Insight Analytical Note

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Standalone Compliance Rule Case Related to Related Party Service Provider Benchmarking

Background:

  • On August 19th 2024, the U.S. Securities and Exchange Commission (“SEC”) settled an administrative proceeding with a private equity real estate adviser for a violation of the Custody Rule and a violation of the Compliance Rule, which related to vertical integration1. This note will focus only on the Compliance Rule violation.
  • The SEC charged this investment adviser with a standalone violation of the Compliance Rule, even though the underlying conflicts of interest associated with vertical integration were disclosed in formation documents.

Key Facts and Allegations:

Compliance Rule Violation – The violation was caused by the adviser not implementing its own written policies.

  • Business: This investment adviser invested in real estate properties.
  • Practices: The investment adviser had a captive property manager and a captive construction manager. 
  • Disclosure:
    • In formation documents, the investment adviser disclosed (1) the existence and exclusive use of its captive service providers; (2) the rates used to calculate fees for the related party service providers.
    • In its Form ADV, the investment adviser disclosed that fees paid to affiliates were”lower or comparable to those that would be charged in arms’ length transactions with third parties” and that it had “adopted written policies and procedures designed to monitor the comparability of its fees with those of unaffiliated third parties.”
      • The adviser may not have had data to substantiate these statements, worsening its Compliance Rule violation.
  • Policies: This investment adviser adopted but did not implement policies and procedures:
    • To no less than annually, verify the fees charged by affiliates for property management and construction management to ensure that they remained at or below market rates for similar services; and 
    • That included collecting fee information for similar property management and construction services provided by unaffiliated third parties, documenting the review, preparing a summary of findings from the data collected, and presenting the summary to the investment committee of the applicable fund to determine if any rate adjustments were necessary. None of this occurred.

Takeaways:

  1. Many times, less is more when it comes to policies – This investment adviser created an elaborate policy which included significant detail about the way benchmarking would be performed. This policy may have been disclosed to investors who would have expected a robust and intricate process. The detail of this policy may have exacerbated the fact that the adviser ultimately did not implement them.
  2. Ancillary fees raise materiality – SEC staff often views ancillary fees – such as the ones charged by vertically integrated real estate advisers – with skepticism. Therefore, a policy designed to control the level of fees an adviser can charge, even when all conflicts are fully disclosed, should be considered high risk and appropriate resources should be dedicated to ensuring proper implementation.

1 In the Matter of FPA Real Estate Advisers, LLC; File No. 3-22021