The SEC’s focus on fund managers’ conflicts of interest is not new. The first wave of enforcement cases focused almost exclusively on private equity. While the interest in private equity continues, recent cases have involved advisers to retail clients and other types of private funds. These recent cases are summarized below.

Importantly, conflicts (including the subsets of those relating to valuations and fees and expenses) remain on OCIE’s list of examination priorities. The most recent case illustrates how three of the priorities dovetail: conflicts of interest, retail investors/those saving for retirement, and fees and expenses.

Retail Clients, Fees and Expenses, September 27, 2019:

• Two affiliated advisers were charged with failing to disclose certain information about how it selects investments for its Managed Asset Allocation Program (MAAP). MAAP is the firm’s retail investment advisory program.
• When selecting investments for MAAP clients, the Advisers favored mutual funds that were managed by Adviser 1. Fifty percent of MAAP client assets were invested in these proprietary funds, resulting in additional management fees to Adviser 1.
• The SEC found that the advisers “always” selected higher cost, non-institutional share classes for MAAP investments. Advisers received revenue sharing payments and avoided paying certain transaction costs, but the investors received lower returns on these investments.
• The Advisers did not disclose these facts to MAAP clients.
• Advisers agreed to pay more than $37 million to settle the charges.

Private Equity Fund, Valuation, September 7, 2018:

• Adviser managed private equity funds, one of which was in its 17th year of operations and had two remaining Portfolio Companies (the Fund).
• Adviser’s Investment Committee directed activities of the funds.
• In late April 2015:
  • Several LPs expressed a desire for a liquidity option that would allow them to exit the Fund.
  • In accordance with the Fund’s LPA, the Adviser’s investment committee decided to dissolve the Fund through a distribution in-kind.
  • Adviser simultaneously presented the LPs with an option to sell their interests to the Adviser’s principal owner (Owner) for cash at a price based on 100% of the Fund’s December 2014 audited NAV.
• On May 1, 2015, Adviser and the Owner received preliminary information indicating that the Fund’s NAV had potentially increased significantly during the first quarter of 2015, which Adviser and Owner did not disclose to the LPs.
• In mid-May 2015:
  • Adviser, acting partly in response to questions from some LPs, decided not to close the Fund to give LPs that wanted to remain the option to do so.
  • At the same time, Adviser revised the offer presented to the LPs to provide that Adviser’s Owner would purchase their limited partnership interests, rather than their in-kind interests, at the same price offered in April.
• The SEC found that:
  • Omitting the information about the potential increase in the value of the Fund’s portfolio companies from its mid-May offer was misleading.
  • In addition, Adviser did not provide the remaining LPs with the first quarter 2015 financial information. According to the Adviser’s calculations, this information still showed an increase in the Fund’s NAV.
• The SEC imposed Adviser and Owner, jointly and severally, a civil penalty of $200,000.

Hedge Fund, Valuation of Swaps and Options, July 18, 2019:

• This case was against an individual Portfolio Manager of a private fund.
• The SEC charged him for mispricing investments, resulting in:
  • Artificially inflated profits.
  • An overstatement of monthly NAV in investor statements.
  • Charging excessive management fees to investors, totaling $577,000.
  • Portfolio Manager also received a $600,000 bonus based on the performance of the fund.
• In addition to the valuation issues, the SEC found that Portfolio Manager used deceptive practices to conceal the mispricing.
• The mispricing occurred because Portfolio Manager used different discount curves for the investments that had similar characteristics and thus should have had offsetting values. He did not have authorization to use different curves.
• The SEC imposed disgorgement of $600,000 (Portfolio Manager’s bonus) and a civil penalty of $100,000.

Fund Manager, Valuations and Policy Failures, June 4, 2019:

• Adviser manages private funds that invest in mortgage-backed securities.
• Adviser’s CIO is responsible for approving valuations.
• The SEC found weaknesses in Adviser’s valuation policies and procedures:
  • The policy failed to articulate how the assets would be valued in accordance with GAAP and the techniques that would be used in valuing the funds’ assets.
  • The policy lacked guidance on the Adviser’s valuation process.
  • The valuation committee had no experience in bond valuation.
  • Adviser failed to implement policies to adequately run their valuations. In particular, the valuations did not maximize observable inputs.
• Because of these weaknesses, Adviser undervalued certain of the funds’ assets.
• Nevertheless, CIO continuously approved valuations submitted to him by Adviser’s traders.
• The SEC imposed civil Penalties of $5,000,000 to the Adviser and $250,000 to the CIO.

Private Equity Fund, Fees and Expenses, May 6, 2019:

• Adviser managed a private equity fund.
• Adviser used fund assets to pay down the Adviser’s line of credit. There were no provisions in the fund’s the LPA that permitted loans to the Adviser.
• Nevertheless, the Adviser transferred $1 million from the fund’s bank account to its own to cover a loan balance that had come due.
• The SEC found that Adviser:
  • Improperly used fund assets to pay for its own expenses.
  • Charged excessive organizational expenses to the fund.
  • Failed to apply a $1.2 million fee offset due to the fund.
  • Failed to issue timely financial statements to fund investors.
  • Failed to adopt and implement policies and procedures.
• The SEC imposed a civil penalty of $100,000.

Private Equity Fund, Fees and Expenses, December 26, 2018:

• Adviser managed private equity funds (Flagship Funds), a separate vehicle for its employees to invest in (Employee Funds), as well as co-investment opportunities.
• The SEC issue with Adviser’s allocation of expenses among the Flagship Funds, Employee Funds and co-investors, and its failure to offset management fees in connection with undisclosed fee-sharing agreements.
• Allocation of Expenses to Flagship Fund:
  • From 2000 to 2016, LPs in the Flagship Funds paid more than their fair share of broken deal expenses, legal fees and consulting fees, when the burden should have been shared by the Employee Funds and co-investors. Although Adviser disclosed that the Flagship Funds would pay such expenses, it did not disclose that the expenses would not be allocated proportionally among all beneficiaries (i.e. the Employee Funds and co-investors).
• Fee Sharing Arrangements:
  • From 2010 to 2015, Adviser entered into agreements with portfolio companies to provide certain advisory services.
  • The fees were supposed to offset the management fees paid by the Flagship Funds, but from 2010 to 2012, Adviser entered into fee-sharing agreements with certain co-investors regarding three of the flagship funds’ portfolio companies.
  • Adviser did not disclose the fee-sharing agreements, which benefited the co-investors at the expense of the Flagship Funds. As a result, the Flagship Funds did not receive about $1 million in management fee offsets.
• The SEC imposed a civil penalty of $400,000.

Private Equity Fund, Fees and Expenses, December 17, 2018:

• Adviser and affiliates (Adviser) managed three private equity funds (Funds).
• The Funds acquired minority stakes in alternative management companies, such as hedge and private equity fund managers (Partner Managers) for management fees and incentive compensation.
• The LPAs for Fund stated that Adviser and the Funds’ GPs will pay their own expenses. Similarly, the Funds’ IMAs stated that the Adviser will pay costs and expenses “associated with the performance of its services hereunder except expenses of” the Funds.
• Adviser established an unincorporated business unit to which day-to-day management of the Funds was delegated.
  • Investment activities were managed by the unit’s Investment Team. Adviser was responsible for “all compensation costs” of investment professionals besides those related to the BSP.
  • A separate Business Services Platform (BSP) provided certain support services and advice to the Partner Managers.
    • In accordance with their organizational documents, the Funds paid the expenses relating to the utilization of BSP up to 50 basis points of committed capital.
    • BSP employees spent some of their time on tasks outside of the scope of BSP.
    • Adviser charged the fund for both BSP-related tasks, as well as other tasks performed by BSP employees. Between 2012 and 2016 about $2 million was paid for tasks not related to BSP.
  • Additionally, the SEC found that Adviser failed to adopt and implement policies and procedures reasonably designed to prevent misallocation of expenses.
  • The SEC imposed: (1) disgorgement of $2,073,988, (2) prejudgment interest of $284,620, and (3) civil penalty of $375,000.

Private Equity Fund, Fees and Expenses, December 13, 2018:

• Adviser managed both PE funds and the personal investments of its principal (Principal).
• Each Fund’s LPA set forth the fees and expenses to be charged by Adviser and created a Limited Partnership Advisory Board to, among other things, review and approve any material conflicts of interest.
• Adviser had the following arrangements with two consulting firms that involved undisclosed conflicts and misallocation of fees and expenses.
  • Consulting Firm A:
    • Provided services to two of the Funds and general deal sourcing services to Adviser.
    • Principal also made a personal loan to Consulting Firm A’s principal that was secured by money owed by Adviser or its affiliates, including the Funds. The loan was repaid through consulting fees paid by one of the Funds to Consulting Firm A.
    • These undisclosed conflicted arrangements resulted in the misallocation of a portion of Consulting Firm A’s fees.
  • Consulting Firm B:
    • Provided services to one of the Funds, a portfolio company of the Fund, and two of the Principal’s personal investments.
    • The Principal also made a personal investment in Consulting Firm B while it was providing services to the portfolio company.
    • These undisclosed conflicted arrangements resulted in:
      • Misallocation of Consulting Firm B’s fees.’
      • Failure to credit funds received by the Principal from Consulting Firm B to the Fund.
      • Failure to offset fees received by Consulting Firm B against Adviser’s management fee after the Principal made a minority investment in Consulting Firm B.
    • In addition, Adviser did not disclose that it charged the Funds for the cost of some in-house employees who assisted in preparing their tax returns, or how it allocated these costs among the Adviser, its affiliates and the Funds.
    • The SEC imposed disgorgement of $1,934,312 and a civil penalty of $1,000,000.

Debt Fund, Investment Selection and Valuation, September 28, 2018:

• Corporation is in the business of facilitating consumer loans via an online platform (Platform). It is the parent company of Adviser.
• Adviser manages several private funds, which purchased interest in loans originated by Corporation.
  • Adviser disclosed that Corporation personnel would manage its investment policy committee, and that Adviser might face conflicts when selecting loans.
  • In addition, the funds would compete with others for investment opportunities on the Platform.
  • Adviser’s disclosure included a statement to the effect that it had policies in place to address these conflicts.
• Adviser caused one of the funds (Fund) to purchase interests in loans at risk of expiring unfunded on the Platform:
  • Those expiring unfunded loans would have lost revenue for the Corporation.
  • Adviser improperly adjusted their valuation model to mislead the Fund.
  • The SEC determined that the Adviser made these decisions for the benefit of Corporation and not the Fund, thus breaching its fiduciary duty.
  • The purchases were also inconsistent with the Fund’s PPM and the Adviser’s disclosures in Form ADV.
• Adviser then improperly stated the returns in reports to the Fund’s investors.
• The SEC imposed civil penalties totaling $4,265,000.