The private fund industry is plagued with bad actors who don’t disclose fees and affiliate relationships. That has directly lead to the new reporting rule issued by the SEC for private fund advisers. The latest firm to get caught is the Prime Group, based in Saratoga Springs, New York. Prime’s business is investing in self-storage properties.
Prime is not registered with the Securities and Exchange Commission as an investment adviser. The new private fund reforms will only be partially applicable. Prime has at least two investment funds according to the SEC order. I assume they fall outside the definition of a “Private Fund” because Prime is relying on the c(5) exemption or claiming that the fund doesn’t invest in securities.
Prime also has an affiliate real estate brokerage firm owned by Prime’s CEO. Prime had employees and independent contractors that sourced acquisitions. When a fund bought one of these sourced acquisitions, it paid a brokerage fee to the affiliate. This arrangement is, of course, very usual and legal. According to the SEC Order, the majority of Fund II’s transactions paid a brokerage fee to the affiliate.
What Prime did wrong was sell interests in the fund without disclosing the payment of brokerage fees to the affiliate. There was some disclosure, but not enough. From the Fund II Limited Partnership Agreement:
“The General Partner may, from time to time, engage any person to render services to the Fund on such terms and for such compensation as the General Partner may determine, including attorneys, investment consultants, brokers, independent auditors and printers. Person so engaged may be Affiliates of the General Partner or employees of Related Persons.”
The SEC stated that “from time to time” failed to reflect that most of the transactions involved payment of the brokerage fee. This sounds a bit like the SEC’s attack on the use of “may” in disclosures.
The PPM for Fund II disclosed other affiliate fees, a 1% acquisition fee charged on all transactions and 5% property management fee paid to an affiliate, but failed to disclose the brokerage fee. It obviously would have been better practice to disclose the fee. It is common to pay a brokerage fee on transactions, although it usually paid by the seller, not the buyer. In my opinion if this is all the disclosures, it is potentially misleading.
The SEC dug further into Prime’s own DDQ and specific DDQs from some investors:
“Do you use the service of a broker to source deals?”
“Prime has not and does not use a broker; all sourcing is done internally.“[Disclose]any fees, including consulting fees, paid to any affiliated group or person.”
“NA.”Any other fees?
“Individual deal team members, unaffiliated with Prime Group Holdings or the fund manager, receive a brokerage fee of 1% to 3% of net purchase price.”
Unfortunately, Prime took a perfectly usual and legal fee and got itself in trouble by not disclosing it.
The twist, at least for a compliance geek, is that the SEC charge was not under the Investment Advisers Act. It was under Section 17(a)(2) of the Securities Act.
(a) It shall be unlawful for any person in the offer or sale of any securities … directly or indirectly—
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”
Since Prime was not registered as an investment adviser and the fund was not a private fund, there is a strong argument that there was no investment advice about securities and therefore the activity falls outside the scope of the anti-fraud provisions of the Investment Advisers Act. But the interests in Prime’s funds are securities, so the Securities Act does apply to the sale of those interests. So the SEC relied on the anti-fraud provisions of the Securities Act.
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