality threshold, she added.

The issuance of a management letter means that auditors have found potentially problematic issues rooted in uncorrected misstatements that can fall into a few categories, Cuello continued. The first is a trivial misstatement, which does not cause auditors to view financial statements to be materially wrong. The other, more serious types are tolerable misstatements, which represent a percentage of the materiality standard that auditors have decided to apply, she added. Anything above a tolerable misstatement will prevent the auditors from issuing the unqualified opinion that auditees desire.

Opinion Letters

The review of financial statements and interactions with clients and third parties will result in the issuance of an opinion in the auditors’ final report. Virtually all firms that undergo an audit would like to receive an unqualified opinion from the auditor, Murdoch asserted. “Issuance of an unqualified opinion means the financials are in good order, and we have not found any significant issues.”

The second-most desirable outcome is a qualified opinion, or what Murdoch and colleagues term an “except for” opinion. That applies to a firm that has stated its financials fairly, with the exception of a specific area identified in the opinion. Examples of circumstances where a firm would receive a qualified opinion include when a digital asset fund has made accurate representations of its financials except for the custody of certain digitals assets, or when a fund manager’s financial statements are in order save for the valuation of a private company that cannot be independently verified.

See “How Do Regulatory Investigations Affect the Private Fund Audit Process, Investor Redemptions, Reporting of Loss Contingencies and Management Representation Letters?” (Jan. 22, 2015).

An auditee that does not receive an unqualified or a qualified opinion may receive a disclaimer, indicating that the auditors do not have enough evidence to issue an opinion either because information requested is unavailable or the firm cannot or will not provide it.

By far the least desirable outcome for the auditee is an adverse opinion, which occurs “when the auditor determines that a company’s financials are materially misstated and do not indicate the company’s financial health,” Murdoch said. The implications of an adverse opinion are potentially quite serious, as it indicates potential fraud and definite misstatements.

An audit opinion may also contain a paragraph calling the reader’s attention to matters that do not necessarily indicate any unfavorable judgement on the auditor’s part, but that the reader should know about, Murdoch concluded. Common examples include the liquidation of a fund by a manager winding up investment activities, and material litigation involving the fund and/or its principals.

The SEC gathered representatives at its Compliance Outreach Program to discuss private fund manager practices and general areas of focus garnering increased SEC scrutiny. One panel featured Shane Cox, Regulatory Counsel, Private Funds Unit in the SEC Division of Examinations (Examinations); Lee A. Greenwood, Assistant Regional Director, Asset Management Unit (AMU) in the SEC Division of Enforcement (Enforcement); Adele Kittredge Murray, Private Funds Attorney Fellow, SEC Division of Investment Management (IM); and Michael C. Neus, chief administrative officer, Brevan Howard US Investment Management LP.

This second article in a two-part series details problematic practices of private credit funds relating to insider trading and valuations, as well as omnipresent SEC concerns about conflicts arising as to disclosures about, and allocations of, fees and expenses. The first article identified specific areas of focus for Examinations and Enforcement under Rule 206(4)‑1 of the Investment Advisers Act of 1940 (Advisers Act), known as the Marketing Rule.

See “Potential Areas of Scrutiny in Future SEC Examinations of PE Sponsors” (Jan. 9, 2025).

Private Credit and Valuations

Private credit is not a new strategy for private funds, but the asset class has grown significantly in recent years, Murray observed. IM is looking at any potential market risks and investor harm that may arise from private credit’s growth and evolution, including:

• how funds are structured;
• how fees are structured;
• how fund liquidity is structured to match the liquidity of underlying assets; and
• its interconnectedness with other market participants.

The definition of private credit and its role in the lending markets are also evolving, Murray noted. Historically, the narrowest definition was direct lending to middle market corporate borrowers, but that has broadened and may now include private asset-backed finance strategies and products, she elaborated. Also, historically, a borrower – often a PE portfolio company – would approach a bank for funds and the bank would set up a syndicate, Neus stated. Following the 2008 global financial crisis, however, banks reduced their balance sheets. As a result, the holders of private credit tend to be narrower, so there are no third-party trades where a piece of a loan is sold, for example.

The growth in the asset class has captured the attention of various market participants and regulators, who are asking questions about transparency, valuations, conflicts of interest and the interconnectedness to other financial institutions, Murray noted. It helps that private credit is held in numerous types of fund vehicles, so there is some data transparency. For example, registered business development companies report on Forms 10‑Q and 10‑K, and registered investment companies report details on private credit strategies for Section 2 and Section 4 reporting funds on the new Form PF, she added.

See “Proskauer Private Credit Survey Finds Industry Cautiously Optimistic” (Mar. 21, 2024).

Examinations Perspective

Examinations’ focus evolves as it responds to new risks or changes within the private funds industry, so there are likely to be more exams of private credit funds given the growth of the asset class, Cox said.

Valuations are a focus area in exams of private credit funds, including reviews of written policies and procedures on valuations to confirm they are reasonably designed and implemented, Cox stated. Exams look at how changes in credit quality at the borrower impacts valuations, including monitoring for:

• payment defaults;
• covenant breaches;
• signs of significant financial distress; and
• evidence the borrower underwent a workout, reorganization or liquidation.

Exams also look at how changes in the market (i.e., in credit spreads or yields) impact the value of private credit investments, Cox continued. Generally, exams look at valuations from a conflicts of interest perspective, so staff will consider:

• how the deteriorating value of a private credit investment is incorporated into the fee calculation;
• provisions in fund documents addressing how an impairment, write down or write off of a private credit investment is treated;
• what fund documents say about the invested capital base when interest is accruing but not being paid; and
• whether the adviser is including accrued but unpaid interest into the investor capital base when calculating the management fee.

See our two-part series: “Latest on Private Credit Funds’ Recycling Provisions, Subsequent Close Models and Use of Levered Parallel Funds” (Feb. 9, 2023); and “Trends in Management Fee Base Calculations, Evergreen Structures and Tax Issues for Private Credit Funds” (Jan. 26, 2023).

In addition, the value of private credit investments can impact the performance returns shown in marketing materials, and Examinations is particularly sensitive to that issue when fundraising for a new fund, Cox said. “If CCOs are not ingrained effectively across the business, then that is an area where they can miss material issues if an adviser has a significant conflict of interest related to fees and portfolio management decisions or issues related to performance marketing.”

Further, advisers may be operating private credit funds alongside other funds that are invested in different parts of a company’s capital structure, Cox noted. Those conflicts are likely to be reviewed during an exam – particularly if the company is experiencing financial distress – because it may be in one fund’s interest for that company to restructure but not in the other fund’s interest, he added.

To further illustrate that point, Neus posited a scenario where a PE fund has a portfolio company that needs financing, so a private credit fund with a similar management company grants the company a two-year term loan. Instead of the term loan coming due and the borrower going back to the market, the private credit fund chooses to extend the loan for the benefit of the operating company. As there is no independent third-party valuation, all the risk is on the management company because the operating company and private credit team have different incentives, he elaborated.

See our two-part series on captive debt and equity investing: “How to Use LPACs and Third‑Party Valuation Providers to Mitigate the Inherent Risks” (Mar. 2, 2021); and “How Sponsors Can Structure and Document Investments to Reduce Inherent Conflicts” (Mar. 9, 2021).

Enforcement Perspective

A recent focus for Enforcement has been how private credit advisers come into possession of material nonpublic information (MNPI) and what they do with that information, Greenwood said. The key provision is Section 204A of the Advisers Act, which requires registered investment advisers to establish, maintain and enforce written policies and procedures reasonably designed – taking into consideration the nature of their business – to prevent the misuse of MNPI, he explained.

From Enforcement’s perspective, a generic, off-the-shelf policy is inadequate, Greenwood continued. To ensure their policies and procedures keep pace with their business practices, advisers need to consider their business lines, whether they overlap and any new business areas they may be moving into in the future, he added.

Overview of Recent Enforcement Actions

Enforcement brought two interesting Section 204A cases in the private funds space, which were settled in August 2024 and September 2024, respectively, Greenwood noted. Both cases involved participation in ad hoc committees of creditors and the risks of receiving MNPI that may impact other business lines, he summarized.

In the first case, Sound Point Capital Management LP (Sound Point) had a credit business and a collateralized loan obligation (CLO) trading business, Greenwood said. Through its credit business, Sound Point received MNPI relating to loans in the CLOs it traded. According to the order, Sound Point was aware it may receive MNPI from its credit business, but there were no written policies and procedures to assess the potential for misuse of MNPI in its CLO trading, he explained.

See “Inadequate MNPI Policies Cost CLO and Private Fund Adviser $1.8 Million” (Jan. 9, 2025).

Similarly, Marathon Asset Management LP (Marathon) regularly participated in ad hoc creditors committees and interacted with investors, financial advisers and consultants, Greenwood continued. Marathon came into possession of MNPI but lacked adequate policies and procedures to address the attendant risks, he added.

Lessons From Marathon and Sound Point

From Enforcement’s perspective, the first key takeaway from Marathon and Sound Point is that advisers must ensure their policies consider the unique components of their business lines, Greenwood asserted. Firms must assess the ways they receive MNPI and how they can mitigate their MNPI risks through policies and procedures, which may entail information barriers, he noted.

Second, when an employee has MNPI and is actively trading in other companies in the same sector, the issues may go beyond compliance with Section 204A, Greenwood stated. In SEC v. Panuwat, the jury returned a verdict in favor of the SEC in April 2024, finding insider trading based on the traditional elements of misappropriation theory:

• Did the receiver have a duty to the source of the information?
• Was that duty breached?
• Was the information traded on?

“It’s always something to be thoughtful of as well in this space when thinking about Section 204A,” he emphasized.

See “Practical Takeaways for PE Sponsors From the SEC’s Victory in First Ever ‘Shadow Trading’ Case” (May 30, 2024).

Third, simply having policies and procedures is insufficient – they must be properly implemented, Greenwood noted. For example, the SEC settled charges against OEP Capital Advisors, LP (OEP) in December 2023. OEP personnel did not comply with the firm’s policies and procedures for disclosing merger-related MNPI to current investors, potential investors and other contacts specified in OEP’s policies. Although OEP used non-disclosure agreements (NDAs) to mitigate MNPI issues, that was not the same as maintaining and enforcing its policies. In addition, OEP did not have policies related to how to use or consider NDAs, he added.

See “SEC Enforcement Action Targets Non‑Violative Use of MNPI Through Policy and Procedure Failures” (Mar. 7, 2024).

The fourth takeaway from recent cases is that firms should arm their compliance groups with the necessary tools to assess MNPI and its materiality, Greenwood continued. Clear escalation protocols should be established, he added.

Finally, prompt remediation and cooperation are incredibly important for all enforcement cases, Greenwood emphasized. “We think about it at the beginning, the middle and the end of our investigations. It’s something that we think about when we craft settlements, and any cooperation and remediation efforts are certainly reflected in our orders – including Sound Point and Marathon.”

As Sound Point and Marathon illustrate, firms may overlook that a breach of duty regarding MNPI need not relate to the issuer of the security that is being traded, Neus observed. For example, a member of an ad hoc creditors committee may realize the company is the largest vendor to another company, and that the committee’s decision to restructure may affect that other company.

In light of those concerns, it is incredibly important to have a firmwide conflicts committee with representatives from compliance, legal, front office, investment and marketing to tie in all the relevant issues so that policies and procedures are effective across the firm, Neus explained.

See “Improper Expense Allocations and Careless Valuation Practices Result in Nearly $4 Million in Fines and Disgorgement for BDC Adviser” (Jan. 10, 2019).

Conflicts Relating to Fees and Expenses

Fiduciary Obligations, Filings and Disclosures

Disclosures in Part 2A of Form ADV should include information that a reasonable investor would need to know to make an informed investment decision, Murray summarized. The Form ADV disclosure obligation works in concert with an adviser’s fiduciary duty obligations, and advisers are encouraged to read the Commission’s Interpretation Regarding Standard of Conduct for Investment Advisers (Interpretation) that was issued in 2019, she added. The Interpretation should be an adviser’s starting point, Neus agreed. There are three elements: disclosure, eliminating conflicts and mitigating conflicts.

See our three-part series on the Interpretation: “What It Means to Be a Fiduciary” (Dec. 3, 2019); “Six Tools to Systematically Identify Conflicts of Interest” (Dec. 10, 2019); and “Three Tools to Systematically Monitor Conflicts of Interest” (Dec. 17, 2019).

The ecosystem in a private fund is different from retail because institutional investors tend to have more robust due diligence processes, so best practice is to include the broad principles and significantly material items in Form ADV and private placement memoranda, Neus said. It is not in the interest of investors to file a Form ADV every month when there is a new conflicted issue, and it is best practice to update Form ADV annually. More details can be provided in due diligence questionnaires, which are usually updated on a quarterly basis, or sometimes semi-annually or annually, he suggested.

Generally, private funds must comply with custody rules and almost always have audited financial statements, Neus continued. GCs or compliance usually overlook the footnotes in financial statements, but they may be considered disclosures. Legal and compliance should look at such footnotes as part of the annual review, he recommended.

Enforcement is focused on “may” disclosures when something is in fact happening, Greenwood said. Charges were recently settled against an adviser that had consulting agreements with third parties, outside revenue streams and investments in activist campaigns alongside private funds, but disclosures stated the relevant activities “may” occur. Enforcement frequently receives exam referrals about “may” disclosures. “We speak with our colleagues in IM and we all agree that it’s a real problem,” he noted.

See “SEC Enforces Its Fiduciary Interpretation by Cracking Down on Use of ‘May’ in Disclosures” (Jan. 7, 2020).

Specific Fee and Expense Concerns

When completing Form ADV, advisers should consider whether they have accurately described fees and expenses, Murray continued. If an investor cannot determine the magnitude of a certain expense, then Examinations or Enforcement may take the view that the expense has not been accurately described. An adviser cannot obfuscate the importance of a fee or an expense in its investor disclosures, she noted.

Typically, fee and expense cases come from exam referrals, Greenwood said. Enforcement discusses the issues with its industry experts in the AMU, Examinations and IM. From an Enforcement perspective, the goal is to not second guess or rewrite contracts negotiated by highly sophisticated parties, but to understand what they say and ensure the registrant is doing what they said they would do about charging fees and allocating expenses, he explained.

Two recent cases involved conflicts around fees or expenses, Greenwood noted. In June 2023, charges were settled against Insight Venture Management LLC (Insight) for charging excess management fees. The limited partnership agreements (LPAs) identified the need to calculate expenses after a reduction for a permanent impairment at the portfolio company level as opposed to the portfolio investment level. The distinction between the portfolio company and portfolio investment levels can be material. In Insight, the SEC order found that Insight was not acting consistently with its documents, he said.

The other key takeaway from Insight is a more nuanced conflict issue, Greenwood continued. The SEC order found that Insight did not disclose a conflict related to its permanent impairment criteria. Specifically, Insight used undisclosed criteria that were so narrow and subjective that very few assets were ever written down to permanent impairment, which was considered a disclosable conflict, he elaborated.

See “SEC Enforcement Action Targets PE Sponsor’s Write‑Down Mechanics and Related Disclosures to LPs” (Jul. 13, 2023).

The second case was against Colony Capital Investment Advisors, LLC (Colony) in September 2024, Greenwood said. The SEC order in that case found that Colony breached its fiduciary duty by failing to follow certain contractually agreed provisions governing the timely disclosure of, and consent to, expenses allocated to a series of private real estate funds that Colony managed. The expenses were being paid by Colony affiliates, the affiliates were providing services and the private real estate funds were making payments back to Colony. That arrangement gave rise to a clear, disclosable conflict, he explained.

Colony’s LPAs generally required the relevant transactions to be disclosed in writing to LPs and LP advisory committees, and LP consent to be obtained, Greenwood noted. If there is cost shifting to any adviser affiliates, the adviser must consider whether that cost shifting is disclosed. Again, cooperation and remediation were important in both Insight and Colony, he emphasized.

Advisers must take a holistic approach when determining whether they are required to register with the SEC. And if they get that determination wrong, the SEC is likely to notice and take action. In a settled enforcement proceeding, the SEC claimed ACP Venture Capital Management Fund LLC (ACP) improperly relied on the private fund adviser exemption from registration under the Investment Advisers Act of 1940 (Advisers Act). ACP had overlapping owners, managers, advisory personnel and operations with another adviser with which it shared office space. The nature and size of the operationally integrated enterprise rendered ACP ineligible for the claimed exemption. Additionally, because ACP should have registered, it was subject to Rule 206(4)‑2 under the Advisers Act – commonly known as the “Custody Rule” – but failed to comply with that Rule. This article discusses the basis for the enforcement proceeding, the alleged violations and the terms of the settlement.

See our two-part series: “Best Practices for Exempt Reporting Advisers to Build and Implement Compliance Programs to Support a Transition to RIA Status” (Jul. 21, 2020); and “Notable SEC Examination Methods and Substantive Focus Areas for Exempt Reporting Advisers and Tips for Avoiding Violations” (Jul. 28, 2020).

ACP and Affiliated Adviser

ACP began operating in 2017. As of November 2018, it had approximately $39.6 million in regulatory assets under management (AUM), according to the settled enforcement order (Order), which covers the period from November 2018 through January 2023 (Relevant Period). By the end of the Relevant Period, ACP managed 12 private funds (ACP Funds), which had approximately $139.4 million in aggregate AUM. The Funds invested primarily in pre-IPO shares or in other funds holding pre-IPO shares.

Non-party Partners Capital Services Inc. (Partners Capital) first registered with the SEC as an investment adviser in 2014. As of the end of the Relevant Period, Partners Capital had 298 advisory clients, all of which were individuals or trusts, and approximately $114 million in aggregate AUM. It invested client assets, directly or indirectly, in publicly traded securities.

Officers and Directors

According to the Order, ACP and Partners Capital had overlapping officers, directors and other key personnel during the Relevant Period:

• “Individual A” owned 50% of ACP and 20% of Partners Capital; served as CCO of both entities; and co‑managed one of the ACP Funds;
• “Individual B” owned 40% of Partners Capital and co-managed 12 ACP Funds;
• “Individual C” owned 40% of Partners Capital, served as its president and co‑managed one of the ACP Funds; and
• “Individual D” owned 50% of ACP and co‑managed 12 ACP Funds, while serving as an accounting consultant to Partners Capital.

Other Personnel

At times during the Relevant Period, two individuals who were registered as investment advisory representatives (IARs) of Partners Capital also served as co‑managers of certain ACP Funds. Additionally, on the recommendation of certain Partners Capital IARs, about two dozen Partners Capital clients invested in ACP Funds. At the time, those IARs were also registered representatives of an ACP affiliate that served as a placement agent for the ACP Funds.

Operations

ACP and Partners Capital also had overlapping operations during the Relevant Period, including:

• shared offices, with no physical separation between ACP and Partners Capital;
• the same email domains and phone numbers; and
• the same information technology system.

Additionally, neither ACP nor Partners Capital had any policies or procedures “to keep themselves separate from one another or protect investment advisory information from one entity from disclosure to the other,” asserted the SEC.

Improper Reliance on Private Fund Adviser Exemption

At the beginning of the Relevant Period, ACP began to rely on the private fund adviser exemption from registration set forth in Section 203(m) of the Advisers Act and Rule 203(m)‑1 thereunder, which exempts from the registration requirement under Section 203 of the Advisers Act a U.S.-based adviser that:

• acts solely as an investment adviser to one or more qualifying private funds; and
• manages private fund assets of less than $150 million.

In reliance on that exemption, ACP began filing Form ADV with the SEC as an exempt reporting adviser.

In the adopting release for Rule 203(m)‑1, the SEC said it “would treat as a single adviser two or more affiliated advisers that are separately organized but operationally integrated, which could result in a requirement for one or both advisers to register,” the Order notes. It based that position on Section 208(d) of the Advisers Act, which makes it unlawful for any person to engage indirectly in any conduct that would be prohibited if done directly.

The SEC alleged that ACP did not qualify for the private fund adviser exemption during the Relevant Period because:

• ACP did not solely advise private funds. ACP and Partners Capital, which were an “operationally integrated enterprise,” also advised individuals and other types of clients; and
• their operationally integrated enterprise had a combined AUM exceeding the relevant registration threshold.

See “Considerations for Advisers to Properly Classify Single Investor Funds Under the Custody Rule and Form ADV” (Feb. 4, 2020).

Failure to Comply With the Custody Rule

Advisers that are registered – or required to be registered – with the SEC must comply with the Custody Rule. A fundamental requirement of the Custody Rule is for an adviser with custody of client assets to undergo an annual surprise verification of custody by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board. Alternatively, an adviser to a private fund may distribute audited financial statements prepared in accordance with generally accepted accounting principles to fund investors within 120 days of the end of the fund’s fiscal year.

ACP had custody of the ACP Funds’ assets because, during the Relevant Period, ACP “served as the investment manager of each of the Funds and a related person of [ACP] served as the manager of each of the Funds,” notes the Order. Consequently, because ACP was required to register with the SEC, it should have either undergone a surprise annual custody inspection or complied with the audited financial statement alternative. ACP, however, did neither.

For enforcement actions involving the Custody Rule, see “SEC Settles Five Additional Enforcement Proceedings for Custody Rule and Form ADV Violations” (May 2, 2024); “SEC Sanctions Investment Adviser Over Shortcomings With Custody Rule Financial Statement Requirements” (Apr. 26, 2022); and “Adviser and CCO Sanctioned for Undisclosed Conflicts; Custody Rule Violations; and Deficient Policies and Procedures” (Dec. 21, 2021).

Remedial Actions

At the end of the Relevant Period, ACP and Partners Capital began working to separate their operations. In agreeing to the settlement, the SEC took into account those prompt remedial efforts, which included:

• instituting separate email domains and phone numbers for ACP and Partners Capital;
• physically separating their office spaces;
• eliminating the overlap in their advisory personnel; and
• implementing operational separation policies and procedures.

Violations and Sanctions

Because ACP did not qualify for the private fund adviser exemption from registration – or any other exemption – ACP violated Section 203(a) of the Advisers Act, claimed the SEC. Additionally, ACP violated Section 206(4) of the Advisers Act and Rule 206(4)‑2 thereunder.

Without admitting or denying the facts alleged by the SEC, ACP consented to entry of the Order, which:

• orders ACP to cease and desist from committing or causing any violations of the referenced provisions of the Advisers Act; and
• requires it to pay a $45,000 civil penalty.

Additionally, ACP has undertaken to engage, within 90 days, an independent public accountant to conduct a verifying examination of the funds and securities held by the ACP Funds. At the completion of the examination, which must be finished within 180 days after the Order’s issuance, ACP must certify to the SEC, in writing, its compliance with this undertaking. The examination must conform to the Custody Rule’s requirements, except it will not be:

• done on a “surprise” basis; or
• subject to the requirements of Rule 206(4)‑2(a)(4)(i), (ii) and (iii), which require the accountant to notify the SEC of completion of the exam, any material discrepancies and any termination of its engagement.

See our two-part series on SEC cooperation credit: “Examining HeadSpin As a Framework for Optimal Remediation Measures” (Jun. 1, 2023); and “Inherent Obstacles to Fund Managers Receiving Full Credit” (Jun. 15, 2023).

Weil has welcomed Andrew B. Dean as a partner in the firm’s securities litigation and white collar defense, regulatory and investigations practices in New York. He focuses his practice on government and internal investigations; regulatory enforcement actions; related civil litigation; and regulatory and compliance issues, including in the asset management context.

For commentary from Dean, see our two-part series: “Latest on Navigating the SEC’s Examination Process and Avoiding Referral to the Division of Enforcement” (May 4, 2023); and “Deep Dive on Compliance Issues Targeted in SEC Examinations and the Agency’s Stance on CCO Accountability” (May 18, 2023).

Prior to joining Weil, Dean served as the Co‑Chief of the SEC Division of Enforcement’s Asset Management Unit (AMU), a national specialized group that focuses on misconduct involving PE funds, hedge funds, venture capital funds, mutual funds, exchange traded funds, business development companies, separately managed accounts and related service providers. Under his leadership, the AMU brought SEC enforcement actions involving, among other issues, a billion-dollar valuation fraud; a massive market manipulation scheme; multiple cherry picking frauds; conflicts of interest; misleading fees and expenses; violations of Regulation Best Interest; “AI Washing;” misleading marketing; the Custody Rule; and prohibited joint transactions.

See “SEC Enforcement Actions Targeting ‘AI Washing’ Follow Familiar ESG Playbook for Emerging Areas of Concern” (May 16, 2024); and “SEC Chair Defends Regulation Best Interest and Investment Adviser Fiduciary Duty” (Sep. 10, 2019).