Fifth Street Finance Corp.'s SEC Problems Could Cost Shareholders

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Among high-yielding business development companies, Fifth Street Finance (NASDAQ: FSC) has a bad reputation -- and deservedly so.

The company allegedly employed accounting gimmicks to hide non-performing assets, inappropriately recognized income ahead of its external manager's IPO, and, just as it appeared that an activist might force much-needed change at the company, the company moved to buy off an activist.

Investors have been so displeased with the company that they took the issue to the courts, and that may ultimately result in a settlement. The company disclosed that a proposed settlement includes a number of shareholder-friendly concessions by Fifth Street's external manager, some significant, some not. But the impact to Fifth Street Finance should be carefully measured.

Making amends

One condition of the proposed settlement is that Fifth Street Finance will receive a $1 million fee waiver for 10 consecutive quarters starting in January 2018. Though good for shareholders at first glance, note that the fee waivers tally to $10 million of total future benefits, offset by $9.7 million of additional expenses incurred by Fifth Street Finance due to lawsuits and an investigation by the SEC in the last nine months. One can thus consider it future payback for expenses in the here and now.

What really matters are the measures intended to create better corporate governance. The proposed settlement calls for disclosure of executive compensation (Fifth Street's managers are technically employed by Fifth Street Asset Management (NASDAQ: FSAM), obscuring their compensation). It would also require that the company's board of directors hold a specified amount of company stock, and establish better processes and committees for managing the risks in the company's investment portfolio.

Data source: SEC filings. Graph by author.

The real meat and potatoes is the mention of enhanced director independence. Depending on the specific terms of this enhancement, it could require that the board is comprised of truly independent directors with limited or no ties to the company's external manager.

Theoretically, a new board of directors free of conflicts of interest could encourage Fifth Street Finance to seek a new manager altogether, almost certainly on less-expensive terms that would result in better returns for shareholders. Remember, activist investor RiverNorth aggressively pushed to find a new manager in its short-lived activist campaign against the company earlier this year. A less expensive fee agreement is by far one of the most important drivers for the company's earnings, and ultimately shareholder returns.

Fifth Street Finance CEO Todd Owens remarked on the company's conference call that it is considering a fee agreement with better terms, suggesting that it may be unveiled in the upcoming quarter. I take that to mean that the so-called "enhancements" to the board of directors have some teeth -- that Fifth Street Asset Management feels compelled to roll out a new fee agreement suggests to me that they're expecting the process of choosing a manager to be much more competitive.

What about the SEC?

Even if the parties involved in the class action settlement sign on the dotted line, Fifth Street Finance and affiliated entities will remain under the microscope. The SEC sent subpoenas and document preservation notices to the Fifth Street entities in March for an investigation of many of the companies' business practices. In particular, the SEC has its sights set on the valuation of Fifth Street Finance's assets, expenses allocated between the companies, as well as statements and/or potential omissions from the entities' SEC filings, among other items.

And while one would naturally assume that this investigation would primarily relate to Fifth Street Asset Management -- the company that manages Fifth Street Finance for a fee -- it's quite possible that some of the costs of complying with SEC requests for information may fall on Fifth Street Finance's shoulders, negatively affecting its earnings.

Fifth Street didn't break out the buckets into which its increased expenses fall (shareholder lawsuit or SEC investigation), and it remains to be seen if the additional expenses will be covered by the company's insurance coverage.

A settlement and increased scrutiny from the SEC could be just what Fifth Street Finance needs to start managing the company for the benefit of its shareholders, rather than its highly paid managers. But for as long as inquiries into its business practices persist, one should expect earnings to be negatively affected by increased operating expenses. Lawyers, unfortunately, don't come cheap.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.