SEC Settles with Investment Adviser Over Expense Allocations, Valuation Issues and Failure to Address the Potential Misuse of Material Non-Public Information between Clients

On December 3, the SEC entered into a consent order (“Order”) with an investment adviser (“Adviser”) to public business development companies (“BDCs”) and other clients, including a hedge fund, alleging failures in the Adviser’s expense allocation practices, valuation processes and policies for preventing the misuse of material non-public information (“MNPI”). 

Expense Allocation Practices

The Order alleges that the Adviser improperly allocated expenses to two of its BDC clients. Although the advisory agreements with the BDC clients required that the Adviser pay “the compensation and routine overhead expenses” of its investment advisory personnel, the Adviser allocated essentially all of its rent and other overhead expenses to the BDC clients when a majority of employees worked solely on other non-BDC clients. In addition, certain expenses of several non-investment advisory employees that did not work on the BDC clients were charged to the BDC clients. These expense practices led to overstatements of expenses for the BDC clients and were not accurately disclosed in the Adviser’s Form ADV.

Valuation Practices

The Order also alleges inadequacies in the valuation process used for valuing BDC portfolio companies. The Adviser’s portfolio management teams — the personnel most familiar with the portfolio companies — were responsible for reviewing valuation model financial data that in the first instance was input by personnel of an affiliate of the Adviser. In several instances, the portfolio management teams failed to correct faulty assumptions and projections for portfolio companies subject to financial deterioration. This caused the BDC client to issue financial statements that were materially inaccurate, including financial statements used during public stock offerings. It also caused the BDC clients’ net asset value to be overstated and, therefore, the Adviser to receive more advisory fees than it should have received.

Policies and Procedures to Prevent Misuse of MNPI

In addition, the Order alleges that the Adviser, in managing both its BDC clients and its hedge fund client, failed to establish, maintain and enforce written policies and procedures to prevent the misuse of MNPI. The Adviser’s marketing materials made clear that the Adviser sought to leverage private company information flow generated through the Adviser’s work for its BDC clients. The Adviser was able to do this through having certain of its investment professionals simultaneously performing work for both its BDC clients and its hedge fund client, which resulted in the Adviser having information about the BDC clients’ portfolio companies that the Adviser could then use to make investment decisions for the hedge fund. While it had a written insider trading policy, the Adviser did not have policies and procedures in place to address the situation of potentially using one of its clients’ MNPI for the benefit of another client.

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In light of the SEC’s continued focus on expense allocation and valuation practices, investment advisers should assess their internal policies to ensure that such policies are consistent with such adviser’s actual practices, client disclosures and governing documents. In addition, the SEC’s concern with the potential issues surrounding the use of MNPI obtained from managing one client for the use of other clients suggests that advisers should assess their current approach to how they use MNPI of both public and private companies across their platform and consider adopting written policies and procedures that address the potential for misuse of MNPI and appropriately train personnel.¹  The Order may also be part of a broader focus by the SEC on BDCs in general, as the SEC entered into a consent order with another BDC on December 4, the day after the Order, relating to accounting issues.

^{1. Some large advisers may address this issue through appropriately implemented information-sharing barriers.↩}

 If you have any questions about the matters addressed in this Kirkland AIM, please contact the following Kirkland attorneys or your regular Kirkland contact.

Enforcement: Neil Eggleston, Kenneth Lench, Robert Pommer, Erica Williams

Regulatory: Norm Champ, Scott Moehrke, Kevin Bettsteller, Michael Chu, Matthew Cohen, Marian Fowler, Nicholas Hemmingsen, Alpa Patel, Elizabeth Richards, Jaime Schechter, Aaron Schlapoff, Reed Schuster, Christopher Scully, Robert Sutton, Ryan Swan, Jamie Lynn Walter, Josh Westerholm, Corey Zarse