Regulators Saying “Think for Yourself”

n a week where the SEC shared its thoughts about the state of newly-registered investment advisers, noting continued marketing and valuation issues, the clear message is that the regulators want firms to identify for themselves needed and adequate controls.

A recent order against a private equity firm is a case in point. The firm settled charges of breaching its fiduciary duty to fund clients when it decided to operate two separate portfolio companies, each owned by a separate fund, on an integrated basis. The breach was a failure to ensure that each fund’s portfolio company did not pay more than a fair share of expenses and a further failure to adopt appropriate policies to address this issue. Since the companies remained separate legal entities owned by separate client funds, the SEC took the position that the adviser owed a fiduciary duty to each fund that included an obligation to adopt written policies to prevent violations of its fiduciary duty from arising.The adviser agreed to pay back fees and to pay a hefty civil penalty on top.

The SEC is clearly signaling that managers need to tailor their compliance programs to their activities and this includes adopting written polices to support fiduciary concerns as circumstances warrant.

The approach is not easy and requires critical thinking, but managers need to undertake bona fide efforts to determine how their operations are impacted by regulatory requirements and to understand how those obligations evolve when business changes occur.

For investors who seek to understand a manager’s exposure to regulatory issues as part of operational due diligence, this also means that the task is not a simple one. A review of a manager’s processes can be a useful indicator of its ability to appropriately apply regulatory requirements to changing business activities. Glossing over change management practices during an assessment may mean that an investor is entangled with a distracted manager for the life of a fund.