Conflicts Of Interest: How High Will The Bar Be Raised? – Fund Management/ REITs

The SEC last month proposed rules under the Advisers Act
indicating a dramatic shift in how the SEC intends to reduce
conflicts of interest involving private fund managers and their
investors. As we previously noted in the context of increased
disclosure obligations, the SEC’s recent approach previews
a sea change redefining the relationship between private fund
managers and their investors. For decades, the SEC has sought to
address potential conflicts through a combination of disclosure and
informed consent, in light of the sophisticated nature of private
fund limited partners. However, the SEC’s proposal now pivots
from that approach, concluding that certain fund manager practices
are inherently conflicted and therefore in some cases necessitate
that the fund manager undertake specific actions, or in other cases
must be flatly prohibited. As the SEC put it in their Proposing Release, “We have observed
certain industry practices over the past decade that have persisted
despite our enforcement actions and that disclosure alone will not
adequately address.”

The SEC’s focus on conflicts of interest is nothing new, and
is a perennial focus of the Division of Enforcement and Division of
Examinations. Under the Advisers Act’s antifraud provisions and
related fiduciary obligations, investment advisers must “eliminate or at least expose through full and
fair disclosure” all conflicts “which might incline an
investment adviser-consciously or unconsciously-to render advice
which was not disinterested.” For fund managers, any
financial determination or allocation involving the manager and the
client (i.e. the fund) has the potential to be seen as a
conflict, requiring adequate disclosure and consent. Now however,
the SEC is taking the position that there are certain conflicts
that private fund investors cannot consent to, no matter how
well-disclosed.

For example, the SEC’s Proposed Rules contain requirements
and prohibitions on the following:

1. Required: Quarterly reporting. The Proposed
   Rules would require all SEC-registered fund managers to provide
   quarterly reports to all investors of: (i) fund-level adviser
   compensation, fees/expenses and offsets, broken down in detail and
   cross-referenced to the relevant sections in the fund’s
   governing documents; (ii) portfolio investment-level adviser
   compensation, again broken down in detail on a per-investment basis
   and (iii) fund-level investment performance, on a standardized
   basis. The SEC’s goal with this proposal is twofold: to provide
   sufficient transparency to permit investors to monitor and police
   the expenses they are bearing, and to provide an apples-to-apples
   basis of investment performance comparison for investors across
   different funds.




2. Required: Fairness opinions in adviser-led secondary
   transactions. The Proposed Rules would also require all
   SEC-registered fund managers to obtain a fairness opinion in all
   adviser-led secondary transactions (which would include most GP-led
   fund restructurings, as well as tender offers and other types of
   secondary transactions). The fund manager would also need to
   provide to all investors a list of all material business
   relationships between the fund manager and the opinion provider
   (and their respective affiliates).




3. Prohibited: Accelerated monitoring fees. The
   Proposed Rules would prohibit these and other fees for services
   that are not provided to a portfolio company. Historically, Enforcement has focused on whether the manager
   adequately disclosed that it could accelerate future monitoring
   fees.




4. Prohibited: Charging the fund for regulatory or
   compliance expenses. The Proposed Rules would also
   prohibit allocating any regulatory or compliance expenses of the
   adviser or its related persons to a fund. This prohibition is not
   limited to SEC investigations or examinations. It also would
   prohibit allocating any start-up and registration compliance
   expenses for first-time fund managers.




5. Prohibited: Seeking exculpation or indemnification for
   simple negligence (or worse). The Proposed Rules would
   also prohibit any fund manager from seeking exculpation or
   indemnification for negligence, recklessness, breach of fiduciary
   duty, willful misfeasance or bad faith, in providing services to a
   private fund.




6. Prohibited: Reducing GP clawbacks for taxes.
   The Proposed Rules would also prohibit reducing general partner
   clawbacks by the amount of any actual, potential or hypothetical
   taxes. This proposal cuts against settled and longstanding
   conventions across the private fund space.




7. Prohibited: Extensions of credit to the fund
   manager:The Proposed Rules would also prohibit borrowing
   or receiving any credit extension from a client, although it is
   unclear how the prohibition would affect typical advancement/offset
   terms of private funds that might be considered an extension of
   credit.




8. Prohibited: Non-pro rata allocation of deal-related
   expenses. The Proposed Rules would also prohibit non-pro
   rata allocations of deal-related expenses and fees among funds and
   co-investment vehicles participating in the transaction. In
   particular, this proposal seeks to ensure that co-investors bear a
   pro rata share of broken deal expenses. Significantly, the SEC
   acknowledges that certain co-investors may commit to a deal but
   refuse to be contractually bound to bear any broken deal expenses,
   which would leave the manger itself as the only remaining party to
   bear such expenses.




9. Prohibited: Certain preferential treatment:
   The Proposed Rules would also prohibit all instances of
   preferential treatment for private fund investors regarding: (i)
   redemptions or other liquidity rights and (ii) information rights
   relating to the fund’s portfolio, in each case to the extent
   the rights could have a material adverse impact on the other fund
   investors, and would prohibit other types of preferential treatment
   (e.g. fee terms) unless fully and specifically disclosed
   to all prospective investors and with annual updates. These
   provisions often appear in side letters requested by certain
   investors, which can be negotiated at the same time or even after
   other investors have already committed to the fund. Importantly,
   the SEC expects such disclosures to be made prior to investors’
   investment in the fund, which could pose significant logistical
   challenges to fund managers in advance of an initial closing given
   how fluid investor negotiations can often be in that context.

As we have noted, many of the foregoing proposals depart from
prior SEC practice, which historically focused on the clarity (or
lack thereof) of pre-commitment disclosures to investors. A number
of these proposals also cut against longstanding commercial norms,
limiting freedom of contract between advisers and investors no
matter how sophisticated or well-represented those investors may
be. If enacted, they would result in significant changes to how
private fund managers operate their businesses and interact with
their investors.

These proposals also serve as a clear indication of SEC exam and
enforcement focus going forward, regardless of the form that the
final rules take. The issues and practices that these proposals
target have been a focus of the SEC’s Division of Examination
and Division of Enforcement for the past decade. This proposal
therefore serves as an indication of where they are likely to focus
their attention going forward.

Conflicts Of Interest: How High Will The Bar Be
Raised?

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