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.

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.

Settlement with Large Firm Audit Partner Reaffirms SEC’s Emphasis on Related Party Disclosures

The SEC’s Division of Enforcement has made a concerted effort in recent months to warn auditors and other corporate “gatekeepers” that it intends to scrutinize the adequacy of related party disclosures in financial filings. This emerging trend continued on April 29, 2015, when the SEC announced the settlement of an enforcement proceeding against McGladrey LLP partner Simon Lesser. See Exchange Act Rel. 74827 (Apr. 29, 2015). Lesser, who served as lead engagement partner during McGladrey’s financial statement audits of investment advisory firm Alpha Titans LLC and several related private funds over a four-year fiscal span, settled claims that he engaged in improper professional conduct within the meaning of Section 4C of the Securities Exchange Act of 1934 and Rule 102(e)(1)(iv)(B)(2) of the SEC’s Rules of Practice. The SEC also alleged that Lesser willfully aided and abetted and caused his audit client to violate Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-2 thereunder.

Lesser’s settlement derived from assertions that Alpha Titans failed to adequately disclose related party relationships and material related party transactions in accordance with generally accepted accounting principles (GAAP). Specifically, Alpha Titans’s chief executive officer and general counsel were alleged to have transferred more than $3.4 million in client assets among the various funds to pay for adviser-related operating expenses during fiscal years 2009 through 2012. These payments purportedly were not agreed to by fund clients or authorized under the various operating documents. As asserted, Lesser knew about these related party relationships and the underlying transactions, which should have been disclosed under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 850, but, nonetheless, “gave his final approval for McGladrey to issue audit reports containing unqualified opinions.”

The SEC also claimed in the settlement that Lesser failed to ensure that McGladrey’s audits for each fiscal year were conducted in conformity with generally accepted auditing standards (GAAS). Lesser allegedly did not exhibit the requisite level of due professional care in that he “should have … place[d] greater emphasis on the related party relationships and transactions, and the adequacy of the related party disclosures.” The SEC further contended that Lesser did not obtain sufficient audit evidence or prepare audit documentation explaining adequately why he considered the financial statements GAAP compliant absent such related party disclosures. Without admitting or denying the SEC’s findings, Lesser agreed to a $75,000 civil penalty and a minimum three-year suspension from appearing or practicing before the SEC as an accountant.

Although the circumstances surrounding this particular proceeding were announced only last week, high-ranking SEC representatives began eluding to the likelihood of related party-based enforcement actions earlier this year. In late February, Julie M. Riewe, Co-Chief of the Division of Enforcement’s Asset Management Unit (AMU)—the same unit that conducted the investigation against Lesser—provided a revealing glimpse into AMU’s 2015 priorities during her presentation at the IA Watch 17th Annual IA Compliance Conference. Ms. Riewe cautioned:

For private funds—meaning hedge funds and private equity funds—the AMU’s 2015 priorities include conflicts of interest, valuation, and compliance and controls. On the horizon, on the hedge fund side, we anticipate cases involving undisclosed fees; all types of undisclosed conflicts, including related-party transactions; and valuation issues, including use of friendly broker marks.

(Emphasis added.)

Stephanie Avakian, Deputy Director of the Division Enforcement, provided parallel commentary in the context of auditors and other corporate “gatekeepers” during SEC Speaks 2015 in February. Ms. Avakian emphasized that accounting and financial reporting violations are considered an ongoing enforcement priority with particularized attention to related party disclosures.

Indeed, another recent enforcement proceeding further underscores that last week’s settlement with Lesser should not be construed as an isolated occurrence. The SEC announced a similar settlement with a Hong-Kong based auditing firm and two of its auditors in December 2014, involving an alleged “fail[ure] to uphold U.S. auditing standards and exercise appropriate professional care and skepticism with regard to numerous related-party transactions” not adequately disclosed by a Chinese-based oil company. See Press Rel. 2014-284, SEC Imposes Sanctions Against Hong Kong-Based Firm and Two Accountants for Audit Failures. The firm in that instance agreed to pay a $75,000 civil penalty with the two professionals agreeing to pay penalties of $20,000 and $10,000, respectively, and to accept three-year minimum suspensions. Accordingly, the enforcement action against Lesser is not the first recent settlement involving related party disclosures and, given the SEC’s pointed remarks earlier this year, it almost certainly will not be the last.

SEC Establishes Dedicated Group to Focus on Private Funds

Since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, private funds have become the subject of heightened scrutiny by both the SEC’s Division of Enforcement and the Office of Compliance Inspections and Examinations (“OCIE”). Based on recent announcements, this trend is likely to continue.

In 2012, OCIE announced an initiative to conduct “Presence Exams” or focused, risk-based examinations of investment advisers to private funds who recently registered with the SEC. See the OCIE’s National Exam Program letter. More recently in the SEC’s 2014 CCO Outreach Program, the SEC announced that it had conducted 250 Presence Exams. The SEC added that many of the exams revealed “significant findings,” but did not disclose whether those findings led to enforcement referrals or were resolved in the deficiency letter process. The SEC reiterated that focus areas of the Presence Exams included: (1) investment conflicts of interest including personal and affiliates’ transactions and fees paid to advisers and expenses charged to funds; (2) marketing, including the use of placement agents and using past performance; (3) valuation; and (4) custody.

Recently, the SEC formed a new “group” within OCIE to focus on the approximately 1,500 newly registered advisers to private equity and hedge funds. The new group is being led by two “industry experts” hired by the SEC in the last few years and will include staff from four regional offices across the country. If the group is successful, the SEC intends to expand the unit to additional regional offices.

Traditionally, the SEC has created working groups or specialized units in the Division of Enforcement to focus on what it perceives to be high-risk areas, i.e., where investor funds are most at risk. The Division of Enforcement currently has five specialized units: (1) Market Abuse, (2) Asset Management, (3) Municipal Securities and Public Pensions, (4) Foreign Corrupt Practices Act, and (5) Complex Financial Instruments. These units were formed in significant part due to the criticism of the agency for failing to detect Bernie Madoff’s massive Ponzi scheme. Each of these units is led by a senior officer who reports to the Director of the Division of Enforcement and is staffed by members of regional offices across the country.

It is very likely that the new private equity group will coordinate closely with the Asset Management Unit as that unit has developed significant expertise with respect to hedge funds, investment advisers and private equity funds. One of the group’s leaders, Igor Rozenblit, was with the Asset Management Unit since 2010. Moreover, the Asset Management Unit has been very active in bringing “message” cases against the very funds that the new group is charged with policing.

In addition to forming the new group, the SEC has also asked Congress for additional funds to support its examination program. The SEC seeks to add 316 staff to its examination program. Currently, there are approximately 450 examiners, accountants and lawyers in 12 regional offices. If the SEC receives the additional funds, it could almost double the size of its examination staff allowing it to conduct significantly more exams and assist with more enforcement investigations.

In the last few months, the Division of Enforcement formed three other new “groups” to focus on different areas. Last summer, the SEC announced the creation of: (1) the Financial Reporting and Audit Task Force, (2) the Microcap Fraud Task Force, and (3) the Center for Risk and Quantitative Analytics. These groups, unlike the formal units, will not conduct investigation. They are intended to identify potential violations and make referrals to the investigative staff.