alternative investment funds 2019... the international comparative legal guide to: alternative...

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

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

Rory Smith

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.

iclg to: alternative investment funds 2019 www.iclg.com© Published and reproduced with kind permission by Global Legal Group Ltd, London

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

www.iclg.com2 iclg to: alternative investment funds 2019© Published and reproduced with kind permission by Global Legal Group Ltd, London

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.

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.


“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


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.

iclg to: alternative investment funds 2019 5www.iclg.com


© Published and reproduced with kind permission by Global Legal Group Ltd, London

Michael C. Mascia Cadwalader, Wickersham & Taft LLP 227 West Trade Street Charlotte, NC 28202 USA Tel: +1 704 348 5160


URL: www.cadwalader.com

Wesley A. Misson Cadwalader, Wickersham & Taft LLP 227 West Trade Street Charlotte, NC 28202 USA Tel: +1 704 348 5355


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.



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


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.

davis Polk & wardwell llP adviser exams: mitigating enforcement risks


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.




■ 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



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.




■ 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.



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.


28. Id.

29. Cybersecurity Risk Alert.


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.




Leor Landa Davis Polk & Wardwell LLP 450 Lexington Avenue New York, NY 10017 USA Tel: +1 212 450 6160


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


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.




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

alternative investment funds 2019... the international comparative legal guide to: alternative...

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