Whitepaper: Best Practices for Managing Allocation of Fees and Expenses and Conflicts of Interest
November 30, 2016
By Jeff Stomski
Over the past few years, the SEC has made clear that allocation of fees and expenses and conflicts of interests are a priority for them when conducting exams. In 2014, a former director of the SEC Office of Compliance Inspections and Examinations (“OCIE”) highlighted allocation of fees and expenses and conflicts of interests as areas of particular concern when examining private fund managers.1 In 2016 the director of the SEC’s Division of Enforcement stated that the SEC will send a clear signal to industry participants that their practices must comport with their fiduciary duty and disclosures in their fund organizational documents.2 As such, the SEC has dedicated significant resources in raising the awareness of potential risks associated with this area of an investment adviser’s business.
Inappropriate charging of fees and expenses or inadequate disclosures of conflicts of interest can be a breach of fiduciary duty for an investment adviser and/or a violation of the antifraud provisions of numerous federal securities laws. The following list illustrates the provisions governing enforcement actions related to these areas:3
- General antifraud provisions of Section 17(a) of the Securities Act of 1933 and 10(b) of the Securities Exchange Act of 1934 would apply to a fund’s general partner and its sponsors.
- A fund’s investment adviser is subject to various antifraud provisions of Section 206 of the Investment Advisers Act of 1940 (“Advisers Act”), specifically sections 206(1), 206(2), and 206(4).
- Section 206 also imposes a fiduciary duty that states an adviser must always act in the best interest of its client and must disclose all material facts to its clients, especially if there is a potential conflict of interest.
- Section 207 of the Advisers Act prohibits the making of false statements in a report to the SEC.
- Rule 206(4)-7 under the Advisers Act requires registrants to adopt compliance policies reasonably designed to prevent violations of the Advisers Act
- Rule 206(4)-8 under the Advisers Act covers fraud by an adviser to a pooled vehicle such as a private fund.
As anticipated by its highly focused and publicized campaign, the SEC’s Division of Enforcement, working closely with OCIE, has recently imposed large sanctions against private fund managers related to fee and expense allocations and conflicts of interest (see table).4 In these actions, the SEC’s Division of Enforcement has held many “gatekeepers” responsible for the breach of fiduciary duty by specifically naming members of investment advisers’ boards as respondents. Additionally, in targeting practices previously viewed as “generally accepted” by investment advisers, the SEC has taken the firm position that unless fee/expense allocations and conflicts of interest are clearly disclosed and controlled, they may breach the adviser’s fiduciary duty or violate antifraud provisions of federal securities laws.
For the topics under SEC scrutiny, the sanctions against firms can be broadly summarized as:
- Charging or allocating undisclosed fees and expenses
- Misallocating or shifting expenses
- Failing to provide adequate disclosures of conflicts of interests
| Charged or allocated
undisclosed fees and expenses
|Misallocated and/or shifted
| Failed to provide adequate
disclosures of conflicts of interest
The Blackstone Group
Settlement: $39 million
Kohlberg Kravis Roberts & Co.
Settlement: $30 million
Fenway Partners, LLC, et al
Settlement: $10.2 million
Taberna Capital Management
Settlement: $21 million
Lincolnshire Management, Inc.
Settlement: $2.3 million
JH Partners, LLC
Kingdom Legacy Fund, LLC
Cranshire Capital Advisors, LLC
Apollo Management, et al
Settlement: $40.2 million
Specific fees and expenses under the SEC’s microscope include:5
- Due diligence and broken deal expenses
- Monitoring and consulting fees related to portfolio companies owned by private equity funds
- Legal and compliance expenses
- Permissible expenses of the fund vs. investment adviser expenses
- Allocation of fund expenses amongst multiple fund entities
Although recent sanctions have targeted private equity fund managers, we believe the SEC will sharpen its focus on hedge fund advisers by applying the knowledge gained during these examinations. Comments from SEC representatives indicate that managers should anticipate heightened scrutiny and examination focus in this area, and additional sanctions as a result.
Regardless of whether an investment adviser manages a private equity fund or hedge fund, he or she must take appropriate action to evaluate the current state of the business, identify and correct deficiencies, protect investors, ensure compliance with applicable regulations and guard against business interruptions and regulatory enforcement attributable to improper allocation of fees and expenses and conflicts of interest.
Best Practices & Controls
Common deficiencies noted in enforcement cases resulting in violations include:
- Failure to develop a sound governance framework
- Inadequate compliance policies, procedures, and oversight
- Failure to adopt a written allocation and/or disclosure policy
- Insufficient or unclear language in disclosure documents
- Failure to implement sufficient technology and/or work-flow
Incorporating best practices that satisfy applicable regulations and the implementation of effective internal controls related to conflicts of interest, fee and expense allocation and related disclosures is paramount to mitigate regulatory and business risk for any investment adviser. We have compiled the following list of best practices to assist investment advisers in developing a sound governance framework and culture of compliance within their organizations.
- Ensure complete disclosure of fee and expense allocations by clearly defining fee structures and expense allocations and their methodology in fund agreements and governing documents, including the specification of all expenses borne by the fund and those borne by the manager. Additionally, for those expenses to be allocated to the fund, document and provide the methodology for allocating expenses among multiple fund entities if applicable. Areas of consideration to achieve these disclosures include:
- Clear indication of compensation being paid to the investment adviser
- Consistency between fund agreements, governing documents, regulatory filings, investor due diligence documents and questionnaires
- Annual review of offering and governing documents to keep all documents current and ensure alignment with policies, procedures, disclosures and filings
- In making expense determinations, question whether a reasonable investor would expect a given expense be charged to the fund or borne by the adviser based on a fair reading of the fund’s governing documents (see #6)
- Ensure criteria for allocation among multiple fund entities is fair, equitable and applied consistently
- “Tone from the top” focused on strict adherence to fee and expense allocation policies, procedures, and disclosures
- Clearly defined roles of individuals within the organization
- Segregation of duties between individuals authorized to approve fee and expense allocations and individuals in the accounting/finance department
- Ensuring the Compliance Department employees possess sufficient industry and regulatory knowledge, have access to appropriate resources, and are able to devote sufficient business time to carry out their duties
- Regular and timely updates to all manuals, policies and procedures to reflect current practices and address regulatory priorities
- Annual review of the effectiveness and adequacy of all policies in line with Advisers Act Rule 206(4)-7, especially those related to allocation of fees and expenses and conflicts of interest, and in cooperation with the firm’s risk assessment process
- Continuous monitoring and audit trail, including evidence of CCO review and sign-off (see #6 below)
- Obtaining consent from investors for any changes to governing documents
- Reimbursing investors in for fees/expenses when incorrect allocation resulted in overcharging
- Developing a framework to remediate deficiencies, complete regulatory updates and consider of self-reporting
- Disclosing significant transactions and potential conflicts of interests to investors prior to completion of such transactions when practical
- Regular interdepartmental review (finance/accounting, legal and compliance) of expenses incurred and allocated to verify reasonableness
- Supervisory oversight of expense allocations and documentation of management’s justifications for making specific expense determinations as well as any actions taken to remediate issues
- Regular review of current practices and work flows to conform to written methodologies, policies, procedures and disclosures
- Charging/allocating undisclosed fees and expenses
- Misallocation or shifting of expenses
- Failure to provide adequate disclosures of conflicts of interest
Given that conflicts of interest and fee and expense allocation issues are a high priority for OCIE, it is critical that private fund managers conduct regular reviews of their practices to not only ensure they are compliant with policies, fund documents and disclosures, but also that they’re in-line with industry best practices.
1 U.S. Securities and Exchange Commission, Spreading the Sunshine in Private Equity, https://www.sec.gov/news/speech/2014--spch05062014ab.html (May 6, 2014).
2 U.S. Securities and Exchange Commission, Securities Enforcement Forum West 2016 Keynote Address: Private Equity Enforcement, https://www.sec.gov/news/speech/private-equity-enforcement.html (May 12, 2016).
3 U.S. Securities and Exchange Commission, Laws that Govern the Securities Industry Internet Archive, https://www.sec.gov/about/laws.shtml
4 U.S. Securities and Exchange Commission, Administrative Proceedings Internet Archive, https://www.sec.gov/litigation/admin.shtml
5 U.S. Securities and Exchange Commission Office of Compliance Inspections and Examinations, Examination Priorities for 2016, https://www.sec.gov/about/offices/ocie/national-examination-program-priorities-2016.pdf