Exempt Reporting Advisers Faced Significantly More SEC Enforcements In 2022 – Securities

The Securities and Exchange Commission (SEC) brought an
unusually high number of enforcement actions against exempt
reporting advisers in 2022 — that appears to be more than the
prior three years combined and a record number for a single year.
This uptick in SEC enforcement activity should serve as a reminder
for exempt reporting advisers of the regulatory risks they face
under the Investment Advisers Act of 1940 (Advisers Act) and other
aspects of the federal securities laws.

BACKGROUND

“Exempt reporting advisers” are investment advisers
that rely on Section 203(l) or Section 203(m) of the Advisers Act.
Section 203(l) generally provides an exemption from SEC
registration for investment advisers that provide advice solely
with respect to “venture capital funds.” Section 203(m)
generally provides an exemption from SEC registration for
investment advisers that provide advice solely to private funds and
have less than $150 million in assets under management (or, for an
investment adviser whose principal place of business is outside of
the United States, have less than $150 million in assets under
management attributable to a U.S. place of business).

While not subject to registration with the SEC, exempt reporting
advisers are still subject to certain provisions and rules under
the Advisers Act as well other parts of the federal securities
laws. Exempt reporting advisers are also subject to SEC
examinations, even though the SEC staff has historically not
conducted examinations of exempt reporting advisers on a regular
basis.¹ It is notable, therefore, that certain of the
enforcement actions below appear to arise out of SEC
examinations.

PAY-TO-PLAY

Exempt reporting advisers are subject to Rule 206(4)-5 under the
Advisers Act (the “Pay-to-Play Rule”). In the private
fund context, the Pay-to-Play Rule generally prohibits a private
fund adviser and its “covered associates” from making
political contributions to certain US state or local government
officials (or candidates for such offices) who have direct or
indirect influence over the decision of a US state or local
government entity to invest in a private fund. For example, the
Pay-to-Play Rule restricts contributions to a state governor or
treasurer (or candidate for such office) who appoints the trustees
of a state pension plan that is a current or prospective
investor.

SEC enforcement actions for violations of the Pay-to-Play Rule
are the largest category of enforcement actions against exempt
reporting advisers both last year and historically, making up
approximately a third of the enforcement actions against exempt
reporting advisers. The most recent SEC enforcement actions on the
Pay-to-Play Rule include the following:

• Canaan Management, LLC, SEC Release No. IA-6126 (September 15, 2022)
  (with respect to a $1,000 contribution to candidate for Governor of
  California by a covered associate when the Regents of the
  University of California was an existing investor)




• Highland Capital Partners LLC, SEC Release No. IA-6128 (September 15, 2022)
  (with respect to a $1,000 contribution to a candidate for Governor
  of Massachusetts by a covered associate when the Massachusetts
  Pension Reserves Investment Management Board was an existing
  investor)




• StarVest Management, Inc., SEC Release No. IA-6129 (September 15, 2022)
  (with respect to $1,000 and $400 contributions to a candidate for
  Mayor of New York by two covered associates when the New York City
  Employees’ Retirement System and the Teachers’ Retirement
  System of the City of New York were existing investors)

These enforcement actions also highlight the difficulties
relating to the strict liability associated with violations of the
Pay-to-Play Rule: (i) Each action involved contributions made well
after (in most circumstances, more than a decade after) the
government entity investor had committed to the associated
closed-end fund, so there was no implication of a quid pro quo
associated with the contribution; (ii) in one case, the
contribution was returned, and in another case, the covered
associate attempted to have the contribution returned; and (iii) in
two cases, the candidates were unsuccessful.

Exempt reporting advisers who have existing investors or who are
soliciting prospective US state or local government investors (such
as pension plans and university endowments) should make sure that
they are taking their regulatory obligations seriously with respect
to the Pay-to-Play Rule. It appears that most of these actions do
not arise out of SEC examinations but come out of the Public
Finance Abuse Unit of the SEC Division of Enforcement. In addition,
much of the relevant information on political contributions is
publicly available.

FIDUCIARY DUTY AND DISCLOSURE OBLIGATIONS

Exempt reporting advisers are subject to Section 206 of the
Advisers Act and Rule 206(4)-8 under the Advisers Act. Among other
things, Section 206 of the Advisers Act imposes a fiduciary duty on
investment advisers with respect to their “clients,”
which, in the private fund context, is the private funds (and
generally not the investors in such private funds). Rule 206(4)-8
generally prohibits an adviser to a pooled investment vehicle from
(i) making untrue or misleading statements of material fact, or
omitting a material fact, in communications to investors or
prospective investors, and (ii) otherwise engaging in fraudulent,
deceptive, or manipulative conduct with respect to investors or
prospective investors.

Leaving aside enforcement actions relating to misappropriation
and similar types of fraud, there was a notable uptick in
enforcement actions relating to violations of Section 206 and Rule
206(4)-8. Examples of enforcement actions against exempt reporting
advisers for these violations include the following:

• Alumni Ventures Group, LLC, et al., SEC Release No. IA-5975 (March 4, 2022)
  (materially misleading statements regarding management fee
  calculations, inter-fund loans, and cash transfers between funds
  that violated fund operating agreements, and undisclosed conflict
  of interest regarding determination of terms of inter-fund
  transactions)




• Corona Associates Capital Management, LLC, et al., SEC Release No. IA-6062 (June 30, 2022)
  (failure to comply with fund agreements, specifically failure to
  have the audit required by fund agreement)




• Energy Innovation Capital Management, LLC, SEC Release No. IA-6104 (September 2, 2022)
  (errors in calculation of management fees)




• SparkLabs Global Ventures Management, LLC, et al., SEC Release No. IA-6121 (September 12, 2022)
  (inter-fund lending program that was in violation of the fund
  governing documents)

An exempt reporting adviser should carefully review whether the
adviser is compliant with the relevant fund governing and
disclosure documents, particularly with respect to the calculation
of fees and conflicted transactions. The calculation of the
management fee and other fees covers not just ensuring an accurate
calculation but also related issues, such as valuation practices
(including writing off or writing down investments) to the extent
that such fees are based on the value of the investments.
Compliance with fund disclosure documents also includes compliance
with descriptions of the investment process, including due
diligence, and the investment strategy. Finally, exempt reporting
advisers should review their disclosure and procedures for
conflicted transactions. These issues are heightened during periods
of financial distress.

The SEC has historically used Section 206 and Rule 206(4)-8 as
the basis for many enforcement actions against SEC-registered
private fund advisers, and it appears that the SEC is now
increasingly using them to pursue enforcement actions against
exempt reporting advisers. For this reason, exempt reporting
advisers should also review the current and historic areas of focus
for SEC enforcement against SEC-registered private fund advisers,
including, for example, the allocation of fees and expenses and the
disclosure of, and consent to, conflicts of interest.

OTHER ENFORCEMENT AREAS

Exempt reporting advisers are subject to Section 204A of the
Advisers Act, which requires that an investment adviser adopt
policies and procedures to prevent the misuse of material nonpublic
information. Exempt reporting advisers, like all other market
participants, are also subject to potential insider trading
liability. In 2022, there was an enforcement action against a
trader of an exempt reporting adviser for misusing material
nonpublic information to engage in a fraudulent front-running
scheme (although, notably, the adviser itself was not subject to an
enforcement action).²

Furthermore, exempt reporting advisers are subject to other
regulations outside of the Advisers Act beyond insider trading
laws. For example, several SEC enforcement actions prior to this
year focused on violations of Rule 105 of Regulation M of the
Securities Exchange Act of 1934, which prohibits selling short an
equity security that is the subject of certain public offerings and
purchasing the offered security from an underwriter, broker, or
dealer participating in the offering, if such short sale was
effected during the restricted period.³

Finally, there were no enforcement actions in 2022 alleging
improper reliance on either Section 203(l) or Section 203(m).
Historically, the SEC has brought only a few such actions. Each
involved improper reliance related to two investment advisers that
were operationally integrated but sought to be treated separately
with respect to their Advisers Act status.⁴ However,
exempt reporting advisers should still exercise caution with
respect to their Advisers Act status even in the absence of
enforcement actions in 2022.

Footnotes

1. Rules Implementing Amendments to the Investment
Advisers Act of 1940, SEC Release No. IA-3221 (Jun. 22, 2011) at
text accompanying n.188 (“[W]e do not anticipate that our
staff will conduct compliance examinations of [exempt reporting
advisers] on a regular basis”) and n.188 (“Our staff
will conduct cause examinations where there are indications of
wrongdoing, e.g., those examinations prompted by tips,
complaints, and referrals”).

2.Sean Wygovsky, SEC Release No. IA-6155 (Sep. 29,
2022).

3. See, e.g., Helikon Investments Ltd., SEC Release
No. 34-93091 (Sep. 21, 2021); Rockwood Investment Management, Inc.,
SEC Release No. 34-73106 (Sep. 16, 2014); Formula Growth, Ltd., SEC
Release No. 34-73119 (Sep. 16, 2014).

4. See Penn Mezzanine Partners Management, L.P., SEC
Release No. IA-3858 (Jun. 20, 2014) & TL Ventures, SEC Release
No. IA-3859 (Jun. 20, 2014) (operationally integrated with one
adviser seeking to rely on Section 203(m) and the other on Section
203(l); Bradway Capital Management, LLC, SEC Release No. IA-4733
(Jul, 25, 2017) (operationally integrated with one SEC-registered
adviser and one seeking to rely on Section 203(m)).