Financial Services Alert - September 27, 2011

The SEC initiated a cease and desist proceeding with respect to the alleged actions of a former principal and partner (the “Partner”) of an investment adviser (the “Firm”) that manages a number of private equity funds and is registered under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  The SEC alleges, among other things, that (i) the Partner usurped investment opportunities from private equity funds managed by the Firm (the “Funds”) and (ii) the Partner violated the Firm’s policies and procedures by improperly keeping a bonus received as an outside director of a portfolio company owned by the Funds and making misrepresentations to the various parties about his interest in the Partner Vehicle (as defined below).  This article summarizes the SEC’s principal allegations against the Partner, which have not been proven.

Background.  According to the SEC’s order instituting the cease and desist proceeding, the Partner and a friend started an investment club (the “Partner Vehicle”) to make certain investments.  According to the SEC, the Partner contributed no capital to the Partner Vehicle, but in return for investment advice shared equally in profits and losses after his friend’s capital was returned. 

In 2006 and 2007, the Firm investigated the possibility of investing some of the assets of the Funds in a particular potential portfolio company (the “Portfolio Company”).  The Partner was assigned as the lead sponsor (i.e., the person at the Firm with primary responsibility for that specific portfolio company opportunity) of the possible investment in the Portfolio Company.  The Partner co-authored a memorandum recommending that the Funds invest in the Portfolio Company.  Ultimately, the Firm’s Investment Committee decided to invest some of the Funds’ assets in the Portfolio Company.  However, in order to secure the opportunity to invest in the Portfolio Company, the Firm committed to invest an amount in the Portfolio Company that was greater than the amount that they intended the Funds to invest, and, as a result, the Firm decided to syndicate (i.e., offer to investors other than the Funds) a portion of the committed investment in the Portfolio Company. 

Portfolio Company Investment by Partner Vehicle. The SEC alleges that, without authorization or instruction from the Firm or its Investment Committee, the Partner decided to syndicate a portion of that investment opportunity to the Partner Vehicle, and unilaterally increased the size of the syndication.  The SEC contends that the resulting decrease in the size of the Funds’ collective investment in the Portfolio Company was a misappropriation of a lucrative investment opportunity that should have gone to the Funds. 

Disclosure Failures and Misrepresentations. The SEC alleges that the Partner did not disclose his involvement with the Partner Vehicle to the Firm (including on required annual and quarterly disclosures), and that the failure to disclose such information was a violation of the Partner’s fiduciary duties and of the Firm’s policies.  Additionally, the SEC alleges that the Partner violated the Firm’s Integrity Policy, which requires that employees obtain approval from the Firm before investing in portfolio companies of the Funds.

Further, the SEC alleges that when communicating with employees of the Portfolio Company, the Partner falsely stated that the Partner Vehicle was his friend’s personal investment vehicle, and that he was increasing the size of the syndication to honor his promise to an outside investor. 

Improper Receipt of Bonus. Following the investments by the Funds (and the Partner Vehicle) in the Portfolio Company, the Partner was named to the Board of Directors of the Portfolio Company as the Firm’s representative.  Subsequently, the Portfolio Company was acquired by one of its competitors (the “Transaction”).  As a result of the Transaction, the Funds (and the Partner Vehicle) each received substantial returns on their investments in the Portfolio Company equal to almost four times their initial investment.  In connection with the Transaction, the Partner asked for, negotiated for and received a bonus payment from the Portfolio Company (the “Bonus”).  No other outside director of the Portfolio Company received a similar payment in connection with the Transaction.  The SEC alleges that the Partner’s receipt of the Bonus was in violation of the Firm’s policies, which prohibit employees from receiving personal payments in connection with the Firm’s transactions.  According to the SEC, the Bonus paid to the Partner not only enriched him personally in violation of the Firm’s policies, but it also reduced the amount of the proceeds from the Transaction which were paid to investors in the Portfolio Company, including the Funds.  Further, the SEC alleges that the Partner’s receipt of the Bonus was in violation of the Funds’ limited partnership agreements, which provide that any compensation paid to the Firm’s employees from a portfolio company must be remitted to the Firm and reduce the management fee payable to the Firm.

Second Portfolio Company Transaction. In 2007, the Firm also committed certain of the Funds to invest in another portfolio company (the “Second Portfolio Company”), anticipating that it would syndicate a portion of the investment commitment.  With respect to this proposed investment, the Partner again served as the Firm’s lead sponsor.  The Partner allocated the entire amount of the syndication designated by the Firm to the Partner Vehicle.  The SEC alleges that when communicating with employees of the Second Portfolio Company, the Partner again inaccurately stated that the Partner Vehicle was his friend’s personal investment vehicle.

An amendment to Rule 14a-8 (also known as the shareholder proposal rule) adopted concurrently with the proxy access rule (Rule 14a-11) that was vacated by the U.S. Court of Appeals for the District of Columbia became effective September 20, 2011 upon its publication in the Federal Register.  The SEC had previously announced that it would not seek a rehearing of the D.C. Circuit’s decision on Rule 14a-11 or appeal the decision to the U.S. Supreme Court (as discussed in the September 9, 2011 Goodwin Procter Alert).  Under the Rule 14a-8 amendment, a shareholder may submit a proposal for inclusion in a company’s proxy materials that seeks to amend a company’s by-laws or other governing documents to establish procedures allowing shareholder director nominees in company proxy materials - in essence, permitting shareholders who meet Rule 14a-8’s eligibility and procedural requirements to propose proxy access procedures on a company-by-company basis.  (The Rule 14a-8 amendment also codifies certain prior SEC staff interpretations regarding shareholder proposals relating to director nominations that will continue to be excludable from company proxy materials under Rule 14a-8.)  The Rule 14a-8 amendment is discussed in more detail in an article describing it and the proxy access rule that appeared in the September 7, 2011 Financial Services Alert.

The OCC issued an interpretive letter (“Letter #1133”) in which it concluded that a transaction involving a national bank’s (the “Bank”) resecuritization of certain residential mortgage-backed securities held by the Bank was permissible.  In Letter #1133, the Bank held a portfolio of non-agency residential mortgage-backed securities (“RMBS”) that were investment grade when issued and when acquired by the Bank.  The Bank proposed to transfer the RMBS to a limited purpose subsidiary of the Bank, which would form several trusts and transfer several RMBS to each trust.  Each trust would then issue new securities backed by the RMBS (the “Re-REMIC Securities”) to the limited purpose subsidiary.  Under the facts of Letter #1133, the Bank would be able to sell the Re-REMIC Securities if market conditions improved.  The Bank stated that it believes that the above-described resecuritization transaction would enhance the marketability of the underlying securities, would improve the Bank’s liquidity position and would “address regulatory concerns relating to the Bank’s exposure to non-investment grade securities.”  The Bank represented to the OCC, among other things, that the purpose of the resecuritization transaction would not be to obtain capital relief under the OCC’s capital rules.  The OCC concluded in Letter #1133 that under these facts (and subject to the conditions imposed by the OCC), the Bank may consummate, pursuant to 12 CFR Part 1 and 12 USC 24 (Seventh), the resecuritization transaction and hold the new securities issued to the Bank as part of the resecuritization transaction.

The SEC issued a rule proposal designed to implement Section 621 of the Dodd-Frank Act, which in broad terms prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity (collectively “securitization participants”), of an asset-backed security (“ABS”), whether or not registered and including a synthetic ABS, from engaging in a transaction that would involve or result in certain material conflicts of interest.  This prohibition applies for one year from the date of the first closing of the sale of the ABS and is subject to exceptions for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making.  Section 621 becomes effective only upon the effectiveness of implementing rulemaking by the SEC.  In addition to the proposed implementing rule, which consists primarily of the statutory text, the proposing release sets forth proposed interpretive guidance regarding the proposed rule and its application.  Comments are due no later than December 19, 2011.