Asset management quarterly - North America

Developments and market trends in North America

SEC enforcement focus on private equity

Author Michael Flamenbaum

On May 12, 2016, Andrew Ceresney, Director of the Division of Enforcement at the Securities and Exchange Commission (SEC), gave a speech reviewing the SEC’s recent focus on the private equity industry.

Ceresney addressed the question of the rationale for the SEC’s focus on the private equity industry given the sophistication of most investors. He explained that retail investors are significantly invested in private equity - for example, through public pension funds. He also observed that university endowments, which fund scholarships, invest in private equity funds. Further, Ceresney noted that even experienced institutional investors can be defrauded by fee and expense practices where there is a lack of transparency.

Ceresney discussed the recent actions brought against private equity fund advisers. Several of these actions were discussed in the prior issue of the Quarterly Global Asset Management Update. Ceresney noted that the SEC’s actions against private equity fund advisers fall into three interrelated categories:

  • undisclosed fees and expenses (e.g., undisclosed conflicts of interest involving accelerated monitoring fees);
  • shifting and misallocation of expenses (e.g., the misallocation of broken deal expenses or the improper allocation of manager expenses to funds); and
  • failure to adequately disclose conflicts of interest (e.g., failure to disclose insider loans).

Ceresney also reviewed three arguments that have been made by fund advisers in the course of the SEC investigations that the SEC staff has rejected:

  • first, some advisers have argued that it is unfair to find advisers liable for inadequate disclosures that were drafted prior to the SEC’s focus on the private equity industry and before many advisers were required to register with the SEC.  To this argument Ceresney stated that private equity advisers have always been subject to certain provisions of the Investment Advisers Act of 1940, and that all investment advisers are fiduciaries subject to the antifraud provisions of the Advisers Act;
  • decond, some advisers have argued that despite inadequate disclosure, investors substantially benefited from the adviser’s services. Ceresney noted that this fact may be relevant to the appropriate remedy.  However, it is not relevant for determining liability.   Rather, investment advisers are fiduciaries with an obligation to disclose all material conflicts of interest; and
  • finally, advisers have pointed to advice received from counsel. Ceresney  stated that advice of counsel will be considered in evaluating the appropriateness of remedies (assuming the adviser waives privilege and completely discloses the advice).  However, he added that an adviser cannot escape liability by pointing to the actions of counsel.

Andrew Ceresney’s speech is a reminder that the SEC continues to investigate private equity fund advisers, and that more SEC actions are likely to come.  Based on the recent enforcement actions, private equity firms should examine and update their policies and procedures as to the treatment and allocation of fees.  In addition, fund advisers should carefully review and evaluate disclosures contained in fund offering documents to ensure that there is enough information for investors to adequately assess the fees and expenses they can expect to be charged.  Moreover, private equity advisers should examine and disclose potential conflicts of interest to investors.

Ceresney also noted that there has been an uptick in investors seeking greater transparency concerning fee and expense practices, and specifically cited the Institutional Limited Partner Association (ILPA) Fee Transparency Initiative.  Private equity advisers might compare their fee and expense disclosures to those contained in the Fee Reporting Template issued by ILPA in January 2016.

Sun Capital – Private equity funds liable for portfolio company withdrawal liability

On March 28, 2016, the United States District Court for the District of Massachusetts (the “District Court”) held that two private equity funds were jointly and severally liable for multi-employer pension plan withdrawal liability incurred by one of their jointly-owned portfolio companies despite the fact that neither fund owned more than 80 per cent of the portfolio company. 

Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, 2016 WL 1239918 (D.Mass. 2016) (Sun Capital II) The District Court ruled that the two private equity funds were engaged in a trade or business and had formed a “partnership-in-fact” that was a trade or business under common control with the portfolio company. As such, the two funds, as partners of the partnership, are jointly and severally liable for such liability.


Under the Employee Retirement Income Security Act of 1974, as amended (ERISA), withdrawal liability can be imposed on the withdrawing employer and all of the “trades or businesses” that are under “common control” with the withdrawing employer.  In general, ERISA provides that a parent is under common control with its subsidiary if the parent owns at least 80 per cent of the subsidiary.

Scott Brass, Inc. (SBI), the portfolio company in the instant case, incurred $4.5 million in withdrawal liability when it went bankrupt and ceased contributions to the New England Teamsters and Trucking Industry Pension Fund (the Pension Fund).  At such time, SBI was owned by Scott Brass Holding Corp., which was owned by Sun Scott Brass, LLC (the LLC). Sun Capital Partners III, LP (Fund III) owned 30 per cent of the LLC, and Sun Capital Partners IV, LP (Fund IV, and together with Fund III, the Funds) owned the other 70 per cent of the LLC. The Pension Fund asserted that Fund III and Fund IV were jointly and severally liable for the withdrawal liability because they were engaged in a trade or business under common control with SBI.

In 2013, the U.S. Court of Appeals for the First Circuit held that Fund IV was engaged in a trade or business, but remanded to the District Court the determination of whether Fund III was also engaged in a trade or business, and whether the 70 per cent ownership of Fund IV and the 30 per cent ownership of Fund III could be aggregated to meet the 80 per cent controlled group test. Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013) (Sun Capital I).

Sun Capital II

Trade or Business

The District Court first held that both Fund III and Fund IV were engaged in a trade or business under the First Circuit’s “investment plus” standard from Sun Capital I, which provides that a private equity fund can be considered to be engaged in a trade or business if, when combined with an otherwise passive investment in a portfolio company, it engages in certain other activities with respect to such portfolio company, focusing in particular on both funds’ receipt of benefits related to their active management of SBI.  Among other things, to support its finding that Fund III had received such economic benefits, the District Court found that the management fee payable by Fund III was reduced as a result of fees paid by SBI to the general partner of Fund III (through a management fee offset mechanism). The Court of Appeals had previously found that Fund IV was engaged in a trade or business based on a similar management fee offset resulting from the payment of fees by SBI to the general partner of Fund IV.

Common Control

While neither Fund III nor Fund IV owned more than 80 per cent of SBI, and despite the fact that both funds were organizationally separate and had different limited partners, the District Court found that Fund III and Fund IV had formed a “partnership-in-fact” under federal law. The District Court found that the following details indicated the existence of a partnership:

  • the Funds created the LLC in order to invest in SBI;
  • the Funds also co-invested in five other companies, using the same organizational structure;
  • the Funds split their ownership in the LLC 70/30 for reasons related to the Funds’ investment cycles, a preference for income diversification and a desire to keep each fund below 80 per cent ownership to avoid withdrawal liability, of which the District Court determined only income diversification is a goal that two independent entities could pursue on their own; and
  • there was no evidence of independence in their co-investments (no evidence that they sometimes co-invested with other entities, or that there was ever any disagreement between the Funds regarding operation of the LLC).

In aggregating the ownership of Fund III and Fund IV, the District Court did not distinguish between parallel funds (which are designed to invest on a proportionate, side-by-side basis in the same portfolio) and successor funds, such as Fund III and Fund IV (which are designed to create different portfolios but typically co-invest in no more than a limited number of investments).

Trade or Business under Common Control with SBI

Finally, the District Court held that the de facto partnership formed by the Funds, which put the Funds in common control with SBI, was engaged in a trade or business under the First Circuit’s “investment plus” standard for the same reasons as the Funds (i.e., its purpose was to make a profit and it was involved in the active management of portfolio companies). As such, the District Court found that the Funds are jointly and severally liable for the withdrawal liability incurred by SBI.


The District Court’s decision in Sun Capital II is significant to private equity firms and investors, and firms should give careful consideration to the structure and operation of their funds and investments where portfolio companies have multi-employer pension or defined benefit liabilities. Where a fund (and any of its related funds) will own 80 per cent or more of a portfolio company, a private equity firm should apply more extensive due diligence in examining the pension liabilities of target companies and negotiate appropriate representations and indemnities. Where exposure to such liabilities is material, firms will need to consider bringing in unrelated co-investors to own 21 per cent or more of the portfolio company. In addition, given the emphasis of the courts in Sun Capital I and Sun Capital II on the receipt of fees from portfolio companies and the resulting management fee offset, firms will need to consider whether to modify such arrangements, as well as how to increase the separation of their funds and portfolio management.

Proposed restrictions on incentive-based compensation for US financial institutions could benefit independent asset managers

Six federal agencies including the Securities Exchange Commission (collectively, the Agencies)1 have approved a joint proposed rule (the Rule) under Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) that prohibits incentive-based compensation arrangements that encourage excessive risk-taking behavior. Section 956 of the Dodd-Frank Act requires the Agencies to issue regulations or guidelines prohibiting certain financial institutions from having incentive-based payment arrangements that encourage inappropriate risks through the provision of excessive compensation or that could lead to a material financial loss.

The Rule replaces a similar proposal from the Agencies in 2011 that was never adopted. The new proposal, which was expected to be released last year but was apparently delayed due to interagency disagreements, is said to take into account public comments received from the original proposal as well as the Agencies’ collective added experiences studying incentive-based compensation arrangements since 2011.

The Rule applies to a range of financial institutions, including registered and unregistered investment advisers that have average total consolidated assets greater than or equal to $1 billion. For investment advisers, total consolidated assets are calculated based on the total assets shown on the adviser’s balance sheet as of the most recent fiscal year end. The Rule indicates that this calculation does not include “non-proprietary assets,” such as client assets under management, regardless of whether such assets appear on the adviser’s balance sheet.

The Rule establishes tiers of covered institutions by asset size and applies less rigorous requirements on the smaller covered organizations. Level 1 organizations have average total consolidated assets greater than or equal to $250 billion; Level 2 organizations have average total consolidated assets greater than or equal to $50 billion and less than $250 billion; and Level 3 organizations have total consolidated assets greater than or equal to $1 billion and less than $50 billion. However, a Level 3 organization with assets between $10 and $50 billion may be required to comply with the more stringent rules for Level 1 and Level 2 organizations if the applicable Agency determines that the organization has complex operations and incentive-based compensation arrangements that are similar to a Level 1 or Level 2 organization or if it is involved in a high risk business.

The Rule prohibits covered organizations from establishing or maintaining incentive-based compensation arrangements that encourage inappropriate risk. An incentive-based compensation arrangement that encourages inappropriate risk is an arrangement in which individuals are provided with excessive compensation, fees or benefits or that could lead to material financial loss to the covered organization. Under the Rule, compensation, fees and benefits will be considered excessive when amounts paid are unreasonable or disproportionate to the value of the services performed, taking into consideration all relevant factors, including but not limited to, the value of all compensation provided to the individual, the individual’s compensation history and the compensation history of individuals with comparable expertise, the financial condition of the covered organization and the compensation practices at comparable organizations. An incentive-based compensation arrangement will be deemed to encourage inappropriate risks that could lead to a material financial loss unless the arrangement (1) appropriately balances risk and reward, (2) is compatible with effective risk management and controls, and (3) is supported by effective governance. The Rule would not apply to incentive-based compensations with performance periods that begin before the compliance date, which would be at least two years following the date the rule becomes final.

Among other things, under the Rule, incentive-based compensation payable to senior executive officers and “significant risk takers” at Level 1 or Level 2 organizations would be subject to a seven year claw back requirement from the date on which such compensation vests. “Significant risk-takers” refer to individuals who are not senior executive officers but who are in the position to put a Level 1 or Level 2 institution at risk of material financial loss. In addition, Level 1 and Level 2 institutions would be required to defer a percentage of qualifying incentive-based compensation for executives and significant risk takers for specified periods of time.

Because the Rule imposes more stringent requirements on institutions with larger balance sheets, we believe the impact of the Rule on investment managers would be largely felt by those firms that are integrated with large, diversified financial institutions. However, this represents a minority of firms. Given the fragmented nature of the investment management industry and its many small- and mid-sized independent firms, we believe relatively few investment managers would be subject to the more restrictive elements of the Rule. In fact, the SEC estimates that of the 669 registered investment advisers subject to the proposal, only 18 would face Level 1 regulation, most of whom are within larger banks.

The Agencies have recognized that the Rule could impact a larger organization’s ability to compete for talent, even acknowledging that these firms may have to pay employees more to make up for the stricter incentive based compensation requirements or even spin off from the larger organization and operate as standalone entities. However, the Agencies believe these risks do not outweigh the risks that the largest financial institutions could have on the markets when they are engaging in inappropriate incentive-based compensation practices.

Given the tiered structure of the Rule, key investment professionals that work for an investment manager that is part of a large Wall Street bank would likely be subject to compensation rules much more limiting than investment professionals performing similar duties for similar clients at an independent investment manager. Assuming the Rule is not modified to address this disparity, the rule could give independent managers an edge in recruiting top talent. The investment management industry has long witnessed a stream of talent leaving large institutions for smaller private firms, and the Rule would only seem to reinforce that trend. As a result, it will be important for investment management firms of all types to monitor closely further developments of the proposed Rule.



In addition, to the SEC, the Federal Reserve, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the National Credit Union Administration and the Federal Housing Finance Agency have jointly proposed this rule.

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