SEC Sanctions Insight For Overcharging Management Fees
On June 20, 2023, the U.S. Securities and Exchange Commission (SEC) issued an Order Instituting Proceedings (Order) reflecting a US$2.35 million settlement with Insight Venture Management LLC (Insight), an SEC-registered investment adviser with approximately US$79 billion in regulatory assets under management.1
Like many private fund advisers, Insight has a fee structure that charges management fees on assets held by its fund clients. The Order indicates that under Insight's documents, investments that are deemed “permanently impaired” cease to be subject to ongoing management fees to the extent of such impairment. The Commission found that Insight (1) overcharged management fees payable by Insight’s fund clients after Insight failed to properly mark-down the value of impaired investments held by such funds, (2) failed to disclose the conflict of interest arising from a fee structure that involved a subjective impairment analysis and a financial disincentive to deem assets permanently impaired, and (3) failed to adopt or implement written policies or procedures reasonably designed to prevent violations of the Advisers Act related to a failure to recognize the permanent impairment of investments. The Commission censured Insight and required it to pay a US$1.5 million civil penalty as well as disgorgement of US$3.8 million of improper fees and prejudgment interest on those excess fees.. The disgorgement was deemed satisfied by Insight repayments to its funds near the end of the SEC’s investigation.
Relevant Facts in Insight
Improper Impairment Analysis and Failure to Reduce Management Fees
According to the Order, Insight improperly used subjective criteria to determine whether and to what extent an investment should be considered permanently impaired. In practice, Insight applied a four-factor test when deciding whether an investment was impaired but then retained and exercised discretion in making the ultimate impairment determination. The Commission found not only that Insight’s test was subjective and difficult to satisfy, but also that Insight did not disclose to fund investors the impairment criteria applied in such analyses. After adopting objective impairment criteria and applying the revised criteria to selected funds during an SEC Examination, Insight reimbursed its investors US$3.8 million in overcharged management fees plus interest on such amounts.
In the Order, the Commission also found that Insight improperly applied a net write off analysis, considering the impact of asset impairment at a fund level, notwithstanding funds’ partnership agreements requiring individual investment level determinations. This failure, according to the Order, allowed Insight to improperly offset impaired investments with non-impaired investments, thereby avoiding a management fee reduction.
The SEC found that Insight’s actions violated Section 206(2) of the Advisers Act.
Failure to Disclose a Conflict of Interest
According to the Order, Insight failed to disclose the conflict of interest between its subjective permanent impairment analysis and the related management fee reduction. The Order notes that Insight did not disclose its permanent impairment criteria, which were subjective, difficult to satisfy, and granted significant latitude in determining whether an asset would be considered permanently impaired. This, according to the Order, presented a conflict of interest that Insight did not disclose. The SEC found Insight’s failure to disclose violated Section 206(4) of the Advisers Act and Rule 206(4)-8.
Written Policies and Procedures
Finally, according to the Order, Insight did not adopt or implement written policies or procedures reasonably designed to prevent violations of the Advisers Act relating to (1) its impairment analysis and the resulting possible reduction in management fees and (2) the conflict of interest created by its subjective and narrow permanent impairment criteria. The SEC found that the failure to adopt written policies and procedures violated Section 206(4) of the Advisers Act and Rule 206(4)(7).
The Insight matter provides several key takeaways for investment advisers with “permanent impairment” management fee reductions to consider.
- Take Care to Adopt and Disclose Objective Valuation Criteria. When establishing practices for determining whether an investment is impaired, it is important to both adopt objective criteria that do not allow significant management discretion and properly communicate this standard to investors.
- Review Current Valuation Practices to Ensure Compliance with Fund Agreements. Investment advisers should review agreements for funds that tie management fees to asset impairment, and ensure that such advisers adhere to the contractual requirements applicable to portfolio investment write downs and write offs. This review should include a retroactive review and possible adjustments to previously charged management fees.
- Disclose Conflicts of Interest Related to Impairment Decisions and Fee Step-Downs. For funds that reduce management fees to reflect write downs, including permanent impairments, take care to disclose the inherent conflict of interest between management determinations as to whether to write down the value of an investment and the resulting reduction in management fees. Disclosure should be made in fund offering documents and operating agreements, either in sections that explicitly discuss conflicts of interest or in sections that discuss valuations and write down determinations.
- Adopt and Implement Written Policies and Procedures Over Impairment Decisions and Conflicts Disclosures. Investment advisers should review policies and procedures related to the calculation of management fees and conflicts of interest, particularly those relating to portfolio investment write downs and write offs, and adopt measures intended to mitigate the risk that such investment advisers improperly delay or reduce valuation write downs and/or write offs in order to avoid management fee reductions.
* James Moes contributed to this Advisory. James is a summer associate in Arnold & Porter’s Chicago office.
© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.