Private funds and the new SEC

The new chair of the Securities and Exchange Commission, Gary Gensler, leads a Democratic majority that is already openly skeptical of private funds.

Last fall, in one of her first public comments as newly minted commissioner, Caroline Crenshaw said she was “disturbed” by the then-Republican-led SEC’s proclivity for “encouraging the growth of opaque private markets at the expense of better-lit public markets.” A day later, then-commissioner (now acting chairwoman) Allison Herren Lee cosigned. It was high time, Herren Lee said, that regulators shore up America’s public markets. Public markets, she said, “provide robust registration and reporting requirements.”

Even without their formal majority, Democrats are already adjusting the Commission’s private fund posture. On March 4, two days after Gensler’s nomination hearing, the Division of Examinations published its 2021 priorities. They include examining firms for robust, independent compliance programs (nearly three-fifths of private fund CCOs wear multiple hats) to show how they manage alternative data, ESG, valuations, liquidity and debt structure.

Perhaps most ominous about all the thunder is that it has not yet been accompanied by Enforcement Division strikes.

Last year, a few canny experts were able to predict the contents of the first-ever SEC risk alert for private funds because they watched enforcement cases carefully. So far this year, Enforcement has been (mostly) muted on questions raised in the exam priorities (see panel on p. 38). More than a few experts wonder if this is the just the quiet before the storm.

Weathermen and wind blows

Private funds will have to be forgiven if they have a sense of foreboding in all this. That does not mean that funds and their advocates should sit quietly, praying the lightning misses them. In fact, one of the things the regulators have made clear is they want to see funds preparing for disaster.

“If I were a compliance officer,” says Philip Moustakis, a partner in Seward & Kissel’s New York office, “I would review my firm’s business continuity and disaster recovery plans, particularly in light of the pandemic, cybersecurity risks, including safeguards around client information and against malicious activities, with a focus on vendor diligence and risks presented by recent changes in how we work.”

More broadly, the SEC’s insistence that it will examine for robust compliance programs ought to motivate funds, Moustakis says. Even if regulators hadn’t stressed it, it might be necessary.

“[The SEC seeing ESG disclosures as a priority] is a paradigm shift”

Carlo di Florio
ACA Compliance Group

“With Gary Gensler [as] the next chairman, we can expect a more aggressive enforcement environment,” he tells Private Funds CFO. “If a manager has been on the fence about whether to add that new hire to the compliance team or devote additional tools or resources to compliance, now would be a good time.”

Kurt Wolfe is a securities litigator with Troutman Pepper’s Richmond office. He says funds ought to start by building out their compliance functions.

“As part of an annual process, you need to sit down and look at your policies and procedures and see how they align with the growth of your business,” he says. “Are there reg or rule changes that impact the way that your P&Ps [policies and procedures] or WSPs [written supervisor procedures] read? If you don’t have the resources or the bandwidth to follow all that, then the exams priorities are incredibly helpful. They put front and center what you ought to be worried about.”

Wolfe says advisors ought to ask themselves a few questions to start:

Do we have a dual-hatted CCO?

Do we have a CCO at all?

How many people are on the team?

Does compliance have the backing of senior management or the board, and how can we tell?

Disclosures as lightning rods

Some experts think private funds might be able to get out of the regulatory and political storm by sacrificing some of their privacy.

Here again the question of “transparency” does not split along partisan lines. In fact, under the Republican-majority SEC, the Commission adopted a host of rules and guidance memos that, even if they did not mandate disclosure, certainly encouraged a bit of it.

Consider the new advertising rule: last year, for the first time, regulators laid out the principles by which private funds can hawk their wares. But in a series of then statements, the new rules also made clear that, if private funds are going to advertise, then they are going to have make a slew of disclosures about those ads.

Democrats have long criticized principles-based rulemaking a la the new advertising rule. Troutman’s Wolfe wonders whether Democrats might warm to the concept now that they are in charge.

“The criticism of principles-based rulemaking is that it’s not rigid enough, and the fear is that you’re inviting arbitrage or even corruption,” he says. “That can definitely be true. But a principles-based approach also gives you flexibility, and that works in any direction. Given their ambitions, I can’t imagine the Commission Democrats are going to want to spend a lot of time going back over Jay Clayton-era rulemakings when they can simply redefine the principles behind those rules and make them work for their majority.”

The last SEC gave private funds gifts such as a widened definition of accredited investors and loosened rules on swaps-based derivatives or market harmonization (the rules that drew Crenshaw’s and Herren Lee’s ire). The new SEC may well find it easier to bend the principles behind those rulemakings to their liking, rather than starting over.

ESG lights the way

Savvy private fund managers who embrace openness might not just head regulators off – they might also get ahead of the market.

Consider environmental, social and governance. Money is already flocking to sustainable or ethical funds. This year, for the first time ever, the SEC made clear that it saw ESG – and especially honest disclosures about ESG policies – as a regulatory priority.

“That’s a paradigm shift,” says Carlo di Florio, former director of the SEC’s exams division. Now a partner with the ACA Compliance Group in New York, di Florio says that ESG “is going to be a driver” of an era of new openness for private funds.

He urges fund managers to focus on five areas:

Disclosures. “Obviously all of the advisors are looking to come to market with ESG, because that’s where the money wants to go,” di Florio says. “But are we doing what we say we’re doing? How are we taking ESG into account?”

P&Ps. Are they aligned with those disclosures?

Advertising. “Forget your existing clients and what you’ve said to them,” di Florio says. “What are you saying in your advertisements? All of that advertising and marketing is going to be scrutinized by the SEC.”

Proxy voting. “Are you actually voting your proxies in a way that’s aligned with your ESG strategies?” di Florio asks.

Business continuity. In the cybersecurity section of the priorities, regulators say they’re going to check for operational resiliency. That, too, is an ESG question, di Florio says. “Are you looking at your business continuity plans and saying, ‘Well, we have business on the West Coast, are we prepared for raging forest fires?’ Floods in the Gulf? How are those being factored into the risk system?”

Regardless of the Commission, President Biden’s decision to rejoin the Paris Climate Accords has already had an outsized impact, di Florio says. It emboldened the EU to enact its own ESG regulations, which are some of the most stringent on the planet. Whether private funds are in Europe or even consider it, it might be wise to look at those EU regulations as a harbinger of things to come on this side of the pond, di Florio says.

Reg D reform

ESG is already driving reform efforts for private fund managers that rely on Reg D exemptions. In late February, Duke Law School’s Global Financial Markets Center released a white paper on the best ways that the SEC could address climate, systemic racism and income inequality. Its top recommendation was to reform Reg D.

“Predicating disclosure on the public/private divide no longer reflects the realities of the market,” the authors wrote, “and private markets need to be better regulated in order to facilitate proper disclosure.”

The paper recommends regulators:

Amend the definition of “shareholder of record,” which the authors say “currently permits private issuers to easily avoid the Section 12(g) trigger by obfuscating the actual owners of their securities.”

“With Gary Gensler [as] the next chairman, we can expect a more aggressive enforcement environment”

Philip Moustakis
Seward & Kessel

Revise exemptions to offer rules “to capture funds with more than $1 billion in assets or more than 100 eneficial owners” and make them register under the Investment Advisers Act.

Change Rules 144A, Rule 506 and Regulation AB “to mandate disclosures for large ‘private’ offerings to better align with the requirements for registered offerings.”

Amend Rules 504, 505 and 506 of Reg D “because the definition of ‘accredited investor’ is far too broad. The SEC should consider revising the ‘accredited investor’ definition to be based on a combination of sophistication, income, wealth and access to the ‘kind of information which registration would disclose,’” the authors write.

One of the paper’s authors is Lee Reiner, executive director at Duke’s Global Markets. The other is Ty Gellasch, a long-time friend of Gensler and Herren Lee. “We’re trying to create, essentially, the menu,” Gellasch tells Private Funds CFO. “Joe Biden’s economic plan is going to center on addressing the existential climate crisis, economic inequality, especially for workers’ rights and wages. A lot of that is going to have to come through the SEC.”