The US Securities and Exchange Commission and members of the private equity industry may be headed for drawn-out and costly court battles over improper fees charged to investors, according to multiple fund lawyers reacting to news that the commission seems ready to launch more enforcement cases on the matter.
More than half of about 400 private equity firms examined by SEC staff have “charged unjustified fees and expenses without notifying investors,” according to a recent Bloomberg report citing an anonymous person with knowledge of the findings.
“My guess is that a fair number of these situations may relate to situations where the SEC staff disagrees with a good faith judgment call made by the manager about the appropriate allocation of an expense,” said Debevoise & Plimpton funds partner Ken Berman.
Accordingly, some fund advisors facing major enforcement action may contest rather than settling the matter, predict multiple industry legal experts. Following enforcement action, fund advisors can bring an administrative action before an in-house SEC judge, whose ruling can be appealed to the SEC’s five commissioners.
Already, the SEC is in the middle of an administrative proceeding with Clean Energy Capital, thought to be the first private equity firm to face charges over a misallocation of fund expenses since the commission launched a two-year sweep into newly-registered private equity firms in 2012.
It is understood the agency is in the final stages of that investigation, which will culminate in one or more risk alerts, or other after-action reports, detailing the commission’s findings. Some believe the Bloomberg news is a precursor to that report’s release. The SEC declined to comment.
“It wouldn’t shock me if some enforcement cases involving fee allocation issues are already in the SEC’s pipeline,” said one US-based funds lawyer speaking on the condition of anonymity.
The SEC’s findings on fees likely covers a wide range of fund expenses that can be “anything from $500 plane tickets that shouldn’t have been charged to the fund, to potentially millions of dollars,” said a second anonymous private equity lawyer. “When the SEC says that half the industry is doing something wrong on fees, that probably means they’re looking at a whole range of issues.”
Despite the potential for court proceedings, sources expect private equity firms charged with misallocating fund fees in the tens of thousands of dollars or less to settle any charges. A more common scenario is likely a GP reimbursing the fund for any disputed fees before enforcement charges are brought.
“When you’re talking about a multibillion dollar firm, these are small time expenses the advisor would rather concede then seem uncooperative with the SEC,” the second lawyer said.
The SEC determines if an expense is split fairly between investors and fund advisor by examining the limited partnership agreement (LPA), said Igor Rozenblit at a national compliance outreach seminar held earlier this year at the commission’s headquarters.
Rozenblit is a private equity specialist in the SEC’s division of enforcement who will reportedly co-head an inspections team dedicated to private equity and hedge funds alongside Marc Wyatt, who is considered one of the SEC’s in-house hedge fund experts. It is unclear if the new unit has any connection to the findings on fees.
“When you get into esoteric expenses like bringing portfolio company executives to play golf in Scotland, [the] first thing we do is go to the LPA and see if there’s a carve out for this type of expense,” Rozenblit said at the seminar.
However, sufficient disclosure is not always enough to justify a fee expense, warn legal experts.
“There could be a situation where, for example, a GP visits a company in Orlando, Florida to kick the tires on a potential portfolio company, but brings his or her family and charges the fund four tickets and an extended hotel stay,” said Scott Gluck of law firm Venable.
During the seminar, Rozenblit also highlighted fees charged to portfolio companies as an area of concern. One key issue is that under some long-term monitoring fee contracts, GPs can terminate these agreements while still receiving all future fees.
“When I first got to the SEC, I was surprised by the number of firms engaged in this type of conduct,” said Rozenblit. “It’s concerning because a large amount of LPs don’t really know it’s happening…and it’s reasonable to assume some type of breakdown in disclosure here.”
Rozenblit also said inspectors will look for disclosures around operating partners or senior advisors that appear to be part of the management firm, but actually receive compensation that is separate from the management fee; as well as GPs that charge investors for traditional back office functions like accounting and legal.