SEC CHARGES INVESTMENT ADVISER OF HIDING POOR PERFORMANCE OF LOAN ASSETS IN CLO FUNDS

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

03/30/2015 09:45 AM EDT

The Securities and Exchange Commission announced fraud charges against an investment adviser and her New York-based firms accused of hiding the poor performance of loan assets in three collateralized loan obligation (CLO) funds they manage.

The SEC’s Enforcement Division alleges that Lynn Tilton and her Patriarch Partners firms have breached their fiduciary duties and defrauded clients by failing to value assets using the methodology described to investors in offering documents for the CLO funds, which have portfolios comprised of loans to distressed companies.  Instead, nearly all valuations of loan assets have been reported to investors as unchanged from the time they were acquired despite many of the companies making partial or no interest payments to the funds for several years.  Investors have not only been misled to believe that objective valuation analyses were being performed, but Tilton and her firms allegedly have avoided significantly reduced management fees because the valuation methodology described in fund documents would have given investors greater fund management control and earlier principal repayments if collateral loans weren’t performing to a particular standard.  Tilton and her firms also consequently have misled investors about asset valuations in fund financial statements.

“We allege that instead of informing their clients about the declining value of assets in the CLO funds, Tilton and her firms have consistently misled investors and collected almost $200 million in fees and other payments to which they were not entitled,” said Andrew J. Ceresney, Director of the SEC’s Enforcement Division.  “Tilton violated her fiduciary duty to her clients when she exercised subjective discretion over valuation levels, creating a major conflict of interest that was never disclosed to them.”

According to the SEC’s order instituting an administrative proceeding, CLO funds raise capital by issuing secured notes and using proceeds to purchase a portfolio of collateral typically comprised of commercial loans.  Investors are paid based on cash flows and other proceeds from the collateral.  The three CLO funds managed by Tilton and the Patriarch Partners firms are collectively known as the Zohar funds, and more than $2.5 billion has been raised from investors.  Tilton’s investment strategy for the Zohar funds has been to improve the operations of the distressed portfolio companies so they can pay off their debt, increase in value, and eventually be sold for a profit.

The SEC’s Enforcement Division alleges that under the contractual terms of the deals, Tilton and her firms are required to categorize the value of each loan asset in monthly reports by using a specific method set forth in deal documents.  To be assigned the highest category, a loan has to be current in its interest payments to the Zohar funds.  The category of each asset impacts the calculation of a fund’s “overcollateralization” ratio, which reflects the likelihood that investors will receive a return on their principal.  If the overcollateralization ratio falls below a specific threshold, Tilton and her firms are not entitled to receive certain management fees and may be required to cede more control of fund management to investors.

The SEC’s Enforcement Division alleges that rather than following the required methodology for valuing these loan assets, Tilton and her firms have maintained their control over the funds and preserved their management fees by not lowering an asset’s category until she decides to cease financial support of the distressed company.  Thus the valuation of an asset simply reflects Tilton’s subjective assessment of the company’s future.  Absent an actual overcollateralization ratio test, investors aren’t getting a true assessment of the actual values of their investments, which in reality have declined substantially.

The SEC’s Enforcement Division further alleges that Tilton and her firms were responsible for misstatements in the quarterly financial statements of the Zohar funds.  When preparing these financial statements, they failed to conduct a required impairment analysis on the assets of the Zohar funds despite disclosures stating that such analysis had occurred.  They also falsely stated that assets of the Zohar funds were reported at fair value.  Tilton repeatedly and falsely certified that the financial statements were prepared in accordance with Generally Accepted Accounting Principles (GAAP).

The SEC’s Enforcement Division alleges that Tilton, Patriarch Partners LLC, Patriarch Partners VIII LLC, Patriarch Partners XIV LLC, and Patriarch Partners XV LLC violated Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206-4(8).  Patriarch Partners LLC also is charged with aiding and abetting violations by the others.  The matter will be scheduled for a public hearing before an administrative law judge for proceedings to adjudicate the Enforcement Division’s allegations and determine what, if any, remedial actions are appropriate.

The SEC’s investigation has been conducted by Amy Sumner, Amanda de Roo, and John Smith with assistance from Judy Bizu.  Also contributing to the investigation were Allison Lee, Creola Kelly, and Brent Mitchell.  The case has been supervised by Laura Metcalfe, Reid Muoio, and Michael Osnato.  The Enforcement Division’s litigation will be led by Dugan Bliss, Nicholas Heinke, and Ms. Sumner.

SEC CHARGES FORMER HEDGE FUND MANAGER WITH TAKING EXCESSIVE FEES TO REMODEL HOME

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission announced charges against a former hedge fund manager accused of fraudulently taking excess management fees from the accounts of fund clients and using their money to remodel his multi-million dollar home and buy a Porsche.

An SEC Enforcement Division investigation found that Sean C. Cooper improperly withdrew more than $320,000 from a hedge fund he managed for San Francisco-based investment advisory firm WestEnd Capital Management LLC.  While WestEnd disclosed to clients the withdrawal of annual management fees of 1.5 percent of each investor’s capital account balance, Cooper actually withdrew amounts that far exceeded that percentage.  He then transferred the money to personal bank accounts so he could spend it freely.  Cooper’s misconduct occurred for a two-year period until he ceased misappropriating fund assets when the SEC began an examination of WestEnd in April 2012.

WestEnd, which expelled Cooper and reimbursed the hedge fund once it became aware of his scheme, is being charged separately by the SEC for failing to effectively supervise him.  The firm agreed to pay a $150,000 penalty to settle the SEC’s charges.

“Cooper betrayed the hedge fund’s investors by lining his own pockets with fund assets that he had not earned,” said Marshall S. Sprung, Co-Chief of the SEC Enforcement Division’s Asset Management Unit.  “His fraud went undetected because WestEnd had no internal controls to limit Cooper’s ability to withdraw excessive amounts from the fund.”

According to the SEC’s order instituting a litigated administrative proceeding against Cooper, he began indiscriminately withdrawing money from the hedge fund – WestEnd Partners L.P. – in March 2010.  Cooper mischaracterized the withdrawals as management fees in the fund’s books and records, but they bore no relation to the actual amount of fees that WestEnd had earned.  The SEC Enforcement Division alleges that, in reality, Cooper simply was using the hedge fund as his own private bank.  He had sole authority to transfer money out of the fund, and there were no controls in place at the firm to prevent him from making improper withdrawals.  Once he routed the money into his personal accounts, Cooper purchased a $187,000 Porsche amid other lavish spending.

The SEC Enforcement Division alleges that Cooper, a resident of New Orleans, willfully violated Sections 206(1), 206(2), 206(4), and 207 of the Investment Advisers Act of 1940 and Rule 206(4)-8.  Cooper is charged with aiding, abetting and causing WestEnd’s violations of Section 206(4) and Rule 206(4)-7.

According to the SEC’s order instituting a settled administrative proceeding against WestEnd, Cooper operated the hedge fund with little to no supervision from others at WestEnd, and he had sole discretion to calculate and wire out money that he claimed the fund owed to WestEnd.  Besides its failure to adopt any policies or procedures that imposed the necessary internal controls, WestEnd also failed to maintain several required books and records relating to its finances, including the management fees it collected from the fund.  

WestEnd consented to the entry of the order finding that it violated Sections 204, 206(4), and 207 of the Advisers Act and Rules 204-2(a)(1), (2), (6), and (7) and 206(4)-7.  The order also finds that WestEnd failed to reasonably supervise Cooper within the meaning of Section 203(e)(6) of the Advisers Act.  In addition to the financial penalty, WestEnd agreed to cease and desist from committing or causing future violations of these provisions without admitting or denying the findings.  The settlement also requires the firm to retain a compliance consultant.

The SEC’s investigation was conducted by Eric Brooks and Erin E. Schneider of the Asset Management Unit in the San Francisco Regional Office.  The SEC’s litigation against Cooper will be led by Sheila O’Callaghan and Mr. Brooks.  The SEC examination that led to the investigation was conducted by Ed Haddad, John Chee, Karah To, and Arturo Hurtado of the San Francisco office’s investment adviser/investment company examination program.