Private funds can draw lessons about how to prioritize their compliance efforts and practices in response to a series of warnings by newly-appointed federal regulators of increased scrutiny, regulation, and enforcement activity.
On March 21, 2022, the U.S. Attorney for the Southern District of New York (SDNY), Damian Williams, identified private funds as an enforcement priority, one that will have the SDNY increasing its focus on investigating private funds — including private equity funds, venture capital funds, and hedge funds — for criminal violations. Speaking at the Securities Industry and Financial Markets Association (SIFMA) annual Compliance & Legal Seminar, Williams emphasized that all investors warrant equal protection, regardless of how sophisticated they may be. He also remarked that pension funds are increasingly investing in private funds, seeking higher returns for police officers, fire fighters, teachers, and other municipal workers.
Williams said that the SDNY was particularly concerned about fraud in connection with the valuation of highly illiquid assets and other difficult-to-value assets. He noted the importance of having independence in the valuation function, and disclosing and monitoring any involvement of investment professionals.
As an example, Williams cited the SDNY’s recent prosecution of James Velissaris, the founder and former Chief Investment Officer of investment adviser Infinity Q Capital Management (Infinity Q). On February 17, 2022, Velissaris was charged with allegedly making false and misleading statements regarding Infinity Q's valuation process for certain investments in its private fund and mutual fund — including statements regarding the purported independence of that process — and fraudulently mismarking those securities to inflate the value of the funds. Infinity Q reportedly sought to attract public pension funds, university endowments, and charitable foundations as investors in its private fund, in addition to retail investors for its mutual fund.
Private funds have also increasingly been a focus of the SEC. Simultaneously with the SDNY, the SEC filed an enforcement action against Velissaris. In announcing the SEC's charges, the Director of the Division of Enforcement, Gurbir S. Grewal, remarked that the case “affirms our commitment to using all our tools to root out misconduct in the $18 trillion private fund arena, a growing market attracting more and more institutional investors, including public pension funds, university endowments, and charitable foundations.”
Examination priorities likewise reflect the SEC’s desire to protect investors through robust oversight of private funds. As discussed further in a separate alert, on March 30, 2022 the Division of Examinations released its 2022 Examination Priorities report, which calls out private funds as the first “Significant Focus Area,” displacing retail investors, which had been the first priority in each of the annual Examination Priorities since 2015.
The SEC is also making disclosure and conflict of interest issues at private funds a priority of new rulemaking. On February 9, 2022, the SEC announced proposed rules that would require private funds to provide certain disclosures to their investors, including quarterly statements detailing fund performance, fees and expenses, and manager compensation. The SEC’s proposed new rules would also prohibit certain activities that the SEC deems to present too great a conflict of interest to be cured by disclosure, including with respect to limitations on liability and certain preferential treatment of investors. Earlier this year, on January 26, 2022, the SEC also proposed amendments to Form PF that would require increased reporting by private equity funds of transactions the SEC views as presenting significant conflicts of interest, signaling an expanded use of Form PF in examinations and enforcement and beyond its original systemic risk reporting purpose.
Private funds should heed these warnings. They should revisit and examine their policies and procedures, including with respect to valuation processes and documentation, fee and expense disclosures, and conflicts of interest. Compliance is key — not only will the SEC be looking at the sufficiency of private fund compliance programs, but as Williams intimated in his remarks, a strong compliance program is the best way to avoid wrongdoing that might trigger a government investigation in the first place.