On May 26, 2020, the Securities Exchange Commission (“SEC”) announced a settlement with Ares Management LLC (“Ares”), a Los Angeles-based private equity firm and registered investment adviser. Ares agreed to pay $1 million for failing to implement and enforce written policies and procedures reasonably designed to prevent the misuse of material nonpublic information (“MNPI”). The SEC’s order found that Ares violated the compliance policies and procedures requirements of Sections 204A and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-7 thereunder. One of the most glaring failures was that Ares’ compliance department did not take into account the risks created by its employees having seats on the board of directors for a portfolio company (“Portfolio Company”) while continuing to participate in trading decisions concerning the Portfolio Company. As a result, the firm lacked an effective mechanism for identifying and monitoring MNPI as it came into the firm.
Background
In 2016, Ares heavily invested several million dollars of client funds in the Portfolio Company in the form of both debt and equity investments. A confidentiality agreement was executed by the two parties when the initial investment was made and remained in effect from that point on. As a condition of the allocation, Ares was permitted to appoint two directors to the board of the Portfolio Company, with one being a senior member of Ares’ deal team (the “Board Members”). During the Board Members’ service, they, along with other members of the deal team, received information that could potentially have been MNPI, but was not properly vetted. The information received included potential changes in senior management, adjustments to the Portfolio Company’s hedging strategy, efforts to sell an interest in an asset, and decisions with respect to the Portfolio Company’s assets, debt, and interest payments, amongst other things. During this time, Ares purchased more than one million shares of the Portfolio Company’s publicly-traded equities, which was roughly 17% of the stock float. Ares’ policies required approval from the compliance department before proceeding with the transaction which was properly sought and granted.
Ares’ MNPI Policies and Procedures
Ares had written policies and procedures that were somewhat designed to prevent trading while in possession of MNPI. However, Ares did not require its compliance department to sufficiently inquire and document whether the relevant deal team possessed MNPI concerning the Portfolio Company prior to approving the trades. Without an effective fact-finding process, the pre-approval procedure was largely superficial and compliance could have unknowingly been approving transactions involving issuers about which the deal team had MNPI.
Ares had a restricted list and any company for which an Ares-managed fund had a control position (including serving on the board for a company) was placed on the restricted list. Any trades in securities on the restricted list were subject to a “hard stop” and required compliance pre-approval. If they maintained a board seat on a publicly listed portfolio company, compliance was required to confirm with the portfolio company that its trading window was open, and to confirm with the relevant employee that the firm was not in possession of MNPI on the issuer prior to allowing the firm to trade. Ares used a compliance reporting system (“System”) to document the review and approval process.
The SEC found that the Portfolio Company was properly restricted, and that compliance confirmed when trading windows were open. However, the compliance staff failed to prevent the potential misuse of information given the board seat arrangement. There were no entries in the System that would show an analysis into whether Ares had MNPI. Even when such inquiries were made, the entries in the system lacked consistency and detail. When the compliance staff asked the Board Members and deal team if they had potential MNPI, the review process called for these employees to self-evaluate whether the information was material.
Conclusion and Takeaways
Notably, this enforcement action does not include any insider trading charges. Ares was penalized solely for failing to effectively implement compliance procedures to address the risks associated with employees having board seats. This case shows that private equity fund managers are not immune to MNPI risk, and should adopt and implement clear MNPI policies and procedures and adhere to those policies. While many managers assume regulators will take a “no harm, no foul” approach, this action proves otherwise.
Another key takeaway from this action is the importance of consistent documentation. In the order, the SEC specifically pointed out the numerous instances where documentation was insufficient to thoroughly explain the approval process. Without proper documentation, it is almost impossible to prove that any of your policies and procedures were actually followed. The same can be said about the vetting for MNPI. Poor documentation will generally lead to further inquiry by the SEC.
Advisers should review both their business practices and investment strategies to gauge where MNPI may flow into firm. From there, they should tailor their policies and procedures to mitigate those specific risk areas. Importantly, a portfolio company does not need to be a public issuer to potentially expose an adviser to MNPI. Their activities or deals may involve MNPI. Where certain employees are at a higher risk of being exposed to MNPI, as in this case, additional steps should be taken, including training on identifying MNPI, enhanced compliance oversight, and regular check-ins to assess compliance with the policies and procedures. These employees should not be expected to assess materiality on their own. Rather, compliance staff should be proactive and independent in their assessment. Additionally, increased monitoring (e.g. reviews of emails, deal team notes, calendars, etc.) should be conducted on these higher risk employees. Regardless of whether information is determined to be MNPI, the analysis should always be documented to evidence the fact that the review actually occurred. Half of the battle during a regulatory examination is illustrating that you have an effective process in place.
Greyline is assessing how this case will impact each of our clients. We encourage others to reach out for assistance in reviewing their MNPI policies and procedures.
