SEC intensifies enforcement ahead of regulation changes

As the SEC clamps down on capital markets 'misconduct', the industry prepares comment letters in response to the Commission's proposed regulation changes.

Enforcement by the US Securities and Exchange Commission has ramped up in recent years. The regulatory body filed 434 new enforcement actions in the financial year to 30 September 2021, representing a 7 percent increase over the prior year, it said in a statement. Of these actions, 159 were against registered investment advisers or investment companies.

“We go after misconduct wherever we find it in the financial system, holding individuals and companies accountable, without fear or favour, across the $100 trillion-plus capital markets we oversee,” said SEC chairman Gary Gensler.

The SEC awarded a total of $564 million to 108 whistleblowers and obtained more than $1.4 billion in penalties during the period, a 33 percent increase over amounts ordered in the prior fiscal year.

In the private funds industry, Gensler has his sights on the specific areas of fees and expenses, performance metrics, fiduciary duties, conflicts of interest, side letters and Form PF, according to remarks he made during the Institutional Limited Partners Association Summit in November.

Since then, the SEC’s Division of Enforcement has brought actions against investment advisers, including New York-based Global Infrastructure Management, for failing to offset certain portfolio company fees against management fees charged to clients. Last year, Elliot Smerling, the founder of Florida-based adviser JES Global Capital, was charged with multiple crimes in relation to falsifying bank records and other documents to obtain around $140 million in credit lines.

Industry pushback

The consensus among market participants speaking to Private Equity International about the proposed rules is that the more the PE industry expands its access to retail investors, the more it will come under regulatory scrutiny – whether on performance, fees reporting or ESG metrics.

Some note that enforcement will not be easy, with the SEC having to collect more detailed information than needed to safeguard against systemic industry risk or to enhance investor protection. There is also going to be significant pushback on aspects that are fundamental to how private fund sponsors function, such as the preferential treatment rule, which would require managers to disclose preferential terms to all current and prospective LPs.

“These are contracts that we’ve been negotiating between GPs and LPs for decades now, and among sophisticated and discerning participants in the private equity marketplace,” says Marco Masotti, a New York-based partner at law firm Paul Weiss.

“The regulator is now getting involved [in] what are some very basic contractual terms. It’s quite astonishing and, when you speak to some of the mid-market managers running good businesses, a little demoralising.”

While the proposed rules represent a more aggressive phase of regulating private equity funds, the scope and focus of enforcement will depend on how they are finalised.

The SEC’s proposals are undergoing public comment periods of up to 60 days. With three of the four SEC commissioners endorsing the proposals, some industry insiders expect them to be adopted largely unchanged.

Others point to the long period of time and multiple hurdles that separate proposal from implementation, suggesting they are likely to be watered down before eventually coming into effect – potentially not until 2023.

“The SEC seems to be rushing through these proposals given the mid-term election that can change the composition of Congress,” says Joseph Zargari, a partner at law firm Morgan Lewis & Bockius. “It would not be surprising to see final rules by the fall or end of the year with a longer compliance date.”