On July 6, the Securities and Exchange Commission (SEC) reached a settlement with respondent Paramount Group Real Estate Advisor LLC (Respondent) regarding certain alleged violations of the Investment Advisers Act of 1940, as amended (the Advisers Act).
The SEC determined that Respondent willfully violated Section 206(2) of the Advisers Act, which prohibits an investment adviser from engaging in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client, as well as Section 206(4) of the Advisers Act and Rule 206(4)-8 thereunder, which prohibit any fraudulent, deceptive or manipulative act, practice or course of business by an investment adviser to an investor or prospective investor in a pooled investment vehicle.
The SEC proceedings were related to actions by the Respondent, a registered investment adviser, during a transaction in March 2014 in which Paramount Group Real Estate Fund III, L.P. (“Fund III”), an advisory client of the Respondent, sold a parking garage investment to Paramount Group Residential Development Fund, L.P. (RDF), another advisory client of the Respondent, for the purpose of developing the location into a residential property. The Respondent orchestrated the $64.65 million sale and, at the time of the transaction, the Respondent and its affiliates owned 3% of Fund III and 26.7% of RDF.
In connection with the transaction, the SEC alleged that the Respondent failed to cause RDF to reimburse Fund III for certain development expenses Fund III incurred before the sale as part of earlier efforts to have the garage rezoned for residential purposes. This failure came despite the Respondent’s commitment to Fund III’s investor advisory committee (Fund III IAC) at the time Fund III IAC approved the sale to RDF that the reimbursement would be made.
When the initial discussions commenced regarding this sale, it was contemplated that the garage would be valued by independent appraisers between $45 million and approximately $50 million, and Fund III IAC approved the sale on the basis that Fund III would receive no less than $45 million from the sale and reimbursement of all expenses incurred by Fund III in respect of the garage (which totaled $4.5 million at the time of the sale).
The Respondent received three appraisals with respect to the property and was obligated to set the valuation of the garage for purposes of the sale to RDF at no less than the average of the highest two of the three independent appraisals. That resulted in a valuation of $64.65 million. However, the highest appraisal premised its valuation of the garage on the basis that it would be able to obtain the beneficial zoning changes, while the other appraisal valued the garage as it was currently zoned. Respondent then elected not to cause RDF to reimburse Fund III for the development expenses incurred by Fund III because, in Respondent’s view, the $64.65 million price already reflected the increased value that would result from the zoning change, since one of the appraisals assumed the upzoning would be achieved.
Because the Respondent had previously committed to reimburse Fund III for these expenses, combined with the fact that Respondent and its affiliates owned a greater interest in RDF than they did in Fund III, the SEC stated that Respondent “could not effectively consent on behalf of Fund III or the Fund III Limited Partners to eliminate the reimbursement requirement.” The settlement order did not specify whether the SEC viewed this transaction as a principal transaction given the level of ownership of RDF by Respondent and its affiliates (and did not claim a violation of Section 206(3) of the Advisers Act, which one would expect if the transaction were viewed as a principal transaction), but instead seemed to focus solely on the conflicted nature of the transaction given Respondent’s varying level of ownership across the two funds involved in the transaction. It is unclear why the appraisals were made on the basis of different assumptions, which created the valuation disparity and led Respondent to make a judgment that it likely felt was fair to both clients.
This issue was uncovered in a July 2015 inspection by the staff of the SEC’s Office of Compliance Inspections and Examination (OCIE). Following the OCIE examination and further discussion with both OCIE and the SEC’s Division of Enforcement, the Fund III Limited Partners were reimbursed for the full $4.5 million of developmental expenses in 2015 and Respondent agreed to settle the allegations and pay a civil penalty of $250,000, accept a censure, and cease and desist from any further violations of Sections 206(2) and 206(4) of the Advisers Act, as well as Rule 206(4)-8.
Ultimately, investment advisers need to tread carefully when effectuating cross-trades between their advisory clients, especially where there is a disparate level of ownership by the adviser and its affiliates in the advisory clients that are involved in the transaction.
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