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Compliance Failures Cost BDC Manager $4 Million in Penalties and $2.6 Billion in Assets

 A BDC manager’s compliance failures led to nearly $4 Million in fines, disgorgement and penalties and the loss of its advisory business.   The SEC charges the firm with misallocating overhead expenses to the registered Business Development Companies it managed and with overvaluing portfolio companies.  The SEC maintains that the registrant used material nonpublic information about BDC portfolio companies to benefit affiliated hedge funds that it managed.  In 2014, the firm had over $2.6 Billion in assets under management but withdrew its adviser registration in 2017 following the SEC enforcement action.  The SEC asserts violations of the compliance rule (206(4)-7) in addition to a laundry list of other securities laws violations.

Failure to implement an effective compliance program has consequences beyond penalties and fines.  The negative impact to a firm’s and its principals’ reputations could ultimately bring down the entire franchise. 

SEC Warns Advisers about Fee and Expense Practices

The SEC’s Office of Compliance Inspections and Examinations has issued a Risk Alert detailing investment adviser failures to properly calculate and disclose fees and expenses.  OCIE cites failures to properly value assets, thereby leading to overbilling, using the incorrect fee rate, and billing based on the wrong time period.  OCIE also details faulty disclosure practices including Form ADVs that do not reflect actual billing practices and failures to fully disclose compensation arrangements.  OCIE also highlights fund sponsors that misallocate expenses.  The OCIE findings result from issues identified in deficiency letters issued in recent SEC exams.  The Risk Alert advises that firms take action by reimbursing clients and enhancing policies and procedures.

OUR TAKE: These Risk Alerts often precede enforcement actions.  Compli-pros should review their fee billing and disclosure practices in anticipation of an OCIE sweep.

 

Large BD/IA Pays $2.2 Million for Recommending Wrong Mutual Fund Share Class

A large BD/IA agreed to pay $2.2 Million in remediation, interest and penalties for failing to recommend the lowest mutual fund share class available to retirement plan customers. Instead of recommending load-waived “A” shares, the respondent recommended other higher-cost share classes that resulted in compensation paid to the BD/IA.  The SEC faults the firm for failing to have adequate systems and controls in place to ensure that retirement clients benefitted from available discounts.   The SEC also asserts that the BD/IA omitted necessary disclosures about revenue sharing and the impact on overall investment returns.  An SEC Enforcement official warned that “these types of actions remains a priority for the Division” as evidenced by its recently-announced Share Class Selection Disclosure Initiative.

OUR TAKE: Firms must implement a system to ensure that eligible clients get the waivers to which they are entitled.  Compliance can’t rely on reps self-policing, especially when they receive higher compensation on certain share classes.

 

Chief Accounting Officer Barred and Fined for Approving CEO Expenses

The SEC barred and fined a public company Chief Accounting Officer for approving undisclosed expense reimbursements for the company’s CEO.  The CEO ultimately repaid the $11.285 worth of perquisites incurred over a 5-year period for personal items such as private aircraft usage, cosmetic surgery, cash for tips, medical expenses, charitable donations, and personal travel expenses.  The SEC asserts that the CAO approved the expenses in violation of company policy and without appropriate backup documentation and then failed to disclose the reimbursements in the company proxy statements.  The SEC charges the CAO with causing the company to file false reports.

OUR TAKE: We wrote on Friday that the SEC is looking to hold financial executives accountable.  In this case, the SEC doesn’t even allege that the CAO derived any personal benefit by approving his boss’s expenses.  Regardless, the SEC holds him accountable for allowing wrongdoing to occur.

 

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.

 

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.

 

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.