It is probably hard to believe that the SEC was once a respected and feared agency. Today’s example shows severity of its capture by the firms it nominally oversees and how it shirks duties mandated by Congress. The agency is operating in such a cozy manner with private equity firms that as one investor described it:
It’s like FBI sitting down with the Mafia to tell them each year, “Don’t cross these lines because that’s what we are focusing on.”
That behavior stands in stark contrast to how the SEC operated in its heyday. And even though today’s case study makes for a tidy example of the agency’s decline, it also epitomizes the sort of cronyism we’ve been chronicling for years.
Background: How the SEC Punted on Supervising Private Equity Firms
Regular readers may recall that Dodd Frank required the SEC to take on the supervision of the fund management activities of private equity firms with over $150 million in assets. Its initial exams found that more than half of the firms were engaged in serious abuses, including what in any other line of work would be called embezzling. And contrary to the agency’s experience in other fields, the scamming was more prevalent at the largest firms.
So what did the SEC do? Despite a series of high profile articles by Gretchen Morgenson, then at the New York Times, and Mark Maremont of the Wall Street Journal, detailing specific frauds and naming perps, the SEC engaged in wet noodle lashings. Its pattern was to file only one major enforcement action over a particular abuse, and went to some lengths to spread the filings out among the biggest firms, which meant it was pointedly engaging in selective enforcement, punishing only “poster child” examples and letting other firms who’d engaged in precisely the same abuses get off scot free.1
And the fines and disgorgements were of the “cost of doing business” level.
On top of that, the then head of examinations at the SEC, Andrew Bowden, started air-kissing private equity firms in interviews. As we wrote in late 2014:
Readers may recall that in May, SEC inspection chief Andrew Bowden gave what was by regulatory standards a blistering speech describing widespread misconduct in the private equity industry. His detailed account followed SEC Chairman Mary Jo White setting forth uncharacteristically clear-cut details of private equity abuses in testimony to Congress….
More than four months later, the SEC isn’t merely sitting pat. It has been making the rounds, both with insider private equity journalists and in closed door meetings. Bowden has been making so many conciliatory noises that it’s clear, absent more public pressure or continued media revelations of industry misconduct, that the SEC is unlikely to do more than engage in a few image-saving wet noodle lashings, such as its small dollar enforcement action this week against a private equity firm no one ever heard of.
Even worse, a careful reading of Bowden’s recent remarks indicate that the SEC isn’t merely retreating from its earlier bold talk. It appears to be actively enabling a massive coverup of these abuses. Mind you, this is even worse than the SEC’s limp-wristed enforcement of financial-crisis-related misconduct against the too-big-to-fail banks.
Specifically, the SEC told private equity firms that they could continue their abuses if they ‘fessed up in their annual disclosure filings, the so-called Form ADV. The term of art is “enhanced disclosure”. Since when are contracts like confession, that if you admit to a breach, all is forgiven? Only in the topsy-turvy world of SEC enforcement.
Even though Bowden made the mistake of being too obvious about his fondness for private equity firms, by launching into a cringe-making speech about how terrific he thought they were and then saying he wanted his son to work in the industry, which led to his defenestration,2 the policies that started on his watch continue today. For instance, we’ve chronicled how SEC officials go to great lengths not say anything bad about their charges, such as admitting that they’ve found abuses in more than half of the private equity fund managers they examined, then trying to depict those abuses as mere mistakes by well-meaning players. Anyone who has read a private equity limited partnership agreement will quickly infer that its complexity is to hide tricky features. And even then, some of the really brazen provisions are out in the open, like the egregious indemnification provisions that amount to a waiver of fiduciary duty.
How the SEC Cozies Up to Private Equity Firms
One way to find out how much regulators coddle the entities they nominally oversee is to go to conferences where agency officials speak to audiences of lawyers. You’ll often see an unseemly amount of chumminess, in large measure due to how many conference-goers themselves once worked for the agency.
A law firm has done the great unwashed public the favor of showing how captured the SEC is in a tidy document. Partner Jahan P. Raissi of Shartsis Friese, a well-regarded San Francisco boutique law firm that focuses on venture capital and smaller private equity firms, released an updated version of a speech he gave in October on SEC examinations of investment advisers.
The big point of this missive is to clue firms in that haven’t yet gotten the memo, that SEC exams, which are supposed to be about whether the firm is obeying the law and complying with its legal agreements, are “cooperative” exercises! Nothing to worry about!
Let’s go through the key paragraphs, starting from the top:
The Examination Program.
The SEC’s examination of investment advisers – conducted by the Office of Compliance Inspections and Examinations (referred to as “OCIE”) – is in many ways a model of what financial regulation should be. The examination program comes pretty close to striking the right balance between cooperative regulation that helps advisers to comply with regulatory requirements, on one hand, and punitive regulation through uncovering violations for enforcement action, on the other. What is often not appreciated is that the examination program meets its investor protection objective primarily by providing individual advisers and the industry generally with guidance in complying with regulatory requirements. Of course OCIE’s examinations are also designed to and do uncover situations where a referral to enforcement is appropriate, but referrals to enforcement are not the primary purpose of examinations and they occur in only a small percentage of examinations (fewer than 5% in 2019).
Translation: Good SEC for leaving the industry pretty much alone! The SEC should be reinforced not wanting to harsh anyone’s mellow unless it really really has to. So play along with SEC deciding to play nice guy/regulatory coach rather than watchdog. Sometimes the SEC does manage to stumble over stuff it can’t ignore, but hardly ever (notice how that lower than 5% figure contrasts with the SEC’s initial finding on private equity exams of over 50%, and SEC chair Mary Jo White later had stern words to say about hedge funds).
Back to the newsletter:
While most advisers do not view a visit by examiners as a “cooperative” exercise, the reality is that the vast majority of issues identified by examiners are essentially suggested improvements where a simple correction or procedure enhancement is all that is required. In fact, if an adviser ignored the majority of an examination’s findings it is likely that nothing serious would come of it (this is to illustrate a point – I don’t recommend doing this). Also, while no one wants to receive a deficiency letter following an examination, the overwhelming majority of deficiency letter comments are not referred to enforcement. Rather, most comments highlight issues the adviser should improve or minor violations that can easily be fixed. Another way in which the program is cooperative is through its publications and outreach programs. OCIE publishes an annual list of exam priorities for the upcoming year, giving advisers notice of the issues that will be examined so advisers can review and improve those areas before they are examined. OCIE also published periodic risk alerts, which highlight the areas where the examiners are seeing a high rate of deficiencies in their field examinations. Finally, each year OCIE holds dozens of regional and national compliance seminars. In other words, advisers are provided with the benefit of knowing what issues OCIE plans to focus on, the common issues the examiners are seeing in the field, and guidance on creating an effective compliance program – all to help advisers improve their compliance programs.
Translation: It no doubt seems very threatening that the SEC can make Masters of the Universe like you sit down with them and answer questions about how you run your business and even demand to see records. But they are a bunch of lapdogs. What they find is usually unserious (but comply anyhow, it will look way better if you do something bad later). Plus they tell you way way way in advance what they are going to be looking at this year, so you can tidy everything up before they get there. Isn’t it great to get exam questions before the test?
Returning to the document:
Yes, it remains true that some examinations take too long, involve too many document requests, and result in incorrect or trivial deficiency comments. However, these tend to be the exceptions and in any large program there will always be some variability in quality and outcomes. On the whole, the program should be commended for its transparency, calibrated responses to issues identified in examinations, improved industry knowledge, and increased efficiency.
Translation: You need to stay cool if they look like they don’t know what they are doing and waste your time. It is to your benefit that they don’t understand what they should. If they do manage to be alert enough to catch you having done something bad, they tend toward minimalist action. They do seem to be getting smarter over time but not enough to cause trouble.
The next paragraph explains that most exams are general reviews, meaning tea and cookies conversations to understand the adviser’s business. The SEC often asks the firm to prepare an overview in the form of a slide deck. Ahem, why doesn’t the SEC ask instead for investor marketing materials and see how accurate and complete they are? Oh, that might be work, plus the advisers might see it as mean. Can’t have that, now can we?
The article continues by saying the current SEC chairman Jay Clayton is mainly concerned with protecting retail investors. That means private equity firms that raise money from “accredited investors” can rest easy.
Mind you, this SEC complacency continues after a group of 13 prominent state and local officials such as former California Treasurer John Ching and New York City Controller Scott Stringer sent a letter to the SEC asking the agency to provide for more transparency and oversight for private equity firms. We criticized the letter because it amounted to these officials, who are also pension fund trustees, trying to fob off their supervision failures on the SEC.
But this missive was also tantamount to an admission, as we pointed out in a Bloomberg op-ed, that these pension funds aren’t sophisticated enough to invest in private equity and should therefore not be treated like accredited investors, i.e, they really do need to be protected from themselves like retail widows and orphans.
Mind you, it’s easy to snigger at the fawning conduct of the SEC. But this sort of undue deference is what brought about the 737 Max debacle. If the crisis wasn’t enough of a wake-up call to lead to more serious oversight, what will it take?
1 For instance, an audience member grilled the then SEC head of enforcement, Andrew Ceresney, at a conference about “symbolic enforcement“:
Both Blackstone and KKR had recent enforcement actions and Blackstone was fined for not disclosing accelerated monitoring fees but KKR was not even though it was engaged in effectively the same behavior. KKR was fined for broken deal expenses but Blackstone was not even though they were engaging in the same behavior.
Bowden: Let me throw my two cents in, which is this is something I ran into for like 25 years in the industry. So when I was in the industry and I’d be on panels like this, a lot of the older people would talk about growing regulation, ’cause it has increased, right, over the last couple of decades, I don’t think there’s any two ways about it, and they’d sort of lament and say, I have money to get out of the business, there’s too much regulation, it’s not worth it any more.
And even when I was in the industry, I’d always look at them and say, like, “What are you talking about? This is the greatest business you could possibly be in. You’re helping your clients.”
I think if you look at McKinsey studies, the average asset manager, I’m not even talking about private equity, the average asset manager has margins of 25 or 30 percent. Like what, who else out there is in a business that’s that good? And I reckon, it’s sort of interesting for me for private equity in terms of all we’ve seen, and what we have seen, where we have seen some misconduct and things like that, ’cause I always think like, to my simple mind, that the people in private equity, they’re the greatest, they’re actually adding value to their clients, they’re getting paid really really well, you know, if I was in that position, the one thing I would think to myself as I skipped to work was like just “Let’s not mess it up. You know, this is the greatest thing there, I’m helping people, I’m doing OK myself.”
And so my view on the small ones is, I still think this is one of… I tell my son, I have a teenaged son, I tell him, “Cole, you want to be in private equity. That’s where to go, that’s a great business, that’s a really good business. That’ll be good for you.”
So for me personally, as we share our opinions…
Questioner [interrupting]: I’d love to hire your son, by the way. That’s a deal.