Over the last several years, the Securities and Exchange Commission (SEC) has targeted private equity funds for various fee allocation arrangements and conflicts of interest. Rather than describing the fee practices as fraudulent, which would require a showing of scienter, the SEC has concluded that the private equity advisers committed disclosure violations. However, a recent proceeding in which the SEC secured a settlement based on both breach of fiduciary duty and fraud may foreshadow a more aggressive approach. Some context first.
Many of the proceedings against private equity fund advisers involve undisclosed fees. The settlement in In re Blackstone Management Partners L.L.C. is representative. There, three investment advisers affiliated with Blackstone entered into monitoring agreements with portfolio companies owned by the funds that Blackstone advised. Under the monitoring agreements, Blackstone charged each portfolio company an annual fee in exchange for providing certain consulting and advisory services. Blackstone, however, failed to disclose to the funds that it could accelerate the payment of future monitoring fees upon the private sale or IPO of a portfolio company. Based on these facts, Blackstone settled with the SEC and consented to an inadequate disclosure violation under Section 206(2) of the Investment Advisers Act, which, as the settlement makes clear, does not require a showing of scienter. The SEC has brought similar disclosure actions involving monitoring fees against private equity advisers Apollo and Fenway Partners.
Other recent SEC proceedings against private equity fund advisers have focused on the misallocation of expenses. For example, in In re First Reserve Management, L.P., First Reserve allocated to its funds certain fees and expenses of two entities formed as advisers to a fund portfolio company. This practice enabled First Reserve to avoid incurring certain expenses in connection with providing advisory services to the funds. In a settlement with the SEC, First Reserve consented to a disclosure violation of Section 206(2) without a finding of scienter. Similarly, private equity giant Kohlberg Kravis Roberts agreed to settle with the SEC for a Section 206(2) violation for improperly disclosing that it allocated to one of its funds the due diligence expenses related to unsuccessful buyout opportunities. As another example, Cherokee Investment Partners was charged with improperly allocating to its funds certain consulting, legal, and compliance-related expenses. Consistent with these other private equity proceedings, the SEC highlighted that the Section 206(2) violation did not require proof of scienter.
The SEC has not shied away from its disclosure-based approach. To the contrary, in a 2016 speech about private equity enforcement, Andrew Ceresny, the former director of the division of Enforcement said that “[w]hile our actions have taken no position on the propriety of these fees, the increased transparency has fostered a healthy dialogue between investors and advisers on what sorts of fees are appropriate.” As to whether the SEC would “bring a case asserting that a particular type of fee constitutes a breach of fiduciary duty,” Ceresny said that “it is [his] belief that awareness and transparency of fees generally will lead investors and advisers to reach an appropriate balance in terms of types and allocation of fees.” As it turns out, the SEC’s first private equity fee case of 2017—against SLRA Inc.—involved both breach of fiduciary duty and fraud.
Scott Landress was the founder of Liquid Realty, which formed two funds in 2006 to invest in real estate private equity transactions. According to the SEC’s allegations, as real estate values collapsed during the financial crisis, Landress asked the funds on three separate occasions for additional compensation to make up for reduced management fees. Each time he was rebuffed. Undeterred, Landress instructed SLRA, which was the successor to Liquid Realty, to invoice the funds 16.25 million pounds. A month later, Landress for the first time told the funds that SLRA had earned these additional fees for services provided by an SLRA affiliate. However, there was no documentary evidence that the funds hired the affiliate to perform any services.
The settlement order with the SEC provided that SLRA and Landress breach their fiduciary duty to the funds by improperly withdrawing 16.25 million pounds. In addition, the settlement stated that “[e]ven if Landress had in fact hired a Liquid Realty affiliate in 2006 to perform services for the Funds, the retention of an affiliate of the General Partner and [Liquid Realty] was a related-party transaction and created a conflict of interest,” which Landress was required to disclose. The SEC determined that, unlike the earlier private equity cases, SLRA and Landress willfully violated Section 206(1) of the Advisers Act, which is an antifraud provision that requires a showing of scienter. See SEC v. Steadman, 967 F.2d 636, 641 n.3 (D.C. Cir. 1992) (concluding that “scienter is required” under Section 206(1)). The SEC permanently barred Landress from the securities industry and ordered him to pay a $1.25 million penalty.
It remains to be seen whether SLRA signals a different enforcement approach in the private equity industry. On the one hand, as emphasized in the SEC’s accompanying press release, the decision to pursue a breach of fiduciary duty and fraud violation was clearly influenced by the fact that “Landress and SLRA helped themselves to millions of dollars’ worth of fees to which they had no legitimate claim.” As such, the SEC may have just viewed the facts there as fundamentally more egregious than those in the typical fee and expense cases from the last several years. On the other hand, however, the SEC’s order stated that the failure to disclose the related-party transaction was a breach of fiduciary duty “[e]ven if” Landress had in fact hired the affiliate to perform the work. That finding suggests that the SEC may be more inclined to bring breach of fiduciary duty or fraud claims where private equity advisers fail to disclose improper fee arrangements. In light of this uncertainty, lawyers and investment advisers should keep a close eye on the SEC’s private equity actions in late 2017 and 2018.