Inadequate Disclosure of Fee Calculations May Lead to Fee Returns
Advisers writing fund offering materials and operative documents must take care when disclosing how they calculate fees and expenses. A wrong word or phrase – writing "average" instead of "aggregate," for instance – is all it might take for the SEC to state that a disclosure is inadequate and that clients must be refunded a great deal of money.
Denver-based adviser Coachman Energy Partners is allegedly a case in point. In a recent settlement with the agency that centered on the adequacy of fee and expense calculation disclosures, the advisory firm agreed to pay more than $2.2 million in disgorgement and prejudgment interest to four private oil and gas funds they managed. While the amount was offset by outstanding fees and expenses that the funds owed the adviser, Coachman still wound up with approximately an $891,500 disgorgement and interest bill. The firm and its owner, Randall Kenworthy, each also had to pay a $50,000 fine.
"From 2011 through 2014, Coachman failed to adequately disclose its methodology for calculating the management fees and management-related expenses it charged the funds," the SEC said in its administrative order instituting the settlement. "As a result of its inadequate disclosures, Coachman overcharged the funds approximately $1.1 million in management fees and $449,000 in management-related expenses."
Client fees and expenses, it should be no surprise, are areas the agency’s Division of Enforcement pays close attention to in its role protecting securities investors. In March 2016, for instance, another advisory firm, Atlanta-based Marco Investment Management, and its owner, Steven Marco, settled charges with the SEC that it charged clients too much in fees as a result of calculating them differently from the way agreed to in its advisory agreements (ACA Insight, 3/14/16).
Cases involving fees and expenses "come up time and time again," said Stradley Ronon partner Lawrence Stadulis. "The manner in which firms calculate and charge their fees and expenses has been an ongoing concern. Firm must calculate these in the manner disclosed."
"Coachman and Kenworthy are pleased to put this matter behind us," said an attorney representing both parties.
The firm, the funds and the fees
Coachman, which the agency said has approximately $63.4 million in assets under management, has been registered as an adviser with the agency since March 2014, so much of the period during which the SEC alleged that the failure to disclose took place occurred prior to its SEC registration. Kenworthy is the firm’s sole owner, and also serves as its chief executive officer and managing member. The advisory firm provides its services to four private oil and gas funds.
The agency said that Coachman charged each fund an annual management fee of 2 to 2.5 percent of the aggregate capital contributions made to each fund as of the final day of the year. This, however, according to the SEC, was not what the funds had agreed to.
"The offering materials and operative documents for the funds, as well as the Forms ADV filed by Coachman in January 2014, October 2014, February 2015 and July 2015, each of which was reviewed and approved by Kenworthy, failed to properly disclose that management fees would be based on year-end capital contributions," the agency said. "Instead, these materials appeared to disclose that Coachman charged maintenance fees and expenses based on the average [emphasis ACA Insight] amount of capital contributions under management during the course of the year."
"As a result of charging the funds management fees based on year-end rather than the average amount of capital contributions under management during the course of the year, Coachman, through Kenworthy, overcharged the funds $1,128,9016," the SEC said.
"It is common in the industry for firms to base fees on the average amount of capital contributions," said Stadulis. "One of the lessons here is that to the extent you are charging fees in a novel way, make sure you disclose that."
A matter of expenses
As for expense disclosure, the administrative order states that, from 2013 through 2014, Coachman charged its funds management expenses based on 1.5 percent of the aggregate capital contributions made to each fund as of the final day of the year.
But as with the fee disclosure, a similar disclosure problem arose. "The offering materials and operative documents for [two of the funds], all of which were reviewed and approved by Kenworthy, failed to adequately disclose that those funds would be required to reimburse Coachman for management expenses by as much as 1.5 percent of year-end capital contributions," the agency said. "Instead, these materials appeared to disclose that Coachman charged management expense reimbursements based upon the average [emphasis ACA insight] amount of capital contributions under management during the course of the year."
"As a result of charging [the two funds] management expenses based on year-end rather than the average amount of capital contributions under management during the course of the year, Coachman, through Kenworthy, overcharged [the two funds] a total of $449,294," the SEC said.
"‘Average’ vs. ‘aggregate’ may be about only one word, but that word had a pretty big impact on the total fees paid to the adviser," said King & Spalding partner Alec Koch. "Advisers need to be aware that the SEC is going to closely scrutinize whether the fees they charge are consistent with the disclosures they made to investors. When they’re not – and especially when, as in this case, the discrepancy favors the adviser – the SEC likely will see that as a potential violation."
While one takeaway from this settlement that may be obvious is that advisers need to "read the fee provisions in their offering and operative documents and follow that to the letter," said Ropes & Gray partner Jason Brown, he said another is that advisory firms need to "make sure that the people who calculate the fees know how they work."
"There should be a process in place at firms so that a second person on the finance team compares fees when they are calculated to what was disclosed," he said, adding that this does not necessarily need to be done every time fee calculations occur, depending on the circumstances, but should be performed on at least on a periodic basis during each year, with some general oversight by compliance.
While the discrepancy between what the funds’ offering and operative documents in terms of fee and expense calculations compared to what Coachman actually charged the funds constitutes the majority of the agency’s enforcement action, there is another allegation as well.
According to the administrative order, the advisory firm, through Kenworthy, "caused one of the funds to enter into a transaction with an affiliated entity without properly disclosing or obtaining investor consent to the conflicts of interest associated therewith."
Here’s what the SEC said happened: Coachman, through Kenworthy, in June 2014, caused one of the funds "to enter into an asset purchase agreement whereby [the fund] purchased certain oil and gas leases and related assets, together with an account receivable . . . , from a related fund (the ‘selling fund’) previously managed by Kenworthy." Known as the "Steelhead transaction," it occurred, the agency alleged, at a time when the selling fund was managed by a company in which Kenworthy was a 50 percent owner.
In addition, according to the administrative order, prior to the transaction, both Coachman and Kenworthy were aware of information "that called into question the collectability and resulting valuation of the account receivable."
"At the time of the Steelhead transaction, Coachman and Kenworthy failed to adequately disclose to [the fund’s] investors conflicts of interest associated with the transaction," the SEC said. The agency’s allegations included that:
Kenworthy had previously managed the selling fund and had a 50 percent ownership in the selling fund’s manager;
The cash portion of the purchase price for the transaction "would be used to pay the manager’s debts;" and
The questionable collectability of the account receivable "could cause [the fund] to overpay for that asset."
"As a result of its failure to properly disclose and obtain investors’ consent to the conflicts associated with the Steelhead transaction, Coachman, through Kenworthy, caused [the fund] to overpay for the account receivable by approximately $510,000," the agency said.
Charges and remedial action
The SEC, as part of the settlement, charged that Coachman willfully violated, and Kenworthy willfully aided and abetted and caused Coachman’s violations of two sections of the Advisers Act: 206(2), which prohibits fraud; and 207, which prohibits making untrue statement of material fact in any registration application or report filed with the Commission.
The agency did credit both the advisory firm and Kenworthy with "remedial acts promptly undertaken," and that may be a reason for the relatively small civil money penalties.