Permission, Disclosure Required Before Tapping Funds to Keep Business Afloat
It probably can’t hurt to be reminded that the funds an adviser manages are not piggy banks that advisers can dip into when needed. Even if an advisory firm believes it is entitled to compensation beyond what it is contractually due, any such remuneration must be approved by the fund’s investors and fully disclosed.
A February 7 settlement between the SEC and an advisory firm certainly appears to drive home that message. The California-based private equity adviser, Scott Landress, was barred for life from the securities industry and ordered to pay a $1.25 million civil money penalty for allegedly withdrawing improper fees from two private equity funds he managed.
Landress, according to the agency’s administrative order instituting the settlement, managed the funds through his firm, SLRA, and earned management fees based on the net asset value of the underlying investments, which were primarily in real estate trusts in the United Kingdom. But while initial results from the funds, formed in January 2006, were positive, the SEC said, the investment took it on the chin after the financial meltdown and, as a result, so did SLRA and Landress.
"SLRA’s fees shrank and its management costs increased as real estate property values fell during the financial crisis, and the funds’ limited partners declined several requests by Landress for additional compensation to cover the shortfalls," the agency said.
Then the line was crossed, if the SEC is to be believed. In early 2014, Landress "directed SLRA to withdraw 16.25 million pounds from the funds …, purportedly as payment for several years of services provided by an affiliate. He subsequently transferred the money to his personal account." Further, the agency charged, "SLRA and Landress did not disclose the related-party transaction and the resulting conflicts of interest until after the money had been withdrawn."
"Private equity fund advisers have a duty to act in the best interest of their clients, but Landress and SLRA helped themselves to millions of dollars’ worth of fees to which they had no legitimate claim," said SEC Division of Enforcement associate director Scott Friestad.
"While it may appear that this type of case is vestige of global financial crisis, the underperformance of a fund and the attendant costs of operating a fund are not uncommon," said Faegre Baker Daniels partner David Porteous. "This case reflects the importance of clients and investors understanding compensation mechanisms at the outset and when, through circumstances beyond even a manager’s control, incentives can become reversed so that a manager, as alleged here, could not economically continue to operate without sustaining a loss and there did not appear a way out when investors would not adjust or work with the manager."
"This does not and did not justify a manager’s alleged misconduct," he said, "but a wary client or investor should understand that when a manager is not only working for free but at a loss, that is not a good situation for anyone and represents a risk – not necessarily a fraud risk, but that the manager is in a difficult situation and interests are not aligned. At that point, a manager should be considering options to wind down the fund and/or attempt to work with clients and investors in renegotiating the operating documents to at least cover costs."
"While it may seem to an adviser providing ‘additional’ services to a client in a volatile time that it should be paid for those additional services, the SEC has made clear that advisers cannot make up compensation schemes from whole cloth and not tell the client about it," said Pasquarello Fink partner William Haddad. "Even if Landress and his firm believed that they were ‘owed’ this money for their hard work in a tough market climate, the decision of whether to award such additional compensation clearly rested with the funds’ advisory committee (comprised of representatives from the funds’ limited partners)."
"This case turns on the issue of timely fee disclosure and not whether the services were provided," said Baker Hostetler partner John Carney, who represented Landress. "Indeed, the SEC order expressly acknowledges that the global financial crisis caused Mr. Landress ‘to perform additional services’ and that he ‘worked to minimize the funds’ losses and avoid threatened foreclosures’ through restructurings, recapitalizations and asset dispositions. Scott Landress even updated the limited partners as the work was performed. The issue was the lack of timely disclosure that additional fees would be due. The message of this case is that fees must be disclosed as earned to maintain a claim."
Both Landress and SLRA, as part of the settlement, were found to have willfully violated Sections 206(1) and (2) of the Advisers Act, both of which prohibit fraud. In addition, they were found to have willfully violated Section 206(4) and its Rule 206(4)-8, which outlaws making untrue statements of material fact.
Funds, investments and compensation
The funds were formed by Landress, with himself as the general partner, through a predecessor entity for the purpose of investing, through real estate trusts, in certain real estate private equity secondary transactions, including the purchase of pre-existing investor commitments to real estate private equity funds. The limited partners of the funds Landress managed included university endowments and pension funds that together committed approximately $400 million in 197 office, retail and industrial properties. All the investments in the funds were covered by limited partnership agreements, and each LPA provided for the creation of an
As part of the agreement, the funds’ general partner - in this case, also the investment adviser – would be compensated by a management fee of 1.25 percent of the funds’ net asset value, carried interest, and liquidation fees upon the funds’ termination.
Did the LPAs allow for additional compensation? Yes, but, the SEC noted, a section of the LPA specifically stated that such compensation may be received, "provided, however, the advisory committee must approve all such transactions." The LPAs also required that any excess distributions to the general partner, calculated when the funds are liquidated and based on their overall performance, must be reimbursed to the funds, in a provision known as the "giveback obligation," the agency said.
Performance before and after
The funds did pretty well in the early days. Up until 2007, "the funds’ performance met or exceeded investment plan objectives, returning 63 percent of paid-in capital to the limited partners and reporting a gross internal rate of return of approximately 50 percent," according to the SEC.
Things changed, however, once the financial crunch hit. "Between 2007 and 2009, real estate property values declined and, by the second quarter of 2009, the funds’ net unrealized asset value had fallen 94 percent," the agency said.
Since the adviser’s management fees were based upon the net asset value of the funds’ underlying investments, the blow was felt. Management fees fell 62 percent in 2009, while the impact of the global crisis caused the adviser to perform additional services. "The lower-than-expected management fees were insufficient to cover … expenses," the SEC said.
Three times – in October 2009, July 2010, and November 2011 – Landress asked the advisory committee for additional compensation to make up for the reduced management fees, but each time, according to the agency’s administrative order, he was rebuffed.
Throughout this period, Landress and other advisory firm personnel "worked to minimize the funds’ losses and avoid threatened foreclosures, including through asset dispositions, negotiations with the funds’ lenders, and restructurings and recapitalization." He kept the limited partners informed about the work as it was performed, but, the SEC said, "made no disclosure to the advisory committee of any additional fees for this work. The limited partners understood this work to fall within the scope of the management fees."
Then, according to the agency, on January 7, 2014, Landress directed the advisory firm’s director of finance and accounting to invoice the funds on behalf of SLRA and withdraw 16.25 million pounds from the funds’ accounts and deposit it in SLRA’s account. "On the following day, despite objecting, the finance director did so."
"In February 3, 2014 letters to the limited partners – nearly a month after directing that the 16.25 million pounds be withdrawn from the funds’ accounts – Landress for the first time asserted that SLRA had earned these additional fees," the SEC said. "In particular, Landress, acting on behalf of the general partner, claimed that work that had been performed by an affiliate of the general partner on behalf of the funds entitled the affiliate to compensation" under the LPAs.
But the funds and the limited partners had not been made aware of the existence of these claimed services prior to this time, the agency said. The limited partners objected to the service fee withdrawals and demanded the return of the 16.25 million pounds. "SLRA declined to do so, and on March 4, 2014, Landress caused the money to be transferred to a personal account."
A lawsuit between SLRA and the limited partners then followed, as well as an SEC investigation. In February 2016, a final settlement between the parties was reached, under which SLRA returned $24.4 million to the limited partners.
Landress’ and SLRA’s "failure to disclose the existence of the service fees prevented the limited partners from understanding that any work being performed was not covered by the management fees and that the funds might owe additional fees and prevented the limited partners from factoring the service fees into their investment decisions," the SEC said.