Gatekeepers – Compliance Building

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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Trustee Charged As A Failed Gatekeeper

The Securities and Exchange Commission announced that a subsidiary of Oklahoma-based BOK Financial Corporation agreed to pay more than $1.6 million to settle charges that it concealed numerous problems and red flags from investors in municipal bond offerings to purchase and renovate senior living facilities. According to the SEC’s order, BOK Financial failed in its gatekeeper role as indenture trustee and dissemination agent for the bond offerings.

In a case brought last year, the SEC filed charges against Christopher F. Brogdon for dozens of municipal bond and private placement offerings in which investors supposedly earn interest from revenues generated by the nursing home, assisted living facility, or other retirement community project supported by their investment. But Brogdon secretly commingled investor funds instead of using the money to finance the project described to investors in the disclosure documents for each offering and diverted investor money to other business ventures and personal expenses.

According to the SEC’s order, BOK Financial, and a former senior vice president at the bank, Marrien Neilson, became aware of numerous red flags:

Brogdon was withdrawing money from bond offering’s reserve funds and failing to replenish them.
He had failed to file annual financial statements for the bond offerings.
The nursing home facilities serving as collateral for one of the bond offerings had been closed for years.

But Neilson allegedly warned others that disclosing red flags could impair future business and fees from Brogdon, upset bondholders, and cause regulatory issues for bond underwriters. So Neilson and BOK Financial decided not to inform bondholders as required.

BOK Financial settled the charges. Neilson is challenging the charges, so we only have the SEC’s side of the story.

Neilson was the primary recipient of bonus compensation awarded on the basis of the fees paid to BOKF for the Brogdon Bond Offerings. She also received bonus compensation for other bond offerings that financed the sale of Brogdon-owned nursing homes and assisted living facilities to third parties. The SEC charged that she knew or recklessly disregarded that Brogdon was supposed to make disclosures to the bondholders about the red flags.

In the SEC Order, there are numerous emails showing Neilson in a poor light:

“In a March 1, 2010 email to one of Brogdon’s assistants regarding late debt service payments for an offering, Neilson states that the late payment put her “in an extremely awkward position” because “the Reserve Fund has previously been used and not replenished and I did not call a default.” In the same email, Neilson states that “[b]ondholders are going to want to know why we don’t used [sic] the Reserve Fund.” Neilson also states that “we need to disclose the other Reserve funds if they are not replenished,” asking Brogdon’s assistant “if you want a list of them and how much?”

I assume Brogdon was trying to keep his enterprise afloat and Neilson was helping him kick the can down the road. Perhaps a little more debt can buy a little more time to get cash flow positive. That didn’t happen and the debt facilities finally went into default and bankruptcy.

The gatekeeper should have stopped the fraud. Instead, it helped with a dozen more offerings expanding the scope of the fraud.

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Château de Crécy-la-Chapelle: Gate by Baishiya 白石崖
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SEC Charges Fund Administrator as a Failed Gatekeeper

The Securities and Exchange Commission charged Steven Zoernack and his firm EquityStar Capital Management with fraud for stealing investor money and hiding his criminal past. The SEC brought fraud charges against ClearPath Wealth Management and its principal, Patrick Evans Churchville, for operating a fraudulent scheme that resulted in at least $11 million in losses to investors. One thing in common between the two firms was that both used the same fund administer.

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SEC investigations found that Apex Fund Services missed or ignored clear indications of fraud while record-keeping and preparing financial statements and investor account statements for funds managed by ClearPath Wealth Management and EquityStar Capital Management.

This is another case of the SEC charging a gatekeeper for failing to identify and stop fraud.

The SEC’s order finds that in regard to ClearPath Apex failed to act appropriately after detecting undisclosed brokerage and bank accounts, undisclosed margin and loan agreements, and inter-series and inter-fund transfers made in violation of fund offering documents. Apex failed to correct previously issued accounting reports and capital statements and continued to provide materially false reports and statements to the funds’ independent auditor. Apex should have known that ClearPath would use Apex’s false reports to communicate financial positions and performance to the ClearPath funds’ investors.

The SEC’s order finds that in regard to EquityStar and Zoernack, Apex accounted for more than $1 million in undisclosed withdrawals as receivables owed to the funds, despite no evidence that it was able or willing to repay the withdrawals. Apex confronted Zoernack about the withdrawals and concluded he was unlikely to repay the funds. But Apex still did not properly account for Zoernack’s withdrawals even as they started to consume a significant portion of the funds’ assets. Apex sent monthly account statements to investors that it knew or should have known materially overstated the investors’ true holdings in the funds.

Apex was a failed gatekeeper. The SEC will bring charges for not taking appropriate steps. In this case, Apex knew its reports were false and still sent them to investors or to the funds knowing that they would be given to investors.

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Château de Crécy-la-Chapelle: Gate by Baishiya 白石崖
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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.

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

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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Château de Crécy-la-Chapelle: Gate by Baishiya 白石崖
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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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