The U.S. Securities and Exchange Commission (SEC or Commission) issued a cease and desist order on September 22, 2014 (Order) against private equity fund adviser Lincolnshire Management, Inc. (Lincolnshire).1 The Order alleged that Lincolnshire violated Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act) by breaching the fiduciary duty that it owed to two separate private equity funds when Lincolnshire allegedly allocated shared expenses between a portfolio company held by one of those funds and a second portfolio company held by the other fund, in a manner that improperly benefited one fund over the other. The Order further alleged that Lincolnshire failed to adopt and implement written policies regarding the allocation of expenses between the two funds in violation of Rule 206(4)-7 under the Advisers Act. While neither admitting nor denying the allegations, Lincolnshire agreed to pay approximately $2.3 million to settle the SEC’s charges, including a $450,000 civil penalty.2
As articulated in a May 2014 speech by Andrew J. Bowden, Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), OCIE has recently identified disclosure and allocation of fund expenses as one of several common areas of deficiency among the private equity advisers that it has examined.3 In particular, in his speech, Mr. Bowden stated that OCIE had identified “violations of law or material weakness in controls” in more than half of the 150 private equity firms examined by OCIE when reviewing their treatment of fees and expenses. The Order highlights the SEC staff’s focus and concern regarding advisers’ allocation of expenses across multiple funds and in fact takes such focus one step further by alleging improper allocation of expenses at the portfolio company (rather than fund) level. The Order also highlights the importance for an adviser to maintain and adhere to written procedures that allocate expenses relating to shared services in a fair and reasonable manner across multiple funds (and portfolio companies, if relevant).
Alleged Violation of Advisers Act Section 206(2)
Background. According to the Order, Lincolnshire advised multiple private equity funds, including Lincolnshire Equity Fund, L.P. (LEF) and Lincolnshire Equity Fund II, L.P. (LEF II). In 1997, LEF acquired Peripheral Computer Support, Inc. (PCS), a California-based company. Four years later, LEF II acquired Computer Technology Solutions Corp. (CTS), a Texas-based company, with the intention of integrating these two companies and ultimately marketing them for a combined sale. In this respect, even though each portfolio company continued to be held by a separate fund with its own distinct group of investors, the Order alleges that PCS and CTS were functionally managed as one company. For example, Lincolnshire caused the two companies to integrate their financial accounting systems and a number of business and operational functions, including payroll and 401(k) administration, human resources, marketing and technology. In addition, the two companies entered into a joint line of credit, formed a joint management team and marketed themselves using a joint logo in certain instances.
Allocating Shared Expenses between PCS and CTS. Because PCS and CTS each derived a benefit from the shared business and operational functions summarized above, Lincolnshire developed a general, unwritten policy of allocating the expenses relating to those shared services between the two companies (which, as a result, also impacted the indirect allocation of such expenses to each private equity fund). Under this policy, shared expenses were generally allocated based on the proportion of each portfolio company’s individual revenue to the combined revenue of the two companies.
While Lincolnshire and the portfolio companies generally adhered to this policy, the Order alleges that a portion of the companies’ shared expenses was misallocated, resulting in one portfolio company paying more than its share of such expenses. As an example, the Order states that (1) PCS paid all of the administrative expenses related to payroll and 401(k) administration for the employees of both portfolio companies for at least eight years, and (2) PCS’ wholly owned Singapore subsidiary sold supplies to, and performed services for, CTS at cost and CTS did not contribute to the general overhead costs related to the provision of such supplies and personnel. Similarly, the Order alleges that several employees performed work that benefited both portfolio companies, but the salaries of these employees were not properly allocated between the portfolio companies in accordance with Lincolnshire’s unwritten allocation policy. In one specific example, the Order alleges that, when executives of PCS and CTS were paid transaction bonuses as part of the sale of both companies in 2013, LEF, which owned PCS, paid 10% of the bonuses of two executives who were solely CTS employees.
Section 206(2) of the Advisers Act prohibits investment advisers from directly or indirectly engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” A violation of Section 206(2) of the Advisers Act does not require proof of scienter. Because Lincolnshire allegedly allocated expense among PCS and CTS improperly, and because each portfolio company was owned by a separate and distinct fund, Lincolnshire allegedly breached its fiduciary duty to both funds in violation of Section 206(2) of the Advisers Act by causing one fund to incur more than its proper share of the shared expenses.
Alleged Violation of Advisers Act Section 206(4) and Rule 206(4)-7
Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder require registered investment advisers, such as Lincolnshire, to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act. With respect to this requirement, the Order alleged that Lincolnshire failed to adopt and implement procedures to address conflicts and related issues arising from the integration of the two portfolio companies. Specifically, while it was Lincolnshire’s general practice to allocate expenses based on the proportion of each company’s revenue to the combined revenue of the two companies, Lincolnshire allegedly failed to implement written expense allocation procedures, and neither PCS nor CTS had any written agreements related to sharing expenses or setting forth each company’s respective rights and obligations.
Considerations for Advisers after Lincolnshire
In light of this Order, investment advisers that manage multiple funds or accounts that benefit from, and incur expenses related to, shared infrastructure or services may benefit from reviewing their existing written policies and procedures concerning shared expense allocation. Among other things, such policies and procedures should seek to ensure the fair allocation of fees and expenses, not just at the fund level but also among portfolio companies.
While the Order implies that Lincolnshire’s general revenue-based allocation policy was reasonable and fair, investment advisers should note that the Order did not identify a specific acceptable formula for allocating shared expenses. Allocations of a particular kind of shared expense will necessarily depend on the nature of the shared benefit and its relevance to the applicable funds, accounts or portfolio companies. Therefore, investment advisers would be well served to consider carefully each shared expense separately when determining appropriate allocation methodologies. For example, an allocation methodology based on assets under management may be appropriate for certain items whereas fixed allocations may be appropriate in others. Further, given the Order’s focus on expense allocations occurring at the portfolio company level that then have an impact at the fund level, investment advisers may also benefit from drilling down into their investment structures when identifying whether or not two or more funds or accounts share expenses.
Expense allocation methodologies implemented by an investment adviser should be maintained in writing and advisers may be well served to document any deviations from these methodologies. Advisers should review their written guidelines on a regular basis to ensure that they are consistent with actual practice and remain accurate and complete.