Private Equity Facing Increased SEC Scrutiny Amid Ambiguous Rules

The SEC created some mild waves in late September when it entered into a modest enforcement settlement with Lincolnshire Management Inc., one of the less prominent private equity firms.  Lincolnshire agreed to pay $2.3 million to settle SEC charges that it did not properly allocate certain expenses between two of its funds.  See here.  Private equity entities incur significant expenses in the course of managing companies they control which have to be allocated among the various investment vehicles owning those companies (typically a series of limited partnerships in which investors provide capital for the acquisitions).  The SEC charged that in the course of integrating the operations of two of its portfolio companies, Lincolnshire’s allocation of expenses was not consistent with its internal policies.  Approximately $25,000 per year paid to administer a 401(k) program for both companies allegedly was funded by only one of them (for 8 years), and some other employee expenses were not properly allocated.  For this alleged transgression, Lincolnshire, without admitting or denying any violations of law, agreed to pay the SEC so-called “disgorgement” of $1,500,000, prejudgment interest of $358,112, and a civil penalty of $450,000, totaling $2,308,112.  You can see a copy of the settlement here: In re Lincolnshire Management.

In reality, given the extensive allocations of costs private equity funds normally must make, the fact that an investigation led to only a relatively minor charge suggests Lincolnshire did a pretty good job of allocating its common expenses.  And how the allegations justify a “disgorgement” of $1.5 million is a mystery, since disgorgement is only supposed to consist of ill-gotten gains, and it’s hard to see how the charged violations resulted in anything like that type of gain (or, in fact, any gain at all).  But SEC settlements are typically a product of unfettered power on one side and expediency on the other.

The significance of this enforcement action is that the private equity sector appears to be in the crosshairs of the SEC.  In April, it was reported that, as a result of new provisions in the 2010 Dodd-Frank Act, the SEC set up a new private equity unit to look into how private equity and hedge funds value their assets, disclose their fees, and communicate with investors.  Private equity funds, a major force in the institutional investor sector, now know that SEC enforcement investigations and actions are going to proliferate.

Interestingly, it has been reported that the SEC has internal disputes over how this new regulatory focus is going to move forward.  Different SEC offices have had at least one open disagreement about how to use the enforcement mechanism where the governing rules are at best ambiguous.  Examiners in the SEC’s home DC office were keen to move forward by means of enforcement, while those in New York said that in this situation new rulemaking is needed, rather than developing the scope of requirements in what are usually settled enforcement actions.

Litigators take note that such disagreements reflecting the ambiguity of regulatory requirements are just the kind information that might yield useful results in civil discovery in contested actions.  But the major private equity funds are highly unlikely to contest SEC enforcement demands.  Even unreasonable SEC settlement demands are likely to be met and viewed as a “cost of doing business,” allowing these lucrative financial juggernauts to continue to focus on making money.

Straight Arrow

November 17, 2014

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