Compliance for Fund Managers

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In this article we will share an overview of compliance best practices and discuss the impact of the new SEC ruling for emerging managers venture capital (EMVC) with the knowledgeable minds at Cedar Mountain. One of the highlights in creating The Venture Fund Blueprint has been the opportunity to connect with each of you, hearing your questions, feedback, and viewpoints on setting up a top-tier venture firm rooted in operational excellence. Compliance is crucial to a venture capital (VC) fund, regardless of its size, for the long-term advantages of risk mitigation, investor trust, and operational efficiency.

Question #1: Which VC firm violations could prompt SEC pursuit and fines?

The U.S. Securities and Exchange Commission (SEC) regulates various aspects of the securities industry, including the activities of VC firms. Potential violations that could prompt SEC pursuit and fines include:

• Misappropriation of Funds where fund assets are used for unauthorized purposes or personal benefit.
• Misrepresentation and Fraud where false or misleading information is provided about investment strategies, fund performance, fees, or any other material aspects.
• Inadequate Disclosures where not all relevant information is disclosed to investors, especially about fees, fund performance, and conflicts of interest.
• Breach of Fiduciary Duty where investment advisers are not upholding their fiduciary duty to act in the best interest of their clients; this includes conflicts of interest that are not properly disclosed or managed.
• Exempt Reporting Advisers and Custody Rule Considerations where Exempt Reporting Advisers (ERAs) are not bound by the SEC’s custody rule that mandates Registered Investment Advisors (RIAs) to conduct independent audits of private fund financial statements and provide the audited reports to investors, the significance of such independent fund audits, especially in the realm of illiquid funds, often leads investors to contractually secure these safeguards from their investment managers; if a fund manager has committed to these audits to Limited Partners (LPs) but fails to follow through, the SEC has the authority and precedent to intervene.
• Valuation Issues where exempt reporting advisers should comply with fund documents, ensuring accurate fee calculations, managing conflicted transactions, maintaining proper valuation practices, and adhering to declared investment strategies, with heightened attention to disclosures and conflict procedures during financial distress.
• Pay-to-Play Violations where investment advisers make political contributions to influence adviser selection.
• Insider Trading where members of a VC firm trade on material nonpublic information.

It is worth noting that while many VC firms benefit from certain exemptions (like the exemption from registration for VC firms under the Investment Advisers Act), they are not exempt from the anti-fraud provisions and other key requirements. VC funds are able to avail themselves of the venture capital operating company (VCOC) exemption (think active participation in portfolio companies) and thereby are not subject to registration as an investment adviser, though they must still file as an exempt reporting adviser. While the fiduciary obligations of an ERA are straightforward, other ERA obligations are not. All the items noted above relate to an ERA’s fiduciary obligations applicable to all fund managers, regardless of status. It is essential for VC firms, irrespective of their size, to be aware of their regulatory obligations and to have robust compliance mechanisms in place.

Question #2: What is the political contribution rule? How does it impact my venture capital fund? What are the compliance implications?

The political contribution rule typically refers to Rule 206(4)-5 of the Investment Advisers Act of 1940 in the U.S., which was established by the SEC and addresses “pay-to-play” practices in which investment advisers make political contributions with the goal of influencing the selection of the adviser to provide advisory services to government entities. The rule primarily targets advisers to public pension funds, but it can have implications for venture capital funds, particularly if they manage money for public pension plans.

The main rules are as follows:

1. Restriction on Compensation — If an investment adviser makes political contributions to elected officials or candidates who can influence the selection of the adviser, the adviser is prohibited from receiving compensation for providing advisory services to that government entity for two years.
2. Banning Third-Party Solicitors — The rule prevents investment advisers and their covered associates from paying third parties, including placement agents, to solicit government business on their behalf unless those third parties are registered broker-dealers or registered investment advisers themselves, and they are subject to pay-to-play rules.
3. Recordkeeping — Investment advisers are required to keep records of political contributions made by the firm and its covered associates.

EMVC Application

If your venture capital fund seeks investments from or advises public pension plans or other government entities, you will need to be cautious about political contributions to avoid triggering the two-year compensation ban. Even if your fund does not currently have public pensions or government entities as investors, you will still want to monitor this area if you are considering such investors in the future. It is prudent for funds to establish policies and procedures to monitor and report political contributions by covered associates, including pre-clearance processes for contributions and regular training to ensure associates are aware of the rules, and to maintain comprehensive records of all political contributions made.

Pro-Tip

It is best practice to disclose your political contribution policies and procedures to potential and current investors.

Question #3: As an emerging manager, do I need to worry about CFIUS?

The Committee on Foreign Investment in the United States (CFIUS) reviews transactions that could result in control of a U.S. business by a foreign entity to determine if such transactions could have an impact on the national security of the United States. Whether or not an emerging manager needs to worry about CFIUS largely depends on the specifics of the fund and its transactions, such as:

• Foreign Limited Partners — If your fund has foreign Limited Partners (LPs), especially those with significant influence or control over the fund’s decisions, CFIUS considerations become more relevant.
• Target Investments — If your fund invests or plans to invest in U.S. businesses that operate in sectors critical to U.S. national security, e.g., defense, critical infrastructure, critical technologies, CFIUS will likely be more relevant. The 2018 Foreign Investment Risk Review Modernization Act expanded CFIUS’s jurisdiction to include non-controlling investments in certain U.S. businesses involved in critical technology, critical infrastructure, or sensitive personal data.
• Mandatory Filings — Under the Foreign Investment Risk Review Modernization Act (FIRRMA), certain transactions require mandatory declarations to CFIUS. If your fund’s transactions fall within these categories, compliance is not optional.
• Potential Penalties — Non-compliance or failing to consider CFIUS where applicable can result in significant penalties, including fines or forced divestment of the acquired U.S. business.
• Fund Structure and Terms — The terms of your fund, side letters with LPs, and the overall fund structure can all impact CFIUS considerations. For instance, if foreign investors can influence investment decisions or gain access to technical data of portfolio companies, it might trigger CFIUS concerns.
• LP Information Access — If foreign LPs have access to sensitive information about portfolio companies, this could also be a factor in CFIUS considerations.
• Reputation and Future Transactions — Beyond immediate regulatory implications, CFIUS reviews, or lack thereof if required, can impact a fund’s reputation and complicate future transactions.

While not every emerging manager needs to be deeply concerned about CFIUS, it is crucial to be aware of it, especially if you have foreign investors or are investing in sectors sensitive to U.S. national security. Given the complexities involved and the potential consequences of oversight, it is advisable to consult with legal experts familiar with CFIUS when setting up a fund or considering specific investments.

Question #4: For EMVCs, what are the roles of Legal and Compliance? I already have a lawyer; is that not enough? Is it not cheaper for my lawyer to just handle everything?

In the dynamic world of venture capital, legal expertise is not just helpful — it is essential. Legal counsel expertly navigates the complexities of fund formation, meticulously crafts and negotiates investment deals, and ensures unwavering compliance with the labyrinth of securities laws. They are the vigilant guardians in due diligence, skillfully mitigating risks and dissecting the legal intricacies of potential investments. When disputes arise, they are the cool-headed negotiators, and, as investments mature, they are the strategic architects behind successful exit strategies. In this high-stakes realm, they are also the trusted liaisons with valued investors, ensuring transparency and adherence to agreements. In summary, they are the legal conductors orchestrating the symphony of our venture capital endeavors.

Another component of best practices in structuring for a venture capital fund is a robust compliance team, steadfastly ensuring every move aligns with the intricate dance of regulations set by authorities like the SEC. Compliance is the architect and enforcer of our internal ethical code, tirelessly auditing our activities to ensure we walk the straight and narrow. Their keen eyes assess and mitigate risks, safeguarding our investments from unseen pitfalls. They are educators too, empowering our staff with knowledge on ethical investing and compliance protocols. Meticulous record-keepers, they maintain a clear ledger of our actions and decisions, ensuring every investment step is transparent and accountable. They are the vigilant sentinels, diligently conducting AML and KYC checks, and they are the diligent scribes, ensuring all our regulatory reports and filings are as punctual as they are accurate. In essence, they are the ones who keep our venture funds secure, ethical, and on the right side of the law.

EMVC funds care deeply about compliance because it is not just good practice — it is a key part of your role as a fiduciary agent representing the interest of investors. Savvy investors often demand it as a non-negotiable; for funds over $150mm, it is a regulatory must-have; and, for funds under $150mm assets under management (AUM) who hope to grow, it is a cornerstone of a stable and growing firm. Starting off with a robust compliance program is not just playing by the rules; it is laying a foundation of trust and professionalism that resonates with both investors and regulators. In the competitive world of EMVC, having a solid compliance framework is not only about avoiding trouble but also about setting a standard of excellence from the get-go.

Having a lawyer or legal team is crucial though not the end-all for all your needs. While your legal team excels in fund formation and contracts, compliance requires a different focus, often extending beyond their usual scope. It is not so much about profitability but specialization. Lawyers, while invaluable, typically work on an hourly basis, which can add up. Contrastingly, compliance firms offer a wide range of services under a monthly subscription, presenting a more economical option. It is akin to the difference between a specialized gourmet dish and a well-rounded meal plan; both have their unique benefits, but the latter offers consistent, comprehensive coverage. In essence, complementing your legal expertise with a dedicated compliance firm is not just prudent; it is a cost-effective strategy to ensure seamless operations.

Question #5: What are the best practices for a healthy compliance program at a <$150mm VC fund?

For a VC fund, even with a size of less than $150 million, a robust compliance program is crucial. Implementing best practices ensures that you not only meet regulatory requirements but also instill trust among your investors. Here are some best practices to consider:

• Policies and Procedures Manual — Create a detailed policies and procedures manual that covers all regulatory requirements applicable to your fund. This manual should be tailored to your fund’s specific operations and risks. It is not enough to have a generic manual; it needs to reflect the actual activities and risks of your fund.
• Designate a Chief Compliance Officer — Even if you are a smaller fund, having a designated individual responsible for compliance ensures that there is always someone keeping an eye on regulatory matters. The CCO does not necessarily have to be a full-time role but should be someone knowledgeable about the regulatory landscape.
• Regular Training — Ensure that all employees, especially those making investment decisions or interacting with investors, are trained regularly on compliance matters. This helps in keeping everyone updated on regulatory changes and reinforces the importance of compliance.
• Internal Audits — Maintain thorough records of all transactions, communications, decisions, and justifications, especially when it comes to valuations and conflicts of interest, as proper record-keeping is crucial. Periodically, conduct internal audits to review and test your policies and procedures. This will help you identify any gaps or areas that need improvement.
• External Reviews — Consider periodic external reviews or mock audits by compliance consultants. An external perspective can provide insights that might be missed internally.
• Manage Conflicts of Interest — Conflicts of interest can arise in various situations, such as co-investments, fee arrangements, or side deals. Ensure that all potential conflicts are identified, disclosed, and appropriately managed.
• Investor Communications — Be transparent and communicate consistently with your investors. Regular updates about the fund’s performance, fees, and any significant decisions are essential. Transparency helps in building trust and can also act as a deterrent against potential compliance lapses.
• Whistleblower Policies — Establish a whistleblower policy where employees can report any unethical or non-compliant activities without fear of retaliation.
• Cybersecurity — With increasing cyber threats, having a cybersecurity policy is essential. Ensure that sensitive data, both of your fund and your portfolio companies, is protected.
• Code of Ethics — Establish a code of ethics that sets clear standards for professional conduct. It should cover areas like personal trading, gifts, and entertainment.
• Portfolio Company Due Diligence — Ensure you have a robust due diligence process for evaluating potential investments, especially from a compliance perspective. This can help in identifying potential regulatory risks at an early stage.

Remember, a healthy compliance program is not just about checking boxes. It is about creating a culture where regulatory compliance and ethical behavior are integral to the fund’s operations. Given the complexities and potential consequences of oversight, many VC funds also find it beneficial to periodically consult with legal or compliance professionals.

Even for smaller VC funds under $150 million, a robust compliance program is not just best practice; it is a trust-building cornerstone. This entails crafting detailed policies, regular training, internal audits, and managing conflicts of interest. It is about nurturing a culture where regulatory compliance and ethical behavior are integral, not just checking boxes. Whether dealing with SEC regulations, political contribution rules, CFIUS concerns, or establishing a solid legal and compliance framework, these guidelines are not just about avoiding trouble; they are about setting a standard of excellence and trust in the complex world of venture capital.

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Disclaimer: The information contained herein is based on a fictitious entity and must not be construed as legal advice or a representation of any actual, existing entity, organization, or individual. The providers, companies, examples, products, and services shared represent only a subset of available options and are based solely on internal fund manager conversations. These options are intended to be a general framework, not an exhaustive catalog, and should not be viewed as legal or tax advice, endorsements, recommendations, approvals, or rankings. We encourage you to do additional research into each category to find the resources that best fit your specific needs.

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Sincere appreciation to our contributing author Meher Haider , Co-Founder at Cedar Mountain. Thank you to my co-author of The Venture Fund Blueprint, Shea Tate-Di Donna!

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Kaego Ogbechie Rust is CEO at Foresight Advisors — working with foundations, investment firms, non-profits, and for-profit ventures — offering comprehensive support across vision & strategy, investing & financing, and operational planning during critical periods of your growth.
If you’re looking for help, contact kaego@foresightadvisors.co or visit www.foresightadvisors.co.

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