SEC fines BDC investment adviser for misallocation of expenses and valuation failures

by Eversheds Sutherland (US) LLP
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On December 3, 2018, the Securities and Exchange Commission (the SEC) entered an order (the Order) to settle charges arising out of an enforcement action against Fifth Street Management, LLC (FSM). FSM disclosed in March 2016 that the SEC’s Division of Enforcement sent document subpoenas and preservation notices relating to a variety of issues, including some raised in an ordinary-course examination of FSM by the SEC’s Office of Compliance Inspections and Examinations (OCIE) in October 2015. 

FSM provided investment advisory services to FSM affiliated companies, including two business development companies (BDC-1 and BDC-2, or collectively, the Fifth Street BDCs), two collateralized loan obligation (CLO) funds, and a private hedge fund. 

The Order covers FSM’s activities during 2013 and 2014, during which period FSM had as much as $2.633 billion under management. The Order centers around three main issues: (1) the misallocation of adviser expenses to the Fifth Street BDCs, (2) repeated errors in the valuation process, and (3) the failure to protect material non-public information. As a result, the Order found that FSM violated multiple sections of the Investment Advisers Act of 1940, and the rules promulgated thereunder, and caused the Fifth Street BDCs to violate several pertinent sections of the federal securities laws. Under the Order, FSM was censured, and must pay disgorgement of nearly $2.0 million and a civil money penalty of $1.65 million to the SEC.

Misallocation of Employee Compensation, Rent and Other Overhead Expenses

Between June 2013 and September 2014, FSM employed between 52 and 75 individuals. During that time, FSM allocated the compensation expenses for eight or nine of its employees to the Fifth Street BDCs, while allocating nearly all of the rent and overhead expenses of its workforce to the Fifth Street BDCs. According to the Order, this resulted in the Fifth Street BDCs overpaying an additional $1.2 million in rent and overhead expenses to FSM. 

The Order also notes that FSM improperly charged approximately $120,000 in employee compensation to the Fifth Street BDCs. According to the SEC, the employees in question were, at the time, working on SEC filings in preparation for an FSM affiliate’s 2014 initial public offering. The Order also alleges that FSM failed to disclose these expense reimbursement arrangements in its SEC filings.

Errors in Valuation

The Order found that throughout 2013 and 2014, FSM failed to “reasonably conduct quality control reviews” of the BDCs’ quarterly valuation models—in violation of its own valuation process—resulting in inaccurate portfolio company valuation. For example, in one situation, the Order alleges FSM analysts repeatedly failed to input a decline in expected EBITDA into the valuation model of a portfolio company; this resulted in the company’s overvaluation in the range of $7.2 million to $19 million. The incorrect valuations were then presented to the board of BDC-1, and were incorporated into its SEC-filed reports, as well as filings related to the sale of its shares. As a result, according to the SEC, the net income for one of BDCs was allegedly overstated by at least $10 million and up to $22 million. The Order alleges that these inflated valuations allowed the Fifth Street BDCs to trade at higher prices that they may have otherwise. 

The Order also alleges that the BDCs paid advisory fees to FSM based upon the value of their assets and their performance and, as a result of FSM’s failure to maintain accurate valuation models, paid FSM excessive advisory fees. 

Failure to Prevent Misuse of Non-Public Information

Lastly, the Order states that some of FSM’s investment professionals performed work for both the Fifth Street BDCs and FSM’s hedge fund. These investment professionals had access to material, non-public information (MNPI) about the Fifth Street BDCs’ portfolio companies. Although FSM maintained an insider trading policy, the policy failed to address the scenario of using one client’s MNPI to benefit another client, in violation of federal regulations requiring sufficient internal controls. 

What This Means for Other BDCs

In 2017, Oaktree Capital Group became the investment adviser to the Fifth Street BDCs in a $320 million transaction and has since renamed them. FSM which did not admit to or deny any of the SEC’s findings, is no longer an investment adviser registered with the agency; officials there could not immediately be reached for comment. Under the settlement, FSM will pay disgorgement of just more than $1.999 million, prejudgment interest of $334,545, and a civil money penalty of $1.65 million to the SEC. As a result, both the timing and the organizational dynamics are unique to the FSM Order. However, there are several lessons that can be drawn from the Order:

  • Continued SEC focus on allocation of expenses. In 2018, OCIE issued a Risk Alert highlighting the SEC’s heightened interest in the allocation of expenses between funds and their managers. In the Risk Alert, OCIE staff identified various instances of potential misallocation of expenses by advisers to private and registered funds. For example, OCIE staff observed that advisers allocated distribution and marketing expenses, regulatory filing fees and travel expenses to clients instead of the adviser, in contravention of the applicable advisory agreements, operating agreements or other disclosures. As a result, BDCs may wish to review their governing documents and disclosures (including Form ADV) to confirm they accurately present allocation of expenses.
  • Valuation. Valuation has been, and continues to be, an area of interest to the SEC as it relates to BDCs. Dalia Blass, Director of the SEC’s Division of Investment Management, spoke recently to Congress about the Division’s efforts, in coordination with the SEC’s Office of the Chief Accountant, to update SEC guidance on valuation of portfolio securities and other assets held by registered funds and BDCs. The updated guidance is a part of the division’s year-long review of board responsibilities, which seeks to identify areas where board oversight is most valuable and how board responsibilities are affected by changes in technology, the market, and various accounting and auditing standards. Last year, Director Blass had identified working with the Office of the Chief Accountant to provide updated valuation guidance as one of the key 2018 IM initiatives. 
  • Compliance Policies and Procedures. Since the financial crisis of 2008, the SEC has directed more of its attention to insider trading activities by investment advisers, including those to private funds, and their employees, through the use of the SEC’s enforcement resources and during adviser examinations. Key to such policies and procedures are measures to protect against the misuse of MNPI, and the use of “information barriers” designed to separate and isolate departments or personnel with access to MNPI from those making investment decisions, thereby restricting the flow of information. As part of the regular review of its compliance policies, BDCs should ensure their MNPI and insider trading policies are appropriately constructed.

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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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