Bruce Karpati, the Chief of the SEC Enforcement Division’s Asset Management Unit, held a Q&A session entitled “Private Equity Enforcement Concerns” at the Private Equity International Conference held in New York on January 23, 2013. He addressed private equity firm activities of concern, how the SEC is tracking those activities, and ways firms can avoid getting into trouble. [Read more...]
SEC Enforcement Division’s Asset Management Unit’s Chief Anticipates Increase in Private Equity Enforcement
SEC Enforcement Division’s Asset Management Unit Chief Reveals New Priorities in Regulation of Private Funds
Bruce Karpati, Chief of the SEC Enforcement Division’s Asset Management Unit, gave a speech entitled “Enforcement Priorities in the Alternative Space” on December 18, 2012. The recently established 75-member Asset Management Unit (AMU) is dedicated to investigating investment advisers, investment companies, hedge funds, mutual funds, and private equity funds making up the “alternative space” referred to in the speech’s title. Karpati addressed current enforcement priorities, touching upon, among other topics, the AMU’s enhanced expertise, investor risks, and how the hedge fund operating model incentivizes misconduct. As outlined in Karpati’s speech, the AMU’s current priorities indicate that, while traditionally hedge funds and private equity funds were lightly regulated, this will likely no longer be the case.
The loose regulation of private funds is the result of the assumed sophistication of the investors involved, the burgeoning market, increased industry specialization, and regulatory changes mean that unsophisticated investors are increasingly investing in private funds and even sophisticated investors are often unable to evaluate the risks involved in their investment. Unsophisticated investors are increasingly exposed to hedge funds indirectly through pensions, endowments, foundations, and other retirement plans. The increasing retail nature of hedge funds has encouraged wealthy but unsophisticated investors to invest directly, and the upcoming elimination of the prohibition on general solicitation and advertising will expose a much broader pool of investors to what previously would have been private offerings. In addition, alternative investment vehicles often involve complicated investments that create significant opportunity for fraud, even when investors are relatively sophisticated. Finally, smaller hedge fund advisers — where most hedge fund fraud occurs — are exempt from registration under federal securities laws. As a result, they may not have effective compliance policies, are not subject to inspection by the SEC, and are not required to comply with SEC advertising rules for investment advisers. Karpati highlighted the AMU’s concern that unregistered advisers may fail to limit offerings to accredited investors or fail to abide by other restrictions placed on registered advisers.
Karpati went on to discuss how the hedge fund operating model itself gives rise to conflicts of interest and incentives to commit fraud. First, hedge fund managers are compensated by both management fees and performance fees, so they often have an incentive to overvalue assets or engage in riskier strategies. Hedge fund managers also face considerable pressures to yield high returns. Finally, it is easy for fund advisers to engage in related party transactions or give favored treatment to certain investors through preferential redemptions or side letters.
While the SEC previously focused on enforcement of the various rules and regulations governing investment advisers, such as violations of registration and disclosure requirements and failure to adopt and enforce compliance procedures, the AMU’s new priorities, as outlined by Karpati, cover the more amorphous area of an adviser’s ethical obligations to investors and clients. There are many ways that federal securities laws govern such ethical obligations, but two of the most significant are: (i) the Investment Advisers Act of 1940 places a fiduciary duty on investment advisers to their clients and (ii) the anti-fraud provisions of Investment Advisers Act and other securities laws places a duty of disclosure of conflicts of interest to investors. Karpati stated that fund managers must guard against all incentives — even unconscious — that might cause them to provide advice that is not disinterested. It is possible to commit a violation of these laws even if the breach does not actually intend to injure a client. In addition, an adviser can violate the law even if a client does not suffer actual injury.
To effectively carry out enforcement against these kinds of violations, the personnel conducting an SEC examination will need to operate on a more sophisticated level than merely trying to check off a list of requirements that the adviser was required to meet. Karpati revealed that the AMU has hired former industry professionals such as hedge fund managers, private equity analysts, and due diligence professionals. These experts have implemented certain risk-based analytic initiatives utilizing data analysis and designated risk criteria to identify individuals or firms that could be engaged in specific types of misconduct. One such initiative is the “Aberrational Performance Inquiry,” which targets hedge fund performance returns that seem too good to be true. Together with the Division of Risk, Strategy, and Financial Innovation and the Office of Compliance Inspections and Examinations (OCIE), the AMU’s experts analyze performance data of thousands of hedge fund advisers and identify possible misconduct. This initiative has so far yielded seven enforcement actions against hedge fund advisory firms and managers for improper use of fund assets, fraudulent valuations, misrepresenting fund returns, failure to disclose related party transactions, and other misconduct. Another risk analytic initiative is the “Private Equity Initiative,” which seeks to uncover private equity fund advisers that pose a higher risk for certain misconduct, such as improperly failing to liquidate assets or misrepresenting the value of holdings to investors.
Just as enforcing standards of fiduciary duty and the duty to disclose conflicts of interest requires SEC enforcement personnel to think on a more sophisticated level, complying with these requirements will also require investment advisers and fund managers to consider their compliance practices on a more sophisticated level. Merely following bright line rules many no longer be enough.
© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
The Dodd-Frank Act, passed in 2010, includes the so-called “Say on Pay” provision for publicly traded companies. This provision requires that, at least once every three years, the shareholders of a publicly traded company must vote on its executive compensation arrangements. In addition, the shareholders also vote at least once every six years on the frequency of the “say on pay” vote. Shareholders are able to elect whether the vote will happen once every one, two, or three years. In most companies, the shareholders have chosen to have the “say on pay” vote conducted annually. Publicly traded companies are also required to disclose, in any proxy solicitation asking for the approval of a merger, acquisition, or other sale of the company, any compensation from “golden parachutes” that would be triggered. Shareholders also have a chance to “approve” (or not approve) such golden parachute payments.
However, except for the vote on the frequency of “say on pay” votes, none of these votes are actually binding. They are simply there to provide an outlet for the shareholders to express their views on management’s compensation. In addition, the law specifically states that the vote doesn’t create any new or alter existing fiduciary duties of the company’s board of directors. To date, only 37 companies’ boards have received a negative “say on pay” vote.
However, a number of creative plaintiff’s lawyers have tried to use a negative “say on pay” vote as evidence of a breach of fiduciary duty. How have these claims fared? Not very well. Below is a quick summary of the cases where this line of reasoning has been used and the results thus far:
Teamsters Local 237 Additional Security Benefit Fund, derivatively on behalf of Beazer Homes USA, Inc. v. McCarthy (Georgia Superior Court; decided September 16, 2011). This case, litigated in Georgia Superior Court applying Delaware corporate law, arose out of a negative “say on pay” vote that occurred after the board voted to increase executive compensation. The court reasoned that because the negative vote occurred after the board’s action, the negative vote could not be used to prove a breach of fiduciary duty by the board. In addition, the court ruled that, under Delaware law, the negative vote of the shareholders could not be used as evidence to rebut the business judgment rule presumption. (Unfortunately, the ruling was given orally and no written opinion was issued to date, limiting its precedential value).
NECA-IBEW Pension Fund, derivatively on behalf of Cincinnati Bell, Inc. v. Cox (Southern District of Ohio; decided September 20, 2011). Here, a federal court applying Ohio corporate law, refused to dismiss a similar case prior to discovery and trial. The basis used is that Ohio law differs from Delaware law. While Ohio has its own version of the business judgment rule, according to the court, it “imposes a burden of proof, not a burden of pleading” which effectively means a board can’t have the case dismissed prior to discovery (or even trial). Thus Ohio corporate law would seem to be more friendly territory for plaintiff’s attorneys in “say on pay” suits.
Plumbers Local No. 137 Pension Fund v. Davis (U.S. Federal Court, District of Oregon; decided January 11, 2012). This case is another “say on pay” suit involving a company called Umpqua Holdings Corporation. In this case, a magistrate judge recommended that the case be dismissed. The court applied Oregon corporate law, though the court noted that Delaware law often provides guidance for Oregon courts in areas of corporate law that are undeveloped. The court adopted the holding of Beazer and criticized the holding of Cincinnati Bell, rejecting the notion that a negative “say on pay” vote can rebut the presumption of the business judgment rule.
Laborers’ Local v. Intersil (Northern District of California; decided March 7, 2012). Here, a federal court applied Delaware law and dismissed a derivative claim against a board of directors based on a negative “say on pay” vote. The court held that a “say on pay” vote “alone is not enough to rebut the presumption of the business judgment rule.” The opinion also criticized the Cincinnati Bell decision.
The Cincinnati Bell decision has caused great concern within corporate America. It has the possibility of encouraging further lawsuits each and every time the shareholders of a corporation vote against the company’s compensation package. That said, other courts appear to be rejecting its holding, which may in the long run establish a firm rule that negative “say on pay” votes may not be used as evidence of a breach of fiduciary duty by a board.
 Essentially, the business judgment rule, under Delaware corporate law provides that a court will not substitute its own notions of what is or is not sound business judgment if the directors of a corporation “acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”
© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Recently, the Delaware Court of Chancery issued a ruling on the question of whether a manager (or managing member) of a Delaware limited liability company owes fiduciary duties to the company and its members. The court ruled that it does.
As a legal practitioner, this result is unsurprising. I think most business lawyers, both when representing LLC managers and when representing LLCs and their members, operate under the assumption that a manager owes a fiduciary duty of care and loyalty to the company and its members. What is somewhat surprising is (a) that this conclusion was ever in doubt and (b) more importantly, in light of recent comments made by the Chief Justice of the Delaware Supreme Court, this conclusion may still be in doubt if the ruling is appealed.
The case is called Auriga Capital Corporation v. Gatz Properties, LLC. It arose from a failed golf course venture, where the land on which the golf course is situated was leased by an LLC from a family affiliate of the LLC’s manager. The LLC was funded by outside investors who owned a minority interest in the LLC. The LLC then subleased the land to American Golf Corporation. The terms of the sublease permitted American Golf to terminate its sublease in early 2010. Because the golf course was unable to operate profitably, American Golf exercised its early termination option. Ultimately, the LLC was put up for auction and was bought by the manager at a low price, resulting in a large investment loss to the minority members. The minority members filed suit alleging that the manager engaged in a pattern of intentional mismanagement, including rejecting a serious offer from a 3rd party for a purchase of the LLC that would have earned the minority members a full return on their investment. They further alleged that this intentional mismanagement constituted a breach of the manager’s fiduciary duties.
One of the issues in contention was whether, in the absence of any language explicitly addressing the issue, a manager of a Delaware LLC owes fiduciary duties to the company and its members. While the Delaware Limited Liability Company Act does not expressly provide that the traditional fiduciary duties of care and loyalty apply by default to the managers or members of an LLC, the court concluded that such duties are implicit. Indeed, the Delaware General Corporation Law also does not explicitly provide for fiduciary duties for a corporation’s management and yet they are indisputably present.
This conclusion is in line with the expectations of most parties to Delaware LLC operating agreements and with the expectations of most attorneys who draft them. However, whether this conclusion will be upheld on appeal is somewhat in doubt. At a recent seminar, Chief Justice of the Supreme Court of Delaware Myron Steele stated that “[c]ourts should not imply traditional fiduciary duties when LLC agreements are silent.” He based this on the fact that limited liability companies are new entities based on contracts and are not derived from common law. Given that Delaware’s LLC Act emphasises freedom of contract (in section 18-1101(b)) and that contract law provides some level of protection to parties of LLC operating agreements through the implied covenant of good faith and fair dealing, his conclusion was that if an LLC’s operating agreement does not expressly provide for fiduciary duties of managers, “courts should assume the parties did not want [fiduciary duties] to apply at all.” These statements are in direct contradiction to the holding of Auriga, and if Chief Justice Steele should find that two or more other justices on Delaware’s Supreme Court agree with him, the holding may be overturned on appeal. 
In light of this decision and in Chief Justice Steele’s subsequent comments, drafters and parties to LLC operating agreements should be careful to include unambiguous language on whether they intend to include, eliminate, or restrict fiduciary duties. In addition, while this is not a new issue, in contrast to the Delaware General Corporation Law or the limited liability company acts of many other states, Delaware’s Limited Liability Company Act permits parties to an LLC operating agreement to waive a manager’s fiduciary duties. This itself may come as a shock to many seasoned corporate practitioners since fiduciary duty, especially the duty of loyalty, is generally regarded as an unwaivable duty in many other situations.
 The fiduciary duties of care and duty of loyalty arise from common law. Under Delaware corporate law, the fiduciary duties of care and loyalty require that a corporation’s directors (1) must act in good faith, with the care of a prudent person, and in the best interest of the corporation; (2) must refrain from self-dealing, usurping corporate opportunities,
and receiving improper personal benefits; and (3) make decisions made on an informed basis, in good faith, and in the honest belief that such action was taken in the best interest of the corporation.
 The Delaware Supreme Court has five members.
© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Recently, the Delaware Chancery Court ruled on a dispute that heated up between a hedge fund manager and the fund’s seed investor. First, a quick summary of the events leading up to the case: A seed investor provided a large initial investment in a hedge fund. Pursuant to a seeder agreement, the investor had a three-year lockup period, which provided that the investor could not withdraw its capital for three years. However, there was also a “gate” provision in the fund’s limited partnership agreement which permitted the fund manager to stop outflows of capital if it would result in more than 20% of the total assets of the hedge fund being withdrawn in any six-month period. Gate provisions are designed to prevent a situation where some investors withdraw such a large amount of capital from the fund that the investors who remain are harmed by the capital flight. The intent behind the seed investment was that the fund manager would solicit other investors to join the fund during the three-year lockup period. Because the fund manager was unsuccessful at soliciting additional investors, the seed investor desired to withdraw their capital at the end of the third year. The fund manager decided to apply the gate provisions to that withdrawal, restricting the withdrawal to 20%. As a result, litigation ensued.
The investor won the case in the Delaware Chancery Court largely on contract interpretation principals and the basis that the fund manager owed the investor a fiduciary duty and thus could not act against its sole investor’s best interests. This result is largely unremarkable since the investor was substantially the only investor in the fund and consequently there were no other investors for the gate provision to protect. What is remarkable is the failure of the attorneys of both the fund manager and the investor for failing to spot this issue when they were negotiating the seeder agreement. The gate provision of the fund limited partnership agreement and the seeder agreement were in fundamental conflict. It should have been clear from the language of the seeder agreement that either the gate provision applied to any withdrawal after the three-year lockup or that the three-year lockup was in lieu of the gate provision and that such provision was waived for a withdrawal by the seed investor. The presence of such a clarification would have almost certainly avoided this dispute.
Therefore, the lesson is clear: when negotiating a side letter between an investor and a fund, it is important to review the fund governing documents to ensure there are no conflicts (or ambiguities creating potential conflicts) between the provisions of the side letter and the fund governing documents. The side letter should make it clear what rights the fund manager is and is not waiving. Failing to do this can result in expensive litigation down the road.
Case Referenced: Paige Capital Management v. Lerner Master Fund
 Although after reading pages 46-49 of the opinion, it is possible that the issue was brought up but then later avoided to keep the deal moving forward. In any event, this was still sloppy lawyering.
 A “side letter” is a term used to describe any kind of agreement between a fund and a particular investor or a subset of investors that varies the terms of those investors from the terms that apply generally to the other investors. Lockup periods and gate provisions are frequently some of the terms that are altered by a side letter. The seeder agreement in this case is an example of a side letter.
© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.