The SEC breaks new ground in this complaint by suggesting that the firm should have invested client assets in other funds (including funds sponsored by an affiliate of the clearing broker) that did not offer revenue sharing. Most prior revenue sharing cases have focused on the use of higher fee share classes of the same fund. This line of argument raises a concern that the SEC is implicitly advocating for the lowest cost fund regardless of investment mandate or performance. For example, would an adviser violate its fiduciary duty, absent revenue sharing, if it recommended a higher cost fund for reasons other than total expense ratio?
This case should prompt fund financial officers to review the charges imposed by the custody bank. That nickel and diming on everything from wire fees to foreign custody reports may be unlawful. Service providers should also take note that the SEC will initiate enforcement for overcharging registrants even where the service provider itself is not an SEC registered or regulated entity.
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.
hedge fund seeding platform created by a large asset manager agreed to pay over
$2.7 Million in disgorgement, interest and penalties for over-allocating
internal expenses. The respondent
created private equity funds to invest in third party hedge fund managers. The firm then created an internal group of
employees tasked with helping hedge fund managers in which the funds invested
to attract new capital, launch products and optimize operations. Pursuant to their organizational documents,
the funds would pay up to 50 basis points for these activities. The SEC charges that the respondent allocated
all the group’s compensation expenses to the funds even though they spent a
portion of their time on activities that benefitted the fund sponsor and
unrelated to the enumerated activities.
The SEC faults the firm for failing to implement appropriate compliance
policies and procedures and for making material misstatements.
Do not charge expenses to managed funds unless the organizational and disclosure documents are absolutely clear that the funds will bear the expenses. When doing internal expense allocations, always err to the side of benefitting the fund rather than the fund manager.
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.
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.
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.
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.