There's a theory in some circles that when it comes to policing crime, the small things matter; if you allow minor infractions (like smashing windows), potential wrongdoers will assume nobody really cares and more serious problems will surely follow.
This so-called ‘broken window theory’ gained credibility in the 1990s after it was embraced by New York City mayor Rudy Giuliani. The city's violent crime rate plummeted during his tenure, and many experts argued that his crackdown on minor offences and annoyances like subway turnstile jumping and drinking in public was, at the very least, a significant factor.
The 800 or so private fund managers advisors expected to undergo an examination this year should take note – because the US Securities and Exchange Commission seems to be adopting a very similar approach to policing the private equity beat.
Industry compliance experts – who observed the SEC’s behavior before Dodd-Frank gave them full oversight of the industry – tell us inspectors used to allow three strikes before a repeated compliance failure was brought to the enforcement division’s attention. “Now it’s more like two strikes and you’re out,” remarks one consultant.
Will this result in lots more firms being brought to book? It seems unlikely – simply because there isn’t much bad behavior in private equity to begin with. As Debevoise & Plimpton funds partner Michael Harrell notes: “I understand the need for cops, but in the private equity neighborhood there is a vigilant neighborhood watch – the limited partners.”
Nonetheless, the SEC’s tough approach to compliance failures creates certain risks that fund advisors need to be aware of. Already the industry has seen enforcement action taken against firms for technical custody rule violations – even where no harm had been done to investors – and for failure to address compliance gaps flagged in earlier exams.
These enforcement cases are clearly legitimate; rules exist for a reason, after all. But in other areas, the SEC’s low-tolerance mentality is resulting in cases where the alleged compliance infraction is dubious, to say the least.
In one instance a GP hired an outside consultant to update its expense allocation policies in order to meet SEC expectations, only to be told that past funds would now have to be evaluated in line with the new policies.
To avoid enforcement action, legal experts recommend fund advisors undergoing an inspection to proactively request an exit interview, even if it hasn't been offered. And where disagreements arise, advisors should (respectfully) ensure that they are recorded in inspectors’ notes.
In fact, documentation is key. The CCO, or whoever the point person is for SEC communications, should keep a journal of documents requested and provided to SEC staff, as well as document changes made at the firm to address past compliance deficiencies.
During follow-up exams, these safeguards may not be enough to avoid getting a deficiency letter. But it should at least wipe away any impression of being a turnstile jumper.