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Consultant to PE Portfolio Company Charged with Insider Trading

A consultant to a private equity fund’s portfolio company has agreed to pay a fine and disgorgement to settle insider trading charges.  According to the SEC, the consultant obtained impending acquisition information from the acquirer’s Chief Revenue Officer and traded on the information prior to the acquisition announcement.  The SEC also alleges that she passed the information to a friend who also traded.  The SEC asserts that the consultant “violated her fiduciary duties or similar obligations arising from a relationship of trust and confidence” to the client company.

OUR TAKE: Private equity firms registered as investment advisers should ensure that portfolio company officers and consultants comply with the Code of Ethics, including reporting of securities transactions and the obligation to maintain the confidentiality of material nonpublic information.

https://www.sec.gov/litigation/complaints/2017/comp23986.pdf

PE Senior Partner Expensed Personal Items to Funds

The SEC commenced enforcement proceedings against the former senior partner of a large private equity firm for charging personal expenses to the funds he advised.  According to the SEC, the senior partner used his corporate credit card for personal expenses that his firm allocated to the funds.  The funds’ governing documents allowed reimbursement for expenses incurred relating to investments and operations including out-of-pocket expenses for business and travel expenses.  Although the conduct occurred over a 3-year period and the company detected unlawful expenses, the senior partner continued to submit false expense reports for which he was reimbursed.  The firm ultimately terminated the senior partner after he reimbursed the funds for over $290,000 in personal expenses.

OUR TAKE: Private equity firms could avoid these problems by only charging management fees (and carry) and end this practice of charging the fund for out-of-pocket expenses.  Any expense reimbursement issues would be the private matter between the firm and its employees.

https://www.sec.gov/litigation/complaints/2017/comp-pr2017-199.pdf

PE Firm Pays $3.4 Million for Broken Deal Expenses Paid Since 2004

A private equity firm agreed to pay over $3.4 Million to settle charges that it failed to allocate broken deal expenses to co-investment funds as far back as 2004.  The private equity funds reimbursed the respondent for broken deal expenses including costs incurred to develop, negotiate, and structure potential transactions that were never consummated.  The SEC faults the firm, which registered in 2012, for failing to disclose that the funds would pay the broken deal expenses allocable to co-investment vehicles utilized by insiders.  The SEC asserts violations of the Advisers Act’s antifraud provision (206(2)) and the compliance rule (206(4)-7) for failing to implement a written compliance policy or procedure governing broken deal expense allocation practices.

OUR TAKE: The SEC reaches all the way back to 2004 to calculate disgorgement even though the firm did not register until 2012.  Private fund firms that registered in 2012 should re-examine their expense allocation practices for years prior to 2012 and consider LP reimbursement before the SEC brings a public enforcement case.

https://www.sec.gov/litigation/admin/2017/ia-4772.pdf

Private Equity Firm Charged Overhead and Portfolio Expenses to Fund

The SEC fined and censured a private equity manager and its principals for unlawfully charging the fund both portfolio company expenses and adviser overhead expenses.  The PE manager charged the fund certain consulting expenses provided to a portfolio company without offsetting the management fee as required by the LPA.  The PE manager also charged overhead expenses including employee compensation, rent, and the costs of responding to the SEC examination/enforcement.  The SEC charges that the expenses were not authorized in the fund’s organizational or disclosure documents.  The SEC asserts violations of the Advisers Acts antifraud provisions as well as the compliance rule (206(4)-7) for failing to adopt and implement reasonable policies and procedures.  As part of its remediation, the PE firm agreed to hire a new Chief Compliance Officer.

OUR TAKE: It really is better to build a legitimate compliance infrastructure before the SEC arrives rather than in response to an enforcement action.  An ounce of compliance prevention can avoid the reputation-crushing havoc of an SEC enforcement action.

https://www.sec.gov/litigation/admin/2017/ia-4766.pdf

PE Firm Pays Over $1.6 Million for Improper Expense Allocation

A private equity fund has agreed to pay over $1.6 Million in fines and client reimbursement for mis-allocating expenses to its fund.  The SEC charges that the PE firm unlawfully charged legal, hiring, and employee and consulting expenses to the fund.  The SEC interprets the organizational documents as only permitting “normal operating expenses,” including “all routine, recurring expenses incident to” their own operations.  The SEC faults the firm for failing to adopt and implement appropriate compliance procedures including multiple levels of expense review, escalation procedures and oversight.

OUR TAKE: PE firms continue to struggle with expense allocation issues, failing to understand that a fiduciary cannot use a managed fund as a piggy bank to pay firm expenses.  Proper compliance procedures should prevent firms from crossing the fiduciary line.

https://www.sec.gov/litigation/admin/2017/ia-4746.pdf

Unregistered Fund Manager Looted Fund by Inflating Value of Underlying Security

The SEC fined and barred from the industry the principal of a purported private equity firm for looting one fund to pay another by inflating the valuation of an underlying security transferred between the funds.  The SEC pleads that the defendant transferred a worthless interest in a start-up company to one of the funds and then had another fund buy that interest at a $2.8 Million valuation in order to pay off investors in the transferring fund.  The SEC contends that the defendant failed to (i) properly value the security with third-party input, (ii) disclose the inherent conflicts of interest and (iii) comply with statements made in the offering memorandum.  Neither the fund manager nor the principal were registered in any capacity, but the SEC was able to uncover the wrongdoing as a result of litigation brought by the Colorado Division of Securities.

OUR TAKE: The state securities regulators serve a valuable function ferreting out fraud and other wrongdoing by firms that fail to register with the SEC and might otherwise go undetected.

https://www.sec.gov/litigation/complaints/2015/comp23388.pdf

Real Estate Interests are “Securities” Triggering Fund Registration

A purported real estate investment fund violated the Investment Company Act because investments in real estate limited partnership interests and mortgage loans constituted “securities.”  A fund that invests more than 40% of its assets in securities must register under the Investment Company Act, absent an exemption (e.g. fewer than 100 investors, solely offered to qualified purchasers).  According to the SEC, the fund exceeded the 40% threshold when the real estate related securities were added to other publicly-traded stocks and bonds in which the fund invested.  The SEC also accused the fund manager and its principal of failing to fully disclose how the fund would invest.

OUR TAKE: For purposed of the Investment Company Act, the SEC applies a broad interpretation of “security” to include pooled interests in real estate, even though a direct investment in the underlying property would not be counted.  Real estate private equity firms should not assume that they can avoid registration without a deeper analysis of their investments.

https://www.sec.gov/litigation/admin/2017/ia-4725.pdf

Cross-Transaction Was Not Consistent with Disclosure to LP Committee

The SEC fined and censured a registered real estate private equity firm for engaging in a cross transaction between two funds it managed on terms that differed from those disclosed to its LP committee.  According to the SEC, the fund manager committed to the selling fund’s investor advisory committee (IAC) that the purchasing fund would reimburse the selling fund for certain development expenses related to the subject property.  The fund manager later determined that the selling price already assumed the development costs and, therefore, declined to reimburse the selling fund.  However, the fund manager never disclosed to the IAC that it would not reimburse the selling fund.  When the transaction was uncovered during an SEC exam, the fund manager paid $4.5 Million to reimburse the selling fund’s limited partners.

OUR TAKE: Private equity firms can overcome conflicts of interest through disclosure to, and consent by, an independent LP committee.  However, hiding the ball from the LP committee can result in significant penalties and make your firm look less than transparent.

https://www.sec.gov/litigation/admin/2017/ia-4726.pdf

Lack of Compliance Infrastructure Costs Private Equity Firm and Principals

The SEC fined a private equity firm and its principals, and barred the former CFO/CCO from the industry, for engaging in multiple conflicts of interest transactions with the funds.  According to the SEC, prohibited transactions included (i) borrowing from the funds, (ii) failing to make capital contributions, and (iii) using false bookkeeping adjustments to hide transactions.  The transactions violated the LPA and were not properly disclosed in capital call notices or financial statements.  In addition to anti-fraud and books and records violations, the SEC charged violations of the compliance rule (206(4)-7) because the compliance manual did not address conflicts of interest including control by the two principals and related party transactions.  As part of the settlement, the firm hired a new CCO, a new general counsel, a new CFO, and an independent compliance consultant.

OUR TAKE: Hiring a competent CCO before the SEC arrived would likely have avoided the enforcement action and the resulting damage to the firm’s business and reputation.  It appears that the principals had no sensitivity to the regulatory environment in which they were operating.

https://www.sec.gov/litigation/admin/2017/ia-4721.pdf

SEC Offers Relief for Private Equity Holding Companies

 

The SEC’s Division of Investment Management has provided guidance allowing holding companies to avoid Investment Company Act registration.  Under current rule 3a-2, a bona fide holding company could be subject to registration because certain corporate events (e.g. holding cash pending a new deal, acquisition, or tender offer) would exceed permitted passive investment thresholds for more than 12-months.  The staff advises that such holding companies could begin the 12-month clock ticking upon the occurrence of the extraordinary event so long as there is a “bona fide intent to be engaged primarily in a non-investment company business, regardless of whether they operate directly or through a holding company structure.”  The SEC maintains that this relief furthers its mission of facilitating capital formation.

OUR TAKE: This is good news for private equity firms who could otherwise get caught up in the Investment Company Act’s technicalities.  Neither Congress nor the SEC likely intended such firms to register for a temporary period.

https://www.sec.gov/investment/im-guidance-2017-03.pdf