Avoiding The SEC’s Crosshairs

“The SEC is first and foremost a disclosure agency.”1 Predictably, the SEC has carried this mantra into its expanded mission to more aggressively police private equity funds and hedge funds. The precision of the disclosures demanded by the SEC Staff, however, has caught even well-intentioned managers off guard. Best intentions, improved accuracy or even the financial success of a fund will not deter an enforcement action if disclosures are incomplete, outdated or contain errors.

Fortunately, funds now have increased visibility into where and how the SEC Staff will most actively scrutinize statements to investors. Following two years of “presence exams”2 by the SEC’s Office of Compliance Inspections and Examinations (OCIE), targeted speeches by the Commission, and an increase in investigations and enforcement actions, several topic areas have emerged as regulatory “hot spots.” These topics include: (i) valuation methodology (i.e., inconsistencies between disclosed and utilized valuation methodologies and the use of selective data to influence valuations); (ii) inaccuracies in marketing materials; (iii) omissions and errors in disclosing the accounting or allocation of fees and costs; and (vi) the adoption and implementation of regulatory compliance policies and procedures.

One thing is clear: operating under the SEC’s disclosure-based regime requires substantial discipline from fund managers on an ongoing basis. Carefully drafted initial disclosures coupled with thoughtfully targeted compliance efforts, using the lessons from the cases and investigations set forth below, may significantly reduce risk of an enforcement referral following a visit by SEC Examiners.

Valuation cases and investigations emphasize exactitude in methodology disclosures

Unlike a public company with an available market and liquidation value, the valuation of a private entity requires intensive analysis. Because a reasonable valuation for a private entity may be reached through a variety of widely accepted methods, the SEC is hesitant to substitute its own valuation judgments for a fund’s calculations. Instead, the SEC looks to the details of fund disclosures to assess whether a particular description properly informed investors regarding the methodologies used to reach a valuation.