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Private Equity CEO Failed to Supervise CFO/CCO


A private equity firm, the firm’s CEO, and its CFO/CCO were each censured and fined for overcharging the fund, engaging in improper insider loans, and violating the custody rule.
According to the SEC, the CFO/CCO failed to properly allocate management fee offsets for certain deemed contributions, thereby overcharging the fund by about $1.4 Million. The CFO/CCO also arranged improper loans between the fund and the management company and overcharged for organizational expenses. The SEC also charges the firm with failing to deliver audited financial statements within the required 120-day period, in part because one of its auditors withdrew from the engagement. The SEC faults the CEO for failing to properly supervise the CFO/CCO as required by Section 203(e)(6) of the Advisers Act. The SEC alleges violations of the Advisers Act’s antifraud rule (206(4)-8) and the compliance rule (206(4)-7).

Senior leaders will not escape accountability by claiming reliance on subordinates. Also, private equity firms can’t use the funds they manage as their firm piggy banks. They need to implement policies and procedures about the withdrawal and use of funds.

Fund Sponsor Violated Private Offering Rules

The sponsor of a private fund agreed to disgorge its management fees for soliciting investors without a pre-existing, substantive relationship.  The SEC accuses the fund sponsor and its principal with engaging in a public solicitation through a website and media interviews.  The respondents had filed a Form D Notice of a private offering.  The alleged public solicitation violated Section 5 of the Securities Act, which requires a registration statement before engaging in a public offering.  During the unlawful offering, the value of the fund declined 62%, which amounted to over $300,000.  The Order notes that the principal had no prior securities industry experience. The SEC declined to impose further penalties because of the respondents’ financial condition.

Most securities professionals know that you cannot raise capital in a private offering unless the offeror can document a pre-existing relationship with potential investors.  However, as FinTech and the securities markets intersect, the neophytes may not realize that they are tripping over the regulatory wires.  This respondent is lucky that the SEC didn’t order full rescission of the offering and the refund of the amount lost. 

PE Firm Bought Insurance Company Clients and Sold Them Over-Valued Illiquid Assets

The SEC barred and censured the principal of a private equity firm for using his position to mislead advisory clients, sell them over-valued assets, and loot the funds.  The SEC accuses the respondent of acquiring insurance companies, entering into investment management agreements, and then selling over-valued illiquid assets (e.g. paintings, private company venture interests) to the insurance companies to siphon off the general funds.  The respondents did not reveal that the valuation agent for the illiquid assets was an affiliated company controlled by the principals. 

This case has all the features of an advisory fraud: illiquid assets, conflicts of interest, an affiliated valuation agent, and individuals with questionable backgrounds.  It is a cautionary tale for investors, compli-pros, and regulators about how far wrongdoers will go to pursue their illicit intents. 

Private Equity Firm Overcharged Clients for 16 Years

A private equity firm agreed to pay a $400,000 fine and reimburse clients for overcharging fund investors over a 16-year period.  According to the SEC, the PE firm did not proportionally allocate broken deal, legal, consulting, insurance, and other expenses to co-investors and employee co-investment funds, thereby overcharging investors in their flagship funds.  The SEC also accuses the firm of paying portfolio company consulting fees to co-investors, which resulted in lower fee offsets to the detriment of flagship fund investors.  The firm voluntarily agreed to reimburse investors for the expenses and the fees following discovery of the misconduct during a 2016 SEC exam.  The SEC charges the firm with failing to implement a reasonable compliance program as well as the Advisers Act’s antifraud rules. 


If the firm had implemented a reasonable compliance program, discovered the overcharging, and reimbursed clients before the SEC uncovered the violations during an exam, it may have avoided the public enforcement action and resulting fine.  Also, a reasonable compliance program may have avoided the overcharging in the first place.  C-suite executives should re-think the cowboy mentality that ignores compliance until the SEC or a client makes them change.  It’s much less expensive to change the oil every 5000 miles than to replace the engine if it seizes. 

Private Equity Firm Mis-Allocated Expenses and Overlooked Conflicts

 A private equity manager agreed to pay over $2.8 Million in client reimbursements, disgorgement, penalties and interest in connection with mis-allocating overhead expenses and undisclosed conflicts of interest.  The SEC accuses the respondent of allocating a portion of staff expenses to the funds without disclosure or LP committee approval.   The respondent also failed to disclose that the principal had a financial interest in two consulting firms that did work for both the funds and the manager.  The SEC asserts that the firm failed to implement a reasonable compliance program, arguing that such a claim may rest on a finding of negligence.

This is low-hanging fruit for the SEC Enforcement Division.  When you get sloppy with expense allocations and ignore interlocking financial interests, the SEC can easily make its case that the firm acted negligently by failing to implement a sensible compliance program.

Unusual VC Structure and Excessive Fees Result in Industry Bar

The principal of a venture capital firm, registered as an exempt reporting adviser, was barred from the industry for taking fees that exceeded the amounts permitted by the operating agreements.  The VC firm imposed a front-loaded fee structure whereby investors paid fees on committed capital in early years to approximate the amount they would pay over the possible 10-year life of the funds.  The first fund charged an upfront management fee of 17.75% of invested capital, although later structures deferred some of the fees.  The SEC asserts that the defendants collected more than $7 Million in unauthorized fees while commingling funds and entering into conflicted transactions.

Imposing an unusual fee structure raises a red flag for regulators.  Skeptical examiners will spend significant time and resources to understand the fees and ensure they are properly calculated and collected. 

Private Equity Manager Lowballed Purchase Offer to LPs

 The SEC censured and fined a private equity manager for lowballing the price offered to liquidate limited partnership interests.  The SEC asserts that the private equity manager, through its principal, offered to purchase remaining limited partnership interests at the December 2014 valuation.  The SEC faults the firm for failing to revise the price or fully disclose that it had received financial information indicating that the NAV had increased during the first quarter of 2015.  The SEC opines that the offer letter, termed “as an accommodation,” made it appear that the limited partners would receive full value for their interests.  The SEC charges violations of Rule 206(4)-8, the Advisers Act’s antifraud rule.

OUR TAKE: We generally advise against principal transactions with clients/investors/LPs.  Purchasing private interests directly from a client is so rife with conflicts that no amount of disclosure may be sufficient.

 

Private Equity Exec Barred from Industry for Personal Transaction with Portfolio Company

 A private equity firm’s managing partner, who also served as its Chief Compliance Officer, was barred from the industry and fined for failing to disclose his personal interest in a portfolio company.  The SEC alleges that the respondent caused the fund to make a loan to the portfolio company on the condition that the company used a portion of the proceeds to redeem his investment.  The SEC faults the executive for failing to disclose the transaction or to obtain consent to it from the limited partnership committee.  Neither the fund nor the investors lost money because the portfolio company ultimately sold the notes to an unaffiliated third party.

OUR TAKE: Without proper disclosure and consent, a transaction that benefits the fund sponsor or its principals will violate the Advisers Act’s fiduciary duty whether or not the investors suffered any harm.  This case also highlights the perils of the CCO dual-hat model whereby a senior executive with a pecuniary interest also serves as the Chief Compliance Officer, thereby avoiding independent scrutiny.

 

Private Equity Firm Failed to Deliver Financials within 120 Days

 The SEC fined and censured a private equity firm for failing to deliver audited financial statements to limited partners within 120 days of the end of the fiscal year, as required by the custody rule (206(4)-2).  The firm missed the deadline by an average of more than 60 days in every year since it registered in 2012.  Although the staff will give a firm a pass if it misses the deadline due to “unforeseeable circumstances,” the SEC faults the PE firm for failing to make material changes to its compliance processes, thereby leading to a violation in 6 consecutive years.

OUR TAKE: We have found the staff to be fairly reasonable if a firm misses the deadline by a few days because of an unusual event such as a hard-to-value security or a change in auditors.  When you consistently ignore a regulatory requirement and fail to make changes, the Enforcement Division will treat you as a regulatory recidivist and proceed accordingly.

 

PE Firm Pays $6.5 Million to Settle Conflict Allegations over Portfolio Consulting Fees

 

A private equity firm agreed to pay over $6.5 Million in disgorgement, interest and fines for failing to adequately disclose, before commitment of capital, that it would receive accelerated portfolio consulting fees upon IPO or sale of the applicable portfolio company.  The PE firm did disclose in the Limited Partnership Agreement that it received portfolio consulting services and disclosed in its Form ADV that it received accelerated fees.  Fees were also described in the funds’ annual reports and in a side letter for one of the funds.  Also, the PE firm credited a large percentage of the accelerated fees against future management fees.  However, the SEC faults the firm for neglecting to inform all limited partners before committing capital that it would accelerate portfolio consulting/advisory fees upon IPO or sale for based on the present value of contract fees that could extend up to 10 years.  The SEC asserts that only the limited partnership committee could approve these potentially conflicted transactions.

OUR TAKE: The SEC has brought several cases charging PE firms with taking various forms of ancillary fees (e.g. portfolio monitoring, broken deal expenses, overhead expenses).  PE firms should reconsider these ancillary fees in favor of a more inclusive management fee.