Markets Wired

The Securities and Exchange Commission charged Stuart Frost of Laguna Niguel, California, and his investment advisory firm Frost Management Company, LLC, with fraud and breach of fiduciary duties for charging over $14 million in undisclosed and excessive incubator fees to start-up companies in which their advisory clients invested.

According to the SEC’s complaint, Frost and Frost Management Company, investment advisers to five private venture capital funds, raised nearly $63 million for the funds between 2012 and 2016. Frost and Frost Management Company then invested those funds in a portfolio of start-up companies. The start-ups were incubated by Frost Data Capital, LLC, another Frost-owned company, using the so-called “Frost incubator model” and, as such, they paid incubator fees to Frost Data Capital for the purported purpose of providing operational support and other services in anticipation of the companies maturing and ultimately being sold. In reality, as alleged in the SEC’s complaint, a significant portion of the incubator fees were used to cover Frost Data Capital’s overhead and to pay Frost’s exorbitant salary and extravagant personal expenses. When Frost needed more cash to fund his lavish lifestyle, including a personal chef and housekeeper, an archery range, beach club membership, a boat, and luxury cars, he created new start-up companies, invested more fund capital in them, and then used Frost Data Capital to extract additional incubator fees.

As the SEC’s complaint alleges, Frost and Frost Management Company violated their fiduciary duties as investment advisers by failing to disclose the existence of the incubator fees or misleadingly representing that the incubator fees would be charged on a case-by-case basis and the charges were at or below market rate for the services. As further alleged, the excessive payment by the start-up companies of over $14 million in fees weakened their financial condition and prospects for success, which, in turn, harmed the funds’ investments in those companies. The SEC’s complaint also alleges that Frost and Frost Management Company charged two of the funds undisclosed management fees and charged another fund unearned management fees.

The SEC’s complaint, filed in the U.S. District Court for the Central District of California, charges Frost and Frost Management Company with violating the antifraud provisions of Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder. The SEC’s complaint seeks injunctions, disgorgement and prejudgment interest, and civil penalties.

The SEC’s investigation was conducted by Janet Moser, and supervised by Victoria Levin in the Los Angeles Regional Office. The SEC’s litigation is being handled by Donald Searles.