Episode 2: Retailization, AI, and the SEC’s Private Funds Unit

In this episode of Asset Management Corner, Andrew Dean and Chris Mulligan are joined by Igor Rozenblit and Jennifer Duggins, senior compliance professionals and former examiners from the SEC’s Private Funds Unit. They explain the PFU’s role within the Division of Examinations at the SEC, and discuss hot topics of the day, including the retailization of private funds and compliance in the world of artificial intelligence.

Then Andrew and Chris break down the SEC’s dismissal of a lawsuit involving the liquidity rule and what it means going forward, and put in perspective a recent story about private equity fund valuations. (NB, FinCEN announced its intention to postpone the effective date of the AML rule shortly after recording.)

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Transcript

Andrew Dean: Hello and welcome back to Asset Management Corner. We are your hosts, I'm Andrew Dean. He's Chris Mulligan, partners at the law firm Weil and former senior SEC officials in the Division of Examinations and Enforcement. This is the podcast where we talk about all things SEC and asset management. On today's podcast, Chris and I will discuss some recent events, including the SEC's dismissal of the liquidity rule lawsuit, and a news story about valuation.

Chris Mulligan: But first, we are just delighted to be joined by a couple ex-colleagues, Igor Rozenblit and Jen Duggins. Igor Rozenblit is the founder of Iron Road Partners, founded that in 2021 and he is currently the managing partner of Iron Road, specializes in compliance, crisis management and regulatory issues. I worked with Igor extensively when he was at the SEC and it was Co-Head of the Private Funds Unit. He was also Co-Lead of the agency's interdivisional Private Fund Specialized Working Group. We worked together on exams for 10 years. Also here, the other original Co-Head of the Private Funds Unit, is Jen Duggins. We are just delighted to have her. She very recently left the SEC and is now a partner at Optima Partners, specializing in regulatory and compliance issues. Again, prior to just leaving the SEC recently, she also served as the original Co-Head of the Private Funds Unit within the division of examinations from July 2015 to April 2025. I was both of their lawyers for many years at the SEC and I'm absolutely delighted to have them on as our first guest here on the podcast. So, let's get started. Igor, Jen, before we get into substance, I think there's a lot of fascination with the private funds unit. What it is, what it isn't, how it got started. So would you mind telling us about the early days of the private funds unit? Why was it created? How did it get started and what kind of vision did you have for it when it first got underway?

Igor Rozenblit: Thanks Chris, well, it's really great to be together again, together with Jen and you and also Andrew who, as you said, we've worked with for a really long time and it's great to be talking about the private funds unit again, which was really important I think to the Commission. The, you know, the purpose and the genesis of the private funds unit really comes from the idea post-Dodd-Frank that private funds are really complicated animals and in order to examine them effectively you really need expertise and you really need pattern recognition. And, the private funds unit came together really starting in 2014 and then fully crystallizing in 2016 with that mission in mind: to create pattern recognition and examiners so that they could bring the knowledge they gained from examining one private fund to examining another private fund. And, that mission has only gotten more and more important with the growth of complexity in the financial markets.

Jennifer Duggins: Thanks Igor, and I'm so thrilled to be with my fabulous partners again from the SEC and in particular you, Igor will always hold a very special place in my heart. I would just say that yes, I totally agree. The PFU must be here to stay. Absolutely need the expertise that PFU brings, but certainly that all of exams brings. When I joined the SEC staff, examinations of private funds were well underway and in good hand with the regions. As Igor noted with his mission statement about why the PFU was incepted, I think it's important to continue to have that expertise, so that they can be there to help prevent any other big, big Ponzi sized crises. Especially at this time when the SEC is talking about adding in retail investors into the private funds investment area. So, for sure, the private funds unit and all of their colleagues and exams must remain and must continue to be an integral part of the exam story, with respect to investment advisors in the private fund space.

Chris Mulligan: So the private funds unit is, for those who don't know, is a national unit, right? There's individuals in the private funds unit across all the regions and it's a relatively small unit in comparison to the entire IA/IC examination program. Can you talk about how you interact with the regional offices? Because I think we've been seeing the influence of the private funds unit on regional offices, perhaps they're working behind the scenes. But, it's something that we've really noticed, that for such a small unit, there seems to be a lot of influence in the regions in terms of the types of issues that they're looking at.

Jennifer Duggins: Absolutely. But for the regions, the private funds unit cannot effectively operate, specifically related to the selection based on risk protocols. As we all know, the SEC has always been understaffed and has always operated from a mission perspective, looking at the risk that investment advisors, broker dealers, etc. bring into the financial markets. And so with that, they've always had a risk-based approach in exams. The private funds unit has to continue to build on its customer relationship with the regions. The regions have the book of registrants that the private funds unit seeks to examine. The other thing that many don't know is that the additional mission of the private funds unit is to be one of the sources of expertise for private funds throughout the entire agency, where those factors are looking at how private funds impact the market. So that includes the division of investment management. For example, exams has always informed rulemaking. And with that, the regions do partner with the private funds unit, as I mentioned for registrants but also for expertise that they may bring. They also help in times of shortage of staff bring about this nimbleness and focus and attention to the really specific, as Igor would say, areas of opacity that investors, clients, LPS, are not necessarily able to see in the reading through of limited partnership agreements and the like.

Igor Rozenblit: Yeah. The only thing I'll add to that is that, you know, I've always thought of the private funds unit as a place where you can experiment, find issues that you realize are systemic issues, boil them down into, you know, their component parts and then do as much knowledge sharing as you can with the rest of the people in the Commission. So that they can decide whether or not they want to pursue some more issues and they have a playbook to do so.

Andrew Dean: I was just saying, this is Andrew on the enforcement side, that enforcement loved getting referrals where PFU was involved because there was always going to be something extra sophisticated, maybe something outside the box that they haven't seen before. So there was a lot of collaboration, I know and a lot of people look for an enforcement for cases that originate or included members of the private funds unit. What are the big themes that you both are seeing in of the SEC right now? You guys work with exams, you work with a lot of clients who are advisors, what are the big themes you're seeing? Igor, let's start with you.

Igor Rozenblit: Well, it's an interesting time because on one hand there's a lot of regulatory uncertainty driven primarily by the fact that there was a change in administration and the new administration has not yet clearly articulated kind of its priorities set for the private fund space, and the exam space as well. And, as a backdrop to all of this uncertainty is the fact that this is a time of massive industry change and part of this is facilitated by the Commission, who's now focused on capital formation. One particular area, for example, is the democratization of private capital and democratization of alts. Which is a trend that's been going on for a very long time, but has now accelerated, allowing retail investors, who normally do not have access to these complicated private equity and hedge fund financial products, who now have access to them. And in many ways that trend is just getting started but has already kind of turned a lot of policies and procedures and compliance on its head. For instance, in private equity there is this practice of holding portfolio company at cost for six months to a year and then affecting, you know, kind of an affair value process on that. Well, that doesn't work if your assets are now held by any sort of retail product with any sort of liquidity that's, let's say, greater than 10 years, which is kind of what the private equity funds are now because, as new investors subscribe to your fund, you can't really give them the portfolio company that you had at cost six months after you purchased it. So, the more private equity firms subscribe but create retail products, the more they're going to have to change their valuation processes, the more error prone those processes are going to be and, the more the Commission is going to have to adjust.

Andrew Dean: That's obviously a huge issue, Igor. Jen, what are your big takeaways?

Jennifer Duggins: One of the things that I'm seeing in the short time that I've been away from the staff is that there are several firms that, in my experience, even when I was at the SEC and there were administration changes, the belief that because there's an administration change and/or a Chair change, Commissioner change, changes to directors of some of the significant divisions within the SEC that things will shift towards allowing CCOs and the like to have more of a lax attitude about their compliance programs, and I think that's a huge mistake. The theory, you know, can be viewed as, oh well there's this change that's going to be an adjustment, this particular administration may be more in favor of less regulation, less enforcement. But, one thing that's always going to remain steady and, I hope that compliance professionals hear this, is that exams always stays on mission and exams, even with a short staff situation, will find a way to pull teams together, necessary teams with appropriate expertise to continue examining advisors in the space. With respect to enforcement referrals, even though we've seen a decline in the number of staff in the division of enforcement, that does not stop exams from referring matters to enforcement. Additionally, even though we now have a new Division of Investment Management Director in Brian Daly and, we've seen this Chair delete certain rules that were pending, related to private funds and other, there still is a way for exams to inform on rulemaking. And, I think we will continue to see new rules happening, particularly in the crypto space with the crypto task force that Commissioner Peirce has spoken on, as well as around AI. So for sure exams is here to say, referrals to enforcement are here to stay. So the message for compliance professionals is to keep doing what you're doing. Stay diligent and keep listening for the signals that are coming out of the staff, with respect to what they're focusing on in their request list, in their deficiency letters.

Chris Mulligan: Hey Jen, just following up, what are you telling your clients about training and the importance of training around some of these key issues and who should be trained?

Jennifer Duggins: So, with respect to anything new that comes out, so you know we've been talking about retaliation as an example. In my experience in the staff whenever there was a new direction, a different direction that the Commission was potentially going to undertake, we, in the unit, would do our best to come up to speed and learn what that means for private funds. What the impact is, where we may see areas where there may be issues and how to go about the best way to examine for those novel issues. The impact that having retail investors investing in a private fund maybe so, if I could bet my paycheck, I would say that the PFU was already trying to figure out, you know, how we're going to examine those private funds that now have retail investors in their space. And certainly, Chris, I know from, you know, our past experience in working together, we would certainly come to you for training in your legal, consulary style, you know, regulatory liaison and, helping us figure out what that training would be so that the staff understood all of the ins and outs of, let's say, this retail space that many may not have worked in or, you know, have had experience in on the retail side. So, it's important in the SEC. It's also equally important for compliance officers to, you know, be able to understand and have a seat at the table early on if the private fund that they're working with is going to start allowing in retail investors. What are the implications, what are the checks that have to be done, what do people have to know. So I think it's important for everyone in the space, whether you're a regulator or whether you're a compliance professional or whether you're an investor who's interested, learning as much knowledge as possible about the rules and pending regulation. Pay attention to what your law firms are telling you, what your consultants are telling you about how to be best prepared for these changes happening within the SEC.

Chris Mulligan: Yeah, I think that's a great point. It struck me to some degree how similar it is with private firms as it was at the SEC where basically you're trying to get ahead of the issue, you're trying to train, either if you're in the SEC trying to train exam staff or if you're at a private fund trying to train your team, on these new upcoming issues to try stay ahead of the curve. But, I think that's a really interesting point. There's a lot of similarities between what's happening oftentimes within the division of examinations in particular and the private industry. That's a really good point. So let's talk about, you know, we've talked about what we're seeing now. Let's talk about, Igor and Jen, what industry trends you're watching out for. What do advisors need to be mindful of that may be lurking below the surface a little bit, but were expecting to become a bigger issue in the months and years to come?

Igor Rozenblit: Well, one of the ones that we've been watching along with the rest of the industry is the kind of the rise of artificial intelligence and the particular angle that we look at is that, obviously AI has been getting a lot of press and that has caused a lot of our clients to get top down instructions to use AI however they can use AI. There's a lot of pressure on just being able to tell your investors you're using AI and that creates a number of compliance risks. Certainly there's a model risk there if you're using AI and trading. And, there is also this kind of duty of care risk where it's now possible to do research using AI. AI could regurgitate information with a lot of confidence, but yet still be hallucinating and that could create a situation where AI misleads investment professionals on making their investments. And so, training and oversight of that kind of process, I think is really important, and also a compliance function, I think compliance should adopt that perspective. And finally, compliance is also starting to utilize AI in a number of different ways including marketing reviews and e-mail reviews and, of course, AI isn't always as accurate as humans, at least not yet, and it can make mistakes. Just because you use a machine and it looks really good doesn't mean that all the responsibility of accuracy has been transferred to the machine, that you still have that responsibility. And, the more pressure there is to use AI in any way possible, the more this will become an issue in the future.

Jennifer Duggins: Agreed.

Chris Mulligan: Well, I agree with, yeah, I agree with that. And I think you've seen that in some recent enforcement actions, you know, including one recent one against a private company that had developed, said that they developed, a platform to trade crypto assets using artificial intelligence. And basically the complaint from the SEC indicated that the founder was aware of this platform didn't really exist and really didn't utilize AI so, you know, we are absolutely seeing the SEC dig deep both on exams and in enforcement actions on everything related to AI. So, I wholeheartedly agree with that. Jen, what are you seeing?

Jennifer Duggins: Certainly with respect to AI, I agree. I would also say, you know for those in the space trying to figure out you know how do we stay on top of making sure that we are doing what we say we do, that we are taking precautions and having those checks and balances with respect to reviewing what the AI produced, if you're using it in House, having compliance or legal take a look at it for accuracy purposes. It's really important. But, it's no different, I think, and everybody's like “Oh AI, AI” like it's, you know, this shiny new thing and, you know, perhaps the staff, you know, are they ready? Of course they're ready. I mean, if you look at ESG, if you look at alt data, I certainly, you know, heard news reports, as we all have, and you know, if you've had clients, if you've been out here a minute, like Igor has, certainly talked about how some may have, you know, gotten sweeps on, you know, AI, just like they did potentially on, you know, ESG as well as other alt data for example, you know. We heard reports of that in the news and from, you know, law firm papers, etc. So, it's really important to make sure that number one, you always do what you're saying you're going to do, what you're telling investors. If the machine is supposed to do X and produce Y, it needs to. If the machine is supposed to have this happy dance output, make sure it's a happy dance that you're going to be, you know, comfortable with. The other thing, too, is to remember that we do have some compliance dates looming, and I know the school of thought may be, well, the SEC is, you know, deleting some rules that were supposed to be promulgated, are these compliance dates going to happen? And it's this dance, right, that you do. Do I wait and see if the compliance dates are going to, you know, be cut off? Do I prepare now? Do I prepare later? With respect to Reg. S-P with the compliance date, Chris, I think is December. Even if it doesn't go through, I do think in my experience that firms should have an incident response ready. They should have the ability to know when something's happen, how they're going to tell investors, how they're going to tell a regulator, etc. Particularly with respect to PII and customer information. Really important to be on top of that, whether or not the compliance rule for Reg. S-P goes forward or not. With respect to AMO, I mean certainly when I was a CCO, and we're going way back now, we were hearing for years about how IAs we're going to have to do, you know, AML protocols, file SARS, all of that. I hope it comes to pass that we see this through but, we all know that for years firms have been doing best practices in the IA space around AML. So, likely things you already have in your toolbox. Keep moving, keep paying attention, but also just keep plotting along and doing the best that you can to stay on top of making sure you're doing what you're saying you're doing. This is definitely an issue and can get you really caught up in the exam process, should you be examined.

Chris Mulligan: Yeah, great point.

Igor Rozenblit: Can I put in a quick plug for compliance testing? As you know a lot of the federal securities laws around compliance are based on processes that are reasonably designed and I think that it's easy to get overwhelmed by kind of all of this AI and all these new rules and all this change and throw up your hands and say, well, there's nothing I can do about it. If a mistake happens, a mistake happens. But I think that a well-designed compliance testing program that doesn't test everything, but that does do a risk based sample test would be considered as a program that was reasonably designed by the SEC. And, if there are systemic issues, that kind of approach would catch those systemic issues and it is the systemic issues, rather than kind of the ones off you didn't predict, that would create the most trouble for registrants. And so, I'm a big fan of compliance testing.

Jennifer Duggins: Yeah, absolutely and certainly if you don't do it, the staff could and likely will.

Chris Mulligan: Yeah, good point and to your point, Jen, about S-P, I think we are seeing clients generally move forward with those amendments and not a huge lift. And, I do think they reflect best practices even if there is a delay. And of course, it's important to remember that S-P and AML our final rules. So, you know, if this Commission wanted to eliminate them, unlike the proposals that they could just drop, final rules they would actually have to take action, they'd actually have to draft a new rule to get rid of it. So, we're probably talking about delays if anything happens with S-P and AML. And likely not that the rules will completely go away, so whatever work you put in now is probably not wasted. Thanks so much Igor and Jen for joining us today. This was really fun. It's great to see both of you again together and Andrew, we have a lot of memories together. The four of us at the SEC and, it just was really fun to bring you back. And, this will not be the last time we will extend an invitation to you so I hope you are ready to come back at a moment’s notice.

Jennifer Duggins: Absolutely, huge honor to be asked to be guest #2. You know, you guys are the best. Miss you too. Thank you.

Igor Rozenblit: Thanks for having us.

Andrew Dean: Thanks guys. That was fun. Great to have Jen and Igor on. They were true, true legends within the division of exams so, we were excited to have them as guests. Chris, two other things now that we're going to hit on: I want to talk about a really significant development in the registered fund space, involving a dismissal of charges involving the liquidity rule. So okay, some background, in May of 2023, the SEC announced settled charges against Pinnacle Advisors’ CEO for liquidity rule violations. That was a 5-0 Commission vote. The liquidity rule was first proposed in 2015, adopted in 2016, approved 5-0 by the Commission, by the way. Fundamentally, the rule prohibits mutual funds from investing more than 15% of their net assets in illiquid investments, requires funds to take certain prompt or remedial steps if they hold the liquid investments above that limit, and requires funds to adopt liquidity risk management program to assess liquidity risk. And the rule is tied to the statute section 22(e) of the Investment Company Act, which requires a registered advisor to satisfy a redemption request within seven days. So, the idea is, you want to maintain significant amount of liquidity so that folks can get their money out within the seven days and, if you were too illiquid then that may be difficult in times of heightened redemptions. The same day as the settlement with the CEO, the SEC charge Pinnacle Advisors, two of its officers, two independent directors with violations also involving the liquidity rule for the same course of conduct. Chris from the SEC standpoint, I got to say, like you read the complaint, the facts are kind of juicy for the SEC. The adviser, according to the complaint ignored the advice of outside counsel, ignored the advice of the auditor, in categorizing the liquidity of certain positions. The case was in the motion to dismiss stage, defendants had been arguing that the SEC had exceeded its rulemaking authority when it adopted the liquidity rule and, to be clear, it was not an argument that had traction at the time the rule was first adopted, and it didn't get traction at various times when the rule had been amended over the years as well. The idea that there was not this authority to approve the rule. But, the Supreme Court recently came out with some decisions, including Loper Bright, which overruled the Chevron doctrine and generally eliminated judicial deference to a federal agency's interpretation of rulemaking powers. And the court, in this matter, as a result of Loper Bright, asked the parties to address the potential impact, and the SEC was not relying on the Chevron deference and arguing the rule was in the SEC's authority but, the court, in any event, wanted additional briefing. Defendants submitted a brief the SEC did not. Then, on July 11, pretty recently, the SEC dismissed charges against all the defendants. After the dismissal, the SEC issued a statement and “in the exercise of its discretion and as a policy matter the Commission determined that the dismissal of this action is appropriate”. So, what catches my ear there, Chris, is the reference to, as a policy matter, when it recently dismissed a Section 204 Capital A case against an advisor earlier this year. It stated that the dismissal was based on facts and circumstances, it didn't reference it being dismissed as a policy matter. So here it's not clear, though, what policy matter interest is being vindicated by the dismissal of this place. The SEC is not clear about this. So, what does this mean? Could mean a few things. Could mean that the Commission views the liquidity rule as outside its rule, making authority query. What that means for the settled action brought earlier against the CEO. It could also mean that the Commission may be inclined, but hasn't decided yet, to view the rule outside of its authority, but didn't want to commit to a position court without further deliberation that the SEC, in fairness, though, didn't ask for more time, they just dismissed. Perhaps also, the Commission just didn't want the Court to make a ruling on the law, which may have been contrary to what the Commission's ultimate position on the liquidity rule ends up being one way or the other. It's not clear, I don't think right now, where the Commission is going to come out on the liquidity rule. Anyway, more to come on this but, my overall take away is what kind of guidance, what should everyone take away from it. Liquidity rule is still on the books, it’s still a rule, parties need to comply with it. There's still a settled case that was a 5-0 vote against the CEO on the liquidity rule. We're going to definitely keep an eye on further statements and speeches. Maybe we'll get some clarity about why this one was dismissed and what it means for the liquidity rule going forward but, certainly something that we're going to watch closely.

Chris Mulligan: Thanks, Andrew. Another headline about a much more tried and true issue than the first enforcement action under a brand new rule came from a letter from a Congress person to an Ivy League school, raising some questions about some of the valuation practices of the colleges endowment, with respect to its private equity fund holdings. Putting aside the potential politics of this letter or other motivations, I think what the letter did is it raised a really important issue that has been around for a very long time, which is valuations. Valuations, particularly for private equity fund advisors is just incredibly important. It's an evergreen issue on examinations and it, you know, it's because these assets are very difficult to value. And so, it's just an important reminder that private fund advisors need to focus on their policy under the compliance rule. They need to focus on their disclosures, regarding valuation under the marketing rule, which we are seeing more and more emphasis on. Evaluation has always been a big issue, but the marketing rule now puts a lot of heat on any disclosures that you make regarding your evaluation process because that is now an advertisement if it's a contained in your PPM or your slide deck or other marketing materials, and has to be substantiated. It has to be substantiated by your internal valuation process, right. So, this has just raised the stakes on valuation. And then you want to be really careful around any valuation that impacts fee calculations, that's going to be different whether you're a closed end fund or open end fund. But, if valuation is impacting fee calculations, that's when you can really start to draw a lot of attention around your valuation practices. And of course, audits, audits, audits, audits are very important for the custody rule of course, but also important for valuation. If there's going to be any issues, any problems with your audit, you really want to get ahead of that very early on because that is a very important point. So, just another recent headline that's a reminder of a sort of evergreen issue that you really need to focus on. Anything else, Andrew?

Andrew Dean: Yeah, no, Chris. I mean, look, I'll say from my standpoint we kicked tires a lot on that at the SEC. We talked about that a lot with private funds unit and others at the SEC when I was in enforcement. Very challenging cases to bring. There have been some cases that out there that have been brought into space but, as a general matter, I think they are very tough cases for enforcement and I think the best advice for advisors out there is everything you just said. Watch your policies, make sure you're doing everything you say you're going to do. It's a good time to get everything in order while the SEC seems to be resetting right now. That’s it for me though, that's a wrap for today. Thanks for listening and we hope to catch you next time on Asset Management Corner. Take care.

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