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News June 15, 2015 Issue

Allocations Without Disclosure Equal SEC Charges for Hedge Fund Adviser

It’s all about disclosure when it comes to allocations.

Take the case of Alpha Titans, a California-based hedge fund adviser that just got hit with an SEC bill of almost $500,000 in disgorgement and interest, plus a $200,000 civil money penalty. The adviser, as well as its owner and general counsel, who were also charged, perhaps should have known they would draw the agency’s attention by allegedly failing to get authorization from investors through disclosure before diverting fund dollars to pay office rent, employee salaries and more.

But for whatever reason, they allegedly did it anyway, the SEC charged in its administrative order instituting a settlement. Now, in addition to the monetary sanctions, the owner, Timothy McCormack, who also acted as the chief compliance officer in addition to several other titles, and the general counsel and chief operating officer, Kelly Kaeser, are barred from the securities industry for one year. Kaeser was also barred from practicing as an attorney for any entity regulated by the SEC. An additional party, an accountant, who settled with the SEC separately, had to pay a $75,000 fine and cannot practice as an accountant for any entity regulated by the Commission for at least three years.

Perhaps the only solace for the respondents is that they were able to settle without admitting or denying guilt, which is something the SEC has been requiring more often these days.

"Private fund managers must be fully transparent about the type and magnitude of expenses they allocate to funds," said the SEC Division of Enforcement’s Asset Management Unit co-chief Marshall Sprung. "Alpha Titans did not make the proper disclosure for clients to decipher that the funds were footing the bill for many of the firm’s operational expenses."

"This appears to be in a direct evolutionary line of cases involving expense allocations by private equity firms," said Stern Tannenbaum partner Aegis Frumento. The line of evolution, he said, began in 2014 and has included several cases, including the agency enforcement action against Clean Energy Capital (ACA Insight, 3/10/14), which Frumento represented.

Mayer Brown attorney Adam Kanter noted that the expense allegations in the Alpha Titans case could also have been raised against a firm managing funds other than a hedge fund, such as a private equity fund. "A lot of this is reminiscent of things that the Office of Compliance Inspections and Examinations, as well as the Division of Enforcement’s Asset Management Unit, have been talking about – how expenses are reimbursed and allocated."

The defense speaks

The advisory firm and the two executive are "happy to put the matter behind them," said one of the attorneys representing Alpha Titans, McCormack and Kaeser, adding that none of the parties admitted or denied guilt in the settlement. "Upon determining the SEC’s concerns, they took immediate remedial action to amend their PPM and add disclosures concerning expenses."

But that said, there was some frustration because "the rules concerning what must be disclosed in terms of expenses are not immediately obvious or clear," the defense attorney said. In addition, determining what the SEC was concerned about during the investigation was not easy "because when [examiners] are in the midst of an investigation they do not make their concerns clear, leaving it up to those being investigated to interpret (what steps need to be taken) in terms of remedial action," he said. "This is a systemic problem, not just tied to this case."

The main allegations

According to the settlement order, from 2009 through 2012, Alpha Titans and McCormack used fund assets to pay for adviser-related operating expenses in a manner:

  • Not clearly authorized under the funds’ operating documents, and
  • Not accurately disclosed as related-party transactions in the funds’ financial statements.

"Alpha Titans breached its fiduciary duty when it used the assets of fund clients to pay its expenses without clear authorization in the funds’ operating documents," the SEC said. "Further, Alpha Titans and McCormack distributed materially misleading financial statements for the funds that inadequately and incorrectly described the total amount of Alpha Titans’ expenses paid by the funds and the related party relationships."

"It’s interesting how the word ‘clearly’ finds its way into this settlement to describe ‘authorized,’" said Frumento, noting that the SEC staff states in the settlement that Alpha Titans was not "clearly authorized" to use fund assets to pay for adviser-oriented operating expenses. Later in the settlement, he said, the SEC alleges that this lack of clear authority resulted from the firm’s removal of "specific disclosure" from its PPM. "Lack of disclosure, in other words, can lead to lack of authority," Frumento said.

"The Commission’s fundamental problem in these cases is that the Advisers Act is primarily a disclosure act and does not permit easy meddling into the governance of partnerships, which are created under state law," Frumento said. "With cases like this, the staff is trying very hard to regulate the internal governance of entities governed by state law but without good tools to do so. So inevitably we end up with cases like these, which tend to muddy the waters more than they clarify anything. If the staff stuck to disclosure as the objective, these cases would make more sense."

The firm and McCormack were charged with willfully violating, and Kaeser with willfully aiding and abetting, as well as causing, violations of Section 206(2) of the Advisers Act, which outlaws fraud, and Section 206(4) and related Rule 206(4)-8 for making untrue statements to investors in pooled investment vehicles.

"In a nutshell, disclosure covers a multitude of sins," said Frumento. "Most of the practices we see in these cases could not be targeted by the SEC if they were more clearly disclosed." He recommends that advisers seeking to avoid these kinds of problems:

  • Make their expense allocation policies, procedures and methodologies very clear in the limited partnership agreements,
  • Repeat those provisions in the PPMs, and
  • Disclose them again in the financial statements.

The firm’s alleged failure to disclose also meant that the financial statements were not prepared in accordance with GAAP, so Alpha Titans was charged with willfully violating, and McCormack and Kaeser with willfully aiding and abetting, as well as causing, violations of Rule 206(4)-2, the Custody Rule.

Finally, given that McCormack and Kaeser were responsible for preparing, reviewing and updating the firm’s written compliance policies and procedures, the firm was charged with violating Rule 206(4)-7, the Compliance Program Rule, and both McCormack and Kaeser were charged with aiding and abetting, as well as causing, the compliance program violation.

Alpha Titans, its funds and vehicles

Alpha Titans, which was founded by McCormack, has been a registered investment adviser since 2007. It served as the general partner of one feeder fund and the manager of another. According to the SEC, limited partners and shareholders invested money in the feeder funds, and McCormack then directed that money to flow to a master fund. The master fund purchased equity options from a McCormack-formed special purpose vehicle, and the special purpose vehicle then invested that money in an exempted segregated portfolio company, another special purpose vehicle, the agency said.

Sound complicated? What’s important to know is that ultimately, the segregated portfolio company invested the feeder funds’ money in unrelated private funds, according to the SEC, and that McCormack ran the show. He "formed and directed all activities, management and operating polices of Alpha Titans, the feeder funds, the master fund, [and the two special purpose vehicles]," the agency said.

It’s also important to know that the feeder funds paid Alpha Titans management and performance fees. The management fees totaled more than $2 million during the four-year period involved.

Paying the bills

"Alpha Titans and McCormack paid most of the Alpha Titans’ operational expenses with feeder funds’ assets, including Alpha Titans’ employee salaries and health benefits, rent, parking, utilities, computer equipment, technology services, and other operational costs," the SEC said. "The use of fund assets to pay for these expenses created significant conflict of interest between Alpha Titans and McCormack on the one hand, and the feeder funds on the other."

While the funds’ operating and limited partnership agreements provided that the funds would bear all the costs and expense of their operations, they did not contain any language stating that they would bear the cost of the advisory firm’s operational or administrative costs, the agency said.

The SEC makes a point of noting that, prior to August 2009, the expense disclosure provided to investors in the funds’ private placement memoranda was "more detailed" than that provided after August 2009 – although the agency, while stating that the more
specific disclosure constituted about 10 pages of text, does not specifically detail what was included in those pages.

"Of the total payments made from the feeder funds’ assets to pay Alpha Titans’ expenses, $469,522 is attributable to money raised by Alpha Titans and McCormack from investors who invested after August 2009 and received only the inadequate disclosure," the SEC said.

Advisers should make sure that documents such as limited partnership agreements, operating agreements and Form ADV "are consistent with one another" in terms of listing which expenses will be reimbursed and what investors will be charged for, said Kanter. "If you find that you are not doing what your documents say, they should be amended – and you may need to secure consent for the changes from investors."

Mind the GAAP

If the agency’s allegations are true and Alpha Titans failed to disclose fund allocations to pay expenses, it is perhaps not surprising that the firm also allegedly failed to disclose those allocations in its audited financial statements. This led to the firm’s alleged violation of the Custody Rule.

Alpha Titans chose not to submit to the surprise examination required by the Rule, instead taking the option of distributing to the investors annual audited financial statements prepared in accordance with GAAP and audited by an independent public accountant.

But because the firm did not disclose the related-party relationships among Alpha Titans, the feeder funds, the master fund and the special purpose vehicles, as well as McCormack’s control of these entities, as well as the payment of Alpha Titans’ operating expenses, the statements for fiscal years 2009 through 2012 "were not in compliance with GAAP," the SEC said.

Overall, from 2009 through 2012, the segregated portfolio company paid $1.45 million in related-party transactions that were not disclosed in either the feeder funds’ or the master fund’s financial statements, the agency charged. It added that from 2009 through 2011, the master fund paid $1.54 million of Alpha Titans’ employee payroll, benefits and other employee expenses that were not identified as related-party transactions in the notes to the financial statements.