Covid-19 is a double-barreled compliance crisis for private funds.
On the one hand, as cash evaporates it could expose weak investments or even outright fraud and may pressure firms to cut regulatory corners. “Liquidity crunches don’t only cause problems, they reveal them,” says Michael Birnbaum, a partner with Morrison & Foerster’s New York office. “In the extreme scenario, a Ponzi scheme doesn’t work when everyone wants their money. But even a well-run bank doesn’t keep all its assets in one place.”
On the other hand, it’s harder for compliance officers to keep an eye on things when everyone is telecommuting. Private funds are required to be audited, and it’s always possible to bring auditors in to lend a hand about any concerns, but auditors—by definition—are looking for problems after-the-fact. How to get ahead of trouble?
For the compliance officer, the goal is to be “both the check and the balance,” says Genna Garver, a partner in Troutman, Sanders’ New York office, who focuses her practice on private fund regulation.
Practice tip: What if?
Garver says compliance officers can start by asking the worst-case-scenario.
“If it’s not possible to follow the policies and procedures, then what do you do?” she says.
You can begin to build redundancies by focusing on those what if gaps, Garver says.
“If your policy defers to the market price of an asset, make sure there is a back-up valuation plan, such as the use of an external vendor, that kicks in when no market price is available,” she told RCW in an email exchange. “If your firm has a valuation committee, make sure you have a seat at the table to observe compliance in real-time.”
Case study: Deer Park
“If your firm uses valuation models, remember lessons learned from Deer Park and confirm inputs are appropriate and periodically recalibrated,” Garver adds.
Deer Park Road Management Co.s’ flagship fund hadn’t had a losing month in more six-and-a-half years—one of the best-performing hedge funds in the nation between 2009-2015. But last summer, Deer Park wrote $5 million in checks to settle SEC claims that it failed to have adequate P&Ps to address the risk that its traders were undervaluing securities and selling for a profit when needed (RCW June 7, 2019).
Garver suggests that compliance officers put “a matrix desk reference of your firm’s liquidity management rights along with the thresholds/trigger events and lead-times for implementation.”
Practice tip: Fight for autonomy
Birnbaum, the Morrison attorney, says now is as a good a time as any for CCOs to fight for their autonomy.
“If a liquidity crunch is coming, and they do find a potential problem, they have to have a way to address it without bringing it to the person responsible for the wrongdoings,” he tells RCW. “Saying, ‘I found something’ and running to the head of the fund can often risk running straight to the perpetrator.”
Last year, the Department of Justice issued guidance to its prosecutors for evaluating corporate fraud cases. Among its other recommendations, the guidance document said prosecutors should evaluate a compliance program by the “autonomy and resources” behind it.
“As a threshold matter,” DOJ said, “prosecutors should evaluate how the compliance program is structured. Additionally, prosecutors should address the sufficiency of the personnel and resources within the compliance function, in particular, whether those responsible for compliance have: (1) sufficient seniority within the organization; (2) sufficient resources, namely, staff to effectively undertake the requisite auditing, documentation, and analysis; and (3) sufficient autonomy from management, such as direct access to the board of directors or the board’s audit committee.”
In late April, the SEC underlined the importance of autonomy by barring Monsoon Capital founder Gautum Prakash for helping himself to more than $1 million in his fund’s cash for personal expenses (RCW May 8, 2020). Two employees warned Prakash that he was breaching his fiduciary duty to investors by taking out a loan, but since he was the CEO, CCO and CFO, no one could overrule him. The wrongdoing was eventually exposed and disclosed—by auditors—but the damage had been done, the Commission determined.
Practice tip: Testing autonomy
Birnbaum says he understands that private funds in particular run on lean staffs.
“Ideally, you have someone who has an independent function,” he says. “Sometimes it’s a small enough firm that a person might have to wear different hats. But it helps to have that person to be as independent from other decision makers as possible.”
Key questions to ask are: If you have a board, does that chief compliance officer have a path to raise issues with the board? Or do they have to go through CEO, the general counsel? Birnbaum says.
It’s best to start practicing now, in any case, Birnbaum said, because a liquidity crunch just increases the odds that regulators will come calling.
“Human nature plays a role here as well,” he says. “An investor may be disappointed that she is ‘only’ earning 8% on an investment when she thinks she should make 10%. But the investor who is suddenly losing money is more likely to pay attention and question an adviser or money manager, and those professionals are similarly more likely to face regulatory scrutiny when investors start facing losses.”
Got a tip on managing private funds compliance? Contact Bill Myers to share it with your fellow professionals.