Star Investment Manager, Advisers Charged With Fraud by SEC

The SEC issued an Order which charged investment manager Lynn Tilton, known as the Diva of Distressed Debt according to news reports, and her entities with fraud. Specifically, the Order Instituting Proceedings issued by the SEC, claims that Ms. Tilton overvalued certain funds in a manner which was contrary to the authorizing documents and unknown to investors. This resulted in the payment of unnecessary management fees by investors and compromised their rights. In the Matter of Lynn Tilton, Adm. Proc. File No. 3-16462 (March 30, 2015).

Ms. Tilton has managed what are called the Patriarch entities for years. Those entities, named as Respondents, are: Patriarch Partners, LLC (Patriarch), Patriarch Partners VIII, LLC, Patriarch Partners XIV, LLC and Patriarch Partners XV, LLC. Each is indirectly owned by either Ms. Tilton or the manager and a trust for the benefit of her daughter. Ms. Tilton, the CEO of Patriarch, and their employees, run the business of the three other Patriarch Partners entities, each of which is a registered investment adviser and a collateral manager for the Zohar Funds.

The Zohar Funds are CLOs, a securitization vehicle in which a special purpose entity raises capital by issuing secured notes. Proceeds from the note sales are used to acquire a portfolio of commercial loans. The cash flow and other proceeds from the collateral are used to repay the investor note holders of the fund.

The collateral management agreement for each fund permitted the manager to select and manage the collateral held by the fund. The Zohar Funds invested in private, mid-sized distressed companies. The goal was to improve the operations of the distressed portfolio companies to pay off the debt and eventually make a profit. Two tiers of fees are paid. One, the Senior Collateral Management Fee, ties to assets. The other, the Subordinated Fee, is linked to valuation.

The indenture for each Zohar CLO contained certain numeric tests that must be met each month. Once ratio is the so-called Overcollateralization Ratio. It measures the cushion between the value of the collateral and the principal amount of the investor notes. If the specified ratios fall below certain levels, the investors control over the fund can increase and result in the early repayment of the principal. The indenture also requires the collateral manager to categorize each asset every month. The classification is included in a report of the trustee. Specific categories are included in the indentures.

Rather than following the dictates of the indenture, Ms. Tilton used her discretion to determine how an asset should be categorized. The valuation category of an asset was not lowered unless she approved. As a result few assets of the Zohar Funds were downgraded to the lower valuation categories.

If Ms. Tilton had used the methodology for categorization in the indentures the number of assets in the default investment category would have “looked very different,” according to the Order. Certain portfolio companies failed to pay as much as 90% of the interest owed to the Zohar Funds but were not downgraded. The failure to properly classify these assets resulted in the overpayment of almost $200 million in Subordinated Fees to Respondents.

Ms. Tilton’s discretionary approach was not disclosed to investors. Failing to disclose that approach created a significant conflict of interest. The assets also were not valued in accord with GAAP as represented in the financial statements.

The Order alleges willful violations of Advisers Act Sections 206(1), 206(2) and 206(4). The proceeding will be set for hearing.

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