There were several important developments impacting private investment funds in 2020. The SEC continued to prioritize this area of the capital markets, and it issued important rules and guidance impacting private funds and investment advisers. There also were two important court rulings, one by the United States Supreme Court and one by the Delaware Supreme Court. This Article summarizes the most important developments in the private fund space – in chronological order.
OCIE Examination Priorities
On January 7, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) started off the year by announcing its examination priorities. OCIE identified a continued focus on registered investment advisers, including for private funds. Among other things, OCIE explained that it would focus on potential conflicts when an investment adviser provides services to both private funds and to other accounts. It also noted that “OCIE will review RIAs to private funds to assess compliance risks, including controls to prevent the misuse of material, non-public information and conflicts of interest, such as undisclosed or inadequately disclosed fees and expenses, and the use of RIA affiliates to provide services to clients.”
Supreme Court decides Liu
On June 22, 2020, the United States Supreme Court decided Liu v. Securities and Exchange Commission. In an 8-1 decision, the Supreme Court held “that a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible” in civil actions brought by the SEC.
However, the Supreme Court also imposed a number of significant constraints on the SEC’s ability to obtain disgorgement. First, the Supreme Court held that in most cases disgorged sums must be distributed to investors and cannot go into the general government coffers. Second, the Supreme Court explained that the remedy of disgorgement may not be available against parties who are being pursued under a theory of joint and several liability. The Court explained that allowing disgorgement in those circumstances is inconsistent with its reasoning that disgorgement is permitted in order to deprive the wrongdoer of his profits and would transform the remedy into a penalty. Third, the Supreme Court held that the disgorgement remedy is limited to net profits of the wrongdoer and that courts must therefore “deduct legitimate expenses before ordering disgorgement.”
Disgorgement is a critical weapon in the SEC’s arsenal. In fiscal year 2019, the SEC reported that it collected $3.25 billion in disgorgement and distributed $1.2 billion to harmed investors. Liu confirmed that the SEC can continue to seek disgorgement, but subject to a number of important constraints.
SEC Risk Alert Emphasizes Focus on Private Funds
On June 23, 2020, the OCIE issued a risk alert entitled Observations from Examinations of Investment Advisers Managing Private Funds. The risk alert identified three areas where the OCIE has identified deficiencies by investment advisers: (1) conflicts of interest; (2) fees and expenses; and (3) the use of material, non-public information.
The SEC’s decision to issue a risk alert emphasizes the SEC’s continued focus on the private fund space, which is confirmed by its annual enforcement report, discussed below. Since inspections are often a driver of enforcement action, the risk alert also indicates areas where we are likely to see a continued government focus in enforcement actions.
OCIE Cyber Risk Alert Regarding Ransomware
On July 10, 2020, OCIE issued a risk alert regarding ransomware attacks on SEC registrants, including investment advisers. The risk alert highlighted an increase in both the number and frequency of ransomware attacks. It noted that cybersecurity has “been a key examination priority for OCIE for many years, identifying information security as a key risk area on which registrants should focus.”
While noting that there is not a single set of optimal measures, the risk alert identified a number of measures that OCIE has observed registrants utilize to prepare for and address ransomware attacks. These include having incident response plans, cybersecurity training, vulnerability and patch management programs, systems access management procedures and perimeter security.
SEC Expands Definition of Accredited Investor
On August 26, 2020, in a 3-2 vote, the SEC adopted amendments to the definition of “accredited investor.” The amendments expand the definition to allow a natural person to become an accredited investor based on financial sophistication, rather than only based on income or net worth. For the 38 years prior to the amendments, an individual could qualify as an accredited investor if the individual has a net worth of at least $1,000,000, excluding the value of the investor’s primary residence. Alternatively, an individual could qualify as an accredited investor if the individual has an income of at least $200,000 per year for each of the past two years, or $300,000 in combined income if married. The SEC left unchanged the wealth-based tests and thresholds for an individual to qualify as an accredited investor. However, the SEC also added a new category to the definition to allow natural persons to qualify as accredited investors “based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the Commission may designate from time to time by order.”
The divided vote, which was along political party affiliation, revealed a philosophical division in thinking about access to private markets. The Republican members of the Commission favored the rule based on their view that it is important to expand access to the growing sector of private funds – both to help investors obtain investment gains in the market and to allow business to raise capital. The Democratic members of the Commission were critical of the fact that the SEC did not increase the wealth thresholds, which have been unchanged for decades, and raised concerns about the risk associated with the private fund market, particular around transparency.
OCIE Cyber Risk Alert Regarding “Credential Stuffing”
On September 15, 2020, OCIE issued a risk alert focused on “credential stuffing” cyber-attacks to access the client accounts of investment advisers. OCIE stated that it has observed an increase in the number of such attacks against investment advisers and broker dealers. In these attacks, cyber criminals obtain a list of usernames, email addresses and corresponding passwords from the dark web and then attempt to use the same names and passwords (or very similar passwords) on other websites to try to gain unauthorized access to customer accounts. OCIE noted that “[t]he failure to mitigate the risks of credential stuffing proactively significantly increases various risks for firms, including but not limited to financial, regulatory, legal, and reputational risks, as well as, importantly, risks to investors.”
The OCIE risk alert also discussed a number of measures that investment advisers can implement to protect their customer accounts, including establishing effective password procedures, requiring multi-factor authentication, requiring steps to confirm that someone is a human and establishing detection controls.
Supreme Court Denies Cert in Sun Capital
On October 9, 2020, the United States Supreme Court denied the writ of certiorari in New England Teamsters & Trucking v. Sun Capital Partners, 943 F.3d 49 (1st Cir. 2019). The case dates back to a 2013 ruling by the First Circuit, 724 F.3d 129 (2013), holding that multiple affiliated funds owning a controlling interest in a portfolio company can be held jointly and severally liable under ERISA for the pension withdrawal liabilities of a portfolio company. In its 2019 ruling, the First Circuit reversed a district ruling imposing liability on the funds. The First Circuit did not change its 2013 ruling, but it held that, on the particular facts, the applicable multi-factor test for determining whether a “partnership-in-fact” existed among the funds had not been satisfied.
The Supreme Court’s decision to decline to hear the case is an immediate win for the defendants. However, since the First Circuit’s ERISA analysis remains good law (at least in that circuit), it continues to pose a risk for private equity funds that acquire controlling interests in companies with potential underfunded ERISA pension liabilities.
Delaware Supreme Court Decides Solera
On October 23, 2020, the Delaware Supreme Court issued its decision in In re Solera Insurance Coverage Appeals. Sitting en banc, the court unanimously held that an appraisal action under the Delaware appraisal statute does not allege a “violation” of any statute and, as such, is not a Securities Claim under an insurance policy. The court reasoned that when a dissenting shareholder brings an action to have his shares appraised, he is simply asking the court to determine the “fair value” of the shares and not to obtain a determination of wrongdoing.
The ruling has important implications for private equity firms and their D&O insurers. Private equity firms are often involved in transactions in which they acquire publicly-traded shares of a target company, and the transaction is subsequently challenged in an appraisal action. The Solera decision constrains their ability to use D&O coverage as a backstop to a challenge to the share price.
SEC Issues Annual Enforcement Report
On November 2, 2020, the SEC’s Division of Enforcement issued its annual enforcement report. That report confirmed the continued enforcement focus on the private fund space. According to the report, 19% of all enforcement actions and 21% of all civil and standalone administrative proceedings were brought against investment advisers and/or investment companies.
In the narrative discussion of year in review, the SEC emphasized its continued focus on material conflicts of interest by investment advisers. It noted that 100 investment advisory firms had self-reported improper conduct, and returned $139 million to investors, for conflicts of interest concerning higher-fee mutual fund shares. The annual report also noted issues regarding conflicts of interest around advisers’ use of cash sweep arrangements as well as concerns regarding the transparency of certain fee structures.