For private fund advisers, fee and expense reviews are a cornerstone to a sound compliance program. The SEC repeatedly reinforces this axiom, and a recent SEC Settlement Order highlights how the lack of such reviews and the misclassification of expenses can lead to a Custody Rule violation.
In this case, according to the Settlement Order, the Limited Partnership Agreement (“LPA”) expressly excluded placement agent fees from “organizational expenses.” Unfortunately, the private fund adviser charged its client—the Fund—for placement agent fees under the rubric of organizational expenses. Additionally, the CFO transferred funds from the Fund to the adviser in advance of the actual incurrence of organizational expenses. The amounts transferred were estimated future charges, based on amounts incurred in the prior year’s audited financial statements. Mixed into the fee and expense quagmire were “deemed contributions” and offsets to management fees that were not properly applied, as well as a loan based on capital that should not have existed. Nothing in the LPA allowed the Fund to loan money to the adviser, even when funds were believed to be owed to the adviser.
The CFO tracked expenses and reported them to the CEO and the investment committee; the investment committee then determined the amounts to charge the Fund and investors. But, according to the SEC, the CEO did not adequately supervise the CFO and money transfers, and the private fund adviser did not implement a process to determine the accuracy of expense classifications or the accuracy of expenses estimated and charged. Reading the Order, it appears the SEC thought the CEO should have “obtained more detail to understand the specific nature of the transactions [the CFO] executed” and should have substantively reviewed bank statements and reconciliations.
So, what happened? Ultimately, the auditor—engaged to fulfill the Custody Rule’s annual audit provision—identified the misclassification of expenses and improper money transfers between the adviser and its Fund and withdrew from its engagement. The adviser hired a new auditor and remediated—with interest. Nonetheless, the adviser by then had failed to timely distribute to the investors the audited financial statements prepared in accordance with generally accepted accounting principles (within 120 days of the end of its fiscal year). So, the SEC found that the adviser violated the Custody Rule and issued civil monetary penalties against the adviser, the CFO, and the CEO.
Here, the Custody Rule violation was low-hanging fruit for the SEC, but it shows the domino effect for fee and expense missteps. Do not let expense misclassifications and fee miscalculations damage an otherwise sound compliance program and reputation. We often are asked how detailed should fee and expense reviews be? Start with a few basic questions and develop the comprehensive reviews from there. For example, have you recently gone back to the fund documents to determine if existing expense classifications and charges are expressly allowed? Have you documented that analysis? As the CCO, or management, do you know how expenses are actually paid? Does your fund reimburse the adviser for expenses actually incurred or does the fund pay for estimated expenses? For sure, the SEC will examine expense classification, expense payments, and offsets to management fees, so implement the fee and expense review processes now, before the SEC examiners do. If you do not have the personnel to review your processes, or even if you do, consider a third-party risk-assessment by CSS’ professional consulting group Ascendant on fees and expenses.