Documentation trumps all

The challenge:   

Worried that inspectors from the US Securities and Exchange Commission (SEC) could use the report as a blueprint for identifying compliance gaps, some GPs are asking outside consultants to leave nothing in writing following a mock inspection. Others disagree, arguing that the SEC is generally thought to look favorably upon firms that provide mock inspection reports. So who’s right?  

 Todd Cipperman’s response:  

A written compliance review is not an SEC enforcement roadmap. Instead, our experience has shown that compliance reviews often serve to inoculate the firm against enforcement actions.

During exams, the few questions we have received about compliance report findings revolve around how the firm is or has remedied the issues. On some examinations, SEC staff has indicated that they appreciate that the findings have been detailed along with remedies and that the deficiency letter need not duplicate the compliance report findings.

Supporting our anecdotal evidence is that we are unaware of any enforcement action where the SEC simply took the findings of a compliance report and brought a case, but there have been several enforcement cases where the firm failed to document compliance issues that ultimately resulted in compliance failures.

Avoiding enforcement actions based on compliance failures may be the most compelling reason to conduct a third-party review. The SEC has brought many cases against private equity firms for compliance failures that it has argued would have been avoided had the firm conducted adequate compliance reviews. For instance, Guggenheim Partners, which was fined $20 million because the firm’s weak compliance program resulted in failures to disclose insider loan transactions, report required gifts, maintain required books and records, and properly document trade errors. Or, take for instance, KKR – which agreed a $28 million settlement for failing to properly allocate broken deal expenses.

When a private equity firm conducts a compliance review, it should utilize a third-party firm rather than an internal resource. An independent, third-party review has more credibility to the regulators and investors than one conducted by internal personnel that report to senior management.  And, public officials have expressed their support for retaining third compliance firms as the best way to review compliance programs. SEC Commissioner Gallagher was an early advocate for third-party reviews. Chairman of the US House Committee on Financial Services, Jeb Hensarling, has expressed his support, citing the Association of Institutional Investors. More recently, SEC Chair Mary Jo White has asked the staff to study whether the SEC should require all registered investment advisers to engage third parties to conduct compliance reviews.

Private equity firms should also understand that they are not some special class exempt from SEC scrutiny, regulation, or enforcement actions. SEC officials including Marc Wyatt have delivered targeted speeches directed at the private equity industry and its compliance practices. The SEC has backed up their talk with both a specialized unit focused on the private equity industry and a tide of enforcement actions, including those described above.