The Federal Bureau of Investigation needs your help.

Sure, to the insider, the private equity world is a straight game. But to the outsider, it’s got more turns than a four-leaf clover and enough blind spots to make a Ford F-250 look like a bottle of moonshine.

In seriousness, all film-noir lingo aside, the agency, facing an ever-changing industry with a consistent onrush of bad actors, is in great need of aid from private equity professionals to help it determine where the next crimes could occur in the sector and to better understand business practices and potential risks.

Paul Roberts, FBI assistant special agent in charge, tells Private Funds CFO that the bureau’s remit includes investigating misdeeds that have allegedly already taken place, punishing wrongdoers and gathering further intelligence.

 

 

 

 

 

 

 

“We want to know from the private equity world what it is we’re missing”

Paul Roberts
FBI

To better execute those tasks, Roberts says the FBI wants to build relationships with people in the industry to understand changing business practices that could lead to new attack surfaces and gaps in FBI ­knowledge, where crimes are likely to occur. It also wants to educate professionals so that they can understand where there are issues, potential red flags to look for and how to proceed should they suspect a crime has occurred.

“We would like to do more outreach to the PE world because there are a lot of areas for there to be concern,” Roberts says.

But the FBI also wants to hear directly from industry players what potential risks the bureau might be missing or what practices it may misconstrue as bad practices.

Through its outreach, Roberts says, the bureau hopes to build trust with the industry so that professionals feel comfortable contacting the agency when issues arise and are more willing to cooperate with agents if they are ever part of an investigation.

Roberts points to the Great Financial Crisis as an example of what he sees coming. Then, the bureau saw a significant uptick in mortgage fraud only as the credit crisis intensified and financial markets toppled.

Although there is often a lag in fraudulent activity as criminals figure out how to take advantage of the situation, Roberts says there will be new crimes to come up as companies come under the strain of higher interest rates, and thus debt costs.

“We’re going to start seeing where there was fraud in the lending business and where folks stepped into that mid-market level to take advantage of that,” Roberts predicts.

The FBI wants to get ahead of those crimes, this time. By understanding how the industry has evolved as the market moves and how different industries respond to market changes, the FBI can focus on actual risks and threats, rather than wasting time casting a too-wide net, scrutinizing legitimate business practices it doesn’t fully understand.

Roberts points to the fall of Silicon Valley Bank, Signature Bank and First Republic Bank earlier this year. The rescues of SVB and FRB, and collapse of Signature, threw the fund finance market into turmoil, and participants in the various sub-markets within fund finance are feeling different impacts. That’s where bad actors can step in to take advantage of PE funds and their investors.

Indeed, the FBI was behind the arrest, which later led to a fraud conviction, of Elliot Smerling, founder of JES Capital. In May 2022, Smerling was sentenced to 97 months behind bars after admitting to obtaining money for his private equity fund through false documents and assurances provided to lenders, allowing him to obtain about $133 million in subscription credit lines. SVB was the ultimate victim, writing off $70 million.

Getting cozy with the Fuzz

Identifying fraud before it results in significant damage, however, is the main goal.

But there is broad hesitation in the financial industry to get too cozy with the FBI or other regulators, since they are perceived to be undereducated in their markets; and having such a relationship could lead to bigger problems for their firms, as well as hamper their attractiveness as clients to other counterparties and service providers.

“People may hesitate to come to us when there’s a problem simply because they worry that we’re going to investigate or prosecute them no matter what, or that other people in the industry or service providers won’t want to work with them because they willingly come to us,” Roberts says.

It’s because of this that the FBI strives to maintain confidentiality with its industry partners.

“Whether they’re seeing illicit trading or investment fraud, the people in the private equity industry who speak with us are treated as confidential so they will continue to feel comfortable talking to us about what’s going on in the industry and at their own firms. We don’t want to jeopardize that,” he notes.

“People may hesitate to come to us when there’s a problem simply because they worry that we’re going to investigate or prosecute them no matter what”

Paul Roberts
FBI

The bureau is not just looking at the private equity industry for potential wrongdoing, but also as a source of information. And it wants to shed its reputation as wielding an iron fist. Agents want to be able to give feedback on market practices it sees as potentially problematic, Roberts says.

“We want to know from the private equity world what it is we’re missing and what we should be looking into. We want that two-way street to be there, and that’s part of the outreach we want to do,” he adds.

To figure out the areas it should be focusing on, the FBI also works closely with other regulators, including the SEC, FINRA and foreign regulators, to “get the whole picture,” Roberts says, helping it to focus its intelligence gathering and investigation efforts, and identify emerging threats.

Roberts adds that the FBI works particularly closely with the SEC, calling it a “logical partnership.” It works in parallel with the SEC in almost 95 percent of its securities fraud cases, according to the bureau.

97

Number of months behind bars that Elliot Smerling, founder of JES Capital, was sentenced to for fraudulently obtaining money for his fund

Like the SEC, investor protection is a top priority for the FBI. Regulators believe there is a lack of transparency in the private equity space, and the FBI thinks this opacity increases the risk that fund managers may misrepresent fund information. Roberts says the agency wants to see firms make full disclosures about all material details of the funds they manage.

“In the PE world, because there are less stringent disclosure requirements around certain things, there are a lot more areas for people to take advantage,” Roberts notes.

“Those gaps are where we’re looking to get into – where there is a lack of required disclosure so there is room for there to be misrepresentations or omissions of material facts.”

In a move that could make PE activity more transparent, the SEC voted 3-2 on August 23 to approve its Private Fund Advisor Rules, which generally focus on disclosure and reporting obligations, and impose restrictions and disclosure requirements on certain activities, such as charging or allocating certain fees and expenses.

The FBI supports the Private Funds Rules, saying they will assist in both protecting investors and aiding the bureau in its investigations.

Nonetheless, Roberts says, “in the private investment world, you don’t have the same disclosure requirements to the broader general public, so there are more opportunities to manipulate and misrepresent things.”

FBI focus areas

The FBI has identified a number of areas within the private equity market that it thinks are vulnerable to criminal misdeeds. Here are some of them, writes Jennifer Banzaca

SPACs

While the SEC’s Private Funds Rules help improve transparency for private equity funds, the rules don’t apply to SPACs – another investment vehicle the FBI believes lacks disclosure requirements and is at higher risk of fraud.

The FBI’s Paul Roberts explains that the agency is particularly concerned about potential insider trading in SPACs. The bureau is looking at disclosures that have been made to investors in SPACs for misleading and false statements, as well as what managers are telling investors before a SPAC merges with a target company.

“I think the biggest concern for us at the FBI is when managers can let it be known who the SPAC is merging with and any potential insider trading around that announcement. We want to know whether there are people who knew who the merger target was before it was announced and whether they traded on that information,” Roberts says.

The SEC is also concerned with inadequate SPAC disclosures. Last year, the regulator proposed rules requiring SPACs to disclose more details about their sponsors, their compensation, conflicts of interest and share dilution.

Money laundering

Roberts sees an opportunity for collaboration between the FBI and the private funds industry in defeating money laundering. With outreach, the FBI can help private equity firms understand its money laundering concerns, and help firms design robust AML programs that address weaknesses and potential risks.

The FBI, in a document leaked in 2020, gave examples of hedge funds and private equity firms used to launder illicit proceeds. It also stated that current anti-money laundering laws are ill-equipped to stop them.

“Hedge funds and private equity firms receive funds from entities registered in nations that maintain laws conducive to masking underlying beneficial owners, thereby making it harder for US financial institutions and regulators to determine the source of funding. Additionally, hedge funds and private equity firms have been used to facilitate transactions in support of fraud, transnational crime, and sanctions evasion,” the FBI report explains.

Although banks and most securities brokers are required by law to identify the true owners behind investments and report any red flags, private equity firms, venture capital funds and hedge funds are not.

Crypto

“The crypto environment is one of the big areas of focus we have within the financial crimes space right now,” Roberts says.

The FBI won’t provide statistics on cryptocurrency crimes in the private fund industry, including how many crimes the bureau has investigated in recent years and some of the most common issues being investigated, but it says the bureau is highly focused on crypto crimes. Once again, Roberts says it needs the industry’s help to better understand “the intersection of PE and the crypto world.”

“It’s no secret that we’ve been investigating some major players in the crypto space, like FTX, Terra and Mango. We know there are private equity investments in crypto firms. It could be that the PE firms are victims and were misled by some of the brokerages, but we want to know what they have seen from the crypto environment, as opposed to what we have seen and heard from our sources and methods,” he explains.

Senior accountant banned over SPAC

‘Quality controls and audit standards are necessary to maintaining this essential gatekeeping role,’ SEC says in fifth ‘gatekeeper’ case in two years, writes Bill Myers.

A veteran accountant has agreed to accept a three-year exile to help settle SEC accusations that he ignored increasingly dire warnings that his firm’s lucrative SPAC practice was overwhelming the company’s ability to perform even basic accounting practices.

Greg Giugliano had been Marcum’s national assurance services leader for more than 20 years, regulators say. He knew the firm already had basic quality assurance problems even before it began setting records with its SPAC business, according to the SEC. On Giugliano’s watch, the problems became so severe that they “permeated many stages of engagement work, such as client acceptance, engagement partner supervision and review, audit documentation, and technical consultation,” regulators claim in a 16-page settlement order.

Under the terms of the SEC settlement, Giugliano neither admits nor denies the SEC’s accusations. But he’s agreed that for at least the next three years, he’ll take “no leadership, management, oversight, or supervisory position at any registered public accounting firm” and he will have “no decision-making role in connection with (i) performing client acceptance or continuance functions for any engagement to perform attestation or assurance services for any entity that files financial statements with the Commission; or (ii) the quality control system at any registered public accounting firm.” He’s also agreed to accept censure and to pay $75,000 in fines.

‘The strain’

Neither Giugliano nor officials at Marcum responded to Private Funds CFO’s request for comment. In late June, Marcum officials agreed to pay $10 million to settle SEC accusations that the firm was so focused on getting SPAC business aboard – in 2020 and 2021, Marcum audited more than 400 of the 860 SPACs that went public – that it overloaded, and basically capsized, its already listing accounting practice.

“The strain of this exponential growth in Marcum’s public company practice exposed substantial, widespread, and pre-existing deficiencies in the firm’s underlying quality control policies, procedures, and monitoring that Giugliano oversaw,” regulators claim.

“Giugliano was aware that, in the period immediately preceding the SPAC market’s explosion, Marcum’s annual inspections by the [Public Company Accounting Oversight Board] had revealed an increasing number of deficiencies.

“Giugliano was also aware that Marcum was subject to consecutive PCAOB enforcement orders – in 2019 and 2020 – related to quality control failures concerning independence and client acceptance; the 2019 order also sanctioned Giugliano based on the PCAOB’s findings that Marcum violated independence standards.”

‘Gatekeeper’ enforcement

The Giugliano case is a fresh reminder that the SEC is serious about private funds enforcement, and especially about private fund “gatekeeper” enforcement. Between 2016 and 2021, regulators filed six cases against private funds’ outside auditors. Giugliano’s is at least the fifth case against a private fund auditor or audit partner since March 2022.

Say the regulators: “The quality control system that Giugliano oversaw failed, and as a result, over a multi-year period, certain Marcum audits were not conducted in compliance with audit standards.”