Private Equity Fund Advisers Agree to Settle Charges of Improperly Disclosing Acceleration of Monitoring Fees and Improperly Supervising Expense Reimbursement Practices

In a recent action, the SEC demonstrated its continuing focus on private equity fund advisers’ fees. On August 23, 2016, Apollo Management V, LP, Apollo Management VI, LP, Apollo Management VII, LP, and Apollo Commodities Management, LP (collectively, “Apollo”), agreed to settle charges brought by the SEC for “misleading fund investors about fees and a loan agreement and failing to supervise a senior partner who charged personal expenses to the funds” in violation of Sections 206 and 203 of the Advisers Act. Press Release No. 2016-165.

According to the SEC Order, Apollo advises a number of private equity funds that own multiple portfolio companies. Like most private equity fund advisers, Apollo charges annual management fees and certain other fees to the limited partners in its private equity funds and charges monitoring fees to certain portfolio companies under separate monitoring agreements. Release No. 4493. Investors benefit from the monitoring fees in that a certain percentage of the monitoring fees are used to offset a portion of the annual management fees. The SEC found that the monitoring agreements allowed Apollo, upon the triggering of certain events, to terminate the agreement and accelerate the remaining years of the monitoring fees to be collected in a present value lump sum termination payment. Triggering events included the private sale or IPO of a portfolio company. The SEC found that the accelerated fees created a conflict of interest for the adviser and noted that while the accelerated monitoring fees reduced annual management fees paid by the funds, the accelerated payments reduced the portfolio companies’ value prior to their sale or IPO, thereby “reducing the amounts available for distribution to the” the funds’ investors. The SEC found that Apollo did not disclose to the limited partners “its practice of accelerating monitoring fees until after Apollo had taken accelerated fees.” Id.

In addition, the SEC found that in June 2008, the general partner of one of Apollo’s funds entered into a loan agreement between the fund and four parallel funds in which the parallel funds loaned an amount to fund equaling the carried interest due to the fund from the recapitalization of two portfolio companies owned by the parallel funds. Until the loan was extinguished, taxes owed by the general partner on the carried interest were deferred and the general partner was required to pay accrued interest to the parallel funds. While the parallel funds’ financial statements disclosed the interest, Apollo’s failure to disclose that the accrued interest would be allocated solely to the account of the general partner was determined to be materially misleading.

The SEC further found that a former Apollo senior partner, on two occasions, improperly charged personal expenses to Apollo-advised funds and the funds’ portfolio companies, and in some instances, fabricated information to conceal his conduct. Upon discovery of the partner’s conduct, Apollo orally reprimanded the partner but did not take any other remedial or disciplinary steps.

Finally, according to the SEC, Apollo also failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the undisclosed receipt of accelerated monitoring fees and failed to implement its policies and procedure concerning employees’ reimbursement of expenses.

Without admitting or denying the SEC’s findings, Apollo agreed to pay $40,254,552, consisting of a disgorgement of $37,527,000 and prejudgment interest of $2,727,552. In addition, the SEC assessed a $12.5 million civil penalty,  stating that the penalty is not higher due to Apollo’s cooperation during the investigation and related enforcement action. The SEC reserved the right to increase the penalty should it be discovered that Apollo knowingly provided false or misleading information or materials to the staff during the course of its investigation.

Third Circuit Defined “Investment Adviser” In Sentencing Appeal

Everett C. Miller pleaded guilty to securities fraud after he sold more than $41 million in phony, unregistered promissory notes in his firm, Carr Miller Capital, LLC, that falsely promised high returns with no risk. As part of his plea, Miller and the government stipulated to what they considered to be an appropriate offense level under the United States Sentencing Guidelines (the “Guidelines”). At sentencing, however, the district court applied the four-level investment adviser enhancement provided for by the Guidelines for securities laws violations perpetrated by “investment advisers,” as that term is defined by the Investment Advisers Act of 1940, 15 U.S.C. § 80b-2(a)(11). See U.S.S.G. § 2B1.1(b)(19)(A)(iii). Due to the enhancement, Miller received a 120-month sentence.

On appeal, Miller challenged, among other things, the application of the investment adviser enhancement, arguing that he was not an “investment adviser” under the Investment Advisers Act. The Investment Adviser Act defines “investment adviser,” in part, as a person who “for compensation engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.” 15 U.S.C. § 80b-2(a)(11). Miller argued that he was not “in the business” of providing securities advice; he did not provide advice “for compensation”; and he was not a registered investment adviser.

The Third Circuit first ruled that Miller was in the business of providing securities advice. In so concluding, the Third Circuit looked to a 1987 SEC interpretive release (the “SEC Release”) that stated the SEC considers a person who “holds himself out as an investment adviser or as one who provides investment advice” to be in “in the business.” Applying that guidance, the Third Circuit found that Miller was in the business of providing securities advice because he held himself out as an investment adviser in personal meetings with investors and because he was associated with a registered investment adviser.

The Third Circuit also relied on the SEC Release to conclude that Miller provided the advice “for compensation.” The SEC Release defines compensation as “any economic benefit, whether in the form of an advisory fee or some other fee relating to the total services rendered, commissions or some combination of the foregoing.” The Third Circuit found that the investors’ principal on the promissory notes “became Miller’s compensation—his ‘economic benefit’—when he comingled investors’ accounts and spent the money for his own purposes.”

Finally, the Third Circuit rejected Miller’s argument that he could not be considered an “investment adviser”  solely based upon his association with an investment adviser. The Third Circuit ruled that “[r]egistration is not necessary to be an ‘investment adviser’ under the Act” and thus “Miller was an ‘investment adviser’ under the Act, despite his failure to register as such.”

Given the facts of this case, and the interpretative guidance on which the Court relied, the decision does not come as a surprise.

Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors

On July 14, 2016, RiverFront Investment Group, LLC (“RiverFront”) agreed to settle charges brought by the SEC for failing to “properly prepare clients for additional transaction costs beyond the ‘wrap fees’ they pay to cover the cost of several services bundles together.” Press Release No. 2016-143. According to the SEC, participants in wrap fee programs usually pay an annual fee “which is intended to cover the cost of several services ‘wrapped’ together, such as custody, trade execution, portfolio management, and back office services.” Release No. 4453. The SEC found that under these wrap programs, a sponsoring firm will offer clients a selection of third-party managers, referred to as subadvisors, to have discretion over the clients’ investment decisions. When subadvisors execute trades on behalf of clients through a sponsor-designated broker-dealer, the transaction costs associated with the trades are included in the wrap fee. On the other hand, if a subadvisor sends a trade to a non-designated broker-dealer, a practice known as “trading away,” clients incur additional transaction costs beyond the wrap fee. Continue reading “Registered Investment Advisor Agrees to Settle Charges of Failing to Clearly Disclose Transaction Costs Beyond “Wrap Fees” to Investors”

SEC Strikes a Harsh Tone on Receipt of Transaction-based Compensation by Private Equity Fund Managers

On June 1, 2016, the Securities and Exchange Commission (SEC) sent a warning to private equity fund managers who receive transaction-based fees in connection with the purchase and sale of portfolio companies by charging Blackstreet Capital Management (Blackstreet), a private equity fund advisory firm, and its principal, Murry Gunty with, among other things, acting as an unregistered broker-dealer. According to the SEC, Blackstreet received fees, separate and apart from its management fees, for performing “in-house brokerage services” in connection with the acquisition and disposition of portfolio companies for two private equity funds. The fact that Blackstreet Capital fully disclosed the fees did not affect the SEC’s conclusion that Blackstreet acted as an unregistered broker-dealer.

Blackstreet and Gunty settled, on a neither-admit-nor-deny basis, with the SEC and agreed to pay more than $3.1 million in disgorgement and civil penalties. Importantly, the $3.1 million settlement also reflects other charges such as failing to disclose other fees and failing to implement reasonably designed compliance policies and procedures to prevent violations of the Investment Advisers Act of 1940 and rules thereunder.

Section 15(a)(1) of the Securities Exchange Act of 1934, as amended (Exchange Act) makes it unlawful for any broker or dealer to use the mails or any other means of interstate commerce to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker or dealer is registered with the SEC in accordance with Section 15(b) of the Exchange Act. “Broker” is defined in Section 3(a)(4) of the Exchange Act as “any person engaged in the business of effecting transactions in securities for the account of others.” Over the last several years, the SEC has included violations of 15(a) in numerous enforcement actions involving offering frauds and other situations involving the offer and sale of securities to retail investors.

In its Order against Blackstreet and Gunty, the SEC concluded that by being involved in the purchase or sale of securities, including soliciting deals, identifying buyers or sellers, negotiating and structuring transactions, arranging financing, executing the transactions and receiving transaction-based compensation, Blackstreet was performing brokerage services without having registered as a broker-dealer and, therefore, willfully violated Section 15(a) of the Exchange Act.

Private equity fund managers have recognized the potential that the SEC would take the position that they are acting as broker-dealers. In 2014, the SEC issued a no-action letter that relieved firms from the requirement to register as a broker-dealer in connection with facilitating a sale of a private company as long as they complied with a number of detailed conditions. The conditions included requirements that the manager must never have possession of customer funds or securities; that upon completion of the M&A transaction, the buyer must have control of the target; and that the manager should not provide financing for the transaction.

The SEC’s most recent action in the private equity space emphasizes the SEC’s renewed resolve to more strictly enforce non-fraud based violations and to bring Section 15(a) charges in situations beyond traditional transactions with retail investors. In fact, following the settlement, Mr. Robert B. Baker, Assistant Regional Director in the SEC’s Enforcement Division’s Asset Management Unit, stated “That’s the first case of a private-equity adviser violating section 15(a) of the [Exchange Act] for acting as a broker and failing to register as a broker.” However, even if Blackstreet had contemplated reliance on the no-action positon cited above and such position was available, it did not comply with at least one of the conditions of the no-action letter because, according to the Order, Blackstreet appears to have been involved in arranging the financing for the transactions. Moreover, while disclosure of the fees was important, the fact that they were disclosed had no significance to the SEC’s analysis of whether Blackstreet acted as an unregistered broker-dealer.

Fees related to the acquisition and disposition of portfolio companies are not uncommon in the private equity fund context. In light of the SEC’s action, private equity fund managers should reconsider whether they need to register as broker dealers, take care to comply with all of the provisions of existing no-action letters, seek no-action relief of their own or take other appropriate steps.