By Amy Leisinger, J.D.
The SEC has charged an investment adviser and its principal with improperly charging fees to two private equity funds and using fund assets to cover certain fees and expenses. According to the Commission, the respondents failed to disclose these activities and violated the custody rule by failing to disclose associated related-party transactions in the funds’ audited financial statements. To settle the matter, the respondents agreed to cease and desist from further violations and to pay a $300,000 civil penalty (In the Matter of Potomac Asset Management Company, Inc. and Goodloe E. Byron, Jr., Release No. IA-4766, September 11, 2017).
Improper fees and expenses. Potomac Asset Management Company, Inc. provides investment advisory and management services to two private equity fund clients under limited partnership agreements and private placement memoranda The LPAs provided terms for calculation and payment of capital contributions and the payment of management fees paid to Potomac. The adviser had responsibility for paying manager expenses, including the compensation, rent, and regulatory expenses.
The SEC alleged that, from 2012 and 2013, the adviser and its principal improperly charged $2.2 million in fees to one of the funds and failed to disclose the use of fund assets to pay the fees to the fund’s limited partners. In addition, according to the SEC, after the fund’s portfolio company reimbursed the fees, Potomac failed to offset them against the management fees it charged. Neither the LPA nor the PPM authorized Potomac to charge the portfolio company fees to the fund, the Commission alleged, and the respondents did not disclose the misuse of fund assets to the limited partners.
From 2012 and 2015, according to the SEC, the respondents also used fund assets to pay Potomac’s adviser-related expenses in a manner not authorized by or disclosed in the funds’ governing documents or Forms ADV. The funds’ audited financial statements also failed to disclose these payments as related-party transactions in violation of GAAP, and, as a result, Potomac improperly relied on an exception to the Advisers Act custody rule.
Finally, the SEC stated, Potomac failed to maintain written policies and procedures reasonably designed to prevent violations of the Advisers Act arising from the allocation of fees and adviser-related expenses, and the principal failed to make timely capital contributions to the funds on behalf of the funds’ general partners and did not disclose the issue to the funds’ limited partners.
By this conduct, the SEC alleged, the respondents violated the antifraud provisions of the Advisers Act, as well as the custody rule’s requirement that client assets be maintained with a qualified custodian that provides GAAP-compliant audited financial statements to investors. In addition, they violated Rule 206(4)-7 by failing to adopt and implement appropriate policies and procedures and Section 207 of the Act by making untrue statements in SEC filings, according to the Commission.
Sanctions. Without admitting or denying the SEC’s findings, Potomac and its principal agreed to a cease-and-desist order, as well as censure. They also agreed to jointly and severally pay a civil money penalty of $300,000. In determining to accept the settlement offer, the Commission noted Potomac’s remedial acts and cooperation, particularly its creation of a limited partner advisory board and its retention of a new CCO and an independent compliance consultant.
The release is No. IA-4766.