The SEC’s recent proposed guidance for investment advisers has implications for private equity sponsors. Perhaps the most important part of the guidance for private equity sponsors is that related to the duty of loyalty which addresses conflicts of interest. By nature the sponsor’s relationship with investors is complex, and inherent in almost every structure is a perceived conflict of interest on behalf of the sponsor. The SEC says these conflicts must be clearly explained, and if they can’t be clearly explained they must be eliminated in the view of the SEC.
According to the SEC, the duty of loyalty requires an investment adviser to put its client’s interests first. Accordingly:
- An investment adviser must not favor its own interests over those of a client or unfairly favor one client over another.
- An adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship.
- An adviser must seek to avoid conflicts of interest with its clients, and, at a minimum, make full and fair disclosure of all material conflicts of interest that could affect the advisory relationship.
- The disclosure should be sufficiently specific so that a client is able to decide whether to provide informed consent to the conflict of interest.
The proposed guidance notes disclosure of a conflict alone is not always sufficient to satisfy the adviser’s duty of loyalty and section 206 of the Advisers Act. Any disclosure must be clear and detailed enough for a client to make a reasonably informed decision to consent to such conflicts and practices or reject them. An adviser must provide the client with sufficiently specific facts so that the client is able to understand the adviser’s conflicts of interest and business practices well enough to make an informed decision. For example, an adviser disclosing that it “may” have a conflict is not adequate disclosure when the conflict actually exists.
The SEC notes that a client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit. The SEC believes, however, that it would not be consistent with an adviser’s fiduciary duty to infer or accept client consent to a conflict where either:
- the facts and circumstances indicate that the client did not understand the nature and import of the conflict, or
- the material facts concerning the conflict could not be fully and fairly disclosed.
The SEC notes that in some cases, conflicts may be of a nature and extent that it would be difficult to provide disclosure that adequately conveys the material facts or the nature, magnitude and potential effect of the conflict necessary to obtain informed consent and satisfy an adviser’s fiduciary duty. In other cases, disclosure may not be specific enough for clients to understand whether and how the conflict will affect the advice they receive. With some complex or extensive conflicts, it may be difficult to provide disclosure that is sufficiently specific, but also understandable, to the adviser’s clients. In all of these cases where full and fair disclosure and informed consent is insufficient, the SEC expects an adviser to eliminate the conflict or adequately mitigate the conflict so that it can be more readily disclosed.