LESSONS LEARNED
- Reminder to Private Fund Advisors – Provide your audited financial statements in a timely manner or face custodial violations. The SEC recently reached a settlement with a private equity firm for ultimately failing to distribute audited annual financial statements to its private equity investors on time. The company failed to provide audited financial statements in a timely manner in 2014 and again for fiscal years 2018 to 2020. Although the untimely delivery was the breach, the case pointed out that although the company engaged auditors, the advisor did not produce the requested documents, so the audits could not be completed. The company also reallocated some expenses from the fund to a different fund than the one originally reserved without providing sufficient supporting documentation. To make matters worse, the adviser was also relying on the audited financial statement exception under the custody rule to hold privately offered certificated securities. By failing to deliver the financial statements on time, the company also denied its ability to avail itself of this exception.
The case provides some valuable lessons. To benefit from the exception of audited financial statements under the custody rule, private fund advisers must provide audited financial statements to investors within 120 days of the end of the fiscal year for private funds and within 180 days for funds of private funds. In this situation, the advisor caused the delay by reallocating expenses between funds without sufficient documentation and without consulting the auditor about the change. The adviser also failed to follow the advice of a compliance consultant who recommended the company implement policies and procedures regarding the allocation of fund expenditures. Without admitting or denying the findings of the order, the councilor consented to a cease and desist order and a reprimand and agreed to pay a civil penalty of $75,000. Contributed by Andrea Penn, Senior Director.
- SEC Nails VC Fund CEO for calculations of uncollectible charges and undisclosed interfund loans. The SEC has charged an exempt reporting adviser (ERA) and venture capital fund manager and its CEO for making misleading statements about fund management fees in marketing materials. The company described the fee structure as “industry standard” and “2 and 20”. However, instead of charging a management fee of 2% per year over the fund’s 10-year term, with a separate potential annual performance fee of 20% (what many consider the “industry standard, 2 and 20”), the advisor charged a management fee equal to 20% of an investor’s initial fund investment (representing 2% of the annual fee over the 10-year term).
Advisors should note that the CEO was individually named, perhaps because he endorsed the language and even used it personally. Moreover, he continued this practice despite receiving multiple complaints from investors and questions from the company’s board of directors and other executives. Finally, the CEO admitted that he didn’t know of any other advisor who had earned multi-year management fees at the time of the initial investment.
The CEO has also been involved in inter-fund lending and inter-fund fund transfers in violation of fund operating agreements, without informing investors. To settle the charges, the company repaid $4.7 million to the affected funds and agreed to pay a $700,000 penalty, while the CEO agreed to pay a $100,000 penalty. This case further demonstrates the regulatory scrutiny of private fund advisers, including those exempt from SEC registration. Contributed by Andrea Penn, Senior Director.
- The SEC provides guidance on disclosures for proprietary funds recommending advisers. A major adviser recently reached a settlement with the SEC for investing discretionary client accounts in proprietary mutual funds (“proprietary funds”), resulting in Rule 12b-1, shareholder service and other fees to affiliated entities without proper disclosure. For context, the advisor typically invests clients in model portfolios of individual securities; however, in some cases, the firm has instead invested client assets in one or more proprietary mutual funds intended to reflect the diversification of these individual security portfolios. The adviser also offered mutual funds to provide these strategies, most with two classes of shares – one with 12b-1 fees and one without. Clients coming to the advisor from its affiliated “banking channel” received the 12b-1 no-fee share class, and clients of a third-party advisor received the 12b1 fee-based share class.
In its findings, the SEC offered its thoughts on appropriate disclosures. First, the company did not disclose to clients who did not have enough assets to invest in a managed account that they would be placed in proprietary funds and pay account-level fees in addition to advisory fees. mutual fund. Second, the company also failed to tell clients that it chose its equity rather than “peer funds within the same asset classes.” Finally, the firm failed to inform clients that lower-cost share classes were available if they opened an account through the advisor’s “banking channel” instead of a third-party advisor. While there is apparently no end in sight to the SEC’s pursuit of disputes over stock class selection, this case is informative reading. In particular, companies that restrict access to certain classes of shares by distribution channel must ensure that the conflict information is sufficiently robust. Contributed by Carl Hopfensperger, Senior Director.
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