Five takeaways from SEC enforcement actions

Limited Partnership Agreements have been in the Securities and Exchange Commission’s spotlight since the Dodd-Frank Act required some private fund firms to register with the agency. While most firms have made changes to adhere to the requirements, the SEC has brought action against a number of big names.

In each of these cases, the firms settled, and did not confirm or deny the alleged violations. Nonetheless, the highlighted actions have clarified what is and isn’t acceptable in the eyes of the regulator, and provided valuable guidance in how to comply.

Lesson 1: Clarify disclosure of broken deal costs

The SEC brought action against KKR in June 2015 for breaching its fiduciary duty. The firm allegedly failed to disclose that costs of a broken deal would not be proportionally allocated to co-investing and affiliated investors. The SEC added the firm failed to implement a compliance policy for its fund allocation expenses until a year after it was required.

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“Firms need to have a wide field of vision on categories of costs which could fall foul of their fiduciary duty if allocated to benefit one pool of investors over another,” Henry Kahn, US head of investment management at law firm Hogan Lovells tells pfm.

Lesson 2: Ensure transaction fees are well categorized

In June 2016, the SEC brought action against Blackstreet Capital Management. It alleged the firm received transaction-based compensation for the provision of brokerage services in connection with the buying and selling of portfolio companies while not being registered as a broker-dealer.

The SEC said the firm and one of its principals did these activities itself, “rather than employing investment banks or broker-dealers,” that it collected fees for doing so, and without registering as a broker-dealer. The agency’s report does not state whether the private equity firm offset the fees it received from portfolio companies for the claimed broker-dealer services against the advisory fees to be received from its funds, in whole or in part.

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“It’s common for PE firms to charge transaction fees,” says Kahn. “There’s a school of thought that says if there’s a full offset against a management fee, that cures the issue. But it is not clear whether the SEC would view a partial offset as problematic.”
SEC staff has informally suggested that a full management fee offset resolves the issue, but the position has never been formally confirmed.

Lesson 3: Include monitoring fee arrangements in LPAs

Apollo Asset Management was alleged to have misled investors over fees and a loan agreement, and failing to supervise a senior partner who charged personal expenses to the funds. The SEC investigation, concluded in August 2016, found advisors failed to adequately disclose the benefits they received and accelerated the payment of future monitoring fees owed by the fund’s portfolio companies upon their sale or IPO.

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Firms can include a clause in their LPAs allowing such payments on a one-time basis, but the key to avoiding being caught by this issue is full and proper disclosure.
“Firms should either disclose the monitoring fee arrangement in the fund offering document, or obtain an approval from the Limited Partner Advisory Committee. It’s really important that firms make detailed disclosure of all arrangements that in hindsight could be viewed as benefiting the manager at the expense of the clients/investors,” says Kahn.

Lesson 4: Cover all bases with procedural disclosure

Action was taken against WL Ross & Co in August 2016 for failing to disclose that it interpreted management fee offset provisions in LPAs to exclude transaction fees received by co-investors. The SEC said while individual fund LPAs included these details, the documentation was “ambiguous” over how transaction fees would be allocated in the case multiple WLR funds and other co-investors invested in the same portfolio company, as had occurred here.

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“As registrants, [private equity firms are fiduciaries and] have a higher standard of care. Once you’re a fiduciary, conflicts of interest are a larger concern. General disclosure isn’t sufficient in covering such issues,” says Todd Cipperman, managing principal, Cipperman Compliance Services.

Lesson 5: Be explicit about conflicts of interest

The SEC took action against First Reserve Management over a number of issues. Firstly, it alleged the firm caused certain funds to wrongly pay insurance premiums. Governing documents said the funds would pay insurance expenses relating to affairs of the funds, but in the event the funds were charged for a policy covering the firm, even though some of the premium didn’t arise from the firm’s management of the funds.
The agency also alleged the firm failed to obtain consent from the funds before accepting a discount for legal services – based on the increased amount of work the law firm did for the advisor – that served only to benefit the firm itself. The SEC said this constituted a failure to adequately disclose a conflict of interest, and to receive adequate consent regarding the allocation of fees and certain expenses. 

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Where service provider discounts are not comparable to the discount the funds received, private equity firms should not accept discounts from service providers. The case also highlights the importance of having written compliance policies and procedures in place, and to adequately disclose surrounding conflicts of interest, law firm Dechert says in a client note.

Lessons learned

All of these cases highlight the problem that the industry has had with becoming Dodd-Frank compliant, says Cipperman.
“Often, they don’t fully accept [the need to be compliant] until they are examined on it, or a big institutional LP demands certain information and terms in LPAs. The most common call I receive is for a compliance review following institutional interest in a fund,” he adds.

The SEC has sought to clarify its expectations via actions resulting from its examinations, putting out some markers on what is permitted and what is not, without going through the formality of a rulemaking process. It has also made it clear what constitutes a red flag during an examination.

“SEC inspectors are typically very focused on incentives and compensation arrangements. They’re always attempting to ‘follow the money’ so to speak,” says Luke Wilson, private equity practice leader at ACA Compliance, an investment technology firm. “And from there, anything else that creates a potential conflict of interest i.e., co-investment opportunities, or creates an appearance of a conflict, will catch their attention.”
The agency is also looking for arrangements which, in hindsight, are perceived to benefit the GP. It’s unclear whether the new SEC chairman will change the priorities, but managers are advised to continue conforming to the rules to avoid the risk of being the next firm under the agency’s spotlight. ?