Regulatory relief: Risk, rewards and rope

The pandemic has brought both active relief from regulators and greater unknowns and risks for private funds’ compliance teams, writes Bill Myers

Since the crisis began taking on its ghastly dimensions, American regulators have announced new ‘relief’ nearly weekly, and sometimes daily. Over just the month to mid-April, the US Securities and Exchange Commission eased restrictions on intrafund lending, extended the deadline for Form PF and Form ADV filings, and gave permission to hold remote board meetings. But given the pressures to find cash amid the crisis, that regulatory relief means compliance officers have to be even more careful. Here are the issues to be aware of.

1. Anti-money laundering

“This is a time for more customer due diligence, not less,” says Ross Delston, a lawyer and consultant in Washington, DC. “It’s a tough one, but customer due diligence is always a good idea because customers who are criminals, who are fraudsters, who are involved in illicit activities bring untold problems to financial firms.”

Delston has spent most of his career helping firms prevent money laundering. He says he’s worried sales teams are going to be more vulnerable to hucksters as the scenery collapses around the world economy.

“They’re in some ways like the virus – once they attach to you, it’s hard to get rid of them,” he tells sister title Private Funds CFO. “Unlike the coronavirus, they’re not going to kill you, but they’re going to be with you a long time. It’s better to stop them at the door rather than let them into your institutions.”

2. Three tips

It’s harder to hear “no” any time, but especially now – and especially because many funds, desperate for liquidity, already see their compliance teams as “cost centers,” Delston says. How, then, to convince management to keep their heads while all around are losing theirs and blaming compliance? Delston has three suggestions:

1. Show executives fraud enforcement cases, even if from different areas of the law or the market. “Management often pays attention when there are large amounts of money in penalties, or possible criminal prosecution,” says Delston.
2. Remind managers of the “high incidences of fraud that arise in a pandemic,” he adds. “All sorts of fraudsters come out of the woodwork during a crisis, and those fraudsters can be clients of the funds” if compliance isn’t careful.
3. Look out for Ponzi schemes. “That’s part of the financial landscape,” Delston says. As investors are facing liquidity crises, they’re likely to try to redeem their funds. When redemptions can’t be met, the schemes unravel.

“Looking at sources of funds of clients is as important, or even more important than it’s ever been,” Delston says.

“That’s not to say that compliance won’t get overruled by the business. It’s a chronic debate that most compliance officers face on a daily basis.”

3. ‘Significant shift’

If all this isn’t enough to focus the minds of compliance then consider pending changes to the SEC’s advertising rule, which hasn’t been updated since the 1960s. “The definition is going to change,” says Kelley Howes, of counsel at law firm Morrison & Foerster. “Things private fund advisors are used to being able to do in a one-on-one context, they may have to rethink. A document that goes to two potential clients instead of just one: that’s going to be a significant shift.”

This could see tension between compliance and marketing, says Kurt Wolfe, an associate at law firm Troutman Sanders.

“How are [compliance teams] supposed to work that into an actual set of procedures they can deploy?” says Wolfe.

“While all that’s going on … I think the marketing people see it as a win. They can use testimonials, past performance … in ways they couldn’t before, in media they couldn’t before.”

4. SWOT analysis

Compliance officers should take two steps, Wolfe suggests. First, conduct a SWOT analysis – strengths, weaknesses, opportunities and threats – of current policies and procedures and contrast them against the proposed rules. “Once you have that framework, you start thinking about the particular kind of clients that we deal with. How do my folks use e-mail, Twitter, radio; how do they fit in with my framework?” he asks.

Second, Wolfe urges P&Ps be redrafted as if any future rules will be onerous. “Understanding that different businesses are going to have different risk appetites, I would generally promote a program around the most restrictive rule, or the most restrictive interpretation of a rule. I think that’s going to be the most defensible,” he says.

5. ‘Have compliance’s back’

Given the latent tensions between compliance and marketing/sales, Wolfe suggests compliance officers begin managing up so that top officials at private fund advisors understand how important these changes are. “Whoever is the person at the top, they have got to make it clear that they stand with compliance, that they have compliance’s back. You don’t want to wait for some sales guy to go rogue on Twitter.”

Howes says the proposed rule “will be a significant infrastructure change” for compliance teams “because they’re going to have to keep records of all these things. “If an advertisement includes certain broadcasts, is there a script? Are you reviewing that? If there’s a public Q&A that you can’t control, compliance people will have to put together some kind of training for the people who are out there, and continually update that training.”

6. Know your customers

Wolfe and Howes agree new advertising rules will require a careful look at investors. “In those pooled investment vehicles, you’re going to have to know whether you’re talking to a retail or non-retail investor,” Howes says.

Under the rules, an accredited investor wouldn’t necessarily be considered a non-retail investor, she says. “That’s a fundamental shift.”

7. New ‘normal’, new insiders

Covid-19 also widens the risk of insider trading by expanding the pool of potential insiders, says Michael Birnbaum, a former SEC trial lawyer now in private practice with Morrison & Foerster.

That means compliance teams have to look way beyond the C-suite and mid-level management for insider trading. Any number of front-line workers could be sitting on a cache of wealth-making details, Birnbaum says.

“This is a good time to make sure your employees are reminded of the policies and procedures – and to make sure your contractors are brought up to speed – because a lot of people are going to have access to material non-public information.”