/>iOn January 10th 2025, the Securities and Exchange Commission (SEC) settled charges against two fund managers (collectively the “Fund Managers”)[1] and their sole owner, chief executive office, chief compliance office and founder (the “Founder”)[2].
The SEC alleged the Founder and the Fund Managers had breached their fiduciary duties owed to the private equity funds managed by the Fund Managers (the “Private Funds”) and related compliance program deficiencies. Specifically, the SEC asserted the Founder and the Fund Managers: (i) impermissibly charged certain expenses to the Private Funds from January 2019 through December 2023 instead of paying such expenses themselves and in so doing failed to disclose the resulting conflicts of interest and (ii) improperly submitted vague and unsubstantiated invoices to the Private Funds without taking reasonable steps to confirm the Private Funds were the proper payees.
Improper Expenses
The SEC raised three specific improper expenses that it viewed as Fund Manager costs that were improperly charged to the Private Funds.
Prior to January 2019, the Fund Managers employed and paid the salary of a full-time, in house chief financial officer (the “CFO”), who provided services to the Fund Managers and not to the Private Funds. When to the CFO left, the Fund Managers outsourced those financial services (totaling approximately US$1.3millon from January 2019 to December 2023) to third-party financial firms and charged those services to the Private Funds. Similarly, in May 2019, a public relations provider was paid by and worked for one of the Fund Managers providing strategic communications and public relations services. However, when re-engaged in 2022, that expense (totaling approximately US$214,000) was instead charged to the Private Funds. Lastly, a legal expense (approximately US$91,000) was charged to one of the Private Funds, but the SEC asserted that more than 70% of those expense were for services performed for the Fund Manager.
In each case, the SEC noted the expenses at issue were not listed or disclosed in the applicable Private Fund governing documents or private placement memorandum as permitted fund expenses, and that when the applicable Fund Manager changed its prior practices and instead held the applicable Private Fund responsible for such expenses, it failed to fully and fairly disclose the payment and the resulting conflict of interest to the investors of the corresponding Private Fund.
Unsupported and Unspecified Expenses
The SEC also took issue with the Fund Managers’ supporting documentation and approval processesfor the improper expenses allocated to the Private Funds, noting that vague and unsubstantiated invoices for amounts to be borne by the Private Funds included generic invoices that described the expenses as “various expenses”, “expense reimbursement”, “due to management Co.” and nothing more, and generic credit card reimbursements with insufficient or no back up or further description including for the Founder’s living and business expenses as well as credit cards held by his family members.
The Settlement between the parties censured the Fund Managers and the Founder for violating the anti-fraud provisions of Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rules 206(4)-7 and 206(4)-8(a)(2). Without admitting or denying the SEC’s findings, the Fund Managers, and the Founder consented to the entry of the order and agreed to pay a civil money penalty of US$250,000 in addition to disgorgement of over US$1.5 million, prejudgment interest of approximately US$272,000.
This order highlights the importance of:
- Clearly drafted private fund governing document provisions outlining, in detail, the expenses to be borne by the private fund and expenses to be borne by the manager and its affiliates.
- Policies and procedures that are reasonably designed to ensure that expenses are allocated in accordance with the applicable private fund governing documents and that require appropriate, clear and supporting records and documented approval processes.
- Established processes to timely review expense allocation practices and related recordkeeping, in particular, in cases of changes in a manager’s favor, such as allocating ongoing expenses previously paid by the manager to a fund and considering if such changes require disclosure to the investors of the impacted private fund.
It is notable here, that the issues for the Fund Managers appear to begin with the departure of the Fund Mangers’ CFO. Fund managers must ensure that they consistently have the appropriate internal staffing and third-party professional services firms’ support to appropriately operate their businesses in accordance with the governing documents of their private funds and related law.
[1] During the periods in question through March 2024, one Fund Manager was a registered investment adviser with the SEC with the other Fund Manager electing to file as a relying adviser thereof.
