Conflicts, Conflicts Everywhere: When “No Harm, No Foul” is Not a Defense
By: Amran Hussein, Partner, Paul, Weiss, Rifkind, Wharton & Garrison LLP[1]
Over the last several years, both the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) and the…
By: Amran Hussein, Partner, Paul, Weiss, Rifkind, Wharton & Garrison LLP[1]
Over the last several years, both the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) and the Asset Management Unit of the SEC’s Division of Enforcement (the “AMU”) have increasingly focused their attention on conflicts of interest with respect to private equity fund managers. This is evident in a review of recent enforcement actions,[2] as well as recent SEC staff speeches. The SEC has made it clear that it views conflicts as material and that investment advisers, as fiduciaries to their clients, must disclose them.
In recent discussions of examination priorities,[3] the OCIE staff noted deficiencies in connection with conflicts of interest, including the allocation of fees and expenses, and allocation of investment opportunities. The most frequently observed deficiencies involved inadequate policies and procedures or inadequate disclosure to investors regarding a private equity fund manager’s treatment of fees and the allocation of expenses among portfolio companies, the fund and/or the manager. [4]
Julie Riewe, Co-Chief of the AMU, recently noted, in the context of conflicts of interest, that there is “no exception to disclosure: no ‘well-meaning or good-faith adviser’ exception for an investment adviser that legitimately believes it is putting its clients’ interests first notwithstanding any conflicts; no ‘mitigation’ exception for an investment adviser that believes it has taken adequate internal measures to account for potentially incompatible interests; and no ‘potential conflict’ exception for an investment adviser that did not act upon the conflict to enrich itself at the expense of its clients.” [5] Differently said, “no harm, no foul” is not a defense; a manager ought to be identifying, disclosing and mitigating all conflicts of interest.
How should a private equity fund manager respond?
– Identification. In a world where many private equity fund managers are no longer “single product shops,” identification of conflicts is an increasingly difficult task. It requires a holistic understanding by legal and compliance professionals of all aspects of the business to appreciate different “moving parts” and the possibilities of conflicts. As a result, a manager should regularly conduct a rigorous evaluation of the firm, personnel, business(es), fee structures, and affiliates to identify any conflicts of interest. In particular, it is important for a manager to re-evaluate its “conflict map” when the business changes — introduction of new products, strategies and business(es) are all likely to give rise to additional conflicts.
– Disclosure. A private equity fund manager should regularly review all of the relevant disclosure documents — among others, Forms ADV, PPMs, partnership agreements — to ensure that all conflicts are disclosed, and disclosed in a manner that allows clients or investors to understand the conflict, its magnitude and the particular risk it presents.
– Mitigation. For conflicts identified and disclosed, if the conflict cannot be eliminated, a mitigation strategy should be adopted. The mitigation approach may differ depending on the type of conflict. The use of limited partner advisory committees in addressing conflicts should be examined. A clear path to resolution of conflicts, while maintaining flexibility to direct (and document) diversions from the general policy, are at the heart of staying compliant while “expecting the unexpected.” The policy and strategy should be applied consistently. It should also be re-evaluated periodically to tailor it to changes in the business.
Paul, Weiss, Rifkind, Wharton & Garrison LLP is a Tier 1 Associate Member of the PEGCC.
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