On September 22, 2014, the Securities and Exchange Commission (the SEC) charged Lincolnshire Management, Inc. (Lincolnshire), a private equity investment advisory firm, with breach of fiduciary duty. The duty was owed to two private equity funds managed by Lincolnshire, which separately owned two portfolio companies that Lincolnshire had decided to integrate. Lincolnshire’s fiduciary duty required it to treat both funds equally in respect of the allocation of management expenses as between the two portfolio companies—proper management required that neither fund could benefit to the detriment of the other. Despite the development of an expense allocation policy to be followed as part of the integration, the policy was disregarded in some instances resulting in one portfolio company bearing an inequitable proportion of the joint expenses. Lincolnshire was charged under Section 206(2) of the Advisers Act (the Act) for the breach of fiduciary duty. Lincolnshire was also charged under Rule 206(4)-7 of the Act for failing to adopt and implement policies to prevent a violation of the Act. While Lincolnshire never admitted to the breaches of the Act, it settled the charges by agreeing to pay roughly $2.3 million to the SEC.
Background to the Lincolnshire Action
The charges in the case against Lincolnshire arose out of the advisory firm’s oversight of internal expenses and management fees allocated between two of its funds’ portfolio companies—Peripheral Computer Support, Inc. and Computer Technology Solutions Corp. Lincolnshire Equity Fund, the first of the two funds at issue, acquired Peripheral Computer Support, Inc. in 1997. Four years later, a second fund, Lincolnshire Equity Fund II, purchased Computer Technology Solutions Corp. It was Lincolnshire’s view that these two companies could have their values increased through integration with one another, and that this value could be realized as profit by ultimately disposing of the two companies as one. Between 2001 and 2009, Lincolnshire began integrating certain operational aspects of the two companies. By 2009, the two companies were jointly managed by one management team including having a shared CEO and CFO, though the companies remained separate legal entities. The two companies paid Lincolnshire $250,000 in consulting fees per year between 2005 to 2013 (the year the companies were ultimately sold). In respect of these and other shared expenses, Lincolnshire’s intent was for the two companies to allocate these expenses equitably and proportionately to each company’s revenue. However, the SEC investigation revealed that shared expenses were being misallocated and not properly documented. One notable example was in respect of third-party payroll expenses and 401(k) administrative expenses for the employees of each of the managed companies, all of which were paid by Peripheral Computer Support, Inc. According to the SEC order against Lincolnshire, "While generally the shared expenses were properly allocated and documented in certain instances, a portion of the shared expenses were misallocated and went undocumented, which resulted in one portfolio company paying more than its share of expenses that benefited both companies."1 In 2013, when the two companies were sold to a single purchaser, executives of both companies were paid bonuses. A misallocation occurred with the paying of these bonuses as well, as Lincolnshire Equity Fund, which only owned Peripheral Computer Support, Inc., paid 10% of the bonuses for two executives who were employed by Computer Technology Solutions Corp. The SEC investigation revealed several other similar examples of such misallocations which, taken together, formed the basis for the charge of breaching the Act.
The Charges Against Lincolnshire—Breach of Fiduciary Duty
Section 206(2) of the Act prohibits investment advisers from engaging in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.2 As a result of the misallocation of funds, Lincolnshire was found by the SEC to have breached Section 206(2) of the Act, and therefore to have breached its fiduciary duties owed to each of the two funds. Rule 206(4)-7 of the Act requires registered investment advisers to adopt and utilize written policies and procedures to prevent violations of the Act and its rules, and as such Lincolnshire was found to have violated this rule as well for failing to properly adopt and implement its written policies.
It is important to note that Lincolnshire only registered as an investment adviser on March 28, 2012, and many of the examples of misallocation of funds occurred prior to its registration. It was registration which brought Lincolnshire under the Act, and subject to SEC enforcement and examinations. It is as yet unclear what the Lincolnshire case means for private equity advisers who file reports with the SEC as exempt reporting advisers. Such advisers, while not subject to the Act in general, are subject to the Act’s anti-fraud provisions (including Section 206(2)). In addition, the SEC has indicated that it expects to conduct "for cause" examinations of exempt reporting advisers when it believes there have been signs of wrongdoing (e.g., exams triggered by complaints or tips) but does not expect to do routine exams of exempt reporting advisers (although it maintains the authority to do so). It is also worth noting that there were no allegations in the charges against Lincolnshire that it had acted with any wrongful intent or that Lincolnshire had benefited in any way from the misallocations of funds. As such, this case seems indicative of the SEC taking a more aggressive approach to enforcement as it continues to focus on the private equity industry and particularly how fees and expenses are handled by advisers to private equity funds.
1 In the Matter of Lincolnshire Management Inc., File No. 3-16139 (SEC September 22, 2014), http://www.sec.gov/litigation/admin/2014/ia-3927.pdf at 27.
2 15 U.S.C § 80b-21.
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