Alternative Investment Funds 2019... The International Comparative Legal Guide to: Alternative...
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The International Comparative Legal Guide to:
A practical cross-border insight into Alternative Investment Funds work
Published by Global Legal Group, with contributions from:
7th Edition
Alternative Investment Funds 2019
Advokatfirmaet Schjødt AS
Anderson Mori & Tomotsune
Attorneys-at-Law Trust
Bär & Karrer Ltd.
Bonn & Schmitt
Brodies LLP
Cadwalader, Wickersham & Taft LLP
Cases & Lacambra
CNPLaw LLP
Collas Crill LLP
Davis Polk & Wardwell LLP
Dillon Eustace
Dubiński Jeleński Masiarz i Wspólnicy sp.k.
Finnius
Flick Gocke Schaumburg
Hassans International Law Firm
Johnson Winter & Slattery
LACOURTE RAQUIN TATAR
Lee & Ko
Legance – Avvocati Associati
Magnusson Advokatbyrå
Maples Group
McCarthy Tétrault LLP
Mori Hamada & Matsumoto
PricewaterhouseCoopers Ltd
sammut.legal
Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Travers Smith LLP
VdA
Vivien Teu & Co LLP
Walkers (Bermuda) Limited
Webber Wentzel
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WWW.ICLG.COM
The International Comparative Legal Guide to: Alternative Investment Funds 2019
General Chapters:
Country Question and Answer Chapters:
1 Operating Private Funds in 2019: Transparency is Key – Greg Norman,
Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates 1
2 The Global Subscription Credit Facility and Fund Finance Markets – Key Trends and Forecasts –
Michael C. Mascia & Wesley A. Misson, Cadwalader, Wickersham & Taft LLP 3
3 Adviser Exams: Mitigating Enforcement Risks – Leor Landa & James H. R. Windels,
Davis Polk & Wardwell LLP 7
4 Bringing Foreign Investment Funds into Japan – Yasuzo Takeno & Fumiharu Hiromoto,
Mori Hamada & Matsumoto 15
5 Andorra Cases & Lacambra: Miguel Cases & Marc Ambrós 20
6 Angola VdA: Pedro Simões Coelho & Carlos Filipe Couto 27
7 Australia Johnson Winter & Slattery: Austin Bell & Andy Milidoni 34
8 Bermuda Walkers (Bermuda) Limited: Sarah Demerling & Nathalie West 45
9 Canada McCarthy Tétrault LLP: Sean D. Sadler & Cristian O. Blidariu 55
10 Cayman Islands Maples Group: Grant Dixon & Andrew Keast 63
11 Cyprus PricewaterhouseCoopers Ltd: Andreas Yiasemides & Constantinos A. Constantinou 71
12 England & Wales Travers Smith LLP: Jeremy Elmore & Emily Clark 81
13 Finland Attorneys-at-Law Trust: Mika J. Lehtimäki 92
14 France LACOURTE RAQUIN TATAR: Damien Luqué & Martin Jarrige de la Sizeranne 99
15 Germany Flick Gocke Schaumburg: Christian Schatz 110
16 Gibraltar Hassans International Law Firm: James Lasry & John Gordon 115
17 Hong Kong Vivien Teu & Co LLP: Vivien Teu & Sarah He 121
18 Ireland Dillon Eustace: Brian Kelliher & Sean Murray 132
19 Italy Legance – Avvocati Associati: Barbara Sancisi & Marco Graziani 143
20 Japan Anderson Mori & Tomotsune: Koichi Miyamoto & Takahiko Yamada 151
21 Jersey Collas Crill LLP: Dilmun Leach & David Walters 159
22 Korea Lee & Ko: Nelson K. AHN & Hyun KIM 165
23 Luxembourg Bonn & Schmitt: Amélie Thévenart 172
24 Malta sammut.legal: Karl Sammut & Bradley Gatt 180
25 Mozambique VdA: Pedro Simões Coelho & Carlos Filipe Couto 188
26 Netherlands Finnius: Rosemarijn Labeur & Tim de Wit 195
27 Norway Advokatfirmaet Schjødt AS: Andreas Lowzow & Cecilie Amdahl 202
28 Poland Dubiński Jeleński Masiarz i Wspólnicy sp.k.: Zuzanna Mariańska-Masiarz &
Michał Żwirski 207
29 Portugal VdA: Pedro Simões Coelho & Inês Moreira dos Santos 214
30 Scotland Brodies LLP: Andrew Akintewe 225
31 Singapore CNPLaw LLP: Amit R. Dhume & Abel Ho 234
32 South Africa Webber Wentzel: Nicole Paige & Gitte Truter 243
33 Spain Cases & Lacambra: Miguel Cases & Toni Barios 250
34 Sweden Magnusson Advokatbyrå: Robert Karlsson & Eric Cederström 259
35 Switzerland Bär & Karrer Ltd.: Rashid Bahar & Martin Peyer 266
36 USA Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates: Heather Cruz &
Anna Rips 275
Contributing Editor
Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Publisher
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Sales Director
Florjan Osmani
Account Director
Oliver Smith
Senior Editors
Caroline Collingwood Rachel Williams
Group Consulting Editor
Alan Falach
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1
chapter 1
skadden, arps, slate, meagher & flom llP and affiliates greg norman
operating Private funds in 2019: transparency is Key
In 2019, the private fund industry seems to have regained, and
exceeded, its pre-crisis position at the forefront of the financial
services industry. In the years preceding 2018, private funds
achieved record-breaking years of fundraisings as an increasing
number of investors redoubled their allocation or made allocations
for the first time to private funds. 2018 saw the fundraising
landscape show some signs of market divergence; whilst large funds
have experienced further growth, smaller funds and first time
managers have not always been as successful in their marketing
efforts. Nevertheless, many were expecting 2019 to herald a new
record year of deal-making and activity from private funds, as some
reports set dry powder (the amount of unspent capital commitments
held by private funds) to be at a record $2 trillion. Despite this,
private fund activity has arguably been rather muted. In the UK, it
has been quasi-impossible to pass a day without reading about
Brexit. At the time of writing, the UK was due to leave the EU on
Halloween under the leadership of a new Prime Minister – it
remains to be seen whether he will have any nightmares on 1
November. Looking to the global macro-economic environment,
the uncertainty regarding US-China relations and elsewhere seems
to have had a dampening effect on world trade.
Against that backdrop, it seems that 2019 may be memorable for
other reasons. For the private fund community, increased focus on
information and transparency appears to be a recurring theme. In
2019, information is king (or queen). Outside of the private fund
world, we have seen the EU’s General Data Protection Regulation
(the GDPR) start to bite, with various regulators across the EU
opting to hand out record breaking fines. Most recently, British
Airways received a fine of £183 million from the UK Information
Commissioner’s Office.
Private fund managers were never meant to be high on the list of
“targets” for the GDPR, but nevertheless it has been high on the
agenda for most operations teams within private fund sponsors. For
such teams, enhancing or improving internal systems and controls,
including those relating to data security, has long been on the
agenda. 2018 highlighted a number of operational failings in fund
management and other financial services businesses, particularly
with respect to the systems and controls procedures. For example,
in one instance a manager’s systems and controls failed to prevent
the comingling of investors’ cash with that of the fund manager.
Investors in private funds are also focussed on increased
information. Due diligence by investors, particularly on new fund
managers, has intensified as more detailed information, site visits
and time with key staff are requested. Private fund sponsors are
having to allocate more time and resources to ensure that their
systems and controls are able to manage this level of scrutiny. With
the speed of change in technology and related regulation, it is no
small challenge for fund sponsors who would have become adapted
to a relatively stable period of regulation relating to private funds.
In addition, 2019 has also seen the Institutional Limited Partners
Association (ILPA) publish an update to its principles for
transparency, governance and alignment of interest in private equity.
Since the first publication of the ILPA Principles, there has been a
strong line taken on alignment of interest and its implications for
private equity fund economics. The third edition of the ILPA
Principles shows a clear trend towards increasing transparency,
including in areas such as fee and expense reporting, notification of
key events such as significant personnel changes (going beyond just
key man changes) and disclosure of standards of care. The ILPA
Principles have not been broadly adopted by fund sponsors,
particularly given that most of the significant private fund sponsors
have long established terms for their fund documents that are
routinely accepted by investors. Nevertheless, a number of the
suggestions, particularly with regard to transparency and reporting
would appear to be a sensible benchmark – not least because many
fund sponsors are already providing much of this transparency in
one form or another. As investors become more sophisticated and
contribute greater allocations to private funds, the desire for
standardised reporting and information is only likely to increase.
The private fund industry may also do well to consider some form of
self-regulation in this area. In early 2019, the European Securities
and Markets Authority (ESMA) published a report exploring
whether the objectives of the Alternative Investment Fund Managers
Directive (the AIFMD) had been met. ESMA commissioned KPMG
to produce this report and its contents seem to signal that “AIFMD
II” may be just over the horizon. One of the core aims of the AIFMD
was to improve investor protection, particularly by increasing
information and disclosure. As the report published by ESMA
shows, very few investors feel that this aim has been achieved.
Instead, fund sponsors have had a significant increase in regulatory
reporting obligations, but regulators have been unable to do anything
with the information, and investors have not seen any tangible
benefit while having to bear the increased costs associated with this
compliance. It seems likely therefore that one focus of any successor
to the AIFMD will be to seek to harmonise and increase reporting by
private funds. One lesson that can be taken from the process through
which the original AIFMD developed, was that having demonstrable
self-regulation can actually have a positive impact: if the private fund
industry can successfully demonstrate that it already provides
investors with appropriate levels of transparency and reporting, then
the impact of any regulation in this area may be mitigated, not least
because appropriate standards will already be in place.
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Greg Norman Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates 40 Bank Street, Canary Wharf London, E14 5DS United Kingdom Tel: +44 20 7519 7192
Email: [email protected]
URL: www.skadden.com
Greg Norman is a Counsel at Skadden, Arps, Slate, Meagher & Flom in its Investment Management Group.
skadden operating Private funds in 2019: transparency is Key
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Skadden is one of the world’s leading law firms, serving clients in every major financial centre with over 1,700 lawyers in 22 locations. Our strategically positioned offices across Europe, the U.S. and Asia allow us proximity to our clients and their operations. For almost 60 years Skadden has provided a wide array of legal services to the corporate, industrial, financial and governmental communities around the world. We have represented numerous governments, many of the largest banks, including virtually all of the leading investment banks, and the major insurance and financial services companies.
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We draw on this data where relevant in this chapter.
2017 2018 Change (%)
Number of
Deals111 133 +20%
Aggregate
Lender
Commitments
$41.65bn $46.34bn +11%
Number of
Banks
Participating
in Our Deals
42 40 -5%
Number of
Sponsors72 90 +25%
3
chapter 2
cadwalader, wickersham & taft llP
michael c. mascia
wesley a. misson
the global subscription credit facility and fund finance markets – Key trends and forecasts
Introduction
The Subscription Credit Facility (each, a “Facility”) and related
Fund Finance markets continued their extensive growth and positive
momentum in 2018. Like virtually every year since the financial
crisis, lender (“Lender”) Facility portfolios grew extensively this
year, in spite of meaningful headwinds and challenges. The market
grew more dynamic and accustomed to frequent evolution and
change. This chapter summarizes the key developments in the
Facility and Fund Finance markets in 2018 and forecasts our
expectations for the coming year.
Cadwalader 2018 Representations
Because the Fund Finance market is not public, it remains
challenging to find actual data to support instincts and suspicions.
To help our clients address that, Cadwalader performed a data
analysis in January where we evaluated every transaction in 2017
and 2018 in which we represented the lead Lender. Our touch points
with the market are extensive and as a result provide a relatively
robust data set that is a good proxy for the U.S. market as a whole:
Resilient Growth
There were a host of headwinds that should have muted the growth
of the Fund Finance markets in 2018, but did not. Fund formation,
the fundamental driver of Fund Finance, was materially down from
2017. Private equity data provider Preqin’s initial figures show that
the number of funds (each, a “Fund”) closed in 2018 (1,733, down
28% from 2017) and aggregate capital raised ($757 billion, down
from $925 billion in 2017) were both down. One-sided and negative
articles in both the private equity and mainstream media continued
to decry “abuse” almost weekly.1 Limited Partners (“Investors”)
more frequently capped Facility size around 25% of Fund size.
There was a very public default. Banks struggled with exposure
limits to Fund Finance established by their risk departments,
heightened awareness and information requests from regulators,
banker turnover and unfilled positions. And yet portfolio growth
marched on.
We believe global Lender commitments increased by 15–20% in
2018, materially exceeding our estimates for the year. We now
estimate the global market at approximately $525 billion. All of the
data points in our portfolio and the business metrics we track
(number of deals (up 20%), Lender commitments (up 11%), number
of discreet engagements, volume of hours billed, revenue, etc.)
support these growth estimates. And anecdotal reports from
Lenders in the market often exceed 20%.
So how does the Facility market continue to grow despite lower
Fund formation statistics and other challenges? At a high level, the
answer is simply market acceptance. The message in the ILPA
Guidelines and from Investors generally has not been to push back
on Facilities per se. Rather, the message has been requests for
transparency, increased reporting and individual loan tenors not
exceeding 365 days or another agreed maximum length. This
messaging has made it clear to Fund sponsors (“Sponsors”) that
disciplined use of Facilities is permissible and likely even
welcomed by Investors, leading to more widespread usage. While
at times it can feel like Facilities are ubiquitous in the market, back
of the envelope math suggests there is still further growth available
by market penetration. Various estimates of dry powder peg the
globe’s aggregate uncalled capital from Investors to Funds between
$1.9 trillion and $2.3 trillion. We estimate the global Facility
market at $525 billion. A Facility advance rate of around 25%
would be atypically low, strongly suggesting there is still inherent
global demand in the macro.
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“Structural Drift”
Jeff Johnston, Managing Director at Wells Fargo, used the term
“Structural Drift” at a conference late last year aptly to describe how
Facility terms continue to creep incrementally in favor of borrowers.
Advance rates are ticking up slightly, concentration limits are
continuing to relax and credit linkage around subsidiary investors is
informalizing. The market is adjusting to Funds bringing their
leveraged finance playbooks to Facility discussions and the
resulting conflict it has with Lenders’ relationship-based approach
to the product area. But for the most part, transaction structures
have held remarkably consistent, and the drift in favor of borrowers
has been accommodative but not disruptive.
Partnership agreements are becoming more explicit around the
permissible scope and tenor of Facilities, a likely fall out from the
ILPA Guidelines and the press coverage. Lenders tend to see all of
this as a credit positive; Investor engagement and understanding
around Facilities reduces the risk of an Investor credibly disclaiming
knowledge of a Fund’s authority to pledge capital commitments.
Increasing concentration in the top-tier fund formation law firms is
also aiding partnership agreement improvements.
A prohibition on overcalls for the purpose of paying management
fees is an increasingly common partnership agreement challenge.
Funds of course want to borrow under the Facility to pay
management fees; Lenders of course structure Facilities with a
borrowing base for the precise reason of having a buffer to absorb
Investor defaults. While many Lenders will not entertain this risk,
there are some compromises making headway in the market:
(i) The Lender will lend to the Fund for management fees, but the
management company agrees to indemnify the bank for any
losses incurred as a result of the management fee overcall
prohibition (i.e., if the Lender lends for management fees and is
not repaid because of the overcall prohibition, the management
company gives the fees back to the Lender).
(ii) The Lender will only lend for management fees if the NAV of
the Fund exceeds a comfortable threshold amount to bolster
the Lender’s secondary source of repayment.
(iii) The Lender will lend for management fees, but only if (a)
there are no defaulting investors to date, and (b) the Fund
agrees to clean down the borrowing within 90 days.
Credit Performance
A. Abraaj. In a first for the modern Fund Finance market, an
event of default on a Facility has been playing out publicly in
the press. Private Equity International has been covering the
Abraaj matter extensively, including their November 26,
2018 article “What happens when subscription credit lines
turn sour?”2 While we cannot comment on the accuracy of
the factual details articulated in the article, an event of default
has clearly occurred, albeit under particularly isolated and
exceptional facts. The market eagerly awaits each additional
development in the Abraaj insolvency.
B. The Market Generally. Outside of Abraaj, however, the
Facility market (as well as NAV-based and hybrid facilities)
all performed exceptionally well from a credit perspective in
2018. Our portfolio had no monetary defaults and the only
exclusion events that came to our attention involved a very
limited number of high-net-worth investors.
Pricing and Tenor
Facility pricing has held steady throughout 2017 and 2018, with
virtually no correlation between spreads and time over the past two
years. According to our data, Facilities to separately managed
accounts priced on average 20 basis points wider than Facilities to
commingled Funds. Hybrid Facilities on average priced 78 basis
points wider. We see almost no correlation between the existence of
an overcall limitation and Facility pricing – quite a curious revelation
in light of how seriously Lender credit teams take overcall
limitations… Tenor is more variable. Our portfolio splits in near
perfect thirds between one-, two- and three-year tenors. Only a small
handful of deals extended beyond three years on a committed basis.
Industry Developments
A. Lender Hiring. Lenders hired extensively in 2018, often
from each other. Headlined by Tom Byrne joining Signature
Bank in August and then proceeding to hire multiple well-
known Fund Finance managing directors, many senior
bankers switched teams. The turnover has created a lot of
career opportunities throughout the industry and upward
pressure on Lender compensation.
B. Fund Finance Servicer Providers. Several firms added Fund
Finance product offerings in 2018, evidence of the maturation
of the industry. Validus Risk Management created a Fund
Finance Advisory practice in London, led by former Lloyds
Bank banker Sarah Lobbardi. Vanbridge, an insurance
solutions provider based in New York, has started consulting
with Lenders on potential risk transfer solutions for their
Facility portfolios. A recruiting and placement firm is nearing
a brand launch announcement. We expect more such product
and company start-ups to enter the industry in 2019.
C. Fund Finance Friday. Cadwalader launched Fund Finance
Friday, a weekly market intelligence and update newsletter,
last fall. Styled more like a “5 Things to Know to Start Your
Day” update piece and not like a traditional legal
memorandum, it has quickly grown to over 1,000 subscribers.
Not surprisingly, the job postings tend to get the most clicks
each week. If you are interested in subscribing (there is no
charge), visit https://www.cadwalader.com/fund-finance-
friday.
D. Publications. Global Legal Group Ltd., the publisher of this
guide, published the third edition of Global Legal Insights –
Fund Finance 2019, now known in the market as the “Pink
Book”. The guide includes 21 product-oriented chapters and
22 jurisdictional updates contributed by many of the world’s
preeminent Fund Finance law firms, a substantial
improvement over the prior editions.3
2019 Forecasts
For 2019, we forecast a growth rate in Lender portfolios of 12%–
17%, although we do not think that growth will be absorbed
uniformly across all Lenders. While there will be challenges, the
sheer volume of flagship Funds from preeminent Sponsors slated to
close in 2019 will absorb very large amounts of additional Facility
commitments. We believe some of these premier Sponsors will be
adding new lenders to their syndicates this year to ensure diversity
of funding sources. We think “Structural Drift” will continue at the
margins, but will be somewhat offset by Lenders’ requests for
improvements based on lessons learned from the Abraaj defaults.
We do forecast Investor interest in Facilities to continue to increase,
heightening the importance of partnership agreement and side letter
due diligence.
cadwalader, wickersham & taft llP facility and fund finance markets
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While we do not contemplate banker transitions as wholesale as last
year, we do think hiring is likely to continue at a brisk pace. We
expect a fair number of industry veterans to change banks in the
front half of the year, creating opportunities for younger bankers.
Lenders continue to wrestle with exposure limits to the industry and
specific sponsors, and thus, interest in risk transfer solutions is
going to increase. Lenders that have historically transacted on a
bilateral basis are going to more frequently be looking for syndicate
partners. The insurance industry is also likely to play a bigger role
in the market going forward. This is likely to result in greater
conformance to market standard documentation, as Lenders are
going to want to ensure their paper is liquid in the secondary market.
2019 Fund Finance Events
The Fund Finance Association has updated its conference slate for
2019. The 9th Annual Global Fund Finance Symposium moved
from New York to Miami, and took place at the Fontainebleau Hotel
over three days from March 24–26. The 5th Annual European Fund
Finance Symposium moved to June and was held at the Landmark
Hotel on June 20, 2019. The 3rd Annual Asia-Pacific Fund Finance
Symposium is scheduled for September 24, 2019, again at the Four
Seasons hotel in Hong Kong. The Cadwalader Finance Forum is on
for October 17, 2019 at the Ritz-Carlton in Charlotte, North
Carolina.
Conclusion
The Facility market appears poised for another solid year in terms of
portfolio growth in 2019. While the Abraaj matter will be watched
closely throughout the year, we continue to believe that the credit
profile of market-structured Facility transactions forecasts well for
Facility performance. The dynamic nature and constant change in
the market will make for a fun and interesting year for industry
participants.
Endnotes
1. See, as illustrative examples, “Subscription Lines in the
Spotlight”, The Triago Quarterly, January 2019, available at
h t tp: / /www.tr iago.com/wp-content /uploads/2019/
01/triago_QuarterlyJAN_2019.pdf; “LPs should voice
discontent over excessive subscription line usage”, realdeals,
February 8, 2019, accessible at https://realdeals.eu.com/news/
2019/02/08/subscription-line-usage-lps/.
2. The article is accessible at: https://www.privateequity
international.com/happens-subscription-credit-lines-turn-
sour/?login=success.
3. An electronic copy of Global Legal Insights – Fund Finance
2019 can be accessed at https://www.globallegalinsights.com/
practice-areas/fund-finance-laws-and-regulations.
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cadwalader, wickersham & taft llP facility and fund finance markets
© Published and reproduced with kind permission by Global Legal Group Ltd, London
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Michael C. Mascia Cadwalader, Wickersham & Taft LLP 227 West Trade Street Charlotte, NC 28202 USA Tel: +1 704 348 5160
Email: [email protected]
URL: www.cadwalader.com
Wesley A. Misson Cadwalader, Wickersham & Taft LLP 227 West Trade Street Charlotte, NC 28202 USA Tel: +1 704 348 5355
Email: [email protected]
URL: www.cadwalader.com
Cadwalader, Wickersham & Taft LLP, founded in downtown New York in 1792, is proud of more than 200 years of service to many of the world’s most prestigious financial institutions and corporations. With more than 450 attorneys practicing in New York, London, Charlotte, Washington and Brussels, we offer clients innovative solutions to legal and financial issues in a wide range of areas. As a longstanding leader in the securitization and structured finance markets, the Cadwalader team features lawyers with a broad range of experience in corporate, securities, tax, ERISA, bankruptcy, real estate and contract law. Consistently recognized by independent commentators and in the league table rankings, our attorneys provide clients unparalleled insight regarding fund finance, asset-backed and mortgage-backed securitization, derivatives, securitized and structured products, collateralized loan obligations, synthetic securities, swap and repo receivables, redundant insurance reserves, and other financial assets.
For more information please visit www.cadwalader.com.
Mike Mascia is Co-Chair of the firm’s Finance Group and a member of the firm’s Management Committee. He has a globally recognized fund finance practice, having represented lenders in subscription credit facilities to real estate and private equity funds sponsored by many of the world’s preeminent fund sponsors. He has been lead counsel on numerous hybrid facilities, and is one of the few attorneys in the United States with experience in both subscription credit facilities and CLOs. Mike represents lenders on leverage facilities to secondary funds and other credits looking primarily to fund assets or NAV for repayment. Mike is the founder of the annual Global Fund Finance Symposium, now in its 8th year, and he is a founding member and the Secretary of the Fund Finance Association.
Wes Misson is a partner in Cadwalader, Wickersham & Taft’s Finance Group. Wes’s practice focuses on fund finance and he has represented financial institutions as lenders and lead agents in hundreds of subscription credit facilities and other fund financings, with his experience encompassing both subscription and hybrid facilities. Wes also works with fund-related borrowers on the negotiation of third-party investor documents with institutional, high-net-worth and sovereign wealth investors.
Wes has served as lead counsel on many of the largest and most sophisticated fund financings ever consummated, notably having assisted more than 37 banks as lead or syndicate lender during the past three years with transaction values totaling in excess of $35 billion. Many of the transactions he advises on are precedent setting, carrying unique structures and complex international components – whether that be foreign limited partners or funds, multi-currency advances or foreign asset investment.
Wes has been recognised as a “Rising Star” in the US in the area of Banking and Finance in the International Financial Law Review’s IFLR1000 Legal Directory, and is also a frequent speaker and an accomplished author in the area of fund finance. He has worked extensively with financial institutions to develop form agreements for fund finance transactions, many of which are the dominant forms used in the market today, and to educate bankers, internal legal counsel and credit officers on hot issues and trends affecting the fund finance market.
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cadwalader, wickersham & taft llP facility and fund finance markets
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7
chapter 3
davis Polk & wardwell llP
leor landa
James H. r. windels
adviser exams: mitigating enforcement risks
I. Introduction
In an evolving securities landscape, examinations of investment
advisers remain a key priority for the SEC’s Office of Compliance
Inspections and Examinations (OCIE). By understanding OCIE’s
exam priorities, proactively testing policies and procedures, and
prudently managing issues as they arise in the course of exams,
investment advisers can reduce the risk that an OCIE exam will lead
to an investigation by the SEC’s Division of Enforcement.
OCIE continued to break its examination record in 2018; it
conducted 2,312 investment adviser examinations in FY 2018,
exceeding the record it set in FY 2017.1 The percentage of advisers
examined has similarly increased over time, from 11% in FY 2016,
to 15% in FY 2017 and 17% in FY 2018.2 The nature of OCIE
examinations has also evolved as the SEC seeks to use its limited
resources to focus on critical risks impacting market participants.3
OCIE Director Peter B. Driscoll has stated that examinations have
become “targeted, shorter, deep dives into high-risk areas that are
published in our priorities.”4 OCIE has expended substantial time
and effort improving its risk assessment and surveillance
capabilities to ensure that it spends its time and resources examining
“those firms and practices that pose the greatest potential risk of
violations that can harm investors and the markets.”5 These efforts
have included developing technological tools that can analyse data
provided by all registrants, not just those selected for examination.6
In describing their shift in priorities, both OCIE and the SEC as a
whole have emphasised the difficulty of monitoring the investment
adviser universe: OCIE estimates that, by the beginning of FY 2020,
OCIE will oversee more than 25,000 market participants, including
more than 13,000 investment advisers managing more than $85
trillion in assets.7
Even with a vastly expanded number of examinations, the technical
deficiency rate has remained largely stable. In FY 2018, 69% of
examinations identified some deficiency, slightly below FY 2016’s
72%.8 The number of examinations resulting in a “significant
finding”, however, has remained substantially lower than earlier in
the decade. In FY 2018, 20% of examinations resulted in a
“significant” finding, comparable to 20% in FY 2017 and materially
lower than 27% in FY 2016 and 35% in FY 2013.9 Similarly, the
number of examinations referred to the Division of Enforcement has
steadily trended downward, from 13% in FY 2013, to 9% in FY
2016, 7% in FY 2017, to 6% in FY 2018.10 More frequent, risk-
based examinations and industry recognition of the SEC’s
willingness to take more aggressive Enforcement action when
necessary have likely contributed to investment advisers’
proactively examining and updating policies and procedures, in turn
increasing compliance and reducing the number of serious
infractions. As OCIE Director Driscoll has made clear, the SEC
hopes that increased transparency of OCIE’s priorities have
encouraged and enabled firms to focus their internal compliance and
“anticipate and preemptively solve compliance issues”.11
This article will first explore five key SEC priorities for investment
adviser examinations and Enforcement actions. It will next focus on
how advisers can proactively identify and address OCIE
examination risks before those exams are requested. Next, the
article will discuss approaches to responding to exam requests given
the potential Enforcement backdrop, particularly approaches to
responding to requests for documents, emails, and witness
interviews that both minimise risk to the adviser and ensure timely,
accurate, and complete cooperation with OCIE. Finally, the article
will discuss the process for OCIE referrals to the Division of
Enforcement, and the circumstances under which an exam
deficiency is most likely to lead to a referral.
II. Exam Priorities
Exam and Enforcement risk is best minimised by implementing a
comprehensive compliance programme covering all aspects of an
adviser’s operations and proactively addressing any issues of
concern prior to the start of an exam. A review of Enforcement
actions and settlements and public statements by SEC officials
highlights five key areas which may pose particular risks of referral
from the exam process to Enforcement, each of which will be
discussed briefly below.
Fee, Expense and Trade Allocation
Allocation of fees, expenses, and trades or other investment
opportunities has been a perennial focus of OCIE attention and SEC
Enforcement actions. OCIE’s FY 2020 budget requests to hire four
new positions to support its exam programme, and that “[i]n
particular, staff will be examining for indications of inappropriate or
inadequately disclosed fees and expenses”.12 Investment advisers’
responsibility to allocate expenses between the adviser and
managed funds, and to allocate fees, expenses, and trades among
clients, creates a number of potential conflicts of interest between
the adviser and its clients.
As discussed at length in our June 2017 and 2016 article, Allocating
Fees and Expenses: The SEC Is Paying Close Attention,13 the SEC
has settled nearly two dozen cases with investment adviser firms
regarding fee and expense allocation.14 Many of these scenarios
involved allocations among advisers, client funds, and co-
investment vehicles. In its April 2018 Compliance Outreach
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Program, and accompanying Risk Alert,15 the SEC distilled the
findings of over 1,500 adviser examinations into several categories
of violations. In broad overview, three key lessons follow:
■ First, the SEC expects that potential conflicts of interest will
be disclosed at the time the investor makes an investment
decision. Once an investment decision has been made, the
SEC appears to believe that disclosures describing how an
adviser will act are far less effective in protecting even the
most sophisticated investors, unless investors are able to act
on such disclosure by consenting or by redeeming.16
■ Second, the SEC expects that disclosures regarding fee,
expense, and trade allocations must precisely describe the
mechanics of allocation and specify both the types of fees,
expenses, and trades that will be allocated and how the
adviser will allocate them in specific circumstances. The
SEC has refused to allow advisers to point to “catch-all”
provisions that permit discretionary allocations of expenses
to avoid liability.17
■ Third, the SEC will require advisers to comply with their
established and disclosed allocation procedures. The SEC
may bring Enforcement actions against advisers that do not
comply with established procedures even in the absence of
significant investor harm.18 OCIE’s 2018 Risk Alert
highlighted a number of categories of deviation from
established procedures. Some, such as charging fees based
on improper valuations, charging fees at rates or according to
a time schedule different from that disclosed to investors,
highlight the importance of careful recordkeeping and
operations. Others, such as failing to aggregate holdings that
would comply for volume discounts, failing to disclose fee
sharing practices, or improperly charging fund expenses,
highlight the importance of a well-resourced compliance
function that can effectively monitor all aspects of an
adviser’s operations.
Advisers can expect OCIE to review the sufficiency of adviser’s
allocation disclosures and compliance from multiple perspectives.
OCIE routinely asks advisers to provide and identify disclosures
made to investors at the time they are committing capital and in the
course of a fund’s life cycle. OCIE will also request the adviser’s
compliance policies and procedures governing allocations and
documentation demonstrating compliance with these policies and
procedures.
To test the adviser’s compliance with its disclosures and policies,
OCIE may request financial records showing how the adviser has
allocated fees, expenses, and trades for a lengthy period of time. In
the event that an adviser lacks the necessary records, the SEC may
ask the adviser to create charts showing the allocated amounts.
Finally, the exam team may ask advisers to explain the rationale
behind allocations of particular interest, either by written
explanations, by providing contemporaneous documentation, such
as email, or potentially in interviews.
Insider Trading and the Treatment of Material Nonpublic Information
Insider trading and the treatment of material nonpublic information
remain a top priority for both OCIE and the SEC’s Enforcement
Division, and likely will always occupy an important position on the
SEC’s exam priority list. Both substantive insider trading issues and
the adviser’s insider trading compliance programme are likely areas
of scrutiny during an OCIE exam.
OCIE exam teams are likely to request general information regarding
a firm’s research and investment decision making process, both
through requests for documents and through written questions. The
exam team will then drill down into specific relationships and
communications that a firm’s portfolio managers and research analysts
have with corporate insiders and other market participants. In recent
years, this inquiry has included a particular focus on how firms control
and monitor one-on-one and small-group communications with
corporate insiders.
Second, the exam team will likely identify particular transactions
for closer review where either there is unusually positive
performance or the transaction is outside the scope of the adviser’s
ordinary areas of investment focus. The exam team can be expected
to review sample investment files and emails relevant to those
flagged transactions. Portfolio managers and analysts identified
through that review may be interviewed. OCIE often requests
significant background information to understand the sources of
information used by the adviser and to confirm that there was no
improper use of material nonpublic information.
Third, OCIE exam teams will likely scrutinise the compliance
department’s control and oversight over the use of nonpublic
information. Materials analysed will include written policies and
procedures, logs of contacts with industry consultants and with
personnel of publicly-traded issuers, and records of trainings
regarding insider trading. Recent settlements have demonstrated the
SEC’s close attention to alleged failures in sufficiently tailoring
policies regarding the misuse of material nonpublic information.
Valuation
Valuation methodologies and disclosures are consistently identified
as an examination focus in the SEC’s annual publication of national
exam programme examination priorities. Kristin Snyder, OCIE’s
Co-Head of the SEC’s Investment Adviser/Investment Company
Examination Program, reaffirmed the focus on valuation for private
fund advisers at a Q&A panel following the SEC’s 2018
examination priority announcement. Investors and the SEC demand
reliable calculations of a fund’s value. Advisers can expect to face
continued scrutiny of both valuation policies and procedures and the
oversight of those policies.
The SEC has made clear that particular attention will be paid to
advisers’ valuations used to calculate management fees. Examiners
will also review whether assets are valued in accordance with
investor agreements, disclosures, and the firm’s policies and
procedures and whether there have been breakdowns in compliance
controls. Difficult-to-value or illiquid instruments will face
enhanced scrutiny. Advisers can also expect that OCIE exam staff
will devote particular attention to any instances in which the
valuation process described to clients is not ultimately followed or
the valuation methodologies are modified without being
communicated to investors.
SEC examiners will expect firms to have a clearly defined, step-by-
step valuation procedure which is memorialised in written policies
and procedures. Any alternative methods for valuation should be
similarly memorialised. OCIE staff will examine whether detailed
pricing methodologies exist and are consistently applied.
Examiners will also look for documentation of pricing errors, if and
when they occur, and a record of how such errors were corrected.
With the need for accurate valuation information comes the need for
a well-defined and substantial oversight of the valuation process.
OCIE will look for a valuation committee that routinely reviews
valuation methodologies and, where applicable, pricing decisions
and will expect to see clearly defined roles for all those involved in
the valuation process, as well as policies and procedures that
address monitoring and controls for such individuals.
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Advertising
Consistent with the SEC’s focus on investor protection, advertising
has been a priority since the SEC launched its advertising review
initiative in 2016, which the SEC described as a response to having
frequently identified deficiencies in adviser advertising practices.
Indeed, many of the “most frequent advertising rule compliance
issues” are directly relevant to the kinds of marketing
communication that frequently occur between funds and their
investors.19 The Advertising Rule prohibits an adviser from
publishing or distributing any advertisement that contains any
untrue statement of material fact or that is otherwise false or
misleading, and the definition of what constitutes an advertisement
is quite broad.20 The most common and problematic deficiencies
involve the sharing of misleading performance results, misleading
claims of compliance with voluntary performance standards,
cherry-picked profitable stock selections, and misleading one-on-
one presentations.21
In a sweep investigation of potential violations of the Advertising
Rule, the SEC demonstrated its willingness to bring significant
charges against investment advisers when it found that 13
investment advisory firms had repeated F-Squared Investments’
false performance data, which had been substantially inflated.22 The
13 firms did not sufficiently substantiate the information that F-
Squared Investments had provided, and the then-SEC Enforcement
Director emphasised that advisers “must verify the information first
rather than accept it as fact”.23 The SEC’s focus on advertising has
also evolved as new strategies emerge. In late 2018, the SEC
brought two enforcement actions against “robo-advisers” for
publishing allegedly misleading advertising.24
Over the course of an exam, OCIE can be expected to scrutinise
presentation decks used when meeting with investors, standard due
diligence questionnaire responses, investor letters, and other routine
marketing communications. Because in-person or telephonic
meetings can be just as important as printed disclosures and
marketing material, OCIE will also scrutinise compliance manuals
and policies and procedures governing these kinds of oral marketing
communications. OCIE’s review of advertising materials is, of
course, not only targeted at advertising compliance: many of the
other exam priorities, such as fee, expense, and trade allocation turn
on how an adviser describes its practices to investors in disclosures
and advertising material.
Cybersecurity
OCIE first identified cybersecurity as an exam priority in 2014 and,
recognising the growing threat of cyber intrusion and the increasing
reliance of investors on the internet for account access and securities
transactions, the SEC has since placed greater emphasis on
evaluating and addressing cybersecurity risk. The SEC has noted
the increasing frequency and complexity of cyber-related
misconduct affecting the securities markets.25 In August 2017, the
SEC described cybersecurity as “one of the top compliance risks for
financial firms”.26 OCIE’s cybersecurity concerns have grown as the
market becomes increasingly entangled with cyberspace, creating
heightened risks for targeted firms, market participants, and retail
investors alike. The SEC has noted that the rapid growth of
distributed ledger technologies and the cryptocurrency markets
present challenges to the staff, requiring additional expertise and a
continuously improving programme.27 Accordingly, in its FY 2020
budget requests, the SEC specifically sought additional staff to
monitor critical securities market infrastructure for significant cyber
events.28
In August 2017, the SEC issued an alert detailing observations from
75 examinations conducted in connection with OCIE’s cybersecurity
initiative. The findings were troubling: while nearly all investment
advisers had written policies and procedures addressing
cybersecurity issues and corresponding protections, those policies
were often too general, not tailored to the firm’s business model, or
simply not reflective of actual practices at the firm.29
In preparing for an OCIE exam, investment advisers should first
ensure that it has in place sufficient written cybersecurity policies
and procedures. OCIE’s August 2017 cybersecurity observations
have a detailed list of the kinds of policies that OCIE says firms may
“wish to consider”. OCIE expects mandatory cybersecurity
awareness training for employees and contractors.
After examination of the contents of the firm’s policies and
procedures, OCIE will consider whether these policies are followed.
For example, if there is a policy that states employees cannot use
home computers in their professional capacity or must use secure
mobile devices, OCIE will seek evidence that, in fact, employees
are not using home computers in a professional capacity and cannot
accept firm emails on an unsecured personal mobile device.
OCIE will also look for risk assessments, such as tests of cyber
vulnerabilities or documented understandings of where sensitive data
resides and whether it is adequately protected. OCIE will similarly
expect advisers to have in place an incident response plan, which
should address potential cybersecurity incidents. Because vendors
are entrusted with sensitive data, OCIE expects firms to also consider
whether to perform due diligence on third parties with access to
investor information. If an adviser’s internal review identified
cybersecurity deficiencies, OCIE will scrutinise the efforts made to
mitigate the issue and expect policies and procedures to have been
revised to prevent the same future deficiency.
III. The Exam Process
A. Before OCIE Arrives: Exam Preparation
The first step in the OCIE exam process is preparing for an exam –
which should begin before an exam is on the horizon. By knowing
the areas OCIE likely will focus on during an examination, advisers
can identify potential issues and take corrective action, if necessary,
before OCIE arrives. The SEC’s focus on transparency, continued
effort to effectively allocate its limited resources through risk-based
analytics, and advocacy of strong adviser compliance programmes
provide an encouraging environment for investment advisers to
address potential issues before they develop into an Enforcement
action. Cooperation, proactive remediation, and, where appropriate,
self-reporting benefit investment advisers, investors, and the SEC
alike.
There are several key measures that advisers should consider taking
on a routine basis to best prepare for OCIE exams and prevent
subsequent SEC Enforcement actions:
■ Evaluate written policies and procedures to ensure that
they are in place, properly tailored to your firm’s
circumstances, and up to date. As noted above, a key area
of OCIE focus is evaluating whether written policies and
procedures are in place, sufficiently tailored to the specific
firm, up to date, and followed. Advisers should thus
regularly review their policies and procedures, with
particular attention given to those areas relevant to the SEC’s
priorities. Where applicable, policies should be updated to
reflect current best practices. Advisers should also ensure
that policies are followed and that steps taken pursuant to
these policies are documented.
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■ Ensure any deficiencies noted in prior OCIE exams have
been addressed. OCIE is focused on addressing repeated
deficiencies; in fact, one of its “performance goals”
announced in its FY 2020 budget request is to increase the
“percentage of firms receiving deficiency letters that take
corrective action in response to all exam findings”.30 Firms
should therefore closely examine any issues that have been
addressed in prior examinations. All deficiencies previously
identified by OCIE should have been fully resolved in a
timely manner. Firms should expect OCIE to follow up on
those earlier issues, and advisers should be prepared to
explain changes made to policies or implementation practices
to address those deficiencies, and demonstrate that past
deficiencies have not been repeated.
■ Determine whether any further action is needed to remedy
past deficiencies or to proactively address potential
deficiencies. Once risk areas have been identified, the adviser
must also determine whether any proactive remedial action is
needed. Some remedial steps will be straightforward –
updating out-of-date policies or implementing new
procedures to follow an emerging best practice. Judgments
around other potential remediations may be more complex
and nuanced and involve a balancing of considerations,
particularly in areas where OCIE and Enforcement priorities
appear to be evolving. Whether or not a decision is made to
remediate, it is essential to be prepared to explain to OCIE the
firm’s decision, and decision-making process.
■ Develop a regularised procedure for OCIE exams,
including a process to manage interactions with examiners,
document production, and responses to requests. Advisers
should designate a coordinator to serve as a primary point of
contact for the OCIE staff in order to maintain clear
communication and ensure that requests are dealt with
promptly. This also facilitates proper record keeping and
improves the ability to efficiently produce documents upon
request.
Perhaps the best way to ensure that the above exam preparation
steps occur on a routine and regularised basis is to make them part
of an adviser’s regular compliance procedures. By integrating this
prospective review into a regular compliance review, advisers can
ensure that steps are taken regularly, systematically, and with ample
time to assess and implement any remedial action. This is only
possible, of course, if advisers ensure that their compliance function
has sufficient resources to proactively address potential exam
issues, allowing the firm to substantially lessen resource
expenditure, disruption, and risk later on.
B. Responding to Written Requests
OCIE exams ordinarily commence with a series of written requests
for documentation and information. Before responding to written
requests from OCIE, investment advisers should consider the full
context of each request and the potential Enforcement implications.
Although responding to such requests can seem like a rote exercise,
initial requests offer critical insight into what OCIE may have
identified through its pre-exam risk assessment as issues for
enhanced scrutiny. OCIE inquiries should not be viewed through
the adversarial lens of civil litigation, however. Rather, written
requests should be approached as an opportune time to begin
building a cooperative relationship with OCIE examiners through
timely and accurate responses:
■ Consider the aim of written requests and evaluate
whether additional information should be provided. An
adviser’s goal in responding to a request should be both to
fulfil the request and to ensure that the adviser has provided a
complete and accurate response to OCIE. When a written
request is received, an investment adviser should first
consider the aim of that request. Does the request relate to
the examination and Enforcement priorities identified above?
How does the request relate to the firm’s business and
strategies? What would someone in an Enforcement capacity
be looking for in the responses? By reflecting on these
questions, an adviser can better determine whether there is
information outside the scope of the request that might be
provided to ensure that OCIE has a complete and accurate
picture of the adviser’s practices.
■ Evaluate follow-up requests with particular care to
identify potential target areas. Follow-up requests offer
even more refined insight into OCIE’s thinking. These
requests enable advisers to determine whether the OCIE
inquiry is, in fact, aimed at the issues initially believed to be
the focus. By their nature, follow-up requests suggest
OCIE’s interest has been piqued: a follow-up request for fee
allocation data for the past X years, for example, is a strong
indication that OCIE has flagged this area as high-risk for the
firm and is taking a careful look at the issue. Follow-up
requests should also prompt advisers to more closely
consider whether there exists additional information that,
while not directly responsive to the request, would be
relevant to the general line of inquiry and may be beneficial
to proactively share.
It is important to maintain thorough records of all materials
provided to OCIE. Even though information requests often arrive
on short notice with tight deadlines, firms should keep a detailed log
of every document or item provided to OCIE, as well as a copy of all
materials produced.
C. Responding to Electronic Communication Requests
OCIE exams frequently include requests for the production of email
and other electronic communications. Recent practice indicates that
OCIE increasingly seeks all emails from selected senior personnel
(including portfolio managers and analysts) over extended time
periods, resulting in extensive initial email production. Email
collection, review, and production can become expensive and time
intensive and are fraught with pitfalls, from inadvertent production
of privileged material to technical issues in search or production.
OCIE has also recently sharpened its focus on forms of electronic
communication other than email. Indeed, in a recent risk alert,
OCIE undertook a review of electronic communications from which
it excluded email on the ground that “firms have had decades of
experience complying with regulatory requirements with respect to
firm email, and it often does not pose similar challenges as other
electronic communication methods”.31
In contrast to document review in the civil litigation context, the
timeline for most OCIE exams typically makes it impossible and
unduly expensive to review, before producing, every email of
multiple employees sent or received over a broad time period. It is
essential, however, to have steps in place to protect privileged
information and obtain a general understanding of what information
is being produced and what the exam team may focus on. The
essential parts of a review strategy include the following:
■ Identify potentially privileged material before
production. Producing privileged materials to the SEC
without taking reasonable steps to avoid production risks
waiving the privilege with respect to the documents or
potentially over the entire subject matter of the
communications. Advisers should therefore take reasonable
efforts to remove privileged material from the production
before the documents are produced to OCIE. Among other
search approaches, advisors should consider identifying
relevant attorneys, and documents or communications sent to
or from those attorneys, or created by or for counsel, should
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be searched for and analysed. This narrowing of criteria can
help identify the documents that most require review so that
privileged material is not inadvertently produced.
■ Develop a search strategy to identify highly relevant
documents, ideally before production. An additional search
strategy will be needed to identify the key non-privileged
documents in the production. This search, which will likely
feature search terms and may be narrowed to particularly
significant document custodians over a particular time period,
will depend on the relevant exam priorities and the factual
context of the exam. Ideally, the search strategy employed
will yield a small document set that is manageable to review
before production or before follow-up communications are
required with OCIE.
D. Requests for Interviews
OCIE frequently requests one or more interviews with an adviser’s
personnel in the course of an exam. Initial interviews routinely cover
general questions about the entity and the activities to be examined,
which allows the exam staff to develop a preliminary understanding of
the firm’s compliance practices and its adherence to policies and
procedures. To the extent that the exam staff has identified particular
areas of focus, they may request supplemental interviews. The topics
of such interviews may suggest that the exam team is giving increased
scrutiny to a particular aspect of the adviser’s business or a particular
transaction. Such targeted interviews require a shift in thought process
and preparation, with witness preparation demanding careful attention.
■ Treat OCIE interviews with the same care you would
afford to an interview or deposition in an Enforcement
investigation. While there should be no lessening of
cooperation and transparency with OCIE, preparation for
interviews should be thorough and comprehensive. The
interviewee’s statements about what occurred and why it will
become part of the permanent record of the matter and will
follow the adviser to any Enforcement action that may arise
out of the exam. If the interviewee’s statements are
inaccurate for any reason, it may be difficult to correct them
at a later stage or dispel any misunderstandings they may
have caused. Advisers must therefore carefully consider the
background of an interview request, understand the intended
scope of the interview, gather documents and emails relating
to the relevant transactions or events, and determine a
preparation approach with the interviewee.
■ Carefully consider which adviser personnel can best serve
as interview subjects. OCIE may request to conduct an
interview on a particular subject or transaction rather than to
interview a specific person. Advisers and their counsel
should consider who among the adviser’s personnel with
knowledge of the subject would best present a complete and
accurate account of the relevant facts, and have sufficient
“big picture” perspective to situate a transaction or
occurrence in the adviser’s overall business. For example,
junior employees may have had direct “hands-on”
involvement in a particular transaction but may lack the
perspective or experience to provide a complete report to
OCIE. Conversely, a senior employee may be able to present
the best overview of a subject but may lack detailed firsthand
knowledge of a relevant occurrence. Advisers and their
counsel should carefully balance these considerations when
selecting interviews subjects.
■ Prepare for OCIE interviews just as you would prepare
for a deposition. Ideally, advisers would provide interview
subjects with relevant documents and conduct preparation
meetings in advance of the interview. The purpose is to
understand fully what the witness recalls and what the
witness would state in response to questions. Mock Q&A
sessions are also an indispensable part of preparation, as an
investigative interview – like a deposition – is very different
from an ordinary conversation. While the short timetable for
OCIE interviews may limit the ability to conduct as extensive
preparation as for a litigation deposition, advisers and their
counsel should develop a preparation process that ensures the
witness will be prepared in the fundamentals of the interview
process and relevant facts.
E. Remedial Action
Whether to take remedial action in the course of an exam can be one
of the most important and difficult decisions to be made in the
context of managing the risks of subsequent Enforcement action.
Where it is feasible to take corrective action before the conclusion
of an exam, advisers should weigh the following considerations in
making this judgment:
■ Carefully assess the merits of the underlying deficiency.
If OCIE identifies a deficiency, investment advisers should
thoroughly assess the nature and cause of that deficiency.
Advisers should first examine relevant fund agreements and
client disclosures with the goal of identifying opposing
arguments on whether there was a violation of those
agreements and disclosure. Recognising that the SEC may
expect increased levels of detail in agreements and
disclosures, advisers should consider the strength of the
firm’s position on the merits.
■ Consider whether adviser clients may have been harmed
by any deficiencies, and if so, how clients may be made
whole. In situations where there is a close question on the
merits and financial remediation is contemplated, firms need
look closely at whether clients were harmed, whether the
adviser benefited, and whether the deficiency was caused by a
good faith error or technological glitch or whether it resulted
from mal-intent or compliance programme shortcomings. The
particular facts and circumstances will drive every judgment,
but if a firm is faced with an ambiguous or borderline position
on the merits of an issue, which resulted in determinable
financial costs to investors to the benefit of the adviser, prompt
remedial action should be strongly considered.
■ Consider the form of potential remedial action.
Remediation can take many forms: enhancing policies and
procedures, making additional client disclosures, amending
fund agreements, and making financial payments.
Determining how to handle possible remediation begins with
fully understanding the relevant facts and applicable laws and
regulations and how they might apply to the circumstances.
There is often ambiguity about this, as applicable laws and
regulations frequently do not address the situations that arise
and OCIE’s expectations may be based on industry best
practices which are evolving. Given the complex judgments
required to reach a remediation decision, investment advisers
should begin considering remediation options as soon as
issues arise. Waiting for OCIE to raise a concern and then
appearing to remediate only because OCIE has focused on the
issue does not put the firm in the most favourable position.
■ Consider how remediation may be perceived as OCIE
evaluates whether to refer the matter to Enforcement.
When corrective action is undertaken appropriately, the risk
of an issue being referred to Enforcement may be reduced.
Alternatively, the decision not to remediate an issue which
OCIE clearly believes should be remediated can substantially
increase the risk of a referral to Enforcement, which in turn
could lead to substantially greater financial and reputational
costs for the adviser. Remediation itself does not, however,
create a “safe harbour” to avoid Enforcement, and there are
many situations where OCIE will refer an issue to
Enforcement even when an adviser remediates in the course
of an exam.
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■ Remedial action should generally not be seen as an
admission of noncompliance. Advisers may focus unduly
on whether taking remedial action will constitute a
concession, thereby increasing the likelihood of an issue
going to Enforcement, or whether, if there is an Enforcement
investigation, the firm will not receive credit for taking
remedial action in a settlement, resulting in an additional
sanction by Enforcement. While every set of circumstances is
different and should be evaluated accordingly, advisers should
not overthink the extent to which taking remedial action will
impact potential future Enforcement actions. Instead,
advisers should focus on making the best decision with the
available information. It is highly unlikely that positive
remedial steps taken during an OCIE exam will have greater
negative ramifications later on. Even if the issue is referred to
Enforcement, if the SEC’s process works as it should, the firm
should receive full credit, or even greater credit, if the issue
was remediated promptly and appropriately.
F. Referrals to Enforcement
At the conclusion of an exam, OCIE will provide a deficiency letter
which identifies where the SEC views potential violations of laws
and regulations and invites the firm to respond in writing and take
appropriate action in response to the issues raised.32 Firms should
take full advantage of this opportunity and make as thorough a
submission as possible.
The firm’s submission will be closely considered by both OCIE and,
in situations where OCIE has determined that Enforcement action
should be considered, by Enforcement as well. Ultimately there will
be a process involving both groups within the SEC to decide
whether Enforcement should open an investigation. It is possible to
ask for additional meetings or calls with the SEC as this process
progresses, but firms should assume that their written submission
will be the principal basis on which the SEC makes its decision. In
FY 2018, 6% of investment adviser exams resulted in a referral to
Enforcement.33 While it is impossible to predict with certainty
whether a particular issue will result in a referral to Enforcement,
the following factors may be relevant:
■ Referral to Enforcement is more likely where investors
have been injured. OCIE is more likely to refer matters to
Enforcement in instances where there has been a
recognisable injury to investors which is traceable to a clear
violation of the securities laws, in particular to inadequate
disclosures or an undisclosed conflict of interest between the
adviser and clients. Injuries to markets through misuse of
material non-public information and fraud or intentional
misconduct generate similar Enforcement attention.
■ Referral to Enforcement is more likely if the deficiencies
identified relate to areas of SEC policy focus. The SEC
may also identify particular areas – such as the subject matter
areas referred to above – that present emerging trends in
wrongdoing and want to take a public position on an issue.
As a result, Enforcement referrals may be more likely as a
policy or deterrent matter. If the issue is of interest to the
SEC and the SEC sees value in an Enforcement settlement
creating precedent on the issue, this can result in referrals
even when there has been remedial action and cooperation.
Conclusion
With OCIE focused on more targeted, deep-dive examinations into
high-risk areas, the potential for Enforcement investigations
following exams has never been higher. Accordingly, investment
advisers should take scrupulous care in preparing for and managing
the exam process.
Acknowledgment
This chapter builds on a Davis Polk webcast entitled How to Reduce
the Risk That Your OCIE Exam Becomes an Enforcement
Investigation, which the authors presented with Davis Polk
litigation partner Amelia T.R. Starr and Davis Polk litigation
counsel Marc Tobak. The webcast is available at
https://www.davispolk.com/publications/webcast-how-reduce-risk-
your-ocie-exam-becomes-enforcement-investigation. Ms. Starr’s
practice focuses on a wide variety of commercial litigation,
securities litigation, regulatory enforcement proceedings and
insolvency matters. She has a detailed knowledge of the funds
industry, representing the largest fund managers on issues revolving
around breach of contract, breaches of fiduciary duty, valuation
disputes, trade allocation practices, securities and fraud claims,
insider trading and other misconduct. (Tel: +1 212 450 4516 / Email:
[email protected].) Mr. Tobak represents clients in a
variety of complex civil matters, including representing investment
funds and managers in regulatory examinations and investigations.
(Tel: +1 212 450 3073 / Email: [email protected].) The
authors would like to thank Mr. Tobak for his assistance in the
preparation of this chapter.
Endnotes
1. U.S. Secs. and Exchs. Comm’n, Fiscal Year 2020
Congressional Budget Justification Annual Performance
Plan (March 29, 2019) (“SEC FY20 Budget”), 28, available
at https://www.sec.gov/files/secfy20congbudgjust.pdf.
2. Id. at 99.
3. Id. at 26.
4. Melanie Waddell, SEC to Probe Adviser, BD Fiduciary
Compliance With ReTIRE Initiative, ThinkAdviser, Mar. 3,
2017, available at https://www.thinkadviser.com/2017/03/03/
s e c - t o - p r o b e - a d v i s e r - b d - f i d u c i a r y - c o m p l i a n c e -
with/?slreturn=20180411160149.
5. Improving Investment Adviser Compliance, Peter B. Driscoll
(Sept. 14, 2017) (“Driscoll Speech”) available at https://
www.sec.gov/news/speech/speech-driscoll-2017-09-14.
6. Id.
7. SEC FY20 Budget at 26.
8. Id. at 120.
9. Id.
10. Id.
11. Driscoll Speech.
12. SEC FY 20 Budget at 27.
13. Leor Landa & James H.R. Windels, Allocating Fees and
Expenses: The SEC is Paying Close Attention, 5 INT’L COMP.
LEGAL GUIDE TO ALTERNATIVE INV. (2017).
14. More recent fee and expense allocation settlements include In
re Yucaipa Master Manager, LLC, File No. 3-18930 (Dec. 13,
2018) and In re NB Alternatives Advisers LLC, File No. 3-
18935 (Dec. 17, 2018).
15. Id.
16. Id.
17. Id.
18. Id.
19. National Exam Program Risk Alert, The Most Frequent
Advertising Rule Compliance Issues Identified in OCIE
Examinations of Investment Advisers (Sept. 14, 2017)
(“Advertising Risk Alert”) available at https://www.sec.gov/
ocie/Article/risk-alert-advertising.pdf.
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20. The Advertising Rule states that an “advertisement shall
include any notice, circular, letter or other written
communication addressed to more than one person, or any
notice or other announcement in any publication or by radio or
television, which offers (1) any analysis, report, or publication
concerning securities, or which is to be used in making any
determination as to when to buy or sell any security, or which
security to buy or sell, or (2) any graph, chart, formula, or
other device to be used in making any determination as to
when to buy or sell any security, or which security to buy or
sell, or (3) any other investment advisory service with regard
to securities”. Advisers Act Rule 206(4)-1(b).
21. Advertising Risk Alert.
22. SEC Press Release No. 2016-167, Investment Advisers
Paying Penalties for Advertising False Performance Claims
(Aug. 25, 2016), available at https://www.sec.gov/news/
pressrelease/2016-167.html.
23. Id.
24. SEC Press Release No. 2018-300, SEC Charges Two Robo-
Advisers with False Disclosures (Dec. 18, 2018), available at
https://www.sec.gov/news/press-release/2018-300.
25. Stephanie Avakian, The SEC Enforcement Division’s
Initiatives Regarding Retail Investor Protection and
Cybersecurity (Oct. 26, 2017) available at https://www.sec.gov/
news/speech/speech-avakian-2017-10-26.
26. National Exam Program Risk Alert, Observations from
Cybersecurity Exams (Aug. 7, 2017) (“Cybersecurity Risk
Alert”) available at https://www.sec.gov/files/observations-
from-cybersecurity-examinations.pdf.
27. SEC FY20 Budget at 27.
28. Id.
29. Cybersecurity Risk Alert.
30. SEC FY20 Budget at 118.
31. National Exam Program Risk Alert, Observations from
Investment Adviser Examinations Relating to Electronic
Messaging (Dec. 14, 2018) (“Electronic Messaging Risk
Alert”) available at https://www.sec.gov/files/OCIE%20
Risk%20Alert%20-%20Electronic%20Messaging.pdf.
32. Under Section 4E of the Exchange Act, which was added as
part of the Dodd-Frank act, OCIE must provide the
deficiency letter not later than 180 days after the conclusion
of the exam, unless senior OCIE employees extend the
deadline for an additional 180 days after providing notice to
the Chairman and Commission. 15 U.S.C. § 78d-5(b).
33. SEC FY 2020 Budget, at 120.
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Leor Landa Davis Polk & Wardwell LLP 450 Lexington Avenue New York, NY 10017 USA Tel: +1 212 450 6160
Email: [email protected]
URL: www.davispolk.com
James H. R. Windels Davis Polk & Wardwell LLP 450 Lexington Avenue New York, NY 10017 USA Tel: +1 212 450 4978
Email: [email protected]
URL: www.davispolk.com
Davis Polk & Wardwell LLP (including its associated entities) is a global law firm with offices strategically located in the world’s key financial centres. For more than 160 years, our lawyers have advised industry-leading companies and global financial institutions on their most challenging legal and business matters. Davis Polk ranks among the world’s preeminent law firms across the entire range of its practice, which spans such areas as capital markets, mergers and acquisitions, credit, antitrust and competition, litigation and enforcement, private equity, tax, financial regulation, investment management, insolvency and restructuring, executive compensation, FinTech, intellectual property and technology, real estate, and trusts and estates. Davis Polk has more than 900 lawyers in offices located in New York, Northern California, Washington DC, São Paulo, London, Paris, Madrid, Tokyo, Beijing and Hong Kong. For more information, please visit: www.davispolk.com.
Mr. Landa is a partner in Davis Polk’s Investment Management/Private Funds Group. He advises a wide range of clients on the formation and operation of private investment funds, including private equity funds, hedge funds, credit funds, secondary funds, real estate funds, funds of funds and advisory platforms. He also regularly provides regulatory and compliance advice to his private fund clients.
He advises clients on secondary, private equity and public market transactions as well as acquisitions of investment advisers. Mr. Landa also represents several large institutional investors that invest in private funds.
Representative private fund clients have included Blackstone Strategic Partners, Credit Suisse, Avenue Capital, Oaktree Capital, Mudrick Capital, Hitchwood Capital, Perella Weinberg Partners, Reverence Capital, Czech Asset Management, Citadel, Fore Research, Morgan Stanley and J.P. Morgan.
Mr. Windels is a partner in Davis Polk’s Litigation Department. He has experience in a wide variety of federal and state court commercial litigation matters and arbitrations, regulatory enforcement proceedings and internal investigations. Mr. Windels represents public and privately held corporations, financial institutions, hedge funds, accounting firms, and corporate directors and officers.
Representative clients over the last 20 years include Alliance Capital Management, Banco Santander, Barclays Capital, Credit Suisse, Delta Air Lines, Deutsche Bank, Digicel Group, Highbridge Capital Management, J.P. Morgan & Co., Lehman Brothers International (Europe), Metalmark Capital Partners, Morgan Stanley & Co. and PricewaterhouseCoopers LLP.
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mori Hamada & matsumoto
Yasuzo takeno
fumiharu Hiromoto
Bringing foreign investment funds into Japan
1 Overview of Regulations for Foreign Investment Funds in Japan
While there are many varieties of investment vehicles in the world,
in this chapter we discuss unit trust-type investment funds and
partnership-type investment funds, as these are frequently used in
bringing foreign investment funds into Japan.
1.1 Foreign unit trust-type investment fund
When conducting an offer in Japan, a foreign unit trust that is
similar to a Japanese investment trust fund (toshi shintaku) is treated
as a foreign investment trust in Japan and is subject to Japanese
securities laws; specifically, the Financial Instruments And
Exchange Act of Japan (the “FIEA”) in respect of marketing, and
the Investment Trust and Investment Corporation Act of Japan (the
“ITICA”) in respect of regulatory filings with the Financial
Services Agency of Japan (“FSA”).
1.1.1 Public offering of a foreign inv