A settled enforcement action, announced by the U.S. Securities and Exchange Commission (SEC) on September 14, 2016, continues the trend of increased SEC scrutiny of private equity advisers concerning the allocation and disclosure of fees and expenses. In this case, the SEC issued a cease-and-desist order (Order) against First Reserve Management, L.P. (Adviser), an investment adviser registered under the Investment Advisers Act of 1940 (Advisers Act).1
Prior to the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), many advisers to private funds had been exempt from registration as investment advisers, pursuant to former Section 203(b)(3) of the Advisers Act. Title IV of the Dodd-Frank Act eliminated this exemption, causing many previously unregistered advisers to private funds to register with the SEC and thereby become subject to its regulatory oversight and enforcement authority.
In 2012, the OCIE Staff instituted a Presence Exam Initiative, in order to better understand the unique issues and risks surrounding the newly-registered advisers to private funds. After examining more than 150 private equity firms, OCIE identified several “key risk areas,” including improper expenses, hidden fees, and issues in the marketing and valuation of private equity funds.
The enforcement action against the Adviser is the latest in a string of SEC enforcement actions targeting private fund advisers, particularly for violations pertaining to alleged improper fee and expense disclosure and allocation.2 For information regarding the SEC’s enforcement actions against private equity firms with respect to the allocation and disclosure of fees and expenses, please refer to the following Dechert OnPoints: Lessons for PE Managers from the SEC’s Ongoing Scrutiny of Private Equity Funds; Recent Action Highlights SEC’s Continued Scrutiny of Private Equity Firms; and SEC Charges Private Equity Adviser for Unregistered Brokerage Activity.
In the Matter of First Reserve Management, L.P.
The facts set forth in this OnPoint are as indicated in the Order. According to the SEC, between 2010 and 2015, the Adviser: (i) failed to fully disclose certain conflicts of interest to its private fund clients (Funds) and to investors in the Funds; (ii) allocated certain fees and expenses to the Funds without making adequate disclosures or receiving effective consent; and (iii) received discounts on services provided to the Adviser and the various Funds without passing on the discount to the Funds. Because of these alleged failures, the SEC found that the Adviser had violated Sections 206(2) and 206(4) of, and Rules 206(4)-7 and 206(4)-8 under, the Advisers Act.3 Without admitting or denying the SEC’s findings, the Adviser agreed to cease and desist from further violations of the anti-fraud provisions of the Advisers Act and Rules 206(4)-7 and 206(4)-8 thereunder, and to pay a civil penalty of $3.5 million to the SEC. In determining to accept the Adviser’s settlement, the SEC considered the remedial efforts undertaken by the Adviser and the cooperation the Adviser provided to the SEC during its investigation and examination. In addition to the civil penalty, the Adviser refunded to the Funds fees totaling $8,348,215, which had been paid to the Adviser as a result of the various alleged wrongdoings.
Expenses of Two Entities Formed as Advisers to a Portfolio Company
The Order alleged that the Adviser had failed to disclose to certain Funds the Adviser’s conflicts of interest arising from fee arrangements with its affiliated entities. The Adviser managed several Funds, including Funds XII and XII-A, which together owned a 75% investment interest in First Reserve Momentum, L.P. (Portfolio Company Fund), a pooled investment vehicle. While the governing documents of Funds XII and XII-A did not expressly prohibit the Funds from investing in pooled investment vehicles such as the Portfolio Company Fund, the governing documents did state that the Funds would invest “solely” in operating companies.
The Adviser formed two entities (Portfolio Company Advisers) as subsidiaries of, and to provide investment management services to, the Portfolio Company Fund. Additionally, the Adviser structured and operated the Portfolio Company Advisers in a way that the Adviser essentially exerted control over the Portfolio Company Advisers. Beginning in 2013, the Adviser caused more than $7 million (representing over 15%) of Fund XII’s and Fund XII-A’s combined investment in the Portfolio Company Fund to be used to pay expenses related to the creation and operation of the Portfolio Company Advisers, including regulatory registration costs, rent, utilities and salaries.
The Order alleged these payments allowed the Adviser to avoid paying certain administrative costs associated with providing investment advisory services to the Funds. According to the Order, the relationship among the Adviser, the Portfolio Company Fund and the Portfolio Company Advisers, as well as the capital contributed to the Portfolio Company Fund by Funds XII and XII-A, gave rise to a financial conflict of interest that the Adviser failed to disclose to the Funds or the investors therein. Further, the Adviser failed to utilize a mechanism by which the Adviser could present potential conflicts of interest to an advisory board for review and approval. Following an OCIE Staff examination, the Adviser voluntarily reimbursed to Funds XII and XII-A the respective Funds’ investments, in an aggregate amount of $7,435,737, that went toward paying the aforementioned expenses to the Portfolio Company Advisers. The Adviser also provided to the investors in Funds XII and XII-A written notice detailing the nature of the refund and of the Adviser’s expense allocation plans going forward.
The Order alleged that the Adviser caused various Funds to pay insurance premiums that were outside the scope of expenses disclosed to the Funds. The governing documents of the Funds provided that the Funds would bear 100% of the cost of any insurance “relating to the affairs” of the Funds. Beginning in 2008, however, the Adviser caused the Funds to pay 100% of the insurance premiums for a policy covering the Adviser, even though some of the premiums did not arise out of the Adviser’s management of the Funds. After a compliance review by a third party, the Adviser revised its practices so that the Adviser would bear any insurance costs not directly relating to its management of the Funds. The Adviser also voluntarily refunded $733,012 to the Funds, which amount represented their share of past insurance premiums. Further, the Adviser provided written notice detailing the nature of the refunds and the Adviser’s revised practices moving forward.
Legal Fee Discount
The Order alleged that the Adviser had failed to obtain consent from the Funds before accepting a discount for legal services where the discountonly served to benefit the Adviser. Between at least 2010 and 2014, the Adviser retained an outside law firm (Law Firm) to provide legal services to the Adviser and the various Funds. Due to the volume of work the Law Firm was conducting for the Adviser and the various Funds, the Adviser negotiated a discounted legal fee arrangement for itself, but the Funds did not receive a discounted fee.
The SEC considered the timing of the Adviser’s disclosure as a basis for the SEC’s finding that such disclosure was inadequate. The Adviser provided disclosure regarding potential service provider discounts only after investors had made capital commitments to the Funds. Further, the Adviser did not disclose that it had actually received a discount on legal fees while the Funds did not receive a comparable discount on the same services. Following the OCIE Staff examination, the Adviser voluntarily refunded $179,466 to the Funds, which amount represented the discount the Funds would have received if the Adviser had passed on to the Funds the benefit the Adviser received from its discounted arrangement with the Law Firm. The Adviser also provided written notice to the Funds’ investors detailing the nature of the refunds and the Adviser’s plans to pass on any discounts from the Law Firm for future services.
Failure to Adopt Adequate Written Compliance Policies and Procedures
The SEC alleged that in connection with the aforementioned violations, the Adviser had failed to adopt written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder. The Adviser was responsible for appropriately allocating certain expenses among itself and the Funds. Furthermore, the Adviser was responsible for ensuring that its use of a service provider in common with the Funds did not violate the Advisers Act. The SEC alleged that the Adviser did not adopt written policies and procedures to ensure that the fee allocations and other aforementioned conflicts of interest between itself and the Funds were properly disclosed.
The Adviser was found to have violated the anti-fraud provisions of the Advisers Act and rules thereunder due to its failure to adequately disclose or receive effective consent regarding conflicts of interest and the allocation of fees and certain expenses. Additionally, the Adviser did not maintain adequate written compliance policies and procedures to safeguard against these violations. The SEC has increasingly examined private equity advisers and will likely continue to do so, with a particular focus on improper disclosure of conflicts and the allocation of fees and expenses. Private equity advisers should consider whether they have written compliance policies and procedures and adequate disclosure surrounding conflicts of interest and the treatment and allocation of fees and expenses. Furthermore, such policies and procedures should be reviewed on a regular basis in light of the SEC’s continuing activities and evolving guidance. Specifically, private equity advisers should endeavor to provide disclosure, whenever possible, with sufficient time to enable investors to factor that disclosure into their investment decisions in a meaningful way. Advisers should also note that the disclosure issues would generally apply as well to other types of private funds.