Examiners and Enforcement Division Keep an Eye on the Fees and Expenses Ball
Fees and expenses, and how advisers allocate them, constitute much of what compliance is about. While some compliance officers may consider fee and expense†allocation among the most basic of compliance practices, they should avoid the trap of thinking they have it covered, when in fact, they may not. Nor should they be lulled into believing that agency examiners and investigators donít look for such violations, when, in fact, they do. This may be particularly true with private fund advisers.
The SECís September 11 settlement with Maryland-based private equity advisory firm Potomac Asset Management Company and its founder, Goodloe Byron Jr., is a case in point. PAMCO and Goodloe in 2012 and 2013†allegedly improperly charged $2.2 million in fees to one of its funds for services that a PAMCO affiliate provided to a portfolio company of that fund, not the fund itself Ė something that PAMCO was not authorized to do,†according to the SECís administrative order instituting the settlement. Nor, the agency said, did PAMCO disclose those charges to the fund.
PAMCO also improperly used fund assets to pay its own expenses, including compensation and rent Ė and even to pay the costs from the agencyís exam visit in connection with the fee expense allocations, as well as the Division of Enforcementís subsequent investigation.
PAMCO, a relatively small firm with $114 million in†assets under management, agreed, as part of the settlement, to pay a civil money penalty of $300,000. The SEC also censured the firm. It apparently escaped enforced disgorgement and further fines because of remedial†efforts it undertook, including voluntarily reimbursing, with interest, the two funds where fee and expense misallocation were at issue. An attorney representing the firm did not respond to a voice mail or email seeking comment.
"The case is a reminder of the obvious and often highlighted fact that it is imperative than an adviserís†expense and fee practices be fully disclosed and in†accordance with the fundís governing documents," said Shartsis Friese partner Jahan Raissi. "Given the number of significant alleged violations, the fact that the sanctions imposed are not more severe also shows the benefits of firms promptly taking thorough and meaningful remedial measures when regulatory issues are identified."
Shearman & Sterling partner Mark Lanpher said that allocation errors between an adviser and its funds may be more likely to occur with smaller advisers. "Itís more understandable why a smaller adviser may not feel the same degree of separation from his clients."
He suggested the following steps for advisers to make sure these kinds of errors are not happening at their firms:
"When new expenses occur, review them and assign as appropriate;" and
For older expenses, "advisers would be well advised to do periodic reviews to make sure they did not make any misallocations in the past, as the error will be compounded if not discovered and corrected."
The advisory firm and the fees
PAMCO, according to the administrative order, provides advisory management services to two funds, which the SEC identifies as Fund I and Fund II, each governed by a limited partnership agreement and private placement memorandum. Under the LPAs, PAMCO was entitled to receive an annual management fee equal to 2 percent of committed capital, which was required to be offset by a percentage of PAMCOís other income, including other fees it or its affiliates received from portfolio companies.
The LPAs also required PAMCO to be responsible for paying manager expenses, including compensation of PAMCO employees, office rent and regulatory expenses, the administrative order said.
Between 2012 and 2013, PAMCO provided services to a portfolio company of Fund I that generated $2.2 million in charges, the SEC said. However, the agency noted, "instead of charging the portfolio company directly, PAMCO, at Byronís direction, allocated to Fund I, and caused Fund I to pay, the portfolio company fees."
"Neither the LPA nor the PPM authorized PAMCO to charge the portfolio company fees to Fund I," the SEC said. "Moreover, respondent did not disclose to Fund Iís limited partners the misuse of fund assets, and†respondents could not effectively consent to this use of fund assets on behalf of Fund I because they were conflicted as the recipients of the portfolio company fees. The portfolio company ultimately reimbursed the cost of the portfolio company fees."
This, however, did not end things. Under the LPA, PAMCO was required to reduce Fund I management fees by†50 percent of portfolio company remuneration (after taxes and other costs). "However," the agency said, "PAMCO did not offset its receipt of $2.2 million in portfolio company fees against Fund Iís management fee. As a result, PAMCO collected $726,000 more in management fees from Fund I than it was entitled to receive."
The SEC, as part of the settlement, also took the position that PAMCO, at Byronís direction, improperly used assets from the two funds to pay a variety of adviser-related expenses, including:
Compensation to a member of the adviserís investment team. The agency alleged that the person, who it referred to as "Individual A," began working with PAMCO in January 2011 with a requirement that they perform 35 hours a week of consulting work. "PAMCO treated him as a third-party consultant," the SEC said, when "the vast majority of services Individual A provided, and the manner in which he provided them, were typical of the services advisory employees provide to private equity funds in exchange for a management fee. . . .PAMCO not only represented Individual A to be a Ďprincipalí of the adviser, but also a member of the adviserís Ďinvestment team.í Indeed, Individual A engaged in typical adviser activities,†including attending investor meetings, communicating with investors, selecting investments, and working with the fundsí auditor and third-party†administrator to prepare audited financial statements." Beyond that, Individual A received health and other benefits from PAMCO. From 2012 to 2015, the agency said, Individual A submitted fees and expenses to PAMCO each month totaling $489,121, "which PAMCO, at Byronís direction, in turn, allocated to the funds, and caused the funds to pay."
Office rent and other operational expenses. Between 2013 and 2014, the advisory firm allocated to the funds $212,252, "despite language in the funds PPMs and LPAs that PAMCO was to bear these expenses," the agency said.
Costs arising from an exam by the SECís Office of Compliance Inspections and Examinations and an investigation by the Division of Enforcement staff. "The fundsí LPAs provided that the funds would be responsible for the cost of legal and other professional services provided to the funds in connection with the administration or operation of the funds," the SEC said. It noted that, in 2013, OCIE examiners conducted an examination of PAMCO and that, in January 2015, the advisory firm received notice that Division of Enforcement staff would be conducting an investigation of, among other things, PAMCOís†allocation of expenses to the funds. These expenses amounted to just $2,482, but the SECís point about misallocation is the same regardless of the amount involved.
"Altogether, between 2012 and 2015, PAMCO improperly used the fundsí assets to pay $703,855 in adviser-related expenses," the agency alleged.
Violations and remedial acts
The settlement charges PAMCO and Byron with, among other things, having willfully violated Section 206(2) of the Advisers Act, which prohibits fraud; and Section 206(4) and its Rule 206(4)-8 for making untrue statements of material fact.
The agency did credit PAMCO for taking a number of remedial acts and cooperating with the agency staff. These included constituting a limited partner advisory board; hiring a new chief compliance officer; engaging an independent consultant; and voluntarily reimbursing the funds, with interest, for the management fees it failed to offset and the expenses identified in the†administrative order.†