SEC Charges Private Equity Fund Adviser with Misallocation of Portfolio Company Expenses

November 5, 2014

On September 22, 2014, the SEC announced that Lincolnshire Management Inc. agreed to settle charges that it breached its fiduciary duty to a pair of its private equity funds by sharing expenses between a company in one fund’s portfolio and a company in the other fund’s portfolio in a manner that improperly benefitted one fund over another. Lincolnshire agreed to pay over $2.3 million in the settlement, including disgorgement of $1.5 million and a $450,000 civil penalty.

This case follows a recent, well-publicized speech in which Andrew J. Bowden, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), noted that when OCIE examined how fees and expenses were handled by private equity fund managers, OCIE identified what it believed to be “violations of law or material weaknesses in controls” more than 50 percent of the time. Our May 12, 2014, Legal Alert discusses that speech in more detail.

The Portfolio Companies

According to the SEC and public filings, Lincolnshire manages multiple private equity funds that make investments through leveraged buyouts and recapitalizations. In April 1997, Lincolnshire Equity Fund LP (Fund I) acquired Peripheral Computer Support Inc. (PCS) for approximately $5 million. Management of PCS later brought to Lincolnshire an investment opportunity involving Computer Technology Support Inc. (CTS). However, by 2001 Fund I’s commitment period had expired. Recognizing that the two companies would complement each other, Lincolnshire caused Lincolnshire Equity Fund II LP (Fund II) to acquire CTS for approximately $8.5 million.

Upon the acquisition of CTS, Lincolnshire disclosed to investors of Fund I and Fund II that it intended to integrate PCS and CTS where feasible and ultimately market the two companies for a combined sale. Additionally, in its quarterly disclosures to investors of Fund I and Fund II, Lincolnshire provided regular updates on the two companies and on the progress toward their integration and joint sale.

The Integration of the Two Portfolio Companies

According to the SEC and public filings, from at least 2005 to January 2013 PCS and CTS were integrated and, in certain respects, operated as a single business, though they remained separate legal entities. By 2005, the companies had integrated their financial accounting systems and a number of business and operational functions, including payroll and 401(k) administration, and substantial parts of human resources, marketing and technology. An offshore subsidiary of PCS provided parts and labor at cost to CTS, and CTS sold parts at cost to various subsidiaries of PCS. By March 2009, the two companies shared a joint management team and a joint logo that the companies used in marketing and advertising. Ultimately, following two prior attempts at a combined sale, the two portfolio companies were sold together to a single buyer in January 2013.


In accordance with an unwritten policy, Lincolnshire allocated any shared expenses between the companies based on each company’s proportional revenue. Although Lincolnshire generally followed this unwritten policy, the SEC found that “there were times when the shared expenses were misallocated and went undocumented.” According to the SEC, these misallocated expenses included:

  • 401(k) administrative expenses for employees of both companies,
  • salaries of shared employees,
  • costs of shared services provided by a subsidiary of PCS, and
  • bonuses to executives who were employed solely by CTS.

Based on these deviations by Lincolnshire from its own allocation policy, and its failure to document any basis for these failures, the SEC alleged violations of Section 206(2) of the Investment Advisers Act of 1940. Importantly, a violation of Section 206(2) of the Advisers Act can be based on a finding of simple negligence.

The SEC alleged that Lincolnshire caused PCS to pay “more than its share of certain expenses that benefitted both companies.” According to the SEC, this misallocation constituted a breach of Lincolnshire’s fiduciary duty to Fund I and Fund II, and therefore Lincolnshire engaged in a “transaction or course of business which operates as a fraud or deceit upon any client or prospective client.”

Failure to Have Written Compliance Procedures

In addition to the misallocation of expenses, the SEC cited Lincolnshire for failure to have written policies or procedures in place to address the integration of the two portfolio companies. Section 206(4) of the Advisers Act, and Rule 206(4)-7 thereunder, imposes strict liability upon registered investment advisers for failure to adopt and implement “written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules.”

The SEC staff often requires fund managers to prepare and implement written procedures relating to fees and expenses when the staff encounters situations in regulatory compliance examinations where written procedures either do not exist or do not appear to the SEC staff to be effective. The adoption and adherence to clear written procedures tailored to the business and operation of the manager and the portfolio companies should help in preventing, identifying and dealing appropriately with these kinds of fee issues.

Recommendations and Next Steps

This case should serve as a stark reminder to registered investment advisers to:

  • have in place written policies and procedures that specifically address potential issues related to the proper allocation of expenses between and among clients (such as, in this case, the operation of two portfolio companies held by separate funds on an integrated basis);
  • carefully allocate expenses pursuant to those policies and procedures; and
  • carefully document any deviation from those policies, including a detailed description of how the deviation is in the best interest of the adviser’s clients (i.e., the funds).

Note also that Lincolnshire was not registered until 2012, and the misallocations took place from 2005 to 2013. Actions that implicate an adviser’s fiduciary duty (such as expense allocation) should be addressed regardless of the adviser’s registration status at the time, and taking affirmative corrective/remedial measures may be appropriate depending on the situation.

McGuireWoods LLP

The private equity team at McGuireWoods LLP is dedicated to keeping clients advised of new legal and business developments as they occur. If you have any questions regarding these issues, please feel free to contact any of the authors or your primary attorney at McGuireWoods LLP.