Loans From Clients To Investment Advisers: Proceed With Caution

Overview

Investment advisers, registered or not, should anticipate that the SEC will scrutinize any loan (extension of credit or guarantee) from a fund client to another client or to the investment adviser, its general partner or another affiliate during an examination. As a fiduciary to the fund, the adviser owes a duty of care and a duty of loyalty to each of its clients.The SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers details the requirements of each of those duties.

Some of the many questions we frequently hear during SEC examinations include: Was the loan permitted by the fund documents? Was the loan consistent with the fund’s investment objective? Was it in the best interest of the fund? Did the fund forgo other investment opportunities because its capital was deployed to the loan?Was the loan documented? Were the fund investors aware of the loan? Did they consent to it? How was the rate of interest determined?

Two recent enforcement actions reinforce the timeliness of this topic:

CityVest Capital Inc.

In the first, the SEC settled charges against never registered investment advisers CityVest Capital Inc., CV Manager LLC, and against their part-owner and sole operator and CEO, Alan Donenfeld, for breaching their fiduciary duty by failing to disclose conflicts of interest resulting from undisclosed loans to CityVest by funds they advised. CityVest raised $47 million across 15 different access funds that in turn invested in third-party real estate funds.

According to the SEC’s order, Donenfeld, CityVest, and CV Manager borrowed $425,000 from three access funds (the “Access Funds”) that they managed. Donenfeld caused CityVest to take these loans to meet its’ operating expenses, including payroll. He created loan agreements between the Access Funds, CityVest, and CV Manager, that he signed on behalf of each of the Access Funds. While ultimately repaid with interest, the loans and the conflicts of interest associated with the loans were not fully and fairly disclosed to or approved by the Access Funds and their investors.

The SEC found that Donenfeld, CityVest, and CV Manager willfully violated Section 206(2) of the Investment Advisers Act of 1940. Without admitting the findings in the order, Donenfeld, CityVest, and CV Manager consented to a cease-and-desist order and censures. In addition, CityVest and Donenfeld agreed to pay civil penalties of $10,000 each.

Meyer Global Management LLC

In the second case, the SEC charged private fund adviser Meyer Global Management LLC (“MGM”), an SEC exempt reporting adviser (“ERA”) and its CEO, Owen Meyer (“Meyer” and together with MGM, the “defendants”), with defrauding investors and MGM-managed funds in connection with investments in SpaceX, OpenAI, and other pre-IPO securities.MGM and Meyer raised $18.5 million from nearly 100 investors and managed 16 private funds, all pooled investment vehicles, formed to acquire assets in a single private portfolio company.

According to the SEC’s complaint the defendants engaged in five separate fraudulent schemes in which they misused client assets in violation of their fiduciary duties to the funds they advised and lied to investors in those funds. In at least three of the five schemes, the defendants allegedly misappropriated client assets from certain MGM-managed funds to pay for Meyer’s personal expenses.The defendants concealed their actions in one scheme by sending investors statements that inflated their account values. 

In one of the misappropriation schemes involving three MGM-managed funds, defendants allegedly misappropriated portions of investor proceeds and required investors to sign releases accepting distributions of amounts that were less than they were owed in order to get any money at all. The complaint alleges that defendants repeatedly failed to address a capital call deficiency owed by an MGM-managed fund in connection with its investment in SpaceX, resulting in the fund forfeiting its nearly $3,000,000 investment.

One fund, the MGP I (Playstar) Fund, was established for the express purpose of investing in pre-IPO shares of Playstar, an online casino and gambling company.Three investors wired a total of approximately $86,000 into the fund’s account. MGM was entitled to a 1% management fee per year for up to five years and to pay certain specified expenses of the fund. Defendants wired $64,000 to Meyer’s personal accounts that were used to pay legal fees unrelated to the fund. Meyer also allegedly used over $18,000 to pay for a strip club visit. As a result, the fund account had a $0 balance for several months and no investments.Despite the $0 balance, Meyer told investors “I assure you your invested capital is safe.”The SEC alleges that Meyer’s use of the funds amounted to an undisclosed interest-free loan in violation of the defendant’s fiduciary duty.

Throughout the five schemes, MGM and Meyer deceived and defrauded their client funds and investors, put their own interests above the interests of the funds they advised, and failed to exercise reasonable care or act in the best interests of their client funds in breach of their fiduciary duty.

The complaint, filed in the U.S. District Court for the Southern District of New York, charges the defendants with violating antifraud provisions of the Investment Advisers Act. The SEC seeks permanent injunctive relief, disgorgement of ill-gotten gains with prejudgment interest, and civil penalties against both defendants, as well as a conduct-based injunction against Meyer.

Conclusion

In conclusion, loans from fund clients to investment advisers or their affiliates is a source of potential conflicts of interest for investment advisers that must be disclosed.Advisers should not approach these arrangements casually.To the extent possible, they should probably be avoided.At the very least, they should be documented, arm’s length, and done in a manner that is consistent with fund governing documents and the fund’s investment objective.To the extent loans of this nature were not disclosed in the fund governing documents, the consent of investors, or their representatives, such as a board of directors or limited partner advisory committees should be obtained after providing all relevant terms.The fact that the SEC chose to prosecute a case against a small, unregistered investment adviser (CityVest) where the loans were documented and repaid in full with interest is a signal of the importance of this issue despite the small size of the civil penalty.The MGM case is one of many against funds that invest in pre- IPO portfolio companies; we suspect it is not the last.