CozenOConnor-Logo-RGBIn the following guest post,  Elan Kandel, who is a member of the Cozen O’Connor law firm, takes a look at the SEC’s recent investigative interest in the way private equity firms disclose their fees. He also reviews the insurance issues these types of SEC investigations and enforcement actions raise. A version of this article previously was published as a Cozen O’Connor client alert. I would like to thank Elan for his willingness to publish his article on my site. I welcome guest post contributions from responsible authors on topics of interest to readers of this site. Please contact me if you would like to submit a guest post. Here is Elan’s article.




On April 3, 2015, The Wall Street Journal reported that private equity adviser Fenway Partners LLC (Fenway) received a Wells Notice from the U.S. Securities and Exchange Commission (SEC) in March 2015 regarding Fenway’s treatment of fees and expenses incurred by its sponsored funds’ portfolio companies.[i] Specifically, the SEC is apparently investigating how Fenway Partners handles fees and expenses, including payments made for consulting services by portfolio companies, and how such payments are disclosed to fund investors.[ii]

Fenway is the latest in a string of private equity advisers to face SEC scrutiny concerning the adequacy of its disclosure of fees and expenses incurred by a private equity adviser to fund investors. Two days prior to The Wall Street Journal’s report, on March 30, 2015, the SEC’s Enforcement Division commenced public administrative and cease and desist proceedings against private equity investment adviser Lynn Tilton (Tilton), Patriarch Partners, LLC, Patriarch Partners VIII, LLC, Patriarch Partners XIV, LLC and Patriarch Partners XV, LLC (collectively, Patriarch). The SEC alleges that Tilton and Patriarch breached their fiduciary duties and defrauded investors in three of Patriarch’s sponsored collateralized loan obligation investment funds (the Zohar Funds) and improperly collected nearly $200 million in management fees and other expenses.

According to the SEC’s order instituting an administrative proceeding, since 2003, Tilton and Patriarch have breached their fiduciary duties and defrauded investors in the Zohar Funds by failing to value assets using the valuation methodology set forth in the documents governing the Zohar Funds. The Zohar Funds reportedly raised more than $2.5 billion since 2003 from investors and used this capital to make loans to distressed companies. The loans made to distressed companies (the Zohar Funds’ portfolio companies) by the Zohar Funds are the Zohar Funds’ primary assets. Over the past several years, however, many of the Zohar Funds’ portfolio companies have not made interest payments, or have only made partial payments to the Zohar Funds.

As required by the Zohar Funds’ governing documents, Patriarch regularly provided information to the funds and their investors concerning the funds’ performance. Instead of applying the valuation categorizations required under the Zohar Funds’ governing documents, the SEC contends that, at Tilton’s direction, Patriarch did not assign a lower valuation category to an asset unless and until Tilton “subjectively decides to stop ‘supporting’ the distressed company.” As a result of Tilton’s undisclosed and subjective valuation methodology, nearly all of the asset valuations remained unchanged since the time they were acquired. Importantly, had Tilton and Patriarch applied the required valuation methodology, the SEC alleges that “management fees and other payments to Tilton and her entities would have been reduced by almost $200 million, and investors would have gained more control over the Funds’ activities … By applying her own undisclosed discretionary valuation methodology, Tilton created a major conflict of interest.”

The SEC further alleges that the quarterly financial statements for the Zohar Funds were not prepared in conformity with generally accepted accounting principles (GAAP) despite the certification made by Tilton and Patriarch to the contrary.

The disclosure of possible SEC action against Fenway and commencement of enforcement proceedings against Tilton and Patriarch came on the heels of reports in February 2015 that private equity giant KKR & Co. reportedly issued “fee credit” refunds in early 2014 to investors in some of its buyout funds in the wake of an unfavorable SEC examination. KKR & Co.’s fee credit refunds were issued around the same time as the SEC’s commencement of enforcement proceedings against Clean Energy Capital (CEC) and its main portfolio manager, Scott Brittenham (Brittenham) in February 2014.

In the CEC/Brittenham action, the SEC alleged that CEC and Brittenham improperly allocated more than $3 million of CEC’s expenses that CEC managed. The SEC alleged that such allocations were made without adequate disclosure to investors, and therefore constituted a misappropriation of assets from CEC’s funds. On October 17, 2014, CEC and Brittenham agreed to pay $2.2 million in disgorgement and civil penalties to settle the action.

Roughly one month prior to the CEC/Brittenham settlement, on September 22, 2014, the SEC entered into a cease and desist order against private equity adviser Lincolnshire Management (LMI) finding that LMI breached its fiduciary duty to its funds. The SEC charged LMI with failing to allocate expenses properly after LMI integrated portfolio companies of two affiliated private equity funds. The SEC alleged breach of fiduciary duty and failure to adopt and implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 arising from the integration of the two portfolio companies owed by separately advised LMI funds. LMI paid $2.3 million to settle the SEC’s charges in disgorgement and civil penalties.

The SEC has touted the CEC/Brittenham action as its “first-ever” action arising from its focus on fees and expenses charged by private equity firms. The agency’s recent pursuit of Tilton/Patriarch and Fenway confirms that the private equity industry’s fees and expenses and valuation practices, and the perceived lack of disclosure to fund investors, remain on the SEC’s radar. As such, in the coming months, additional disclosures by private equity advisers and the SEC of investigations and possible enforcement actions against private equity advisers should be expected.[iii] In an effort to avoid becoming ensnared by the SEC, private equity advisers should consider examining and clarifying, when applicable, their disclosures of valuations, fees, and expenses and other practices.

From an insurance coverage standpoint, private equity advisers and their insurers should note that depending upon the specific wording of the implicated private equity management and professional liability policy, SEC enforcement actions and the investigations that precede them, may raise a panoply of coverage issues.

As a threshold matter, while the policy’s definition of “claim” is generally defined to include enforcement actions and formal administrative and regulatory investigations, not all policies extend the claim definition to include “informal investigations.” This is particularly relevant when the SEC’s formal investigation does not commence (if at all) for months (or in some cases years) after the informal investigation. For example, according to the civil action filed by Tilton and Patriarch in federal court against the SEC, seeking removal of the enforcement action to federal court, the SEC issued its first document request on December 15, 2009, but did not issue a Wells Notice until October 4, 2014. It is unclear whether the SEC issued its December 2009 document request pursuant to a formal notice of investigation or whether the request was issued in connection with an informal investigation. In the event that the document request was issued as part of an informal investigation, unless the applicable policy’s definition of claim includes informal investigations, the policy would not provide coverage for fees and expenses incurred by the private equity adviser or any of its directors and officers in order to respond. Fees and expenses incurred in connection with an SEC investigation can be significant.

Questions regarding the scope of indemnity coverage may also arise because the monetary remedies sought by the SEC are limited to disgorgement, civil fines and penalties.[iv] In most policies, the “loss” definition contains language excluding “matters deemed uninsurable under the law pursuant to which this policy is construed.” Some policies also expressly exclude “disgorgement or restitution” from the definition of loss, but often subject to certain limitations. Where the definition of loss does not expressly exclude disgorgement or restitution, there is a well-developed body of case law holding that disgorgement is uninsurable as a matter of public policy (even in the context of a settlement agreement as opposed to a judgment or award). It should be noted, however, that some more recently decided cases have rejected insurers’ attempts to deny coverage where it is less than clear that the settling parties were the recipients of the disgorged funds.

Depending upon the wording of a policy’s “fraud and dishonesty” exclusion, an SEC settlement may also raise the potential applicability of a policy’s fraud and dishonest conduct exclusion. Specifically, the fraud and dishonesty exclusion found in most policies requires a “final adjudication” for the exclusion to apply. Coverage issues may arise over precisely what constitutes a final adjudication, particularly in the context of an SEC settlement agreement and implementing order. For example, in J.P. Morgan Securities v. Vigilant Ins. Co.,[v] the insured’s professional liability insurers sought to invoke the policies’ “dishonest acts” exclusions in order to preclude coverage for $250 million in penalties and disgorgement imposed by the SEC against now-defunct investment bank Bear Stearns & Company in a SEC consent order and related New York Stock Exchange stipulation of settlement. The insurers argued that the dishonest acts exclusion was applicable because by consenting to the entry of administrative orders that contained detailed “findings” and requiring Bear Stearns to make “disgorgement” payments and pay penalties, Bear Stearns had been adjudicated a wrongdoer. In its January 15, 2015 decision, the Appellate Division (First Department) of the New York State Court rejected the insurers’ argument, on the basis that the SEC and NYSE settlement agreements expressly provided that Bear Stearns “did not admit guilt, and reserved the right to profess its innocence in unrelated proceedings.” As such, the Appellate Division held that the settlement agreements and their incorporated findings did not constitute final adjudications for purposes of the policies’ dishonest acts exclusions. Accordingly, when entering into settlement agreements with the SEC, policyholders and insurers are advised to keep in mind the potential applicability of the fraud/dishonesty exclusion.

In view of the SEC’s ongoing heightened scrutiny of the private equity industry, private equity advisers are encouraged to examine their disclosure practices closely. Private equity policyholders and their insurers alike are advised to review their applicable insurance policy wording so that the potential risk and exposure associated with matters stemming from such practices may be adequately explored.


[i] Ryan Dezember, “SEC Warns Fenway Partners of Possible Action,” Wall. St. J., April 3, 2015, available at

[ii] Chris Witkowsky, “SEC Investigates Consulting Fees, GP Clawback at Fenway Partners,”, April 6, 2015, available at

[iii] Private equity advisers and their insurers should also anticipate the possibility that disgruntled investors will separately file civil actions asserting claims under federal and state securities law as well as under common law to the extent that undisclosed or inadequately disclosed treatment of fees and expenses, valuations or other practices is material.

[iv] The definition of “loss” generally expressly excludes fines and penalties. Given that an SEC settlement agreement typically expressly delineates that a portion of the relief compromised constitutes fines and penalties, the lack of coverage for such relief is difficult for policyholders to reasonably dispute based on the loss definition. 

[v] 126 A.D.3d 76, 2 N.Y.S.3d 415 (1st Dept. 2015).