The private equity industry has increasingly felt the bite of U.S. Securities and Exchange Commission (SEC) regulators in recent years amidst a steady string of enforcement actions. This enduring regulatory focus has caused many private equity firms to consider what action, if any, should be taken if they discover that they may have run afoul of their obligations. Given that the SEC today vigorously prosecutes all violations as potential enforcement cases, no matter how they come to the agency’s attention, should private equity firms proactively self-report any misconduct or violations of the federal securities laws to the SEC?
First, Fix the Problem
As a threshold matter, firms must immediately get their hands around any possible misconduct or violations that they discover: the scope, materiality (whether quantitative, qualitative, or both), responsible employees, if any, and client or investor harm. If the conduct or violation is ongoing, end it. If clients or investors were harmed or disadvantaged, inform them and remediate. If there is a board, alert the board. If personnel actions are necessary, take them. If there is a whistleblower, do everything possible to ensure that his or her concerns are vetted and resolved as appropriate.
Next, Report the Problem?
The next question – whether a private equity firm should self-report to the SEC – is a complex decision that involves a weighing of real and significant risks with uncertain benefits. In a bygone era, self-reporting was frequently an easier decision: a firm would discover an issue, inform the Division of Investment Management of what it found and the steps it took to remediate, and that would often be the end of the matter. Now, however, with a Division of Enforcement staff – including the Asset Management Unit staff in particular – that is aggressive, has sophisticated knowledge of the asset management space, and is in constant contact and coordination with the Division of Investment Management and examination staff, firms must assume that self-reporting will result in an enforcement action.
It is of course perfectly rational for the SEC, as a law enforcement agency, to aggressively pursue all potential violations of the federal securities laws, no matter how those potential violations come to its attention. After all, the SEC is not running a “catch-and-release,” or even “self-report-and-release,” program. The consequence, however, is that self-reporting carries with it a nearly 100% chance of the self-reporting firm being investigated and made the subject of an enforcement action based on its own self-report.
Given that reality, the reward-risk calculation that informs whether a private equity firm should self-report violations of the federal securities laws to the SEC is now entirely skewed in one direction.
The SEC’s View. On the one hand, in terms of reward, the SEC urges firms to self-report violations of the federal securities laws by touting the benefits from doing so. Those benefits include reduced penalties or, less tangibly, a more benign recitation of the misconduct in an order, or perhaps a sentence noting the firm’s cooperation, or an “administrative summary” instead of a press release. From the SEC’s perspective, these benefits are real, and demonstrate that the SEC actively takes self-reporting into account when determining what remedies are appropriate in the resulting enforcement case.
A Different View of the “Benefits” of Self-Reporting. But there is a fundamental disconnect. Credit in the form of a reduced penalty is simply not meaningful and is entirely unmeasurable by firms, investors, and the public – even though the SEC sees the reduced penalty as meaningful and measurable. Private equity firms care about one thing: avoiding an enforcement action. Because a self-report almost guarantees an enforcement action (and certainly guarantees at least an investigation), rational firms struggle mightily over the self-reporting question when doing so means subjecting themselves and their business to what may be an intrusive, years-long, expensive investigation and then enforcement action. A penalty reduction, or more input on a settlement order, or an administrative summary when the press is going to report on the action regardless, is an insufficient carrot to encourage self-reporting when considering the real stick of reputational damage that would be inflicted by an enforcement action.
The Risks of Self-Reporting. On the risk side of the ledger, there are no aggravating factors for failing to self-report, because self-reporting generally is not required. Rather, private equity firms act in good faith by (1) investigating what occurred and why (and, of course, ending the practice if it is ongoing), (2) making any necessary adjustments to ensure that the violation does not recur, (3) assessing whether any remedial steps are prudent, (4) creating a record of the efforts in this regard, and then (5) simply moving forward. If the issue later comes to light (if, for example, through a whistleblower or by examination staff discovering it), the manager will be prepared to demonstrate that it resolved the issue in good faith, and for the benefit of investors, which, after all, is the SEC’s primary interest. If the issue never comes to light, the firm will have responsibly spared its funds and investors a time-consuming and expensive investigation and a reputation-damaging enforcement action (and potentially parallel private civil actions and/or other collateral consequences).
A Different Calculus. It should be noted that firms in certain circumstances may need to think differently about the self-reporting calculus. Those situations might include:
- potential violations of the Foreign Corrupt Practices Act,
- obligations imposed on publicly traded companies, or their subsidiaries,
- if the discovered conduct is otherwise of such a magnitude that the issue is almost certainly going to come to light,
- if a firm discovers an issue during the course of an SEC examination,
- if a firm has other regulators and/or regulatory obligations, such as Bank Secrecy Act reporting requirements, and
- if a firm has a commercial reason for wanting to self-report, regardless of the consequences.
Meaningful Incentives Would Benefit Everyone
It is to the SEC’s detriment that there is no meaningful carrot that encourages advisers (or really anyone) to self-report. This is because each time a firm decides not to self-report an issue it has discovered, the SEC is deprived of critical information concerning a problematic practice or issue that might be widespread. The result is a serious information gap; solving it would enable the SEC to better protect investors.
Today, however, the SEC vigorously prosecutes all violations as potential enforcement cases, no matter how they come to the agency’s attention. This is a rational approach to enforcing the federal securities laws and is entirely consistent with the agency’s investor protection mandate. As a consequence, however, counsel are forced to advise their private equity clients on a difficult, and uncomfortable, handicapping: namely, what is the likelihood that an issue the firm discovers (and remediates) will be found by the examination staff or a whistleblower? Often that calculation must lead rational private fund advisers and other asset managers to choose not to self-report except in the most extenuating circumstances. Although this might not be an ideal outcome from a regulatory policy perspective, it is, unfortunately, the reality of a system that affords little measurable credit for self-reporting but guarantees a negative outcome in the form of an enforcement proceeding. Unless and until the SEC’s approach changes, defense lawyers vigorously representing their clients need to think long and hard before counseling investment advisers to self-report.