SEC Enforcement on Material Nonpublic Information and Compliance Breakdowns

In a stark reminder of the high stakes in regulatory compliance, the SEC’s $4 million penalty against OEP Capital Advisors catapults the critical issue of safeguarding Material Nonpublic Information and proper electronic communication to the forefront for investment managers. The recent $4 million fine imposed by the Securities and Exchange Commission (SEC) on OEP Capital Advisors for mishandling Material Nonpublic Information (MNPI) and violating electronic communication policies underscores a pivotal moment for the financial industry. This case sheds light on the consequences of non-compliance and the heightened regulatory scrutiny facing investment managers.

Today, we will unpack the details of the enforcement action and draw key takeaways for investment firms aiming to navigate the complexities of the current compliance landscape.

SEC Fines PE Firm $4M Over MNPI and Electronic Communications Violations

The Securities and Exchange Commission (SEC) recently imposed a $4 million penalty on OEP Capital Advisors, commonly known as One Equity Partners, following alleged violations related to Material Nonpublic Information (MNPI) and electronic communications. The investment manager has been registered with the SEC since 2014 and as of December 31, 2022, had approximately $10.7 billion in total assets under management.

This enforcement action sheds light on the importance of compliance in the private fund industry. It highlights the regulatory scrutiny surrounding electronic communications, a common theme evident from the SEC’s enforcement actions over the past year. Below, we’ll delve into the details of the SEC’s case against OEP, examine the implications for investment managers, and discuss key takeaways in an increasingly stringent enforcement environment.

Summary of the SEC Order against OEP

OEP Capital Advisors, a New York-based private equity firm specializing in midmarket investments, recently faced a significant penalty from the SEC for violating its internal written policies regarding protecting confidential information. The SEC¹ alleged that from 2019 to 2022, senior executives at OEP sent emails containing MNPI about potential mergers and acquisitions. These emails were directed to current and prospective investors and industry contacts, many of which were considered marketing communications. This conduct is said to have breached the firm’s policies and violated Section 204A of the Investment Advisers Act of 1940 and Section 206(4) of the same Act, along with Rule 206(4)-7, which require RIAs to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder.

The communications disclosed information involving confidential details about publicly listed businesses and made performance-related claims regarding the firm’s investments. Despite being categorized as marketing communications, these messages lacked approval from OEP’s internal compliance team and did not incorporate the essential footnotes mandated by OEP’s policies regarding marketing activities. Moreover, MNPI was disclosed during OEP’s internal weekly investment update meetings, where specific guests with signed NDAs were present. Despite the routine use of NDAs in OEP’s business operations, there were instances where OEP personnel did not adequately assess whether the potential disclosure of MNPI, given the circumstance, met the criteria for being “necessary for legitimate business purposes”, as stipulated by OEP’s established written policies and procedures.

Additionally, OEP had a policy restricting the use of any security valuation, other than those approved by its Valuation Committee every quarter, for use in its marketing communication with current or prospective investors. Despite the policy, senior personnel at OEP repeatedly asserted specific performance or embedded gains claims based on estimated value calculations that had not yet received approval from the Valuation Committee. These claims were incorporated into emails seeking capital commitments from both potential and existing investors. The assertions suggested opportunities for new investors to benefit from built-in portfolio gains or discounts, and for existing investors to enhance their returns by increasing their initial investment. It is crucial to note that these claims lacked the mandatory explanatory footnotes, as required by the firm’s policies to ensure SEC compliance.

When determining the appropriate action and penalty, the SEC stated they considered OEP’s prompt response to remediate, including enhancement and standardization of compliance policies and procedures related to MNPI, as well as enhanced firmwide compliance training related to investor communications. OEP agreed to a $4 million civil penalty to settle the charges without admitting or denying wrongdoing.

Key Takeaways for Investment Managers

Investment managers should take note of several critical lessons from the OEP case to help prevent similar violations:

Enhanced Employee Training: OEP’s case highlights the necessity of properly educating personnel about regulatory requirements. Investment managers should conduct regular training sessions to keep employees informed about the significance of confidentiality and the potential consequences of policy violations. Training should be engaging and relevant to the day-to-day across various functions, so employees can more easily apply it in practice.

As part of firmwide employee training, it may be worthwhile to share examples of the OEP communication deemed to be violations of the SEC order, to help demonstrate that even seemingly informal communication to current and prospective investors, or industry contacts, could be considered a disclosure of MNPI or advertising and thus must adhere to the firm’s written policies and procedures to ensure compliance.

For example, OEP senior personnel made the following performance and/or valuation-based statements, which were not marketing communications approved by OEP compliance personnel and did not include the required explanatory footnotes: “We generally make 2-2.5x and 25-35 pc irr depending on the time it takes-OEP [Fund] will be high because it happened fast, but still in the 2- 2.2x range…. If we assume we can complete all the combinations in the process [for OEP Fund], realize our usual synergies, and value the cos at a reasonable 8.25x [projected earnings], … an investor in OEP [Fund] could be looking at a [dollar amount] plus embedded gain in the context of a [dollar amount] Fund that is 40 pc plus invested;”

An example of the disclosure of MNPI that was noted in the order against OEP included the following: “Going to [location] to talk to our mgmt. team at [Public Company 1] to tell them we are sellers of our [dollar amount] stake;” “In OEP [Fund], we own 13 cos…. 4 of the 13 [including Public Companies 2 and 3] are in sale or combination processes;” and “[Private Company 1 will realize] as much as [dollar amount] of prospective synergies from [Public Company 4] merger yet to be announced for about 33 pc of equity.”

Ongoing Monitoring and Scrutiny of Electronic Communications: The SEC’s emphasis on electronic communication as a means of sharing MNPI and disseminating advertisements underscores the critical need for investment firms to establish robust monitoring systems. The OEP case brought to light persistent communication violations spanning multiple years. Thorough email monitoring by OEP compliance personnel throughout this period could have mitigated the frequency of the violations and would have demonstrated OEP’s commitment to its compliance program.

While it is commonplace for investment managers to enlist external service providers, such as compliance consultants, to review archived electronic communications, investment managers must acknowledge that the primary responsibility for sufficient monitoring lies with the manager. There is a potential risk of oversight if internal compliance personnel are not actively engaged in the monitoring process. Additionally, as advancements with AI progress in the years ahead, investment managers should stay abreast of technological solutions that may help detect and prevent similar violations and help enhance and streamline the ongoing monitoring process.

Enforcement and Regulatory Environment: The SEC’s heightened efforts under Chair Gary Gensler continue to address compliance failures at investment management firms and align with the increasingly rigorous enforcement environment the industry is facing. Despite an increase in enforcement efforts, the SEC notes that compliance failures remain widespread in the sector.

Looking Forward: Reassessing Compliance Measures

As the regulatory landscape evolves, investment managers must proactively reassess their compliance measures in response to evolving regulations and recent enforcement actions. Staying updated on changes, enhancing electronic communication monitoring, and conducting regular internal audits are crucial steps to prevent violations. Firms should leverage advanced technologies to strengthen compliance capabilities and ensure adherence. The SEC’s action on OEP Capital Advisors underscores the need for a proactive approach, urging investment managers to strengthen compliance measures and avoid similar violations.

SEC 2023 Enforcement Recap: 784 enforcement actions and nearly $5 billion in penalties

In FY 2023, the SEC filed 784 enforcement actions, marking over a 3% increase from the previous year. Within this figure, 501 were new or standalone cases, reflecting an 8% rise compared to FY 2022. The SEC Enforcement Division released a summary of its FY 2023 outcomes, highlighting the achievement of $4.94 billion in total ordered monetary relief. This was the second-highest amount in SEC history after the record-setting amount in FY 2022 when 760 enforcement actions were filed and $6.84 billion in penalties were recovered.

While the FY 2023 aggregate civil penalties of $1.58 billion align closer with historical norms, the total disgorgement and prejudgment interest reached $3.36 billion, signifying a 50% increase from FY 2022. The total civil penalties and disgorgement and prejudgment interest ordered were also the second-highest amounts on record. The significant monetary relief reflects the SEC’s continuous commitment to adjusting penalties for stronger deterrence, a strategy launched in FY 2022.

SEC enforcement covered a spectrum across the securities industry and ranged from substantial fraud cases to emerging risks in crypto asset securities and cybersecurity. Violations were charged against various market participants, including investment firms, gatekeepers, social media influencers, and public companies. Additionally, the SEC acted to safeguard whistleblowers, enforce recordkeeping requirements, and uphold investor protection standards applicable to industry participants such as broker-dealers and investment firms.

The nature of cases brought by the SEC in FY 2023 generally followed recent trends. Cases related to securities offerings saw a 10% increase YoY, likely influenced by the SEC’s crackdown on fraudulent and unregistered crypto offerings. The SEC also intensified its focus on off-channel communications and recordkeeping requirements.

2023 Enforcement Actions of Investment Advisers

First-Time Cases

The SEC brought several first-time cases in FY 2023, many of which featured enforcement of the Marketing Rule that went into effect in November 2022. This included the charges against 9 investment advisers for Marketing Rule violations, as we highlighted in our September Regulatory Roundup article, related to hypothetical performance in advertisements. The first action brought under the Marketing Rule was in August 2023, against a fintech investment adviser, Titan Global Capital Management USA LLC. The charges asserted the adviser artificially boosted annualized performance results for a crypto strategy, omitting disclosures that the results assumed the strategy’s performance over three weeks would extend throughout the entire year. Additionally, the charges emphasized inadequate disclosure of assumptions in calculating hypothetical returns and improper reliance on embedded links to describe the risks associated with relying on hypothetical performance.

Additional enforcement action of the Marketing Rule included charges against DC-based investment adviser, Fundrise Advisors LLC, for not providing sufficient disclosure to clients, after paying over 200 social media influencers and online newsletter publishers to attract potential clients. An additional first-of-its-kind action was brought against another investment advisor, DWS Investment Management Americas Inc, for failing to adopt and implement required anti-money laundering policies and procedures.

Cherry-Picking

In its proactive initiative to identify cherry-picking practices, the SEC took decisive actions against multiple investment advisers during FY 2023. In actions initiated in February and May 2023, the SEC alleged that these advisers and their representatives engaged in the practice of placing trade orders in block accounts. Subsequently, they were accused of selectively allocating end-of-day profitable trades to personal accounts while assigning less favorable trades to client accounts. Further, the SEC argued that one of the advisers made false and misleading statements to clients about trade allocations and the reasons for transferring clients’ accounts to a new custodian following termination by a prior custodian due to suspicious trading. Investment managers should be vigilant to avoid unintentional cherry-picking in their processes, ensuring transparent and equitable trade allocations to uphold regulatory compliance and maintain investor trust.

Custody Rule Violations

The SEC also charged five investment advisors for custody rule violations in September 2023, which in the past was more likely to be deemed a technical violation that resulted in an SEC deficiency letter instead of a formal enforcement action. The SEC alleged the firms failed to comply with requirements related to the safekeeping of client assets, citing lapses in updating SEC disclosures on audits of private fund clients’ financial statements. These firms neglected key responsibilities like conducting required audits, ensuring timely delivery of audited financials, and maintaining client assets with a qualified custodian. Moreover, two firms didn’t promptly file amended Forms ADV after receiving audited financial statements. Another firm inadequately described its financial statement audit status across multiple years in its Form ADV filings. To avoid such violations, firms should prioritize up-to-date SEC disclosures, prompt audits, and accurate information in Forms ADV regarding audit status.

Undisclosed Conflicts of Interest

A significant portion of the SEC’s enforcement actions against advisers stemmed from undisclosed conflicts of interest. For instance, in June 2023, the SEC took action against NY-based private equity fund investment adviser, Insight Venture Management, for inaccurately calculating management fees as per its fund documents. In September 2023, the SEC charged a real estate investment adviser, Prime Group Holdings, for inadequate disclosure of conflicts related to brokerage fees paid to a firm owned by the adviser’s CEO.

Whistleblowers

During FY 2023, the SEC exhibited an increased dedication to preserving the whistleblower pipeline, taking a strong stance against conduct that could hinder potential whistleblowers. This commitment was underscored by imposing a record $10 million civil penalty against D.E. Shaw, as highlighted in Arootah’s October Regulatory Roundup article, for a singular alleged violation of the whistleblower impeding provision.

Furthermore, 2023 marked a record-breaking year for the SEC’s Whistleblower Program, with awards reaching almost $600 million, the highest ever granted in a single year. Notably, a record $279 million was paid to an individual whistleblower. The whistleblower program has emerged as a critical source for enforcement investigations, with the SEC receiving an all-time high of over 18,000 whistleblower tips in FY 2023, representing a remarkable 50% increase from the previous year. This continues to emphasize the program’s success in incentivizing individuals to come forward with valuable information about securities law violations.

Off-Channel Communications & Record Keeping Violations

The SEC continued to crack down on electronic communication and recordkeeping failures, which seems to be an ongoing theme. We highlighted some of these enforcement actions in our October Regulatory Roundup. In summary, the SEC charged twenty-five advisory firms, broker-dealers, and credit agencies combined civil penalties totaling more than $400 million during FY 2023. The SEC, in its persistent efforts to combat off-channel communications, encourages registrants to investigate and self-report violations. Notably in 2023, two broker-dealers received lower civil penalties for doing so.

Looking ahead to FY 2024

We can anticipate the SEC to maintain its rigorous approach to enforcement, prioritizing investor protection and market integrity. The focus on risk-based initiatives, self-reporting, proactive cooperation, remediation, and whistleblower protection can be expected to persist. The SEC’s commitment to ongoing investigations underscores its dedication to identifying and addressing potential threats to investors, even if they do not lead to enforcement actions. As the regulatory landscape evolves, the SEC is poised to adapt its strategies to emerging challenges, reinforcing its role as a market fairness and transparency guardian.

2023 brought significant regulatory changes to the industry, particularly with adopting the new Private Funds rules, which will have a major impact on the investment management industry in the years ahead. The SEC’s unprecedented enforcement and introduction of new regulations underscore the crucial role of a proactive, integrated compliance approach for firms. The era of ad-hoc compliance is long gone. The substantial penalties imposed by the SEC, even in scenarios with the potential to harm investors, serve as a stark reminder of the evolving regulatory landscape. Stay vigilant, stay compliant, and ensure your firm thrives in the dynamic regulatory environment in the year ahead.

The Bottom Line

The SEC’s $4 million fine against OEP Capital Advisors is a potent reminder of the critical importance of stringent compliance with MNPI guidelines and electronic communication protocols. Investment managers must recognize the consequences of non-compliance and the SEC’s unwavering commitment to enforcement. Proactive measures, including regular employee training, rigorous monitoring of communications, and adherence to the latest regulatory directives, are non-negotiable components of a robust compliance framework. As the financial landscape continues to evolve, firms must remain agile, ensuring their compliance practices are not only current but also forward-looking to safeguard against potential violations and foster a culture of compliance and ethical excellence.

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