Out-Law / Your Daily Need-To-Know

Out-Law Analysis 2 min. read

Fund finance due diligence under scrutiny after alleged fraud

Banks that provide credit lines to private investment funds should consider bolstering the due diligence they carry out prior to lending in light of an alleged fraud reported in the US.

A complaint filed before a court in the southern district of New York alleges that private equity manager Elliot Smerling of JES Capital obtained a $95 million loan on a fraudulent basis, forging signatures on subscription agreements and creating false bank records showing the transfer of funds from the supposed investors.

Silicon Valley Bank first disclosed the alleged fraud in a regulatory filing made to the US Securities and Exchange Commission (SEC) on 26 February. Further information was shared by SVB in its subsequent annual report. The bank has estimated that its potential credit exposure to the incident is up to $70 million, net of tax.

In an industry that is heavily reliant on relationships and the reputation of fund managers, there are measures lenders and their credit teams can take to strengthen their processes to ensure that they do not become a victim of fraud. 

Due diligence

A core aspect of a subscription line financing is the due diligence of the underlying fund documentation, of which subscription agreements are an important part. Following this case, it is likely that due diligence procedures will have to be tightened – both on the fund documentation and the identity of the investors themselves.

Overcall rights, in particular, must be subject to further scrutiny and consideration to ensure that any investors who are not fictitious are liable to advance additional commitments to cover any shortfall of commitments due from the fraudulent investors. This overcall right protection would only solve the problems of lenders if not all of the investors have been fabricated.

Investor involvement

Despite the creditworthiness of the investors being a core consideration for lenders, it is perhaps surprising that the investors themselves have very limited involvement in the subscription financing following their subscription to the fund. This presents a challenge to lenders in terms of satisfying themselves as to the authenticity of the subscription agreements.

Lenders may now look to supplement their due diligence on the investors by requiring some sort of direct link to the investors. This may be by requesting a form of credit enhancement from significant investors, such as a comfort letter which confirms their subscription to the fund. Alternatively, lenders may wish to carry out additional checks on investors and their fund documentation – whether these checks are on every investor or carried out on a sampling basis only.


The method of perfecting security over the fund's rights to the uncalled capital commitments was the subject of much discussion following the Abraaj scandal. Abraaj was the largest private equity firm in the Middle East which collapsed amidst allegations of fraud and defaulted on its substantial subscription lines. It is likely that these discussions will be revisited again in light of the JES Capital case.

It is now accepted that notices of assignment, or equivalent, must be delivered to investors at completion of the financing, as opposed to just publication of the notice in the fund's investor reports which had previously been acceptable to many lenders. We do not anticipate that lenders will start to look for security from investors themselves, but we expect more lenders will consider whether investors should have to return signed acknowledgements as a condition to the financing.

Alternatively, and perhaps more palatable to fund managers, lenders may look for evidence that the notices have been electronically acknowledged by investors – such as an email read receipt or delivery of the access report from the fund's investors data site. This could give lenders greater visibility on the security notice process.

Co-written by Lyndsey Mitchell of Pinsent Masons, the law firm behind Out-Law.

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