On September 22, 2014, the Securities and Exchange Commission ("SEC") charged Lincolnshire Management, Inc. ("Lincolnshire"), a New York-based private equity fund adviser, with breaching its fiduciary duty to two investment funds under its management by misallocating expenses between the two funds.¹

According to the SEC's order, Lincolnshire advised both Lincolnshire Equity Fund, L.P. ("Fund I"), formed in 1993, and Lincolnshire Equity Fund II, L.P. ("Fund II"), formed in 1999. In 1997, Fund I acquired Peripheral Computer Support, Inc. ("PCS"). In 2001, after the expiration of Fund I's commitment period, Fund II acquired Computer Technology Solutions Corp. ("CTS"). Lincolnshire disclosed to limited partners in both funds its intention to integrate the two companies and market them for a combined sale.

At Lincolnshire's direction, the management teams of PCS and CTS integrated the operations of the two companies, including their financial accounting systems, payroll and 401(k) administration, and substantial portions of their human resources, marketing and technology departments. The companies also entered into a joint line of credit, formed a joint management team and developed a joint logo. In 2013, PCS and CTS were sold together to a single buyer.

The SEC indicates that many shared expenses were allocated between the companies based on a general policy that shared expenses be borne in proportion to each company's contributions to their combined revenue. However, the SEC cites the following practices of Lincolnshire as improper:

1. Certain shared expenses were misallocated and went undocumented, resulting in one portfolio company paying more than its share of expenses that were for the benefit of both companies. For example, PCS paid the entire cost of certain 401(k) administration services that covered both PCS and CTS employees.
2. Several employees performed work for both PCS and CTS, but their salaries were not allocated between the two companies.
3. A wholly-owned subsidiary of PCS based in Singapore performed services and sold supplies and parts to CTS at cost. However, CTS did not contribute to the general overhead costs of the Singapore subsidiary, which were borne by PCS. For example, certain employees of the Singapore subsidiary were devoted solely to performing work for CTS. While CTS reimbursed PCS for the salaries of those employees, it did not pay any of the costs associated with their office space, their computers or the local business license that PCS was required to maintain in order to do business in Singapore.
4. When executives were paid transaction bonuses in connection with the sale of both companies, Fund I, which owned PCS, paid a portion of the bonuses for two executives who were solely employed by CTS.

As a result of the foregoing, the SEC found that Lincolnshire violated Section 206(2) of the Investment Advisers Act of 1940 (the "Advisers Act") by breaching its fiduciary duty owed to Fund I and Fund II. The SEC also found that Lincolnshire violated Section 206(4) of the Advisers Act and Rule 206(4)-7 thereunder by failing to adopt and implement written policies reasonably designed to prevent violations of the Advisers Act arising from the integration of PCS and CTS and the sharing of expenses between the two companies.

Lincolnshire consented to the entry of the order, neither admitting nor denying the SEC's findings, and agreed to pay $1.5 million in disgorgement plus $358,112 in prejudgment interest and a $450,000 civil penalty.

The Lincolnshire order is a reminder that investment advisers are subject to fiduciary duties under both state and federal law. At the state level, an adviser's fiduciary duties of care, loyalty and candor generally arise out of common law principles of trust and agency, as well as, in the case of an adviser serving as both fund manager and general partner, the default fiduciary duties owed to a partnership by its general partner.² At the federal level, an adviser's duties arise out of the anti-fraud provisions of the Advisers Act, especially Section 206 and the rules promulgated thereunder, which courts have interpreted as imposing an independent federal fiduciary standard on advisers.³ Importantly, this federal fiduciary standard has generally developed independently of, and in some cases may not be coterminous with, state-level fiduciary standards.⁴ While the Advisers Act does not provide a private right of action with respect to violations of Section 206, the SEC has developed a practice of initiating enforcement proceedings against advisers for breach of the federal fiduciary duty, in some cases recovering disgorgement of fees and returning those amounts to advisory clients. As the Lincolnshire order appears to demonstrate, the SEC may be inclined to pursue enforcement action against advisers even where there is no allegation by investors of poor investment performance, no allegation of scienter or unjust enrichment and no effort by investors to pursue damages for breach of state law fiduciary duties.

The Lincolnshire order is also a reminder of the SEC's heightened focus on private equity fund advisers, as discussed in a recent speech by Andrew J. Bowden, Director of the SEC's Office of Compliance Inspections and Examinations ("OCIE").⁵ As Bowden explained, in the wake of the large number of private equity advisers required to register under the Advisers Act as a result of the implementation of Dodd-Frank reforms,⁶ OCIE has made it a priority to develop a greater understanding of the private equity industry. Part of that effort is the Presence Exam Initiative, in connection with which OCIE has performed examinations of more than 150 newly-registered private equity advisers, with a goal of examining 25% of all new private fund adviser registrants by the end of 2014.

Having nearly completed the Presence Exam Initiative, Bowden notes that "the most common observation our examiners have made when examining private equity firms has to do with the adviser's collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time."

The specific observations of OCIE shared by Bowden focus on the following themes:

1. Expense Shifting. Some advisers have been found to shift expenses from themselves to their clients during the life of a managed fund. In certain instances, persons originally presented to investors as employees of the adviser were terminated and re-hired as "consultants" to the fund or a portfolio company, converting expenses originally borne by the manager into fund or portfolio company expenses borne by investors. The SEC has found that many advisers cause their portfolio companies to hire an "operating partner" of the adviser, whose role is to work with portfolio companies to implement operational improvements. Though operating partners may work exclusively for the adviser and function as a member of the adviser's core team, they are in many cases paid by the portfolio company rather than the adviser. The SEC has found that many advisers have failed to disclose to limited partners that such services are essentially being paid for on an "à la carte" basis, on top of the management fee and carried interest charged by the adviser. In other cases, advisers have billed managed funds for overhead expenses that have traditionally been covered by the management fee without proper disclosure to investors. Interestingly, the SEC has noted that the automation of certain back-office processes, such as investor reporting, has resulted in the shifting of expenses where, for example, the cost of reporting software is borne by investors rather than the adviser, who is responsible for delivering reports.
2. Hidden Fees. The SEC has found that some advisers have, without sufficient disclosure to investors, charged administrative fees to their funds or portfolio companies, hired related-party service providers and charged transaction fees in cases not contemplated by the applicable fund documentation. Additionally, some advisers were found to have caused their portfolio companies to enter into monitoring agreements with terms longer than the expected investment hold period, or even longer than the term of the fund. When the fund ultimately disposes of the portfolio company, the adviser collects a termination fee, often calculated by accelerating the monitoring fee payments that would have been made through the remainder of the term of the monitoring agreement. This practice can result in very large fees to advisers, which the SEC has found are often insufficiently disclosed to investors.
3. Marketing and Valuation. The SEC has found that some advisers have artificially enhanced performance data during fundraising periods by, among other things, changing valuation methodologies without adequate disclosure, reporting internal rates of return on a gross basis without deducting fees and expenses, cherry-picking comparables and adding back inappropriate items to EBITDA. The SEC has noted that it is also watching for other potentially misleading marketing tactics, such as the use of projections in place of actual valuations without proper disclosure and misleading statements about the investment team. In particular, the SEC has raised concerns about situations where key adviser principals resign after the completion of a fundraising cycle, suggesting that the adviser knew about the impending change and failed to disclose it to investors.

Bowden's comments and news of the Lincolnshire order should serve as a reminder for investment fund advisers to review their policies and practices to ensure that they are compliant with applicable law, including applicable fiduciary standards at both the state and federal level. Additionally, it is more important than ever for investment advisers to ensure that they are using carefully crafted limited partnership agreements and private placement memoranda that include adequate disclosure of investment strategies, valuation procedures, fees and expenses to be borne directly or indirectly by investors, and procedures for mitigating potential conflicts of interests.

¹ The SEC's press release is available here. The SEC's order is available here.

² This analysis would be comparable with respect to an affiliate of an adviser serving as general partner of a fund organized as a limited partnership or as manager of a fund organized as a limited liability company. See Byron F. Egan, How Recent Fiduciary Duty Cases Affect Advice to Directors and Officers of Delaware and Texas Corporations, University of Texas School of Law 36th Annual Conference on Securities Regulation and Business Law, Dallas, TX, Feb. 14, 2014, at pages 431-462.

³ The seminal case in this regard is SEC v. Capital Gains Research Bureau, 375 U.S. 180, 181 (1963).

⁴ See, e.g., Laird v. Integrated Res., Inc., 897 F.2d 826, 837 (5th Cir. 1990) ("[B]ecause our holding encompasses a developed federal standard it does not require reference to state corporate and securities law or the state law of fiduciary relationships.").

⁵ Spreading Sunshine in Private Equity. Speech by Andrew J. Bowden at the Private Equity International (PEI) Private Fund Compliance Forum 2014, delivered on May 6, 2014.

⁶ Prior to the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, many private equity fund advisers were not required to register under the Advisers Act in reliance on the exemption provided under the former Section 203(b)(3) for an adviser that during the course of the preceding 12-month period had fewer than fifteen clients and did not hold itself out to the public as an investment adviser. For purposes of counting clients under the former Section 203(b)(3), advisers generally were permitted to count each private fund under its management as a single "client," rather than counting the individual investors in each such fund.