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Friday letter: Dodd-Frank doesn’t give you a free pass from the SEC

'What has become clear through the proposed [SEC] rules is that the venture capital exception is not an exception from SEC scrutiny,' says David Larsen, a managing director in Kroll’s Alternative Asset Advisory Practice.

When Dodd-Frank was enacted about 12 years ago, venture capital firms dodged a bullet. Their larger private equity colleagues came under more scrutiny from regulators, but VCs successfully argued that they should largely be exempt from registering with the SEC.

To this day, the vast majority of venture firms are Exempt Reporting Advisers, although some of the largest firms have become Registered Investment Advisers, including Andreessen Horowitz, Battery Ventures and Sequoia.

So why does it feel like the SEC is scrutinizing venture capital firms just as much as it is PE shops? Well, because it is.

“What has become clear through the proposed [SEC] rules is that the venture capital exception is not an exception from SEC scrutiny,” said David Larsen, a managing director in the alternative asset advisory practice at Kroll, whose clients include VC firms, PE firms and limited partners. “It is an exception from registering, but it is not an exception from inspection. It’s not a ‘get out of jail free’ card in the context of treating your investors in accordance with your agreement.”

This means VCs must pay close attention to the SEC’s actions around private funds, which seem to be coming on a weekly basis lately. Just this week the regulator put private funds at the top of its 2022 Exam Priorities and proposed new rules around SPACs, which have become a common exit route for VC-backed companies. Those actions followed the SEC’s proposal of significant new requirements for private funds under the Investment Advisers Act of 1940.

“The SEC is demonstrating, both through their exam priorities and through their rule-making, that the private funds space is absolutely in their purview, is absolutely something they’re focused on and it’s something they are not shying away from, ensuring that investors are protected,” Larsen said.

VCs cannot afford to ignore what the SEC is doing, even if they are Exempt Reporting Advisers. “I think that some managers thought, ‘I’m exempt from registration, therefore the SEC can’t or won’t knock on my door,’” Larsen said. “You should be ready. Even though it may be unlikely or it may not be frequent, you should be ready for the SEC to knock on your door. And when they do knock, they can come in.”

Firms need to be well versed in all the new rules, whether they are about valuations, conflicts of interest, fees and expenses or SPACs. “If the SEC came and asked me questions about each of these points, could I respond in a way that would show that I have been fair in working with my LPs and that I have followed my agreement with my LPs to the letter?” asked Larsen. “Further, I would read in depth the proposed rule on transparency, which deals with adviser-led secondaries and certain contractual provisions where you treat investors differently, which will be prohibited whether you are a Registered Investment Adviser or not.”

The prohibited activities are especially important because they are still banned even if a GP and LP agreed to them in the LP agreement. Exempt Reporting Advisers “need to behave a bit more institutionally,” Larsen said. “Yes, there are certain rules that don’t apply, but there are more and more that do and they need to inform themselves on what those are.”

True, only Registered Investment Advisers should anticipate a formal examination by the SEC. That does not mean, however, that the SEC won’t show up on the doorstep of Exempt Reporting Advisers. “It may be they get an email from someone complaining [such as a disgruntled LP], or it may be that they just check to see if you are appropriately non-registered,” Larsen said. “They also are going to be checking to see – even if you are not a Registered Investment Adviser – are you doing what your LP agreement says you should be doing?”

If a GP does nothing else, it should re-read its LPA and make sure it is following it to the letter. For example, if the agreement says the GP must involve a third party in its quarterly valuations, it had better be doing just that.

“If it says report quarterly, then they should report quarterly,” Larsen said. Even if the GP is down to three investments and its LPs have said not to worry about a quarterly report, the SEC wants to see that the GP is adhering to the agreement, he said, noting that he has been called as an expert witness to testify about just such an issue.