Category: Fees and Expenses

No More Accelerated Monitoring Fees

In the proposed Private Fund Reform Rules, the Securities and Exchange Commission had contemplated a ban on charging a portfolio investment for monitoring, servicing, consulting, or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment. This was an attack on a practice of some private equity firms to enter into a long term agreement with a portfolio company to enter into long term contracts, then have unexpired terms paid at exit.

That ban was dropped as an explicit rule from the reforms package. Instead the SEC made it an implicit rule.

The SEC stated on page 250:

“We believe that charging a client fees for unperformed services (including indirectly by charging fees to a portfolio investment held by the fund) where the adviser does not, or does not reasonably expect to, provide such services is inconsistent with an adviser’s fiduciary duty.”

The SEC also points out that it has brought actions in the past under Section 206(2) against private fund managers for improperly charging monitoring, servicing, consulting, or other fees, which may accelerate upon the occurrence of certain events, to a portfolio investment.

It did so again this week with charges against American Infrastructure Funds because it accelerated a portfolio company monitoring fee without timely disclosure to clients or investors. The SEC’s order also finds that American Infrastructure Funds violated its duty of care by failing to consider whether the fee acceleration was in its clients’ best interest.

I’m not sure why the SEC pulled back and didn’t make the accelerated fee ban explicit. The whole purpose of the series of 206(4) rules is to allow the SEC to “define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.” Instead, the SEC is relying on regulation by enforcement under the fiduciary standard.

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The One with the Failure to Disclose Fees

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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The One with the Miscalculated Fees

The Securities and Exchange Commission has made it clear that one of its primary points of interest with private funds is fees and expenses. Some of that is well-deserved. Some private funds had a history of being opaque about fees and expenses.

A recent enforcement case by the Securities and Exchange Commission highlights mistakes that could easily be made by a fund manager if not paying attention to what the fund documents say. The case against Energy Innovation Capital Management, LLC is illustrative of items to pay attention to when checking management fee calculations.

The first thing to note is that Energy Innovation is a venture capital firm and is an exempt reporting adviser. Those types of firms are not subject to routine examination. I’m intrigued how the SEC came across the fee calculation problems at the firm.

As with most non-hedge private funds, the fund management fee calculation changes after the equity commitment period ends. During the commitment period, the fee is a percentage of committed capital while the fund deploys the capital. Once the commitment period ends, the fund is limited in its ability to make investments and the fee basis is reduced to an amount that generally equates to the amount of capital deployed.

In the Energy Innovation fund the commitment period ended in the first quarter of 2020. The firm changed the calculation as of the end of the quarter. That was inaccurate. The fee should have been pro-rated as of the actual date. Of course, by waiting until the end of the quarter the firm had a higher fee basis for a longer time.

The second problem was that the firm included accrued, but unpaid, interest attributed to certain individual portfolio company securities in the fee basis. Without the language of the fund agreement its hard to tell what went wrong. It may be that the fund documents did not specifically allow it to be included so the SEC took the position that it can’t be included.

The biggest problem is that the firm wrote down individual portfolio company securities and wrote off certain others for valuations, but did not incorporate any of these write-downs into its post-commitment period fee basis.

The final corollary issue was that the firm aggregated invested capital at the portfolio company level in fee basis, instead of at the individual portfolio company security level. The fund documents did not permit aggregation of invested capital at the portfolio company level. I assume this is tied to the treatment of write-downs.

The net result of these problems was that the firm earned $678,861 in excess management fees. Interestingly, the the order did not require repayment of those excess fees. The order notes that “the Commission considered remedial acts promptly undertaken.” I assume the firm had already repaid the excess fees during the examination.

This enforcement action is a warning to other firms that the SEC is laser focused on management fees.

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The One with the Usual 2 and 20

Alumni Ventures Group is New Hampshire-based venture capital fund manager. It raised dozens of funds to pool capital and invest it in small companies. From 2016 through 2020, in marketing the funds the manager said its management fee was the “industry standard ‘2 and 20’.” The funds had a 10-year life.

Most of us realize there is no industry standard and it’s not as simple as 2 and 20.

Instead of charging 2% per year, the firm charged 20% up front, taking the 10 years’ worth of fees at the time of the initial capital contribution. The Securities and Exchange Commission found that this practice was inconsistent with what a reasonable investor would understand without additional disclosure.

In a statement the firm thinks its 20% up front fee is “far better for investors than chasing down small management fees every year for a decade and imperiling the investors’ ownership if the fees are not received.”  

I think that is a stretch. A fund manager can pull the fees from the capital held by the fund. By taking the fees up front, the firm is taking payment before rendering its services.

The firm could have stated that it was taking the 20% fee up front and disclosed that payment in the fund documents and marketing materials. Would that have deterred potential investors from making the investment? The SEC certainly thinks so.

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The SEC Is Not Happy with Form CRS Disclosures

Before the holidays, the Securities and Exchange Commission issued a Staff Statement Regarding Form CRS Disclosures. It caught my attention because this was a weird form of letting the industry know that the SEC had concerns about practices. Then I noticed that the SEC had created a Standards of Conduct Implementation Committee and this statement was coming from the Committee. I poked around a bit to try to find who sits on the Committee, but haven’t had any luck yet.

Form CRS is the customer relationship summary required to be provided to retail clients of an investment adviser or broker-dealer. This was part of Regulation Best Interest that was adopted in June 2019 and required compliance by June 30, 2020. After a year and a half of use, the SEC is digging in deep and trying to make it work right.

The number one problem was that use of legalese and technical language in Form CRS. I’m sure most of these were written by lawyers or heavily edited by lawyers.

They Committee also found some hedging language stating that their relationship summary “does not create or modify any agreement, relationship or obligation” between the client and the firm. The rule doesn’t allow that.

One deficiency that particularly caught my eye was that some firms were using language from the proposed rule rather than the final rule. The Staff Statement highlight some particular language:

For example, many firms included the proposed conversation starters and/or proposed standard of conduct language (i.e., “We are held to a fiduciary standard that covers our entire investment advisory relationship with you.”) rather than the required language as adopted (i.e., “we have to act in your best interest and not put our interest ahead of yours”).

Regulation was a big change in disclosure for retail firms. I’m sure it is particularly hard for dually registered firms that have some of the more difficult conflicts to disclose. Everyone should expect that Form CRS will be a big focus for SEC examination for the foreseeable future.

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The Division of Examinations Is Not Happy with your Fee Calculation

The SEC’s Division of Examination ran a sweep of exams focused on advisory fees, predominantly those charged to retail clients. Not bothering with any clever names, it was simply the Advisory Fees Initiative. The Division placed 130 examination into the Initiative. The results are in a recent Risk Alert: Division of Examinations Observations: Investment Advisers’ Fee Calculations. The sweep focused on three areas:

  1. Accuracy of the fees charged
  2. Accuracy and adequacy of disclosures around fees
  3. Effectiveness of the compliance program and firms’ books and records

There is no bigger conflict with the investment adviser’s fiduciary duty than fees. An investment adviser is literally taking money from it’s client and placing the money in the adviser’s hands.

To summarize the findings in the Risk Alert:

Mistakes were made.

The bad news: exams found lots of different ways that firms messed up billing and taking fees from clients. The good news: there were no novel findings.

I guess the second one isn’t really good news. Firms have been making these same mistakes for years. The Division points back to the 2018 Risk Alert that covers all of these same problems.

The additional emphasis in the 2021 risk alert is on disclosure. The exams identified

Form ADV Part 2 brochures and/or other disclosures, including disclosure that: (1) did not reflect current fees charged or whether fees were negotiable; (2) did not accurately describe how fees would be calculated or billed; and (3) was inconsistent across advisory documents, such as stating the maximum fee in an advisory agreement that exceeded the fees disclosed in the adviser’s brochure

The risk alert does emphasize that firms must have written policies and procedures addressing fee billing and the monitoring of fee calculations.

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Bad Investments and Overcharging

Douglas Elstun failed his clients in two ways. He over charged them and he put them into inappropriate investments.  

Mr. Elstun invested some of his clients’ money in daily leveraged ETFs, which deliver multiples of short-term performance of a stock index. He also invested some clients in inverse ETFs which are designed to deliver the opposite performance of a market index in the short term. If these sound complex, you’re right. A FINRA regulatory notice said:  

“[The ETFs] are highly complex financial  instruments that are typically designed to achieve their stated objectives on a daily basis.” … “[The ETFs] are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.” 

Mr. Elstun used a buy and hold strategy for his clients with these complex ETFs, resulting in millions of dollars in losses. He either didn’t understand the ETFs because he portrayed them as hedges against a market downturn, or he was making misleading statements to his clients.  

Mr. Elstun also overcharged his clients. Even though several advisory agreements stated that he was only entitled to a fee of 1%, he started charging 1.25%. The SEC charged him with falsifying revised agreements. 

In addition to wrongfully increasing the rate, Mr. Elstun also wrongfully expanded the base of assets to apply the rate. For certain clients he included equity in houses, other real estate and vehicles that the clients purchased.  

Mr. Elstun is still contesting the charges so we only have the SEC’s side to rely upon.

Making sure investment advice is appropriate for a particular client is a key compliance role. Any good compliance review should have shown that a long term hold in those ETFs was bad advice. As you might expect, Mr. Elstun was also the CCO of the firm.

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Proration of Expenses and Proving Market Rate

The Securities and Exchange Commission will always be focused on charges to a private fund that get paid to the fund adviser or affiliate. OCIE placed this warning flag in the sand back in 2015. A fund manager has to clearly disclose affiliate fee in the fund documents. If the fee is based on a market rate, the fund manager needs to document the market rate.

The Securities and Exchange Commission fined Rialto Capital Management LLC for misallocating some affiliate costs.

The first failure stated in the SEC order is that Rialto did not properly allocate some expenses between the fund and some co-investment vehicles. It’s not clear what happened from the order. I suspect that some investments had co-investors. Some expense for the investments was paid by the fund rather than the investments. The co-investor was not getting charged for its proportional share and the fund was overpaying its share.

The second failure was not proving that some of its affiliate fees were at market rate. If the fund documents state that a fee will be at or below market rate, then its up to the fund manager to prove it so.

In 2012 Rialto conducted a market rate analysis. However, the firm did not update it from 2013 to 2017.

To compound the problem, Rialto added an 11% overhead factor to the charges for its employees to cover general expenses. Then it increased the factor from 11% to 25% and did not fully disclose this to the funds’ advisory committees.

Although this could have been an accounting oversight, the SEC added in a “willfull” standard to the violation. The SEC also added a hefty fine of $350,000.

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Fund Fee Calculations and Compliance

For investment advisers the key is conflicts. You have to disclose them and property manage them. What is the biggest conflict for an investment adviser?

(The title probably gave it away.) Fees.

This is particularly true for private funds where the investors may not see the actual fee calculation. The basis for the calculation may be complicated to calculate.

I present to you the case of ECP Manager who was the sponsor of a private fund, ECP Africa Fund II PCC. ECP collected management fees from the Fund based on its total invested capital contributions. Under the Fund’s documents, ECP could not take fees for investments that had been written off and had to reduce the fee for investments that have been written down.

In 2010, the Fund obtained warrants on the common stock of an African mining company. The investment didn’t work out and by March 2014, the Fund had valued these warrants at zero. The warrants expired in the next quarter, definitely making them worthless.

Unfortunately for its investors, ECP Manager included $3.41 million of invested capital contributions attributable to those warrants in the three quarters after the warrants expired. Unfortunately for ECP, the SEC discovered the mistake. The SEC estimated the Fund’s investors overpaid $102,304 in management fees to ECP because of the fee calculation mistake.

ECP had to pay make the investors and pay a $75,000 penalty to the SEC.

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The One With the Undisclosed Private Fund Fee Scrape

Every compliance officers knows that undisclosed revenue sources at the expense of advisory clients is going to get their firm in trouble. (That’s probably not true. But If you’re a regular reader of Compliance Building, you know that it leads to trouble.) The latest charge comes against Criterion Wealth Management.

The SEC’s complaint alleges that from 2014 to 2017 the defendants recommended that their advisory clients invest more than $16 million in four private real estate investment funds without disclosing that the fund managers had paid them more than $1 million, which was on top of the fees that defendants were already charging their clients directly.

This just a charge by the SEC and Criterion has not had a chance to defend itself. I’m just writing about this case to expose what can get you in trouble with the SEC as a warning of what not to do.

Criterion arranged for investments with two different real estate private fund managers. In some investments, Criterion would get a large portion of the performance promote. In others, Criterion was paid a trailing fee based on it’s clients’ investment in the funds.

The first arrangement results in depressed returns to the clients and created more income for Criterion. The second arrangement created an incentive for Criterion to recommend their clients stay invested in the funds.

Both of those arrangements would be perfectly fine if properly disclosed by Criterion to its clients. Criterion did have a disclosure in its Form ADV.

“Associated persons of [Criterion] are registered securities representatives and investment adviser representatives of [BrokerDealer,] a registered broker-dealer … In these capacities associated persons may recommend securities, insurance, advisory, or other products or services, and receive compensation if products are purchased through [Broker-Dealer.] Thus, a conflict of interest exists between the interests of the associated persons and those of the advisory clients.”

The SEC thought that disclosure was inadequate. It also cited a statement in Item 14 of Form ADV (referrals) that Criterion did not accept compensation from non-clients in connection with its services.

The SEC noted this problem in an exam and issued a deficiency letter.

This is the second lesson from the case. Fix the problems in the deficiency to make the SEC examiners happy. Or else the lawyers get involved.

In response to the deficiency letter, Criterion sent a letter to its clients that the compensation arrangement had created potential conflicts of interest that were not fully disclosed. The SEC wanted more in the letter. The SEC wanted Criterion to state that it had steered its clients to less-favorable classes in the funds because of the compensation arrangement and that this resulted -and continued to result- in lower returns to Criterion’s clients than other fund investors.

I’m sure there was a lot more back and forth about this than is contained in the complaint. But take the lesson.

With the lawyers involved, they found more problems at Criterion. The firm failed to conduct annual reviews for many years and hadn’t updated its compliance manual in eight years. The SEC also claims that when Criterion used a compliance consultant the firm failed to disclose the compensation arrangement to the consultant.

The complaint also claims that Criterion’s two principals had scienter and should be held personally responsible for the alleged misdeeds. One of the principals also had the title of Chief Compliance Officer, so this case also involves CCO liability. I think this clearly puts in the prong 1 category of being involved in the wrongdoing.

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