Category: Accounting

Charging the Gatekeeper

The SEC charged EIA All Weather Alpha Fund and its investment adviser, Andrew Middlebrooks, for fraud last year. The SEC alleged that Middlebrooks misrepresented the Fund’s performance in order to retain current investors and to induce new investors. The Adviser directed the creation of and approved an inflated NAV for the Fund with false and misleading performance results. The Fund provided investors with statements showing positive returns in the investors’ accounts and purported Fund gains from trading. In reality, the purported gains reflected in the investor statements were false. The Fund had actually lost money.

Normally, you would have expected a fund auditor to pick up on the problem. One of the claims against Middlebrooks and the Fund is that they falsely claimed the Fund had an auditor.

In the past, the SEC has shown its willingness to go after gatekeepers who missed obvious red flags in a fraud, in addition to the fraudster. The obvious target in this case would have been the auditor. The SEC claimed that Middlebrooks fabricated the financial statements and an audit report.

The SEC turned to the fund administrator for culpability. To be honest, I was a bit surprised to hear that there was a fund administrator. Based on the SEC order, it looks like the fund administrator failed to catch the red flags.

The agreement between the Fund and Theorem Fund Services required the fund to appoint an independent auditor to conduct an audit of the fund. At the onboarding in early January 2018, Theorem relied on a representation of the Fund. At year end of 2018, Theorem found out that no auditor had been engaged. That started the process of Theorem ending its services. By then, the damage had been done.

Over the course of 2018 Theorem was responsible for calculating the Fund’s NAV monthly. Theorem did what it was supposed to do and used the trading statements to calculate the NAV. The big failure happened in March 2018 when the fund lost $342,000. Rather than record the loss on the Fund, Middlebrooks decided to treat the loss as a “receivable” from the fund manager. The result would be no reduction of the Fund’s NAV. This treatment of losses as a receivable continued through 2018 and Theorem published investor statements that didn’t show the losses.

As a result of this “weird treatment,” the Fund’s performance for July 2018 since inception was positive 148.39%. The true result was a negative 63.9%.

Obviously the treatment of the loss as a receivable is “weird.” I suppose its possible that a fund could structure a loan from the manager to the fund to cover losses. That would need to be disclosed in the financial statements and creates a whole set of conflicts and compliance issues. Blackstone offered a guaranteed return to an investor in BREIT earlier this year.

Here, there was no disclosure. There was actually no receivable. There was no provision in the fund documents to allow a loan and no note or documentation to evidence the loan resulting in the receivable. Theorem just accepted that the Fund’s word that it was legally liable to reimburse the losses. (They were not.)

In January 2019, the fund switched trading platforms. Theorem at that time required disclosure of the receivable and a plan for its repayment to investors. The Fund did not do so and Theorem terminated the arrangement.

Theorem still provided investor statements with the bogus receivable until the termination was effective 30 days later.

The question I have is “who turned in the Fund and Middlebrooks?” It could have been Theorem. But the charging documents make no mention of Theorem’s cooperation. I think it’s more likely to have been a disgruntled investor.

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The One with the Fixing and Flipping

Angel Oak Capital Advisers sponsored a fund to securitize “Fix and Flip” loans. These loans were targeted at borrowers for the purpose of purchasing, renovating, and selling residential properties. It looks like Angel Oak didn’t get the underwriting correct. Angel Oak saw an unexpected increase in late mortgage payments delinquencies. The securitization had a covenant that required early amortization payments to investors in the securitization if there was a greater than 15% delinquency for two consecutive months.

The “Fix and Flip” loans had escrow accounts to pay draws to borrowers after completion of renovations the properties. The securitization documents said these escrow accounts would be used for renovations and repairs. The documents did not specifically allow the use of the escrow to reduce delinquencies.

Angel Oak divert escrowed renovation funds to bring delinquent mortgage loans into current status and reduce delinquencies. According to the SEC complaint this was not consistent with disclosures made to investors in the certification. Angel Oak contacted delinquent borrowers and instructed them to make requests for escrow funds to reimburse for renovations, with the understanding that the funds would instead be used to pay off delinquent balances. There were email documenting the process with borrowers.

There are emails documenting the decision to seek the diversion of funds.

“We have to keep the 3 month average of 60+ dq [delinquencies] under 15% to avoid an early amortization trigger to trip. This trigger tripping would be extremely negative for our prospects of doing further securitizations and will also negatively impact our broader AOMT shelf.”

The additional problem you can see from that quote is that the early amortization would hurt effort to pull in investors for the next securitization. It’s not just a question of defrauding the current investors, but using the fraud to raise more capital.

As an additional conflict, Angel Oak held a junior position in the securitization. The early amortization trigger would have a substantial, negative impact on that junior position.

Blame was also placed on Ashish Negandhi, a loan portfolio manager responsible for purchasing loans to be securitized by Angel Oak as well as monitoring the securitizations’ performance after their sale to investors.

As a result of the SEC action, Angel Oak agreed to pay a $1.75 million penalty and Mr. Negandhi agreed to a $75,000 penalty.

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The One With the Failure of Auditor Independence

The Securities and Exchange Commission charged PricewaterhouseCoopers LLP and one of its partners with violating auditor independence rules for running a project to upgrade the client’s GRC software while also doing its audit work.

Using the “one” in the title is deceiving. This is the third auditor independence case that the Securities and Exchange Commission has brought this year. In August, the SEC charged RSM International with violating the SEC’s auditor independence rules on at least 100 audit reports. In February this year, the SEC charged Deloitte Touche Tohmatsu LLC, when its consulting affiliate maintained a business relationship with a trustee serving on the boards and audit committees of three funds it audited. You can also add the sanctions by PCAOB against PricewaterhouseCoopers in another matter and another against Marcum LLP.

I found this PwC case to be more egregious.

In 2014, PwC performed non-audit services for the unnamed company “Issuer A” to implement new Governance Risk and Compliance software. GRC systems are used by companies to coordinate and to monitor controls over financial reporting, including employee access to critical financial functions. Issuer A intended to use the GRC software to generate information as part of the company’s control environment and to provide data to assist personnel in forming conclusions regarding the effectiveness of internal controls related to financial information systems.

PwC would be implementing the system that it would ultimately opine on as being effective. It would be a shame if the Issuer A paid all that money to PwC to install the system and then PwC found it was an effective control environment.

Rule 2-01(c) of Regulation S-X sets forth a non-exhaustive list of non-audit services which an auditor cannot provide to its audit clients and be considered independent. See 17 C.F.R. § 210-2.01(c)(4)(i)-(x)

Auditor conflict is not just about money or which revenue stream rules the nest. The intent is to allow the auditor to act an impartial third-party reviewer. It’s the reason that auditors are not allowed to prepare the financial statements and then opine on them.

If the auditors do the books, then they will be very reluctant to point out errors in them. If the auditor designs and implements the company’s internal control system, then of course the auditor will be very reluctant to not opine that the company has good control environment.

For fund managers who rely on auditors for compliance with the Custody Rule, auditor independence is incredibly important.

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Gatekeeper Failure for a Taking Management Fees in Advance

Steven Burrill was using his venture capital fund as a persona piggy bank and the fund’s auditor failed to do anything when it saw the red flags. Now the auditor partner is subject to charges by the Securities and Exchange Commission.

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Private funds typically take management fees in advance. That is not unusual or illegal. SEC filings for registered investment advisers specifically contemplate it. Item 18 in Form ADV Part 2A requires additional disclosures that must be made if you take prepayment of more than $1200 in fees per client six months or more in advance. Most private funds take management fees quarterly in advance to “keep the lights on.”

But Burrill started taking fees earlier than allowed under the fund documents. Eventually, Burrill took more in advance fees than could be expected to earn over the life of the fund. The SEC brought charges against Burrill and he agreed to repay the fees and pay a fine.

As the SEC has done with several other cases, the SEC brought charges against a gatekeeper who failed to act.

Adrian D. Beamish was the audit partner with PricewaterhouseCoopers LLP for the Burrill engagement. According to the SEC order:

From 2009 through 2011, Burrill characterized the payments as advances on future management fees that he would earn through the provision of future management services as the fund’s manager. The payments were made many months—and even years—before the fees were to be earned. In each of these three years, Beamish failed to inquire whether Burrill had the authority to take the unusual payments, nor did he scrutinize the rationale for the payments, which Burrill needed to pay his own personal expenses and to fund his other businesses. Significantly, in conducting the yearend 2012 audit, Beamish learned that the advanced management fee payments that had been paid greatly exceeded any potential future management fee obligations the fund might owe.

The prepaid management fees were almost $5 million at the end of 2009, over $9 million in 2010 and over $13 million by the end of 2011.

“Had Beamish made appropriate inquiries as required by professional standards, his audit team would have likely discovered that the fees advanced to the General Partner had been used for the business operations of affiliated Burrill entities, such as Burrill Securities LLC, and to pay for Burrill’s own personal expenses.”

The SEC charges that Beamish failed to exercise professional care mandated by the accounting standards. According to the SEC, he failed as a gatekeeper.

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Auditor Independence Enforcement Actions

The Securities and Exchange Commission announced its first enforcement actions for auditor independence failures. I expect your auditors may have a bunch of new restrictions and questionnaires when it is time for the annual audit.

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The SEC announced two separate enforcement actions, both involving Ernst & Young.

In one case, Gregory S. Bednar got too cozy with a audit client’s CFO. Bednar and the CFO stayed overnight at each other’s homes, took family trips together and they exchanged hundreds of personal messages.

In the other case, Pamela Hartford violated the auditor independence rule by having a romantic relationship with an executive at an audit client.

According to the SEC’s orders, Ernst & Young required audit engagement teams to follow certain procedures to assess their independence. They asked employees if they had family, employment, or financial relationships with audit clients that could raise independence concerns.  The SEC says that is not enough. Apparently the SEC is expecting a broader question about “non-familial close personal relationships” that could impair the audit firm’s independence.

Ernst & Young’s independence policies “recognized that a non-familial close personal relationship between an engagement team member and a client employee in an accounting or financial reporting oversight role could present an independence problem”.  But the firm had no procedures to identify those relationships and whether a relationship could jeopardize independence.

I expect that audit firms are going to broaden their independence questionnaires. I expect some of the questions and responses could be quite awkward.

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Taking Management Fees In Advance, and Then More

It is not uncommon for fund managers and investment advisers to take management fees payable in advance. At some point, taking fees in advance is just stealing from investors. Steven Burrill and his firm reached that point and went well beyond it.

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To be clear, taking management fees in advance is not illegal. In fact, the SEC filings for registered investment advisers specifically contemplate it. For those of you who recently filed your Form ADV, Item 18 in Part 2A addresses additional disclosures that must be made if you take prepayment of more than $1200 in fees per client six months or more in advance.

Burrill Capital Management was an exempt reporting adviser with the SEC under the Investment Advisers Act. The firm fell into the venture capital firm exemption.

For fund managers, the ability to take a management fee and whether it can be taken in advance is going to be governed by the fund documents. In the case of Burrill Life Sciences Capital Fund III, LP, it appears the fund documents allowed the manager to take the management fee at the beginning of a quarter for the services to be given during that quarter.

Burrill ran into cash flow issues and took cash from the fund as an “advance on management fees” in late 2007 for the first quarter of 2008. It was violation of the fund documents. It was only four days early, but still a clear violation. It was only a small step, but it was a step over the line.

That made it easier for Burrill to take more steps over the line. Burrill continued to take management fees earlier than allowed by the fund documents when the firm encountered cash flow issues.

Since Steven Burrill owned most of the firm, a big chunk of that management fee would end up in his personal accounts. But to make the early advances even worse, Burrill at times directed the early advances to be deposited directly into his personal bank accounts.

By the first quarter of 2012, the firm had taken more in advanced management fees than could be expected to be earned over the life of the fund. But Burrill still kept taking cash from the fund.

Although this comes across as an SEC enforcement case, private action had happened much earlier.

Ann Hanham, Roger Wyse and Bryant Fong,  former employees of Burrill, discovered the problem in 2013. The trio confronted Burrill. After no action was made to repay the fund, the trio went to investors in the fund. The investors removed Burrill as general partner of the fund in 2014. The investors filed a fraud suit against Burrill in 2015. The investors also filed a suit against the fund’s auditor for failing to catch the fraud.

The SEC case resulted in Burrill repaying $4.785 million he took for personal use and a $1 million penalty.

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New ILPA Fee Reporting Template

Investors look for transparency in fees. The Institutional Limited Partners Association published a Fee Reporting Template Last Week to encourage uniformity in the fee disclosures being made to private fund investors.

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The aim of this proposed template is to encourage increased uniformity in the fee disclosures the fund managers provide to limited partners in private funds. ILPA proposes two benefits:

  1. Providing limited partners with an improved baseline of information that lends itself to more streamlined analysis and informed internal decision making
  2. Reducing the compliance burden on fund managers, who face a variety of bespoke template formats

Only two fund managers have signed on as endorsing the template.

Already, the California controller is pitching the SEC to mandate the template as a reporting obligation.

Fees in all investments have disclosure problems. How much are you paying in fees for your mutual funds? I, like many of you, don’t know. Most investors look at overall performance. Low fees are great, but not if it’s for low performance.

Private funds are obviously different form mutual funds. It’s not easy to sell and re-invest the money.

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The SEC Goes After the Gatekeepers: Grant Thornton Edition

“Audit firms must be held responsible when systemic failures such as inadequate engagement procedures, staffing, or supervision cause the firms’ work to fall significantly short of expected standards, particularly when multiple audits and engagements are involved.”

– Andrew J. Ceresney, Director of the SEC’s Division of Enforcement.

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The SEC recently brought separate cases against senior housing provider Assisted Living Concepts and alternative energy company Broadwind Energy for disclosure violations.

When a fraud is uncovered, the Securities and Exchange Commission not only wants to get the fraudsters, it also wants to get those who should have stopped the fraud: the gatekeepers. The SEC also brought a companion case against those firm’s external auditors: Grant Thornton.

Assisted Living Concepts and Broadwind Energy both had the same engagement partner. The SEC brought charges against the engagement partner, Melissa Koeppel, and Jeffrey Robinson who worked on the Assisted Living Concepts audits.

Assisted Living Concepts had faked occupancy levels by including employees and other non-residents as occupants to meet loan covenants. The SEC order claims that the auditor was aware of this red flag and should have done more. If the firm had done so, it would have spotted the fraud.

“Grant Thornton was aware of red flags suggesting audit quality issues in the audits conducted by one of its engagement partners and its audit quality more generally, but failed to remedy the situation,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement

The SEC charges that the auditor should have spotted the issue with an impairment at Broadwind.

“They also failed to exercise due professional care and skepticism or obtain adequate audit evidence related to a significant bill-and-hold transaction.  The revenue from this transaction allowed Broadwind to meet its debt covenants.”

Without admitting or denying the SEC’s findings, Koeppel agreed to pay a $10,000 penalty and be suspended from practicing before the SEC as an accountant for at least five years, and Robinson agreed to pay a $2,500 penalty and be suspended from practicing before the SEC as an accountant for at least two years.

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The SEC Goes After the Gatekeepers

When a fraud is uncovered, the Securities and Exchange Commission not only wants to get the fraudsters, it also wants to get those who should have stopped the fraud: the gatekeepers. The SEC recently brought a case against an investment advisory firm and its CEO for fraudulently inflating the values of investments in the portfolio of a private fund they advised so they could attain unearned management fees. The SEC also brought a companion case against the fund’s external auditors

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Chris Yoo and his firm agreed to settle fraud charges related to his failure to inform clients that they received significant fees when referring clients to invest in the fund. In addition to failing to disclose the conflict, beginning in 2011, Yoo directed the firm to withdraw purported fees that were based on fraudulently inflated investment values or were otherwise disproportionate from the fund’s actual profits. Yoo falsely claimed that the fund owned an asset that had appreciated to approximately $2 million in value. In reality, the fund owned an entirely different asset that was worth less than $200,000. As a result of Yoo’s false claim, the fund’s financial statements materially overstated the fund’s investment values. As a result of the inflated values, they withdrew nearly $900,000 in purported fees to which they were not entitled.

The SEC thought the external auditors should have caught the fraud if the auditors had properly conducted a GAAP audit.

Raymon Holmdahl and Kanako Matsumoto worked for Peterson Sullivan LLP and served as the leads on the audit of Yoo’s fund.

“Holmdahl and Matsumoto did not uncover the fraudulent activity because they failed to properly verify the fund’s assets despite having reason to question Yoo’s valuations,” said Erin E. Schneider, Associate Director for Enforcement in the SEC’s San Francisco Regional Office.

Holmdahl and Matsumoto took over the audit work after the previous auditor resigned because it disagreed with the valuation of a particular security. The old auditor could not find enough evidence of the existence of the asset or its valuation. Holmdahl and Matsumoto failed to get third party verification.

Yoo’s fund claimed to own shares in “Prime Pacific Bank” that were illiquid. The fund used a model to claim a price of $3.22 a share, more than triple the $1 purchase price. In reality, the fund owned shares in “Prime Pacific Financial Services” that traded at price between $0.27 and $0.70 during the relevant period. A third party verification should have caught this name mistake.

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Management Fee “Waiver” Tax Treatment

The Treasury and the Internal Revenue Service issued proposed regulations relating to disguised payments for services rendered by a partner to a partnership. Private fund managers have used management fee “waiver” mechanisms by reducing the management fee payable to the fund’s manager and the receipt of a corresponding profits interest by the general partner. The proposed regulations take a new look at whether that waiver mechanism would be invalid as a disguised payment for services.

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The proposed regulations focus primarily on whether the payment to the service provider lacks “significant entrepreneurial risk.” In determining whether an allocation and distribution arrangement will be treated as a disguised payment for services, the proposed regulations focus on whether the allocation and distribution are subject to this significant entrepreneurial risk. The regulations call for a determination at the time the arrangement is entered into and re-tested at the time of any later modification. An arrangement that lacks significant entrepreneurial risk would be treated as a disguised payment for services. An arrangement that has significant entrepreneurial risk generally will not be treated as a disguised payment for services, although additional factors must be considered.

The proposed regulations set up a presumption that certain circumstances lack significant entrepreneurial risk:

  1. Capped allocations of partnership income, if the cap is reasonably expected to apply in most years.
  2. An allocation for one or more years under which the service provider’s share of income is reasonably certain;
  3. Allocations of gross income;
  4. An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise);
  5. An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.

These are just proposed regulations and are still open for comment. That also means the regulations may change if adopted.

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