IMPACT ANALYSIS: Recent cases against biotech venture fund execs and PwC highlight accounting failures

May 9, 2016

By Todd Ehret, Regulatory Intelligence

(Thomson Reuters Regulatory Intelligence) – A recent settled Securities and Exchange Commission (SEC) action involving a well-known biotech venture capital investment adviser and its top executives is as an excellent reminder to those in the private fund business that private funds are not to be used as personal piggy banks.

The series of missteps at Burrill Capital Management (BCM) involving one of its venture capital funds, Burrill Life Sciences Capital Fund III (Fund III) possibly started out as minor but then snowballed eventually, resulting in lifetime bans, closure of the firm and multiple lawsuits. The events offer excellent tips on what not to do when managing a fund and investment advisory firm of any type. Below we recap what went wrong at the firm.

Burrill Capital and Steven Burrill

According to the settled SEC complaint, former CPA Steven Burrill was an audit partner with Ernst & Young from 1977 to 1993. In 1993 he set up his own advisory firm to provide advice on business strategy and raise venture capital funds focused on the biotechnology industry. He was the sole owner of BCM and was a member of Fund III’s general partner.

Fund III was launched in 2006 with $283 million of committed capital. The fund was governed by a Limited Partnership Agreement (LPA) which detailed the management fees to be paid to Burrill. According to the LPA, Burrill was entitled to collect 2 percent payable on the first day of each fiscal quarter for services to be rendered during that quarter. The LPA did not allow Burrill to take management fees in advance and it did not allow Burrill to borrow from Fund III. It also explicitly prohibited any actions that would be detrimental to the activities and affairs of the fund and required all conflicts of interest to be promptly disclosed to the investors in the fund.

According to the complaint, in 2007 BCM began experiencing cash flow shortages. The expenses for BCM and Burrill personally far exceeded the revenues being generated. Chief Financial Officer Helena C. Sen met with Burill and told him that BCM was unable to make payroll. Burrill instructed Sen to take $400,000 from Fund III to cover the shortfall and to treat the transaction as an “advance on management fees.” Burrill told Sen that it was “strictly a timing issue” as they would have been entitled to the management fee only four days later on January 1, 2008.

In mid-2008, Sen once again informed Burrill that BCM was short of cash and unable to pay expenses including salaries and Burrill’s personal expenses. Burrill again instructed Sen to take an advance on the management fee from Fund III. From this point forward through 2013 when BCM faced a cash shortfall on multiple occasions they repeatedly advanced the payment of the management fee.

Chief Administrative and Legal Officer Victor A. Hebert joined the firm in October 2008 and learned of the practice of taking money from the fund in early 2009. Sen told Hebert about the practice to meet BCM’s cash flow shortages, which was needed to pay their own salaries. Hebert never told Sen to stop taking the money from the fund and the practice continued until eventually Fund III ran out of money.

The trio of Burrill, Sen, and Hebert met frequently to discuss the cash flow problems from 2009 through July of 2013, and the practice of taking the management fees in advance continued. Sen regularly informed them how much had been taken and kept track of the transfers.

In the first quarter of 2012, the total amount taken from Fund III exceed the total amount of management fees that the general partner could earn over the 10-year life of the fund, which was to expire in February 2016. At that point, no additional management fees were due, but they continued to transfer funds from the fund to BCM.

The SEC stated in the settled complaint that, “By May 2013, the money Burrill had taken exceeded the total management fees that could be earned over Fund III’s life by at least $13 million – approximately four years’ worth of fees. Burrill used the $13 million to pay for, among other things, salaries, rent, charitable contributions, Burrill’s family vacation to St. Barth’s and Paris, jewelry, gifts and travel for Burrill’s girlfriend, gifts for Burrill’s wife, private jets and private car service for Burrill and his family members.”

To top it all off, from 2009 to 2014 the trio also sent capital calls to investors asking investors for even more money than was needed for the funds’ follow-on investments. Hebert told Sen how much was needed for the capital calls and Sen prepared the letters to investors which stated that the “proceeds of the capital call would be used for a particular investment.”

The misallocation of funds from Fund III was finally discovered when Burrill Managing Directors Ann Hanham, Roger Wyse, and Bryant Fong realized that the fund lacked the cash to make follow-on investments in August 2013. They confronted Burill, Hebert, and Sen and the trio admitted to advancing the fees and were unable to make the fund whole. Hanham asked whether they had a fiduciary responsibility to report it to the limited partners and Hebert said, “Don’t do anything stupid” and Burrill said she would be putting “one foot in the grave.”

The three managing directors sent a letter outlining the fraud in October 2013 to Fund III’s limited partners. This set into motion a series of events and was the beginning of the end for Burrill, Hebert, and Sen. The six largest limited partners which make up the Limited Partners Advisory Committee, promptly removed the general partner (which included Burrill and Hebert) and replaced them. In March 2014 Hebert resigned and Sen’s position with Burrill was eliminated.

The three managing directors, Hanham, Fong, and Wyse, who stepped forward and reported the fraud, were terminated by Burrill in November 2013.

SEC warnings and actions

The SEC’s focus on accounting issues and allocation of expenses and fees in private equity and private funds has been well telegraphed in recent years. The SEC’s Office of Compliance Inspections and Exams (OCIE) annual exam priorities letter in both 2015 and 2016 warned that fees and expenses associated with advisers of private funds and private equity or venture funds were an exam priority. In the 2015 letter OCIE stated, “Given the high rate of deficiencies that we have observed among advisers to private equity funds in connection with fees and expenses, we will continue to conduct examinations in this area.”

Andrew J. Ceresney, Director of the SEC’s Enforcement Division, said in a statement. “Even though they are exempt from registration, venture capital advisers like Burrill have fiduciary obligations to their clients that we will enforce … Burrill spent his fund’s capital on whatever he pleased, and elevated his own interests above those of investors.”

In response to Sen and Hebert’s failures, Jina Choi, Director of the SEC’s San Francisco Regional Office said, “Gatekeepers play an essential role in every company. Rather than take a stand for the fund’s investors, Hebert and Sen allowed Burrill’s scheme to perpetuate and their salaries were paid out of money Burrill misappropriated from investors.”

The SEC settlement calls for lifetime bans from all three individuals. Hebert was fined $185,000 and Sen was fined $90,000. Steven Burrill and Burill Capital Management was fined $1 million as well as ordered to pay disgorgement of $4.785 million. All three individuals settled the charges without admittiing or denying the SEC’s findings.

PwC Failure?

In 2015 Fund III, under the direction its new general partner filed suit in California Superior Court charging Burrill, Hebert and Sen with fleecing the fund of $17 million and causing further losses of $34 million when the fund was unable to invest in follow-on investments. The suit was later amended to include PricewaterhouseCoopers LLP.

In the suit it is alleged that PwC willfully turned a blind eye to the fraud ignoring warning signs in order to protect business partnerships with Burrill. It questions the PwC’s independence as it points to business “alliances” between the firms going back to 2002.

The complaint added that “PwC’s ‘clean opinions’ were essential to the fraud’s success.” PwC repeatedly signed off on the audits ignoring red flags and failed to verify the legitimacy of the transfers or advances.

Compliance failures and some suggestions

Independent auditors must truly be independent. Any business partnerships, “alliances” or activities with an independent auditor who audits an investment fund could jeopardize the sanctity of the independence.

All cash transfers by managers must be a thoroughly documented and include precise calculations. Round numbers and estimates of payments in advance should be warning flags.

In the transfer of assets from any client account the process must be thoroughly documented. The process should include at least one independent person in the process. An outside administrator, director, or lawyer who is truly independent and has “no interest” in the transaction is an excellent safeguard.

In this instance where Burrill, Sen and Hebert were all in the know, an independent person whose paycheck wasn’t dependent on the transfer might have protected the investors in the fund.

Accuracy and consistency of calculating management fees must be taken seriously by investment advisers. Estimating, pre-paying or borrowing from client assets is an enormous red flag.

Noticeably absent from all of the publicly available information on the Burrill case is the lack of mention of a compliance officer or compliance department of any kind. The trio of Burrill, Hebert, and Sen clearly in a small firm wore multiple hats and performed multiple functions. However, the failure to have another compliance officer of any kind reviewing the transactions should be noted.

The lack of any visible compliance department or compliance officer to perform regular audits or reviews is also a failure that should be noted.

A final lesson is that the credentials of the individuals at the top are no substitute for compliance and oversight. Burrill’s experience as a CPA and partner at a major accounting firm for nearly 3 decades, as well as Sen’s CPA and Hebert’s law license were no reason for PwC to be any less rigorous in scrutinizing the firm’s books.

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Apr. 22. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence. He has more than 20 years’ experience in the financial industry where he held key positions in trading, operations, accounting, audit, and compliance for broker-dealers, asset managers, and hedge funds.)

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