Don’t Allocate Registration, Exam or Investigation Expenses to Funds Without First Disclosing
The SEC on November 5 settled with two affiliated private equity fund advisers for allocating to its funds expenses related to its SEC registration, an examination by the Commission staff, and a Division of Enforcement investigation – all without first disclosing to the funds that it was doing so.
The fine levied against the adviser was relatively small, $100,000 – but the message to newly registered private equity advisers is loud and clear: The SEC has its eye on you and will enforce its rules.
North Carolina-based Cherokee Investment Partners and Cherokee Advisers, the two affiliated advisory firms in question, manage real estate funds that invest in environmentally contaminated property. Cherokee Investment Partners registered with the Commission in March 2012. Cherokee Advisers – which has no employees and is owned by the same persons as Cherokee Investment Partners – never registered independently, but is instead listed as a "relying adviser" on Cherokee Investment Partners’ Form ADV.
May 2011 found the two funds preparing to register. They retained a third-party compliance consultant and a law firm to make sure they did it right. Unfortunately, they allocated the costs of the consultant and the law firm, totaling more than $171,000, to their funds.
"Although the funds’ limited partnership agreements disclosed that the funds would be charged for expenses that in the good faith judgment of the general partner arose out of the operation and activities of the funds, including the legal and consulting expenses of the funds, there was no disclosure that the funds would be charged for the advisers’ legal and compliance expenses," the SEC said.
"The case shows the continued attention the Commission is paying to conflicts and the importance of disclosures in addressing them," said Willkie Farr partner James Burns.
Examination and investigation
The Commission staff conducted an examination of the two Cherokee advisers in 2013 to "review [their] compliance as a newly registered adviser and relying adviser with certain provisions of the federal securities laws," the agency said. Once again, the advisers allegedly allocated expenses, this time totaling more than $239,000, including consulting and legal services, to their funds.
In April 2014, the Division of Enforcement conducted an investigation of the advisers that looked into their allocation of expenses, including legal fees, to the funds. The two advisers allocated their legal costs associated with the investigation to their funds, this time totaling more than $45,000, according to the agency.
Total expenses allegedly allocated by the two Cherokee firms to the funds without proper disclosure: More than $455,000. In March 2015, the two advisers ceased allocating legal and compliance-related expenses to the funds. They reimbursed the funds in full in April 2015.
"As with most private equity cost allocation cases the SEC has brought recently, this case highlights the Commission’s continuing focus on differences between representations to investors and actual practice," said Zaccaro Morgan partner Nicolas Morgan. "Notably, the SEC brought the action despite the fact that the adviser received advice from legal counsel regarding some of the allocations. The adviser’s reliance on legal advice may explain why the SEC brought charges under provisions that do not require proof of actual fraudulent intent and recovered only a combined monetary penalty of $100,000 with no disgorgement."
Violations and penalties
Cherokee Investment Partners and Cherokee Advisers were each charged with violating Section 206(2) of the Advisers Act, which prohibits fraud. They also were charged with violating two rules under Section 206(4): Rule 206(4)-8, which makes it unlawful for any investment adviser to make untrue statements of material fact to an investor or prospective investor, and Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement written compliance policies and procedures, as well failing to review them at least annually. An attorney representing the firms did not respond to a voice mail or an email seeking comment.