PF Managers of Buyer and Seller Real Estate Funds Must Do Right by Both
Private fund advisers specializing in real estate transactions need to beware. Steer clear of conflicts of interest when selling property from one client fund to another. Disclosure must be your watchword and favoritism cannot be shown to either fund, regardless of your firm’s percentage of ownership in each.
New York City-based Paramount Group Real Estate Advisor, a private fund manager with slightly more than $2 billion in assets under management, recently settled with the SEC over allegations involving these issues. The firm was not only censured and forced to pay a $250,000 civil money penalty, but will have to deal with the publicity and the possible loss of credibility that come with such settlements.
Paramount, which provides advisory services to private real estate investment funds that put money in real property, allegedly allowed one of its funds that was buying a property – a garage located next to an office tower – from another of its funds to close the deal without reimbursing the selling fund for certain development expenses. It went along with this lack of reimbursement even though it had earlier promised the selling fund’s investor advisory committee that the reimbursement would occur, the SEC said.
It didn’t help that Paramount held a 26.7 percent ownership stake in the buying firm and only a 3 percent ownership stake in the selling firm, according to the agency administrative order instituting the settlement.
"[Paramount] had a conflict of interest because it owed a fiduciary duty to both sides of the transaction and because it (or entities affiliated with it), at the time, owned a larger percentage share of [the buying fund] than of [the selling fund]," the agency said. "Consequently, [Paramount] could not effectively consent on behalf of [the selling fund] or the [selling fund’s] limited partners to eliminate the reimbursement requirement upon which the [selling fund] investor advisory committee expressly conditioned its approval of the sale of the garage."
"This case reflects the classic example of an adviser believing it had acted in its client’s best interests because the client received a substantial economic benefit in the transaction, but the adviser nevertheless stepped into a violation by failing to disclose important information to the client," said Rogers & Hardin partner Stephen Councill. "It serves as a good reminder that disclosure is always a good idea even when the adviser believes it is doing what is in the best interests of the client."
The funds and the purchase
Paramount’s selling fund, Fund III, owned a San Francisco office tower and garage. Paramount reached the conclusion, however, that the garage portion of the property would be more valuable as a separate residential development. The only problem was that it still needed to be zoned for the proposed size of the residential tower, and Fund III was past its investment period, did not have enough capital to fund a long-term development project, and its mandate did not include a residential property, the administrative order said.
In July 2013, according to the SEC, Paramount held a meeting of the Fund III investor advisory committee, at which it sought approval to sell the fund’s investment in the garage to another Paramount fund, the Residential Development Fund (RDF). Independent appraisers would determine the sales price, which was expected to be between $45 million and the low-$50 million range, the agency said.
During the meeting, the SEC said, Paramount told the Fund III investor advisory committee that Fund III "would be reimbursed for development expenses it had incurred in an effort to get the property upzoned ahead of the sale. At the time, such expenses totaled $3.5 million; by the time of the sale, they totaled $4.5 million." The investor advisory committee approved the sale, partly on the condition that Fund III be reimbursed, as the agency said was promised.
As it turned out, however, two of the three independent appraisals performed came in higher than expected. The appraisals were for $49 million, $56 million and $73.1 million, the SEC said. One wrinkle, however, was that the $73.1 million appraisal was based on the garage’s ability to obtain the residential zoning change, while the other two appraisals were not.
Fund III’s lenders required the price to be no less than the average of the two highest. That meant that the average of the two highest appraisals was $64.65 million, which was the price that Paramount caused Fund III to sell the garage to RDF, according to the agency.
But there was no reimbursement to Fund III for the development expenses, the SEC said. "In [Paramount’s] view, the final price RDF paid to Fund III already reflected the increased value that would result from the upzoning and related expenses because one of the two appraisals ultimately used to calculate the purchase price effectively assumed the upzoning would be achieved."
But that wasn’t enough for the agency. Paramount, it said, "failed to seek approval from the Fund III investor advisory committee or the Fund III limited partners to eliminate the reimbursement requirement as a condition of the sale of the garage to RDF, or to disclose to them, at the time, its decision not to cause RDF to make the reimbursement despite its commitment to do so."
Paramount, the SEC said, had failed to meet its fiduciary duty to both sides because it or its affiliates owned a larger percentage of RDF than of Fund III.
The SEC found out about this situation as the result of a July 2015 exam conducted by the agency’s Office of Compliance Inspections and Examinations. In August 2015, following the exam findings and further discussions with OCIE and the Division of Enforcement staff, an entity related to Paramount reimbursed Fund III the full $4.5 million.
The agency’s enforcement action "highlights the necessity for investment advisers to manage conflicts of interest on an on-going basis," said Pepper Hamilton partner John Falco.
"Firms should have a dynamic process in place for identifying, monitoring and mitigating conflicts that recognizes that an initial conflict clearance may no longer be sufficient as circumstances change," he said. "This requires communication and buy-in among business, compliance and legal functions to make sure conflicts are identified and addressed in an appropriate manner."
As part of the settlement, Paramount was found to have willfully violated Sections 206(2) and (4) of the Advisers Act, as well as Section 206(4)’s Rule 206(4)-8, all of which prohibit fraud. The SEC did credit Paramount with taking remedial acts promptly and cooperating with the agency during its investigation. An attorney representing Paramount did not respond to a voice mail or email seeking comment.