On September 27, 2017, an administrative law judge (“ALJ”) for the United States Securities and Exchange Commission (“SEC”) dismissed the SEC’s administrative proceeding against Lynn Tilton and four Patriarch Partners entities (“Patriarch Partners”) that she owned.  The Commission alleged that Tilton and Patriarch Partners willfully violated Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 (“Advisors Act”), and Rule 206(4)-8 thereunder, by overvaluing the loan-assets of certain funds managed by Patriarch Partners and by issuing financial statements that did not comply with generally accepted accounting principles (“GAAP”).  In the Matter of Lynn Tilton, et al., Admin. Proc. File No. 3-16462, Initial Decision Rel. No. 1182 (Sept. 27, 2017).

Under Section 206(1) of the Advisers Act, it is unlawful for any investment adviser to employ any device, scheme, or artifice to defraud any client or prospective client.  15 U.S.C. § 80b-6(1).  To prove a violation of Section 206(1), it must be shown that the investment adviser was at least reckless in its conduct, meaning that the conduct was highly unreasonable “to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.”  Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d. Cir. 1978) (internal quotations omitted).  Sections 206(2) and 206(4) of the Advisers Act, which each require only a showing of negligence, prohibit investment advisers from engaging in any practice which operates as a fraud or deceit upon any client or that is fraudulent, deceptive, or manipulative.  15 U.S.C. § 80b-6.  Rule 206(4)-8 defines fraudulent, deceptive, or manipulative practices to include: making any untrue statement of material fact, omitting a material fact necessary to make the statements made not misleading to investors or prospective investors, and otherwise engaging in any practice that is fraudulent, deceptive, or manipulative.  17 CFR 275.206(4)-8(a).

By way of background, Patriarch Partners specializes in distressed private equity.  It managed three collateralized loan obligation funds (the “Zohar funds”) that were marketed to sophisticated institutional investors.  The Zohar funds held a portfolio of commercial loans by struggling companies that were selected by Patriarch Partners, and the investors in the Zohar funds received the promise of regular interest payments in return for their investments.  According to the SEC, Tilton and Patriarch Partners violated the Advisers Act by improperly overvaluing certain loans in the Zohar funds’ portfolios, thereby enabling Patriarch Partners to collect inflated management fees without disclosing that fact to investors.  The Commission further argued that Tilton and Patriarch Partners violated the Advisers Act because the Zohar funds’ financial statements to investors were not prepared in accordance with GAAP, given that impairment losses to the value of the funds’ loan-assets were not properly recognized.

In a complete victory for Tilton and Patriarch Partners, the SEC’s ALJ rejected both of the Commission’s arguments.  The ALJ dismissed the administrative proceeding because the SEC did not prove its claims by a preponderance of the evidence.  Specifically, the ALJ held that “[w]hile [Patriarch Partners] did not maximize the ease of finding it, they also did not conceal—omit to state—material information such as the amount of interest actually being paid and the interest rate and principal on the Portfolio Companies’ loans.”  In the Matter of Lynn Tilton, et al., Initial Decision Rel. No. 1182 at 51.  Instead, the ALJ concluded that necessary information on the portfolio companies’ interest payments was included in the Zohar funds’ deal documents and trustee reports, which also disclosed, among other things, that Patriarch Partners may have conflicts of interest in that management fees are derived from the fund values determined by Patriarch Partners, and in that Patriarch Partners and Tilton might own equity interests in Zohar fund portfolio companies.  Further, the ALJ noted that the investors in the Zohar funds were all sophisticated institutional investors and that the standard for materiality should be higher given that they had access to a wide mix of information. 

Separately, regarding the funds’ recognition of impairment losses in their financial statements, the ALJ did not credit Tilton’s defense that she and Patriarch Partners relied upon their accountants.  This was because there was no evidence on the record showing that the accountants were actually asked about the specific impairment policies that the SEC challenged.  The ALJ, nonetheless, held that the SEC did not sufficiently prove that the funds’ statements should have included impairment losses in the context of Tilton’s business model.  Specifically, Tilton’s business model was to continue to support the recovery of struggling portfolio companies, and thus it was difficult to determine the probability of any impairment loss.  Indeed, the statements did disclose the subjective, uncertain nature of the valuation techniques they used.  Moreover, the ALJ held that even if the SEC had proven that the financial statements violated GAAP, that alone would have been insufficient to prove a violation of the antifraud provisions of the Advisers Act.  The SEC would have needed to establish Tilton’s and Patriarch’s intent, as well.

Tilton’s victory may help dispel some criticism over litigating against the SEC on its “home turf.”  While this is only one case, it does serve as a high-profile precedent in which the SEC’s ALJ refused to take the SEC’s allegations at face value, and it gives defendants some comfort that administrative proceedings are not entirely stacked against them.  In addition, the ALJ’s decision is noteworthy for its conclusion that, at least in the context of sophisticated investors, it is difficult to show a violation of the antifraud provisions of the Advisers Act so long as the necessary information is contained somewhere in the total mix of information available to those investors. 

Click here to view In the Matter of Lynn Tilton, et al. 

Click here to view Rolf v. Blyth, Eastman Dillon & Co.