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News April 13, 2015 Issue

Adviser Wants Trial by Jury: Tilton Sues SEC over Administrative Action

The self-proclaimed "turnaround queen" is seeking to turn the tables on the SEC.

The SEC on March 30 filed an order instituting an administrative proceeding against advisory firm CEO Lynn Tilton. The agency claimed that Tilton and her Patriarch Partners advisory firms, which invest in distressed companies, misappropriated almost $200 million from clients by mischaracterizing the performance of fund assets.

On April 1, Tilton, the subject of significant media attention, filed her own complaint against the SEC, challenging the agency’s use of an administrative proceeding. She wants a trial by jury. An administrative hearing, which operates under different rules than litigation, would  irreparably harm her constitutional rights, she argued in her complaint before the U.S. District Court for the Southern District of New York.

If Tilton gets her way, she would not only score a victory for herself and her firms, but may find herself the unexpected champion to a number of industry professionals who have argued that the SEC is relying too much on administrative actions to pursue those it charges.

"The suit was filed in response to the SEC’s decision, after more than five years of investigation, to bring its claims against Tilton and Patriarch in an abbreviated administrative proceeding before an administrative law judge rather than in a U.S. District Court, where there are greater discovery rights and the right to a jury trial," said a spokesperson representing Tilton and her firms. "The SEC wants to litigate this matter in its own administrative court before its own administrative judges, without the same due process rights available to litigants in the federal courts, notwithstanding the collateral damage that may result."

"This is a new trend," said Rogers & Hardin partner Stephen Councill of attorneys for defendants filing cases against the SEC contending that administrative actions are improper. "Several have tried it," he said, noting that one resulted in the SEC dismissing the  administrative proceeding voluntarily and refiling in federal court. On March 3, in another case, a judge ruled against a defendant seeking change in venue from an administrative hearing to a court.

Administrative proceedings

What’s the problem with administrative proceedings? According to SEC commissioner Michael Piwowar, who addressed the subject in a February 20 speech, "there is no jury and cases are presented to administrative law judges that are employees of the Commission. In addition, discovery available to defendants is more limited." (ACA Insight, 3/9/15)

The results tend to favor the SEC. "The Commission has an extremely high success rate when litigating through administrative proceedings," Piwowar said. He noted a November 2014 speech, "Is the SEC Becoming a Law Unto Itself?" by U.S. District Court Judge Jed Rakoff, where Rakoff said that the SEC won 61 percent of federal court trials but was successful in 100 percent of its administrative proceedings and that he saw "no good reason to displace that constitutional alternative with administrative fiat."

On the other hand, SEC Division of Enforcement director Andrew Ceresney takes a different point of view on the subject, as he did when he offered a spirited defense of the use of administrative proceedings in a November 2014 speech before the American Bar Association’s Business Law Section (ACA Insight, 12/8/14).

"My bottom line is that, while we are using administrative proceedings more, we are still bringing significant numbers of contested cases in district courts," Ceresney said. "And our use of the administrative forum is eminently proper, appropriate and fair to respondents."

The Tilton case

The agency’s case revolves around the valuation of collateralized loan obligations (CLOs) in three funds, known as the Zohar funds, which collectively raised $2.5 billion from investors. That money was in turn used by the funds to make investments in distressed companies, and those loans are the primary assets of the funds. "However, many of the distressed companies have performed poorly," according to the administrative order.

The SEC charged that Tilton and three of her Patriarch Partner advisory firms "breached their fiduciary duties and defrauded clients" by failing to value those funds’ assets using the methodology described to investors in the funds’ offering documents. Instead, "nearly all" the loan asset valuations were reported to investors as unchanged from the time they were acquired – "despite many of the companies making partial or no interest payments to the funds for several years," the SEC alleged.

"Investors have not only been misled to believe that objective valuation analyses were being performed, but Tilton and her firms allegedly have avoided significantly reduced management fees because the valuation methodology described in fund documents would have given investors greater fund management control and earlier principal repayments if collateral loans weren’t performing to a particular standard," the agency claimed. "Tilton and her firms also consequently have misled investors about asset valuations in fund financial statements."

Each of the funds’ financial statements were prepared internally, then approved by Tilton, who also signed a certification stating that the balance sheet and income statements were prepared in accordance with GAAP standards, according to the administrative order. Nonetheless, the financial statements were not GAAP-compliant, nor did they present a fair picture of the funds’ financial condition, the SEC said. The order does not refer to the use of any external auditors or accounting specialists.

The amount of the misappropriated management fees and other payments that Tilton and her firms allegedly received through improper valuation? Almost $200 million, the SEC said.

"Tilton violated her fiduciary duty to her clients when she exercised subjective discretion over valuation levels, creating a major conflict of interest that was never disclosed to them," said Ceresney.

Tilton and the Patriarch firms were charged with having willfully violated Sections 206(1), (2) and (4) of the Advisers Act, which prohibits fraud. In addition, they were charged with having willfully violated Advisers Act Rule 206(4)-8, which prohibits fraudulent conduct by advisers to pooled investment vehicles.

Points of view

Of course, this is not how Tilton and Patriarch see things. "We are disappointed that the SEC has chosen to bring an enforcement action that is ill founded and at odds with Patriarch’s investment strategy, which was consistently disclosed since the inception of the funds," said the spokesperson representing Tilton and her firms. "We look forward to the opportunity to vigorously defend ourselves against the SEC’s allegations. … The Zohar note holders are sophisticated investors that have extensive information to evaluate the cash flow performance of the Funds and the performance of the underlying companies."

"This SEC case is one of a long line of enforcement actions challenging the valuation methodology used by a fund adviser," said Zaccaro Morgan partner Nicolas Morgan. "As with most of these types of cases, the SEC does not allege that the adviser’s valuations are false or incorrect. Rather, the SEC alleges that the adviser told its investors in fund governing documents that one valuation methodology would be used when in fact a different ‘subjective,’ non-GAAP compliant methodology was used. The takeaway for fund managers is to ensure that valuation methodologies set forth in representations to investors in fund governing documents match actual valuation practices used."

"It will be interesting to see what the evidence shows about whether auditors or accounting specialists were involved, something the administrative order does not mention at all," said Councill. "If they were, and if Tilton hid or concealed the actual valuation methodology from auditors, I would have expected the SEC to allege that fact. If Tilton claims she did use accounting professionals or auditors, and she’s proven right, the SEC may have some challenges in showing intent to defraud."

Valuation methodology

Each of the Zohar deals is governed by various deal documents, including an indenture and a collateralized management agreement, according to the SEC. Each CLO indenture contains certain monthly numeric tests. "If those tests are not met, the indenture outlines certain consequences, which include increased rights by the investors to control the fund and/or remove the collateral managers, and elimination of the funds’ obligation to pay [one type of] fee," the SEC said. In addition, failure of the tests also changes the waterfall distribution for each fund in such a way that investors would receive earlier repayments on their principal.

Under this arrangement, according to the agency, "Tilton and her firms are required to categorize the value of each loan asset in monthly reports by using a specific method." A loan that was current in its interest payments to the Zohar funds would be assigned the highest category, while those that are not current would fall into lower categories. The category assigned is then used in the calculation of an "overcollateralization ratio," which indicates the likelihood that investors will receive a return on their principal.

"If the overcollateralization ratio falls below a specific threshold, Tilton and her firms are not entitled to receive certain management fees and may be required to cede more control of fund management to investors," according to the SEC’s administrative order.

But that formula, the SEC claimed, was not followed.

Instead, the categories of loan assets were not lowered until Tilton herself decided to cease financial support of a distressed company, the agency charged. "Thus, the valuation of an asset simply reflects Tilton’s subjective assessment of the company’s future. Absent an actual overcollateralization ratio test, investors aren’t getting a true assessment of the actual values of their investments, which in reality have declined substantially."

Disclosure and conflict of interest

Investors were not told about Tilton’s approach to categorization, the SEC charged. That knowledge and the resulting impact on the overcollateralization ratio test "were important to investors and rendered statements about asset categories and [overcollateralization ratio test] results false and misleading," the agency said, adding that the discretionary approach to categorization, contrary to the disclosures made, "also represents a fraudulent and deceptive scheme, practice and course of business."

The SEC, which has made a point of cracking down on what it perceives to be conflicts of interest (ACA Insight, 3/23/15), made clear in its administrative order that it considers this case to be among them, noting that Tilton and her Patriarch firms were making decisions in a way that allowed them "to collect more money from the funds and retain absolute control over their management, regardless of the performance of the funds’ assets."

In addition, the SEC charged Tilton and her firms with providing inaccurate financial statements.