SEC Focus on Fees and Their Disclosure Drives Two Enforcement Actions
It’s not only the fees you charge, it’s whether you disclose them.
Two recent SEC cases – one an administrative settlement with an advisory firm involving exchange fees, the other a court complaint against a hedge fund adviser involving allegedly unearned management fees – demonstrate the Division of Enforcement’s never-flagging interest in fees and how they are disclosed.
A Philadelphia-based advisory firm on September 2 agreed to pay more than $21 million to settle Commission allegations that it charged improper exchange fees to its collateralized debt obligation clients. Just two days later, the SEC settled with a Bellevue, WA-based adviser and its owner after filing a complaint with the U.S. District Court for the Western District of Washington, charging that they inflated the value of investments so they could make more money through management fees.
"We are beginning to see the fruits of the SEC staff’s recent reviews of its investigations into the adequacy of disclosures around fees charged by investment advisers," said Willkie Farr partner James Burns. "Fees have always been an issue the SEC pays attention to, but recently there has been a renewed focus and closer attention paid to the adequacy of disclosures around advisory fees. The question is how many more such cases the agency has in the pipeline and what, if anything, these cases suggest about how advisers should further refine their practices going forward."
"The SEC staff places full and fair fee disclosure at the top of their list of compliance concerns," said Stradley Ronon partner Lawrence Stadulis. "They always have and always will."
"A common denominator between these two cases is they demonstrate that when the SEC announces enforcement priorities they actually pursue them," said DLA Piper senior counsel Patrick Hunnius. "These cases are about fees, but one is also arguably about conflicts of interest and the other also about valuation, two of the SEC’s other priorities this year for private funds."
Nor has the SEC been shy about its plans in regard to fee-based enforcement actions. "On the hedge fund side, we anticipate cases involving undisclosed fees," said Division of Enforcement Asset Management Unit co-chief Julie Riewe, discussing her unit’s 2015 priorities in a February 2015 speech. She also used that opportunity to speak of the AMU’s fund fee initiative, "in which we examine whether advisers made misrepresentations to boards about services provided and fees received."
The agency’s Office of Compliance Inspections and Examinations also views the fees that advisers charge as an area it needs to examine. "Where an adviser offers a variety of fee arrangements, we will focus on recommendations of account types and whether they are in the best interest of the client at the inception of the arrangement and thereafter, including fees charged, services provided, and disclosures made about such
relationships," it said in its list of 2015 priorities. In addition, OCIE said it would pay special attention to fees and expenses in private equity. "Given the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses, we will continue to conduct examinations in this area."
Exchange fee settlement
Advisory firm Taberna Capital Management, an indirect subsidiary of RAIT, a real estate investment trust, was engaged in the business of managing CDOs, special-purpose vehicles sold to investors in order to invest in fixed-income securities or loans, according to the SEC’s administrative order instituting the settlement. The Taberna CDOs were invested primarily in real estate.
The SEC took action against the firm as a result of the adviser’s "multi-year effort to charge and retain certain fees (known as exchange fees) in connection with restructuring transactions undertaken between Taberna’s collateralized debt obligation clients and the issuers of the underlying obligations in the Taberna CDOs portfolios," the agency said.
If that sounds a bit confusing, here’s the nut of the SEC charge: "Between 2009 and 2012, Taberna … retained over $15 million of exchange fees," the agency said. "As Taberna knew, the exchange fees should have gone to the CDOs, and retention of the exchange fees was impermissible under the governing documents of the Taberna CDOs." Beyond that, the SEC said, the exchange fees "created actual and potential conflicts of interest that Taberna failed to disclose to its clients," something the agency said was in violation of the firm’s fiduciary duty.
The adviser also "obscured its misconduct" by improperly labeling the exchange fees as "third party costs incurred" in various documents, the SEC said, adding that it did not mention them in quarterly reports sent to investors, or in its Forms ADV.
"CDO managers have an obligation to act in the best interests of their CDO clients and communicate fairly with them," said Michael Osnato Jr., chief of the SEC Enforcement Division’s Complex Financial Instruments Unit. "Taberna secretly diverted funds owed to CDO clients, and concealed that diversion and the conflicts it created."
As part of its settlement, Taberna agreed to disgorge $13 million, plus interest of $2 million. In addition, it was required to pay a civil money penalty of $6.5 million, and was barred from being an investment adviser for three years.
The firm was charged with violating Section 15(a) of the Exchange Act, which prohibits engaging in transactions unless registered as a broker-dealer, and Sections 206(1), (2) and (4) of the Advisers Act, as well as Rule 206(4)-8, all of which prohibit fraud. Finally the SEC charged the firm with violating Section 207 for making an untrue statement of material fact in its registration applications or reports. An attorney representing the firm chose not to comment.
Summit Asset Strategies Investment Management, which provided investment advice to two private funds, and Chris Yoo, its owner and CEO, on September 4 settled charges with the SEC that they collected unearned management fees by "fraudulently inflating the values of investments in the portfolio of a private fund they advised," according to the agency. On the same day, an advisory firm owned by Yoo, Summit Asset Strategies Wealth Management, settled charges related to Yoo’s alleged failure to let clients know that the adviser "received significant fees when referring them to invest" in a specific fund, the SEC said.
"Yoo manipulated the value of certain fund assets to manufacture millions of dollars in illusory profits that he used to line his pockets with fees he did not truly earn," said Enforcement Division Asset Management Unit co-chief Marshall Sprung. "He also failed to disclose a conflict of interest involving his other firm."
From 2011 to 2015, according to the SEC’s complaint to the court, Yoo "improperly withdrew nearly $900,000 in assets from [a private investment fund] based on Yoo’s manipulation of the value of certain fund assets." This allegedly included misleading both existing and prospective fund investors about the fund’s financial condition by "making materially false and misleading statements about the value of the fund’s investments, and the manner in which Yoo and [Summit Asset Strategies Investment Management] were withdrawing fees from the fund as compensation for their advisory services."
"Yoo falsely claimed that the fund owned a specific bank asset that had appreciated to approximately $2 million in value. In reality, the fund owned an entirely different asset that was worth less than $200,000," the SEC said.
As part of the settlement, Yoo and Summit Asset Strategies Investment Management agreed to disgorge more than $889,000, plus interest of more than $104,000, and a civil money penalty of $150,000. Summit Asset Strategies Wealth Management agreed to disgorge more than $81,000, plus interest of more than $6,600 and a civil money penalty of $100,000.
Yoo and Summit Asset Strategies Investment Management were charged with violating Section 10(b) of the Exchange Act and its Rule 10b-5, Section 17(a) of the Securities Act, and Section 206(4) of the Advisers Act and its Rule 206(4)-8, all of which prohibit fraud. In addition, the two, along with Summit Asset Strategies Wealth Management, were charged with violating Adviser Act Sections 206(1) and (2), which outlaw fraud. Yoo and Summit Asset Strategies Wealth Management alone were charged with violating Section 207 for filing a false Form ADV. The attorney representing Yoo and the two funds chose not to comment on the settlement.