FULL-TEXT of the ALJ's INITIAL DECISION and the OIP Available Via Links
In March 30, 2015, the Securities and Exchange Commission ("SEC") issued an Order Instituting Proceedings and Notice of Hearing ("OIP"), In the Matter of Lynn Tilton; Patriarch Partners, LLC, Patriarch Partners VIII, LL;; Patriarch Partners XIV; LLC; And Patriarch Partners XV; LLC, Respondents (OIP, Invest. Adv. Act 4053; Invest Co. Act 31539; Acct and Auditing Enf. Rel. 3644; and Admin. Proc. File 3-16462 / March 30, 2015), which alleged in its "Summary" preamble:
1. Since 2003, Respondents have defrauded three Collateralized Loan Obligation ("CLO") funds they manage and these funds' investors by providing false and misleading information, and engaging in a deceptive scheme, practice and course of business, relating to the values they reported for these funds' assets. Lynn Tilton, who controls and makes relevant decisions on behalf of each of the Respondents, is responsible for all of these violations.
2. The three CLO funds, collectively known as the "Zohar Funds," raised more than $2.5 billion from investors and used these investments to make loans to distressed companies. These loans to distressed companies are the primary assets of the Zohar Funds. However, many of the distressed companies have performed poorly and have not made interest payments, or have made only partial payments, to the Funds over several years.
3. As required under the relevant deal documents, through the trustee, Tilton's entities regularly provide information to the Funds and their investors about the performance of the Funds. This information includes valuation categorizations of the Funds' assets and financial statements purportedly reflecting the financial position of each Fund.
4. Despite the poor performance of many of the Funds' assets, Tilton has intentionally and consistently directed that nearly all valuations of these assets be reported as unchanged from their valuations at the time the assets were originated.
5. These actions are inconsistent with the categorization methodology set forth in documents governing the Funds. This methodology turns on, among other factors, whether a distressed company has timely made interest payments to the Funds. Instead of applying this methodology, Tilton instead substitutes her own, independent discretion when categorizing the Funds' investments. At Tilton's direction, Respondents will not assign a lower valuation category to an asset unless and until Tilton subjectively decides to stop "supporting" the distressed company.
6. If Respondents had applied the categorization methodology set forth in the documents, certain valuation ratio tests derived from the categorizations would have failed by at least 2009. As a result, based on other provisions in the documents, 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, among other consequences. By applying her own discretion rather than the valuation methodology set forth in the governing documents, Tilton has avoided these consequences and taken 3 excessive fees from the Funds. As a result, Respondents' practices were inconsistent with disclosures and created a clear conflict of interest.
7. Respondents also prepare quarterly financial statements for the Funds, which are provided to investors. These financial statements include disclosures about the Funds' loan impairment policy and portfolio fair value. Tilton certifies these financial statements and represents that they are prepared in conformity with generally accepted accounting principles ("GAAP").
8. However, contrary to these statements, Respondents do not prepare the financial statements in conformity with GAAP. Significantly, rather than applying a GAAP-compliant impairment methodology, Respondents impair assets only when Tilton decides to withdraw support for a distressed company. This approach mirrors the discretionary approach Tilton uses to categorize assets and does not conform with GAAP. It is also inconsistent with other disclosures in the financial statements that falsely indicate that Respondents assess and consider impairment issues and the fair value of the Funds' loan assets.
9. Respondents have never disclosed Tilton's discretionary valuation approaches to the Funds or their investors, much less the conflict of interest these approaches created. As a result, Respondents also breached their fiduciary duties and their contractual standard for managing the Zohar Funds as set forth in the relevant deal documents.
Following the filing of the OIP, Tilton pursued a high-profile and aggressive strategy of appeals, as noted, in part, in "BREAKING NEWS: 2nd Circuit Delivers Blow To Tilton Appeal" (BrokeAndBroker.com Blog, June 2, 2016). Among the issues raised during this phase was a challenge to the constitutionality of the SEC's proceeding as inconsistent with the Appointments Clause of the Constitution, Due Process, and Equal Rights.
Following the federal courts' declination to find in Tilton's favor, the SEC's Administrative Law Judge ("ALJ") Foelak similarly denied such claims. In an impressive and thorough 57-page Initial Decision, ALJ Foelak concluded that the violations alleged in the OIP were not proven by Enforcement and dismissed all charges. In the Matter of Lynn Tilton; Patriarch Partners, LLC, Patriarch Partners VIII, LL;; Patriarch Partners XIV; LLC; And Patriarch Partners XV; LLC, Respondents (Initial Decision; Init. Dec. Rel. No. 1182; Admin. Proc. File 3-16462 / September 27, 2017). In pertinent part, the Initial Decision explains that:
In applying the law to the facts of the instant case, it must be emphasized that the trustee reports and financial statements were not publicly available, unlike financial statements of a public issuer in the issuer's periodic reports published on the Commission's website. Rather, pursuant to the Funds' indentures, they were made available to the noteholders, the trustee, and a limited group of entities. The investors and potential investors in the Funds were Qualified Institutional Buyers and Qualified Purchasers, such as Barclays, SEI Investments, Varde Partners, and MBIA; not, in the words of Commission Chairman Jay Clayton, "Mr. and Ms. 401(k)."61 While there may have been an information asymmetry between Tilton and the noteholders, there was not a power asymmetry.62 While Respondents did not maximize the ease of finding it, they also did not conceal - omit to state - material information such as the amount of interest actually being paid and the interest rate and principal on the Portfolio Companies' loans. This material information underlies the alleged miscategorization of loans and consequent OC Ratio Test in the trustee reports and is related to the alleged improper valuation of assets in the financial statements.
Page 51 of the Initial Decision
ALJ Foelak offered this rationale in support of a significant aspect of her dismissal:
There is no dispute that many borrowers paid less interest than the original coupon rate on their loans. Tilton presented evidence that she amended loan agreements, as permitted by the indentures, by "course of performance" to allow interest payments to be deferred and accrued or otherwise to change the terms - interest rates and maturities - of loans.63 There is no affirmative evidence that she did not amend the loan agreements. In light of the Division's burden of proof and the undisputed fact that she did accept the lesser payments or nonpayments on loans, it must be concluded that she did "amend" the loan agreements. Section 7.7(a) of the indentures effectively gave Respondents wide discretion to amend the terms of the underlying instruments. Further, as found above, the evidence does not establish the specific facts that would constitute a borrower's "default." However, assuming arguendo that asset categorizations and consequent OC Ratio computations were not in accord with the provisions of the indentures, this disparity was disclosed to the investors.
The investors knew that the Funds' business model was to lend to a number of distressed companies with the idea that, while some would succeed, enabling the Funds' investors to be paid, others would fail. Thus, it would be unreasonable to expect that all the borrowers would make 100% of their interest payments. Indeed, an assumption that borrowers' not making 100% of their interest payments would trigger a Fund's Event of Default - due to a failed OC Ratio Test - could result in returning the investors' funds to them soon after they invested, thus defeating the purpose of investing. The trustee reports disclosed that the interest payments received from the Portfolio Companies were far below the amounts due based on the loans' stated interest rates, yet almost no loans were Category 1 or Defaulted Investments. Noting that investors had to glean these facts from different pages of the trustee reports, the Division points to ZPR Investment Management, Inc., Advisers Act Release No. 4417, 2016 SEC LEXIS 2074 (June 9, 2016),64 in which an investment adviser distributed to the public advertisements and promotional materials containing misrepresentations concerning the adviser's past performance, and SEC v. Nutmeg Group, LLC, 162 F. Supp. 3d 754 (N.D. Ill. 2016), recon. denied, 2016 interest rates of the loans and the total actually collected by comparing information disclosed in the same document.66 Not only were these large financial institutions able to obtain the information from the trustee reports, it would have been unreasonable for them to expect all of the companies to pay all of their interest according to the interest rates on their loans, given the business model of loaning to distressed companies.
The Subordinated Collateral Management Fee payments to Respondents resulting from the Funds' passing the OC Ratio Test are disclosed in the Zohar II and III trustee reports, and the Division does not allege that Zohar I ever failed the OC Ratio Test.67 Whether or not Tilton "amended" the loan agreements, the amount of interest actually collected is disclosed in the trustee reports. The total mix of information available to the investors was such that there was no omission to state a material fact or misrepresentation of a material fact. U.S. Dist. LEXIS 68176 (N.D. Ill. May 24, 2016),65 in which an investment adviser inappropriately commingled retail investors' funds and reported this in a misleading way on account statements. These cases are inapplicable to the instant case, in which there was no affirmative misrepresentation of the interest payments collected and in which the investors -- large financial institutions -- could ascertain the difference between the total interest payable based on the nterest rates of the loans and the total actually collected by comparing information disclosed in the same document.66 Not only were these large financial institutions able to obtain the information from the trustee reports, it would have been unreasonable for them to expect all of the companies to pay all of their interest according to the interest rates on their loans, given the business model of loaning to distressed companies.
The Subordinated Collateral Management Fee payments to Respondents resulting from the Funds' passing the OC Ratio Test are disclosed in the Zohar II and III trustee reports, and the Division does not allege that Zohar I ever failed the OC Ratio Test.67 Whether or not Tilton "amended" the loan agreements, the amount of interest actually collected is disclosed in the trustee reports. The total mix of information available to the investors was such that there was no omission to state a material fact or misrepresentation of a material fact.