SEC Scrutinizes PE Fund Manager Adherence to Operating Documents
Private equity fund managers may not be as used to SEC oversight as are other advisers. They would be wise, then, to regard a recent agency settlement as a lesson learned: The SEC will scrutinize books and records to make sure fund managers are operating within the limits of their operating documents. Those that are not may find themselves facing an enforcement action.
Consider the agency’s settlement with Ohio-based private equity fund adviser Resilience Management and its two co-CEOs, Bassem Mansour and George Ammar. They allegedly caused their funds’ general partners’ failure to make timely capital contributions, borrowed approximately $8 million from the funds to pay advisory firm expenses, failed to make proper disclosures to investors, made misleading statements in a variety of documents and, in the case of Ammar, improperly used non-client funds from Resilience without proper authorization and then covered up this activity with false entries in Resilience’s books and records.
Adding to the problem, and something that is likely to always catch the SEC’s attention, was that Ammar was also the chief financial officer of the firm for almost five years and the chief compliance officer for one year.
"It appears that this case has everything but the kitchen sink: allegations of misleading statements, omissions, false entries, improper loans/advances, untimely capital contributions and inadequate compliance policies and procedures," said Bell Nunnally partner Robert Long.
The firm, the funds and the rules
Resilience had assets under management of $329 million held by three private fund clients as of December 2013. The advisory firm was created in June 2001 by Mansour and Ammar, and each partner had a 50 percent ownership stake.
Through Resilience, clients made investments on behalf of the funds in companies that it believed could be performing better or that needed restructuring, the agency said. In addition. Resilience would separately enter into agreements with the funds’ portfolio companies to provide management services. An LPA, which included the terms by which the partners of each fund would make capital contributions to their respective funds, was used to govern each fund.
"Investors contractually agreed to pay their capital commitment over the life of the particular fund through periodic ‘capital call’ demands made by the general partner," according to the administrative order instituting the settlement, with the partner required to make their payments by the drawdown date in the capital call notice.
Resilience, under each LPA, would receive a management fee from the funds. That fee, paid annually, was initially equal to 2 percent of committed capital and, later, to 2 percent of invested capital, the order said. "The funds’ management fees were required to be offset by a percentage of Resilience’s other fee income, including advisory fees received from portfolio companies." The funds were not tasked with paying the advisory firm’s management expenses, such as normal operating overhead, salaries and benefits of the adviser’s employees.
It should also be noted, because it plays a part in the SEC’s charges against Resilience, that the LPAs prohibited the general partners from borrowing from the funds, and that "because Resilience controlled the [general partners], it was also implicitly prohibited from borrowing from the funds."
"Advisers should take note of the SEC’s strict interpretations of provisions in limited partnership agreements," said Paul Hastings partner Nicolas Morgan. "The agency is making clear that it will – with the benefit of hindsight – strictly interpret limited partnership agreement provisions against the adviser."
The SEC’s administrative order lists a number of ways in which it alleges that Resilience and its co-CEOs failed to follow the LPAs and other governing documents. Here are some of those allegations:
Failure to make timely capital contributions. Mansour and Ammar "usually did not make their contributions through the [general partners] to the funds at the time required by the capital calls," the agency said. "Mansour did not make timely contributions to the funds because he did not have the ability to pay. Mansour spoke with his co-CEO and decided that the co-CEO would also not make timely contributions to keep both of their outstanding capital contributions equal to their ownership interests."
Borrowing and advancing. From September 2010 through August 2013, Resilience borrowed approximately $8 million from the funds to pay its expenses, according to the administrative order. The advisory firm "often had insufficient funds to cover its expenses because some portfolio companies were paying little or none of the advisory fees they owed to Resilience," the agency said. Mansour discussed that matter with Ammar and the firm’s then-chief operating officer, according to the SEC, and then "requested or authorized these borrowings, which he referred to as ‘advances,’ from the funds.
Misinterpreting the LPA. Mansour, Ammar and the firm’s then-COO in early 2009 discussed, via email, whether the funds were responsible under the LPA for unpaid advisory fees from the portfolio companies. They concluded that LPA language stating that a fund is responsible for expenses ‘to the extent not paid by or reimbursed by a portfolio company’ meant that the funds were indeed responsible. Resilience "(incorrectly) interpreted this language to mean that if the portfolio companies did not pay their advisory fees, then Resilience could take advances from the funds to cover the unpaid advisory fees," the SEC said.
Failure to make adequate disclosures. While Resilience sent capital call notices to limited partners in the funds when capital was required for particular portfolio company investments and/or expenses, those notices, the SEC said, "omitted to state that capital was also being called for advances to Resilience, or to cover unpaid portfolio company advisory fees, which were not permitted."
Replacement receivables. In December 2012, according to the administrative order, the adviser replaced $1.8 million and $1.2 million of Resilience receivables on the books of two of the funds, respectively, with portfolio company receivables for advisory fees owed to Resilience. According to the administrative order, this was part of an attempt by Resilience, the two co-CEOs and the former COO to reduce the advisory firm’s receivables on the fund’s books through "non-cash" contributions.
False entries in firm’s books and records. Advisory firm staff in March 2013 discovered that Ammar had taken approximately $200,000 in non-client funds from Resilience and "booked the transactions as employee loans over the prior two years. Ammar gave approximately $165,000 to a friend and also took approximately $35,000 to cover his personal expenses." In addition, the agency noted, he covered up these misappropriations by making false entries in the advisory firm’s general ledger. Resilience terminated Ammar’s employment upon discovering these activities, the SEC said, requiring him, as part of a separation agreement, to repay all the missing funds.
"A financial inability to comply with an LPA term (regarding capital contributions) was no excuse in the SEC’s view," said Morgan. "Similarly, while the LPA apparently did not explicitly prohibit certain conduct by the adviser (borrowing from the funds), the agency held the adviser responsible for ‘implicit’ violations of the agreement. And the SEC held the adviser responsible for interpreting the LPAs in a way the SEC disagreed with (regarding taking advances from the Funds to cover unpaid advisory fees by portfolio companies)."
Concerns are raised
Red flags were raised about at least some of these activities, in at least one case by one of the respondents himself.
That occurred in March 2011, the SEC said, when Ammar sent an email to Mansour following Ammar’s transfer of $350,000 from one of the funds to Resilience and then to Mansour. "In the email, Ammar expressed his concern about the amount of Resilience’s borrowings from the fund since the beginning of the year and recommended that Mansour pay the money back," the agency said, adding that Ammar "also stated that, ‘from an SEC compliance perspective, we should not be borrowing from the fund unless there is reason to such as unpaid advisory fees . . . ."
Mansour replied, according to the SEC, that he understood Ammar’s concerns and would soon pay back a significant portion of the advances, and that further advances would not be needed. However, the agency noted, while Mansour did indeed pay back a portion of his borrowing, "Resilience continued to borrow and take advances from the funds."
A new CFO/CCO began working at Resilience in May 2013. Upon discovering the improper advances to the adviser, as well as outstanding general partner calls, he told Mansour and his co-CEO at the time to repay the funds, the SEC said. In addition, the new CFO/CCO contacted Resilience’s auditors and attorneys about the issue. After the new executive raised these points, the agency said, the improper practices stopped, and the advisory firm began paying back the borrowings and outstanding general partner contributions, with interest, to the funds in late 2013.
Violations, remedial efforts and punishment
As part of the settlement, the SEC found that Resilience willfully violated Section 204 of the Advisers Act and its Rule 204-2, the Books and Records Rule, which require advisers to maintain records that are accurate and current. The agency found that Mansour caused this violation, and that Ammar willfully aided and abetted, as well as caused, the violation.
Resilience and Mansour were also found by the agency to have willfully violated Section 206(2), which prohibits fraud; and Section 206(4) and its Rule 206(4)-8, which prohibits advisers from making untrue statements of material fact. In addition, the SEC found that Resilience willfully violated, and Mansour caused, the advisory firm’s violation of Section 206(4) and its Rule 206(4)-7, the Compliance Program Rule, for failing to adopt and implement written compliance policies and procedures.
The SEC credited Resilience, Mansour and the co-CEO at the time of the settlement with taking a number of steps to remediate the violations. These steps included repaying the funds with interest, and disclosing information about Resilience’s borrowing and the late capital contributions to the agency’s Office of Compliance Inspections and Examinations. In addition, the SEC recognized that the adviser hired a compliance consultant to revise its policies and procedures, as well as to conduct training; and hired a new CFO, CCO and general counsel.
Mansour was not barred from the industry. He was, however, barred from providing instructions to individuals in regard to any payment or transfer of assets, including fees and expenses, by an advisory client to anyone affiliated with Resilience; supervising anyone that provides such instructions; or associating with any registered investment adviser other than Resilience. In addition, Mansour agreed to pay a $500,000 civil money penalty. Resilience was censured and agreed to pay a $250,000 civil money penalty.
"The case highlights the value of remedial efforts," said Long. "I suspect the SEC would have taken a harder line had the funds not been repaid, and had Resilience not disclosed the issues to the SEC or taken steps to strengthen its compliance function."
"The message the SEC is broadcasting with this case is: When you identify a violation, remediate and self-report to OCIE," said Morgan. "In light of the fraud allegations, the penalties are fairly light by agency standards."