When people speaking normal non-lawyerly English use the word “deceit,” they generally refer to somebody’s effort to pull a fast one on somebody else. Jones deliberately tries to get Smith to believe that a certain investment is promising, although Jones knows that Smith’s money will certainly or almost certainly be lost. That is the paradigm case for “deceit” as usually employed.
But lawyers know better. Or otherwise, anyway. What they call scienter need not be present in every instance of what they call deceit. For investment advisors and managers, that has been the case at least since the decision of the DC Circuit Court in 1992, SEC v. Steadman, which said, “a violation of Section 206(2) of the Investment Advisers Act may rest on a finding of simple negligence.”
That’s Worth Remembering
As a matter of risk management, advisors have to know when they risk civil enforcement actions, and they should understand that avoiding common-language deceitfulness isn’t enough.
One quite recent case in point involves PE giant Kohlberg Kravis Roberts and the long-simmering subject of the allocation of “broken deal” expenses. The bottom line here is that at the end of June 2015 KKR agreed to pay more than $28 million to resolve charges that it had misallocated “broken deal” expenses. Half of that is disgorgement, the remainder is penalty and pre-judgment interest.
During a six year period that ended in 2011, KKR incurred $338 million in broken deal or diligence expenses that related to unsuccessful buyouts and the like. Nothing wrong with that: not all deals succeed. The allegation of wrongdoing though is this: KKR didn’t allocate any of those expenses to its co-investors, including its own executives, who participated and who benefitted from the firm’s deal sourcing. Nor did KKR expressly state in its fund LP agreements or offering documentation that it did not allocate broken-deal expenses to co-investors. Nor did it have a compliance policy governing such practices until the end of the six year period at issue.
Details and Numbers
The largest PE fund in the KKR stable during this period was the 2006 Fund, with $17.6 billion in committed capital. During the period, this one fund invested over $16.5 billion in various business opportunities, primarily in North America. The SEC’s findings focus specifically on this fund, although they add in a footnote that “other KKR Flagship PE Funds … operated similarly to the 2006 Fund.”
The broken deal expenses, for the 2006 fund and the other “flagship” funds together, during these six years added up to $338 million. KKR allocated these expenses based on the geographical region of the attempted deal. Thus, it allocated expenses pertaining to North American deals to the 2006 fund; with the PE firm itself typically bearing 20% of all such expenses.
For all KKR transactions, of any size, the LP agreements reserved a percentage of fund portfolio investments for its executives, certain consultants, and others. Some part of this percentage was then filled through KKR Partner Vehicles, which invested on a deal by deal basis with no specified committed capital. For the period at issue, 2006-2011, the Co-Investors chipped in $4.6 billion, alongside $30.2 billion invested by the flagship PE funds, $750 million of that coming through the Partner Vehicles.
But given the misallocated described above and the absence of disclosure, the SEC alleges (KKR neither admitting nor denying) that it misallocated $17.4 million in broken deal expenses during the relevant period and that this was a breach of its fiduciary responsibility.
The suggestion, then, is that KKR allowed its executives to enter the PE business on terms that exempted them from costs risked by unaffiliated investors. In terms of the statute, the SEC charged that this behavior was a violation of section 206(2) of the Advisers Act, which prohibits an investment adviser from entering into “any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.”
That brings us back to where we began. Had KKR contested the matter, and had it gone further, the SEC would at no point have been required the show that KKR regarded its own actions as a deceit, a misleading, of any of its investors for the benefit of any others. Negligent accounting that has the effect of deceiving is still … deceit.
The finding acknowledges that KKR has subsequently changed its ways. In 2012, after review by a third-party consultant, it began to allocate broken deal expenses to partner vehicles and other co-investors on the basis of a number of factors, “including the amount of committed capital, the amount of invested capital, and the percentage of transactions in which the KKR Co-Investors were eligible to participate given the Flagship PE Funds’ minimum investment rights.” The SEC doesn’t approve or disapprove of the new system, which it simply says is “not a subject of this Order.”