Podcast: Fraud in the Subscription Facility Market: Lenders’ Response
In this Ropes & Gray podcast, finance partner Steven Rutkovsky and counsel Patricia Teixeira update listeners on the recent fraud case involving JES Global Capital, providing insights into how subscription facility lenders are reacting to the case in their underwriting and diligence processes.
Patricia Teixeira: Hello, and thank you for joining us today on this Ropes & Gray podcast. My name is Patricia Teixeira, and I am a counsel in the New York office of Ropes & Gray in the finance practice group. Joining me today is Steve Rutkovsky, a partner in our finance group, also based in New York. We both spend a significant portion of our time advising private investment funds on their financing needs, including on subscription facilities, NAV facilities and other types of fund financings.
As some of our listeners might recall, earlier this year, I spoke with Patricia Lynch, another Ropes & Gray finance partner who frequently works on subscription facilities, about a case of alleged fraud in which a fund manager, JES Global Capital, forged investor signatures on subscription documents and obtained financing based on such fraudulent documents. At the time, we speculated on the consequences the case might have on the subscription facility market as a whole. We recently had a chance to talk to some of the banks that provide many of the subscription facilities we work on for our clients to see how they’ve reacted to these events in their underwriting and diligence processes.
Steve, before we delve into the measures those banks have been taking, can you give us a recap of this case?
Steve Rutkovsky: Sure. As listeners may recall, back in March, a founder and CEO of JES Global Capital, a Florida-based fund manager, was accused of having forged subscription documents and wire transfer records relating to the formation of a private investment fund. The banks filed a lawsuit claiming that they loaned approximately $150 million on the basis of the forged documents. Since then, judgments of nearly $135 million have been entered against the founder in the civil suit, and the founder has been indicted on criminal charges and is facing decades behind bars. Since the case became public, subscription facility lenders have had time to consider which measures, if any, they can take to protect themselves against similar instances of fraud, which although exceedingly rare, could result in hundreds of millions of dollars of losses to the lenders.
Patricia Teixeira: That’s right. When Patricia and I spoke, we predicted that even though this case grabbed headlines, it would not cause a sea of change in how subscription facilities are diligenced and negotiated, given how relationship-driven this industry is. Steve and I recently reached out to a number of the banks that frequently provide subscription facilities to our clients, and based on the feedback we’ve gotten from them, so far, that prediction seems to have largely played out. Lenders have certainly taken note of the case and some are giving thought on how to adjust their internal policies and guidelines in certain circumstances to try to mitigate this risk of fraud. However, even in circumstances where they are adding additional safeguards, it doesn’t look like they will create a significantly more onerous process, at least not for well-established funds with a good track record. New entrants on the other hand might find that barriers to entry are somewhat higher than they have been historically.
Steve Rutkovsky: That’s right. One of the main takeaways from the conversations we’ve had with the banks is that they make a distinction between large fund managers with long track records of successfully raising and managing funds, and small managers raising a first time fund or those with a narrow investor base. Of course, what constitutes a “large” or “well-established” fund manager varies from lender to lender, and lenders themselves may not even have a bright-line rule. But on the whole, it seems that managers with assets under management above $1 billion—mainly upper-middle market and large-cap fund managers who generally have long-standing relationships with banks—should not see any major change in the process of obtaining and negotiating subscription facilities as a result of the JES Global case.
Patricia Teixeira: Yes. On the other hand, smaller managers—particularly those without a history of obtaining subscription facilities or established relationships in the industry—may be facing some additional headwinds when they want to obtain these types of facilities for the first time. There are already some lenders, that Steve mentioned, who just aren’t willing to lend to managers with less than a certain threshold amount of assets under management, other than maybe as a favor to a relationship client. Where a bank is willing to lend to a new entrant, it may require more diligence measures and safeguards than it has previously. That may include requiring investor letters, at least from the anchor or other significant investors. We have also heard that, when requesting investor letters, the bank might want to have the letter sent directly by the investor to the bank rather than having the manager or its counsel provide them. Lenders may also want to speak to investors over the phone directly to confirm their commitments. Some also mentioned they place a high value on in-person diligence, and by that they mean meeting the new manager in person at the manager’s main office in order to spot any red flags.
Steve Rutkovsky: That’s right, and as you discussed in your last podcast, many limited partnership agreements expressly require investors to deliver—if requested by a subscription lender—a written confirmation of the investor’s capital commitment to the fund. Although banks have historically not required those written confirmations, they generally have the right to do so. As a result of the JES case, we would expect lenders to increasingly make use of this right that exists in most partnership agreements.
Patricia Teixeira: That’s right, though I thought it was interesting that one of the banks we talked to that had already started to ask to speak to investors directly in certain cases noted that in the handful of cases where they’ve asked to be put in contact with investors, they had not gotten any pushback from managers on those requests and that they kept the calls quick and non-eventful, which itself is a great indicator that the manager has nothing to hide and also may speak to the fact that both managers and investors understand where the lenders are coming from. And since most partnership agreements require investors to fund capital calls without set-off, counterclaim or defense, limited partners could be liable for repaying lenders in a JES-type scenario up to the amount of their commitments. So, it may be that investors themselves are open to quick checks directly from a bank in the interest of protecting themselves from potential liability, at least while the JES case remains fresh in their minds.
Steve Rutkovsky: Another measure available to lenders is to require that all of the fund’s bank accounts, including the account which receives capital contributions, be maintained with the lender and not with a third party bank. This creates an additional point of contact between the fund and the bank, and the more points of contact there are, the more chance the bank will be able to spot any discrepancies or failures by investors to fund their capital contributions. While subscription lenders always get a pledge of bank accounts, keeping the accounts with the lender affords an additional layer of protection than relying on separate deposit account control agreements with a third party bank.
Patricia Teixeira: One recurring theme in all our calls was that good client selection criteria is still the best remedy. I’d also note that we did not hear from the banks we spoke to that they’ve been implementing new economic safeguards to address the risk of fraud. It also doesn’t look like banks are reassessing their guidelines on concentration limits or pricing the risk of fraud into subscription facilities. They haven’t mentioned adding borrowing base eligibility criteria; requiring an initial capital call to be made within a certain period of time after closing; or adding “clean down” requirements, which require the banks to pay down the facility for a certain amount of time each year. To be clear, these are all features that we have seen in subscription facilities before, in particular, in the lower end of the market, but there doesn’t seem to be a correlation between the use of these features and the JES case. Fortunately, it doesn’t look like the case is changing the basic commercial nature of the subscription facilities or its availability, even if new entrants might need to be prepared to jump through a few additional hoops during the diligence process.
Well, this concludes today’s update. Thank you, Steve, for joining me today for this discussion. And thank you to our listeners. For more information on what we’ve discussed today, or other topics of interest to private funds or institutional investors, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these areas, please do not hesitate to contact any of us. You can also subscribe and listen to other Ropes & Gray podcasts wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.