Operational Regulatory Risks Facing Private Equity Firms

by Reed Smith

If you work in the private equity world, you probably know that you are already exposed to a variety of regulatory risks and obligations that can have a significant impact on your firm’s operations and financial rate of return. But you may not be aware that regulators and prosecutors are increasingly focusing on private equity firms. Some recent examples—and warnings—are below.

Tax Problems

The New York Attorney General’s Office is investigating numerous private equity firms for converting the fees charged for managing investors’ assets into fund investments. The practice, known as a “management fee waiver” or “fee-waiver conversion,” occurs when private equity firms grant investors a waiver of their management fee—typically charged at 1 percent to 2 percent of investments—in exchange for being able to use that capital as their own investment income in the fund. As fund investments, the income would be taxed as capital gains at 20 percent. Without the conversion, the fees would be ordinary income, taxed at rates of about 40 percent. The U.S. Treasury, Internal Revenue Service (IRS) unit that covers private equity firms has said that the IRS is looking at the practice and does not like what it sees. See Mark Maremont, IRS Eyes a Private-Equity Tax Move, Wall St. J., May 10, 2013; Nicholas Confessore, et al., Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms, N.Y. Times, Sept. 1, 2012.

Accounting and Valuation Problems

The U.S. Department of Justice (DOJ), the Massachusetts Attorney General, and the Securities and Exchange Commission (SEC) have been investigating whether a private-equity fund held by a publicly listed company improperly inflated its value. The government appears interested in determining whether an overvaluation skewed the overall results of the fund by showing that the fund earned 38 percent after fees, which were up from a 6.3 percent loss leading up to the alleged overvaluation. The rise in performance preceded fundraising of more than $55 million over the following year. The fund has paid millions to settle claims in the various ongoing investigations. Recently, the SEC stated that it would continue to scrutinize the valuation practices of money managers. See Gregory Zuckerman & Jean Eaglesham, Oppenheimer & Co. to Pay Fine Over Fund, Wall St. J., Mar. 11, 2013; Hazel Bradford, Oppenheimer paying investors in SEC settlement over valuation issue, Pensions & Investments, Mar. 11, 2013 (discussing continued scrutiny of valuation practices); Gregory Zuckerman, U.S. Probes Fund Operated by Oppenheimer, Wall St. J., Mar. 13, 2012.

Fund Fees and Expenses Problems

The SEC has announced that it is closely scrutinizing whether the fees and expenses that private equity firms charge investors are fair and adequately disclosed. The agency has been asking for detailed breakdowns of entertainment and travel expenditures, in some cases asking specific questions such as why the firm used a private jet or flew first class at the fund’s expense. See Julie Steinberg, SEC Digging Into Fund Fees, Wall St. J., Mar. 19, 2013.

Antitrust Problems

The Antitrust Division of DOJ has been investigating whether certain private equity firms colluded through so-called “buying clubs” or “club deals” to lower the purchase price of leveraged buyout targets. The investigations have spurred private suits against the private equity firms, in some cases costing the firms in excess of $100 million in legal fees. See DOJ probes Del Monte sale to private equity investors for antitrust violations, Smart Business, Nov. 29, 2011; Peter Lattman, Judge Widens Antitrust Suit Against Private Equity Firms, N.Y. Times, Sept. 8, 2011 (discussing legal fees); Arleen Jacobius, Club deal probe could be good news for investors, Pension & Investments, Oct. 16, 2006.

Foreign Corrupt Practices Act (FCPA) Problems

The SEC has been investigating whether certain private equity firms violated the FCPA by making unlawful payments to obtain investments from sovereign wealth funds. Private equity firms can face potential FCPA parent-subsidiary liability for bribery committed at their portfolio companies, regardless of whether those portfolio companies are publicly traded or privately held, and even if the bribery occurred before the acquisition. When a private equity firm acquires a company that violated the FCPA, it may inherit the FCPA liability as well. In an indication that both the SEC and DOJ are continuing to devote substantial resources to FCPA enforcement, the agencies issued an unprecedented voluminous guide on FCPA compliance and enforcement. See Peter Lattman & Michael J. De La Merced, S.E.C. Looking Into Deals With Sovereign Funds, N.Y. Times, Jan. 13, 2011; Criminal Division, U.S. Department of Justice & Enforcement Division, U.S. Securities and Exchange Commission, A Resource Guide to the U.S. Foreign Corrupt Practices Act 1, 27-33 (2012) (discussing parent-subsidiary and successor liability).

Fundraising Problems

In April 2011, Steven Byers, the former president and chief executive officer of the private equity firm WexTrust Capital, was sentenced to serve 13 years in prison and pay $17 million in restitution and forfeiture on charges stemming from a fraud that involved raising money from investors for private placement real estate offerings, but then using the money for other purposes without the investors’ knowledge. See Press Release, U.S. Department of Justice, Former CEO and President of WexTrust Capital Sentenced in New York to 160 Months in Prison for Real Estate Investment Fraud Scheme (Apr. 11, 2011); U.S v. Byers, No. 08-Cr-1092 (S.D.N.Y. June 29, 2011) (Amended Order of Restitution).

Insider Trading Problems

In April 2010, King Chuen Tang pleaded guilty to insider trading charges and admitted that, as the Chief Financial Officer of a private equity fund, he misappropriated inside information regarding Tempur-Pedic International, Inc. and Acxiom, and shared that inside information with friends. Both he and his friends allegedly made approximately $5.5 million from the trades executed after learning of the inside information. Tang was sentenced to one year in prison and three years of supervised release. See Press Release, Northern District of California U.S. Attorney’s Office, Former CFO And Two Associates Given Prison Sentences For Multimillion Dollar Insider Trading Scheme (Mar. 1, 2013).

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Got your attention? If you have any of these or similar problems now or see them potentially coming your way, it is important that you have experienced counsel ready to deal with regulators and prosecutors, and to conduct any needed internal investigation. By doing so, you can effectively manage the problems and decrease the potential disruption to your firm’s operations and the related financial risks.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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