SEC’s books-and-records crackdown nears smaller PE firms

The SEC’s crackdown on books-and-records violations has reached small- and mid-sized private fund managers, compliance experts tell Private Funds CFO.

The commission announced an exam sweep in late 2021, shortly after it settled a books-and-records case with broker-dealer JPMorgan for $125 million. Regulators followed that up with a risk alert for private fund advisers – only the second such alert in the SEC’s history – warning the industry that (among other things) it had a books-and-records problem.

As so often happens in an exam-and-enforcement sweep, regulators started with the biggest businesses. Private equity giants Blackstone, Apollo, KKR, Carlyle and TPG have all told their investors they’ve received document requests about how they’re complying with books-and-records rules. Over the last several months, regulators have begun asking ever-smaller private fund managers, multiple compliance lawyers tell Private Funds CFO.

“It’s trickling down,” says David Tang, a partner with Dorsey & Whitney. “Traditionally, when we see a request for communications, it’s often around trading or MNPI. Now you’re seeing a separate request saying, ‘Make sure you give us all the electronic communications in all formats.’”

‘Shock and awe’

Under Investment Adviser Act rules, registered investment advisers are required to track, monitor and log communications with investors or potential investors in an easily accessible, easily searchable, “write once, read many” archive. Books-and-records violations are subject to strict liability. Regulators don’t have to prove intent to file a suit.

Since the JPMorgan case, regulators have announced more than 30 other settlements, bringing in nearly $2 billion in fines. Most of the cases have landed on broker-dealers, who are subject to stricter recordkeeping standards. No one thinks things will end there.

“I think the spring will bring shock-and-awe and the entire summer will see the private fund industry trying to interpret what they’re dealing with,” says Michael Osnato, a former senior SEC enforcement lawyer who is now a partner with Simpson Thacher & Bartlett. “Our expectation is that we’ll likely see those cases in the next quarter and I think they’ll be significant not just in the profile of the firms but in the penalties they impose.”

The SEC has cracked down on books-and-records violations before. The latest sweep surprised advocates with its depth, breadth and ferocity. Regulators have been asking for “any off-channel business communications,” and they’ve been filing subpoenas for individual records by employees’ names.

Perfect storm

For private fund managers, books-and-records issues are a kind of perfect storm. A rising generation of private equity and LP staff grew up texting, using WhatsApp, Signal, iMessage and other electronic messaging platforms that focus on protecting users’ privacy. The covid-19 pandemic shuttered offices and made it even easier for fund staff to chat outside company-approved and monitored channels. Just as those two fronts were colliding, Gary Gensler became chairman of the SEC, promising to crack down on “Wall Street” generally, and private funds particularly.

Regulators say the books-and-records sweep isn’t just a form of “broken windows” policing. “Recordkeeping failures undermine our ability to exercise effective regulatory oversight, often at the expense of investors,” the SEC Enforcement Division’s deputy director, Sanjay Wadhwaw, said last summer, as the Commission announced 11 fresh settlements totaling $289 million in fines.

Tang, for one, is willing to take regulators at face value on this point.

“This issue gets under the SEC’s skin more than usual because it fundamentally interferes with their ability to monitor market participants,” he says. “When we come in as a regulator and ask for your records, and you give us 90 percent of what was there, that undercuts our mandate. We can’t properly examine you, we can’t properly litigate against you – you’re missing records. We can’t be the SEC if this is how you’re going to proceed.”

Answers, and questions

There aren’t many easy answers for private fund managers here. Some firms, for instance, might be willing to pay for company phones and to require employees to use them to conduct business, or insist that employees install company-approved apps on their personal phones. That can be expensive, and it also can disrupt relationships between firm staff and the investors they’ve been talking to for months and even years.

“If you’re chasing a deal, you are building a relationship with the CEO of a company that you want to make an investment in,” says Cheyenne Ehrlich (see above video), founder and chairman of FirmScribe, a company that helps firms track and log iMessage data, in an interview from Private Funds CFO’s New York forum. “And relationships are about intimacy; at the end of the day, they’re about trust. It’s a certain place in my relationship with you when I feel I’m comfortable enough texting with you, and vice versa. And you cannot get deals if you’re not texting and your competitors are.”

Another problem is that few third-party apps designed for books-and-records compliance “offer a good texting experience,” Ehrlich adds.

“Apple’s put $1 billion into making iMessage great,” he says, “and this app was made by an offshore developer who’s very talented and worked on it for 12 weeks, but things you spend $1 billion on generally can be a little bit better than things you spent 12 grand on.”

‘Room to push back’

For all of that, private fund managers may still have room to maneuver. To begin with, investment adviser’s books-and-records standards are looser than those facing broker-dealers. In early 2023, 10 industry groups sent a letter to Gensler warning him that he might be overstepping his authority and that he could well face a court challenge.

A court challenge requires a firm willing to risk a court loss and a massive court fine. As regulators work their way down the AUM scale, though, and as they insist on staggering penalties to settle a case, they may make a court challenge more likely, Simpson Thacher’s Osnato says.

“There’s a lot of room to push back and say, ‘Not everything is within the scope of the rule. People can communicate without violating the rule,’” he says. “As you get deeper into an enforcement cycle, you often see firms say, ‘I just want to resolve this case.’ The wild card is going to be whether the SEC insists on exorbitant penalties, and a firm says, ‘I’d rather let a judge decide this.’”

It may be time for regulators to have another look at their goals, Osnato says.

“Following the lessons learned from recent settlements, the private equity industry has reacted in a positive, reputable way,” he says. “They train their people and their surveillance is much more enhanced. From a policy point of view, the SEC has achieved what they set out to do. If they push too hard, you might have a firm saying, ‘I’m willing to fight this,’ and a court will agree that the enforcement is circumscribed, and the SEC will be bound by precedence.”

Editor’s Note: Cheyenne Ehrlich spoke to us at the Private Funds CFO’s New York forum in January. You can watch his full interview below. To watch, read or listen to dozens of similar interviews, webcasts, peer-to-peer discussion groups and other support services available at Private Funds CFO’s membership network, click here.