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News May 4, 2015 Issue

Advisory Agreement Case: SEC Files New Charges After $55M Court Win

Watch out for those old active advisory contracts. They can come back and bite you.

The SEC on April 28 instituted administrative proceedings against adviser Charles Kokesh. The Commission action followed a March 30 final judgment by the U.S. District Court for the District of New Mexico, in which Kokesh was ordered to pay more than $55 million in disgorgement, interest and civil money penalties. The final judgment was the result of a November 2014 five-day trial that led to the adviser’s conviction of misappropriating almost $35 million in client funds from 1995 through July 2007 at two registered advisers he controlled (ACA Insight, 11/17/14).

Now, with the SEC order of administrative proceedings, Kokesh faces the prospect of additional sanctions.

What Kokesh did was receive prohibited reimbursements, distributions and performance fees from four business development companies he managed, said the SEC, which filed the original complaint against him in October 2009. The payments were not allowed by the firm’s advisory agreements with the four BDCs, according to the complaint.

The alleged crimes occurred well after the advisory agreements were signed. While the improper expense reimbursements began in 1995, the business development companies had raised funds from investors from 1987 to 1993 pursuant to agreements that were signed "in the 1980s and 1990s,"according to the SEC.

One lesson that advisers can take away from this case is that the SEC "will carefully scrutinize the fees and expenses that they charge their clients and look to see whether expenses charged separately are for items that should be covered by the management fee," said Mayer Brown attorney Matthew Rossi.

"The final judgment in this case shows the importance the SEC places on investment adviser representations to investors about the use of their funds," said Zaccaro Morgan partner Nicolas Morgan. "The SEC scrutinizes any discrepancies between distributions, performance fees, and expenses and representations to investors about those topics in documents such as proxy statements and reports filed with the SEC. In this case, both the judge and jury appeared to strongly agree with the SEC’s view."

Of the approximately $55 million judgment, about $53 million was for disgorgement and interest, and approximately $2.35 million was a civil money penalty. The SEC charged Kokesh with violating Section 57 of the Investment Company Act for stealing funds; Section 13(a) of the Exchange Act and several of its rules for filing false and misleading annual and quarterly reports; Section 14(a) of the Exchange Act and its Rule 14a-9 for issuing false and misleading proxy statements; Section 205 of the Investment Company Act for misuse of the mails and interstate commerce to commit fraud; and Sections 206(1) and (2) of the Advisers Act for aiding and abetting his advisory firms in committing fraud. An attorney representing Kokesh, reached by telephone, did not comment on the final judgment or the case.

The BDCs and the agreements

Just how did the payments received by the advisory firms from the business development companies differ from what the SEC said the advisory agreements allowed? According to the agency, here are some of the ways:

  • Reimbursement. The advisory agreements said that the advisory firms would be reimbursed by the business development companies for operational costs, which were defined as expenses related to the selection of portfolio companies or to proposed investments. Specifically prohibited was reimbursement for rent, salaries and fringe benefits incurred by any controlling persons of the Kokesh advisory firms. What the SEC said happened: The advisers caused the four business development companies to reimburse the Kokesh Advisers at least $15 million for rent, salary and fringe benefits in violation of the advisory agreements.
  • Distribution. The advisory agreements called for the business development companies to pay 99 percent of any distribution to investors and 1 percent to the Kokesh advisory firms until the investors received a complete return of their initial investment. Afterwards, each business development company was to receive 80 percent of the distributions, with the advisory firms receiving the remaining 20 percent. The only exception to this arrangement was for distributions to cover tax liabilities associated with the sale of business development company assets. What the SEC said happened: From 1995 through 1999, the advisers caused three of the four business development companies to pay the advisory firms $760,000 in distributions without corresponding distributions to investors. There were no tax liabilities that would have allowed such distributions.
  • Performance fees. Under the advisory agreements, the advisers would receive a performance fee of 20 percent of each business development company’s portfolio gains, calculated as no more than 20 percent of the net profit of the partnership after taking into account all cumulative net loss. What the SEC said happened: The advisory firms calculated net profit "by combining both realized and unrealized gains in each [business development company’s] portfolio," the agency said. "Because the calculation included unrealized capital gains, the Kokesh Advisers charged the BDCs higher performance fees than they were allowed to charge under Section 205(b)(3) of the Advisers Act," not to mention their advisory agreements.