In recent years, the Securities and Exchange Commission (SEC) has brought a variety of highly publicised enforcement actions against private equity firms. By virtue of the long-tail nature of private equity investments, the cases focus on conflicts arising years after the original investment. Accordingly, these cases were not charged as standard fraud-in-the-sale cases but, rather, were pursued as cases sounding in breach of fiduciary duty. The focus on these cases led to a host of settlements that shed light on the SEC’s current perspective on pursuing private funds and on the development of breach of fiduciary duty principles. These principles are relevant across the spectrum of private funds, including real estate, debt and hedge funds. This article provides a contextual backdrop for these cases, highlights the key cases and examination trends, and offers practical guidance for private fund advisers who wish to assess and remediate their potential vulnerabilities to similar claims.
II Background on conflicts of interest and SEC enforcement of private equity industry
i SEC enforcement and examinations in private equity industry
Before 2010, with a few exceptions, private equity fund advisers generally did not register with the SEC and, while still subject to the securities laws, largely operated outside the SEC’s regulatory regime. Nonetheless, issues within the private equity industry were beginning to be identified by both domestic and international entities. For example, in May 2008, the Technical Committee of the International Organization of Securities Commissions (IOSCO) issued a report setting forth perceived regulatory risks in the private equity industry, including increasing leverage, market abuse, conflicts of interest management, transparency, overall market efficiency, diverse ownership of economic exposure and market access.2 In November 2009, IOSCO issued a subsequent report focusing on conflicts of interest within the private equity industry, including the use of third-party advisers, lack of disclosure, and calculation of fees.3 In May 2011, the SEC cited IOSCO’s November 2009 report as a useful public source describing conflicts of interest that private fund advisers may face.4
In March 2012, provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) became effective. It extended the registration requirements of the Investment Advisers Act of 1940 (the Advisers Act) to most private equity advisers. Around the same time, the SEC’s Division of Enforcement announced the creation of specialised units, such as the Asset Management Unit, to develop expertise on the private equity industry and its common business practices. In addition, the Office of Compliance Inspections and Examinations (OCIE) formed a Private Funds Unit with personnel focusing on private equity firms.
OCIE also began periodic examinations of private equity advisers. In October 2012, in response to the new Dodd-Frank provisions, OCIE began its Presence Exam Initiative among newly registered investment advisers. The purpose of this initiative was, in part, to deepen the SEC’s understanding of the private equity industry and better assess the issues and risks associated with this business model. Over the past few years, OCIE has gained added knowledge about the private equity industry by including industry experts from outside the agency on its teams.
Through examinations, OCIE and the SEC more broadly have identified a number of perceived deficiencies within the private equity industry, and have begun providing guidance to assist private equity advisers in bolstering their compliance programmes. A notable example of this guidance was the highly publicised ‘Sunshine Speech’ by Andrew Bowden, then of OCIE, in May 2014, which made clear that the SEC was focusing, and would continue to focus, on the private equity industry.5
One of the common themes discussed in SEC guidance – and seen in examinations and enforcement matters – is that the private equity industry presents unique regulatory challenges and conflicts of interest because of its business model. Private equity investors commit capital for investments that may not produce returns for years. Private equity investors therefore enter into agreements that are intended to govern the terms of their investment throughout the fund’s life, which routinely exceeds 10 years. Unlike many other types of investments, it is difficult for an investor to readily withdraw its capital from a private equity fund investment. Moreover, typical investment advisers generally do not wield significant influence over companies in which their clients invest, and when they do, the adviser’s control is generally visible to its investors and the public. In contrast, the private equity model allows a private equity adviser to use client funds to obtain a controlling interest in a non-publicly traded company, thereby obtaining significant influence over that company. Private equity advisers frequently are very involved in managing investments, such as serving on the company’s board, selecting and monitoring the management team, acting as sounding boards for CEOs, and sometimes assuming management roles. In the Sunshine Speech, Andrew Bowden explained that: ‘[T]he private equity adviser can instruct a portfolio company it controls to hire the adviser, or an affiliate, or a preferred third party, to provide certain services and to set the terms of the engagement, including the price to be paid for the services [. . .] or to instruct the company to pay certain of the adviser’s bills or to reimburse the adviser for certain expenses incurred in managing its investment in the company [. . .] or to instruct the company to add to its payroll all of the adviser’s employees who manage the investment’. Bowden noted that in his view this model results in conflicts beyond those faced by typical investment advisers.
Another common theme relates to disclosure. Cases and speeches suggest that for an adviser to satisfy its fiduciary duty under Section 206 of the Advisers Act, the adviser must disclose all material information at the time investors commit their capital, including potential conflicts of interest. In the SEC’s view, limited partnership agreements often contain insufficient disclosure regarding fees and expenses that could be charged to portfolio companies, as well as allocation of these fees and expenses. The SEC has also indicated that private equity advisers have often used consultants, or ‘operating partners’, who provided consulting services to portfolio companies and were paid directly by portfolio companies or the funds without sufficient disclosure to investors. There have also been alleged instances of poorly defined valuation procedures, investment strategies and protocols for mitigating certain conflicts of interest, including investment and co-investment allocation. The SEC has suggested that the private equity industry has suffered from an overall lack of transparency. In the SEC’s view, some limited partnership agreements do not provide investors with sufficient information to be able to monitor their investments and the investments of their adviser. Although investors engage in substantial due diligence prior to investing in a fund, because of the unique nature of the private equity model, there has rarely been meaningful investor oversight after closing. This limited oversight has the potential to increase the inherent temptations and risks already present within the private equity model.
Finally, much of the SEC’s focus in the private equity industry has been on conflicts of interest. In a February 2015 speech,6 Julie M Riewe (then co-chief of the Asset Management Unit) stated that nearly all SEC enforcement matters involve examining whether an adviser has a conflict of interest and, if so, whether the adviser eliminated or disclosed that conflict. According to Riewe, conflicts of interest include situations where there is a ‘facial incompatibility of interests, as well as any situation where an adviser’s interests might potentially incline the adviser to act in a way that places its interests above clients’ interests, intentionally or otherwise’. Notably, under this model, a conflict of interest does not require that an investor be harmed by the conflict, or that the adviser intended to cause harm to the investor. It only requires the possibility that an investment adviser’s interests could run counter to those of its investors.
As a result of the SEC’s highly publicised focus on the private equity industry, investment advisers have been reviewing and changing their practices. However, the SEC’s enforcement efforts and focus on the private equity industry have continued. In May 2016, Andrew Ceresney (then director of the Division of Enforcement) categorised the SEC’s continued enforcement efforts in three groups: (1) advisers that receive undisclosed fees and expenses; (2) advisers that impermissibly shift and misallocate expenses; and (3) advisers that fail to adequately disclose conflicts of interest.7
These areas of enforcement are relevant to not only the private equity industry, but also other types of investment advisers, who are evaluating their practices and procedures, real estate, debt and hedge funds. While conflicts of interest have not been front and centre in hedge fund exams historically, examiners are beginning to ask conflict-focused questions. It is therefore important for all advisers to have an understanding of relevant areas of SEC enforcement and potential conflicts of interest, which are described in more detail below.
III Conflicts of interest
The SEC’s interest in the private equity industry encompasses a wide range of topics, from the highly publicised accelerated monitoring fee issue to the lesser-known conflicts-of-interest issues brought up in examinations. Private equity advisers should be aware of significant areas of enforcement that have increasingly been a subject of SEC focus over the past few years, including undisclosed fees and expenses, misallocation of expenses, inadequate disclosure of investments or loans, relationships with third-party service providers and discounts received from service providers. While the SEC’s enforcement actions cover just a few of the potential conflicts of interest,8 these actions provide good examples of SEC enforcement’s approach to conflicts and the evolution of obligations arising from Section 206 of the Advisers Act. Notably, under Section 206, the SEC focuses not only on identification of conflicts, but also on the policies and procedures in place for identifying and mitigating such conflicts.
i Undisclosed fees and expenses
The SEC’s focus on the receipt of undisclosed fees and expenses has been highly publicised. One very notable example is the practice of obtaining accelerated monitoring fees from portfolio companies, which was highlighted by Andrew Bowden in the Sunshine Speech in 2014.
For instance, in a recent SEC settlement, the SEC alleged that the adviser terminated monitoring agreements with its portfolio companies and accelerated the monitoring payments in these agreements. The adviser had disclosed that it could receive monitoring fees from portfolio companies, and disclosed the amount of the accelerated fees after they had been collected. However, the SEC alleged that the adviser failed to disclose to investors that it would accelerate payment of future monitoring fees upon the sale or IPO of a portfolio company. By the time disclosure was made of the accelerated fees, limited partners were already committed to the funds and the fees had been paid. The SEC also noted that certain of the adviser’s agreements had ‘evergreen’ provisions that automatically extended the life of the monitoring agreements for an additional term, and that, on occasion, the adviser received fees that surpassed the length of time that it provided monitoring services to the portfolio company. The SEC therefore alleged that the receipt of the accelerated monitoring fees constituted an undisclosed conflict of interest.
ii Misallocation of expenses
The SEC has made clear that an adviser is required to allocate expenses so that the expenses are borne appropriately and proportionately by the entity that incurred and benefitted from the expenses, unless the arrangement is otherwise disclosed to investors. This situation has arisen in a variety of contexts, such as misallocation of expenses between a fund and the adviser, misallocation of expenses between funds, and misallocation of expenses where co-investors have invested in a fund.
The SEC has found that an adviser is not permitted to allocate its own operating expenses to funds or portfolio companies if this practice has not been disclosed to investors. For example, in the SEC’s settlement with Cherokee Investment Partners and Cherokee Advisers (together, Cherokee),9 the SEC alleged that Cherokee allocated to its funds US$455,698 in consulting, legal and compliance-related expenses incurred in the course of registering as an investment adviser. Cherokee did not disclose to investors that funds would be charged for the adviser’s legal and compliance expenses. Cherokee ceased this practice in March 2015 and reimbursed the funds for these expenses in April 2015. Nonetheless, because Cherokee had failed to disclose this practice to investors, Cherokee ultimately paid a US$100,000 civil money penalty to settle this matter.
The SEC also alleged that First Reserve Management misallocated expenses to funds without making appropriate closures or obtaining consent.10 First, the SEC alleged that First Reserve misallocated the fees and expenses of two entities formed as advisers to a fund portfolio company, which allowed First Reserve to avoid incurring certain expenses in connection with providing advisory services to the funds. Second, the SEC alleged that First Reserve misallocated premiums for a liability insurance policy covering First Reserve for risks not entirely arising from its management of the funds, when the governing fund documents provided that the funds would only pay insurance expenses relating to the affairs of the funds. To resolve these allegations, among others, First Reserve committed to reimburse the funds and revise its practices and disclosures, and agreed to pay a civil money penalty of US$3.5 million.
Finally, the SEC has also made clear that an adviser must allocate expenses shared by multiple funds proportionately or in compliance with the governing fund documents. For instance, the SEC charged Lincolnshire Management for misallocating expenses between two portfolio companies.11 Lincolnshire had merged two portfolio companies and managed them as one company, although the two portfolio companies remained distinct legal entities that were owned by two separate funds. However, the SEC alleged that Lincolnshire allocated a disproportionate share of the companies’ joint expenses to one portfolio company, to the detriment of that portfolio company’s fund’s investors. For example, it claimed one portfolio company paid for third-party administrators to provide payroll services, but both portfolio companies used these services. Similarly, it stated that certain employees did work that benefitted both companies, but their salaries were not allocated between the two companies. Lincolnshire agreed to pay US$1.5 million in disgorgement and prejudgment interest, as well as a civil money penalty of US$450,000, to resolve these allegations.
iii Undisclosed loans and investments
The SEC considers undisclosed loans and investments, as well as misallocation of investment opportunities, to be a potential conflict of interest. The SEC’s settlement with JH Partners provides a good example.12 In that matter, the SEC alleged that JH Partners and certain of its principals provided a loan to the funds’ portfolio companies, thereby obtaining interests in portfolio companies that were senior to the equity interests held by the funds. JH Partners allegedly caused more than one of its funds to invest in the same portfolio company at differing priority levels from another fund, which could have potentially favoured one client over another. In the SEC’s view, these undisclosed arrangements could have caused the adviser to favour itself or one of its funds over another fund, as a result of its more senior investment position in the portfolio company. The SEC alleged that JH Partners did not adequately disclose the potential conflicts created by these undisclosed loans to the relevant advisory boards. To settle these allegations, among others, JH Partners agreed to pay a civil money penalty of US$225,000.
iv Undisclosed relationships with third parties
The SEC has also focused in recent years on undisclosed relationships with third parties, including third-party service providers. The SEC has determined that these undisclosed relationships can constitute a conflict of interest, even where the undisclosed relationship does not harm investors.
One recent example of an undisclosed relationship with a third party comes from a resolution with Centre Partners Management.13 In the settlement order, the SEC alleged that Centre Partners failed to disclose relationships between certain of its principals and a third-party information technology service provider, as well as the potential conflicts of interest resulting from these relationships. Specifically, three of Centre Partners’ principals occupied seats on the service provider’s board of directors, and the wife of one of the principals was a relative of the provider’s co-founder and CEO. Although Centre Partners provided extensive disclosure on its use of the service provider and its advantages – and neither Centre Partners nor its principals profited from the relationship – the SEC alleged that the lack of disclosure about the relationships between the provider and the Centre Partners principals constituted a conflict of interest. Put differently, the SEC did not allege any actual conflict (i.e., that the terms were off-market, that the services were not appropriate or that the owners profited from the arrangements). Rather, the SEC asserted that, because this relationship constituted a potential material conflict, it should have been presented to the limited partners’ advisory committee under the terms of the limited partnership agreements. To resolve these allegations, Centre Partners agreed to pay a civil money penalty of US$50,000.
v Undisclosed discounts from service providers
The SEC has also considered undisclosed discounts received by third-party service providers to be a conflict of interest. In these situations, the SEC has concluded that, because the adviser is receiving an undisclosed benefit in the form of a discount, the adviser cannot consent to the adviser’s practice of receiving the discount on behalf of the funds.
For example, in its settlement order with First Reserve (discussed earlier), the SEC alleged, inter alia, that First Reserve arranged for a law firm to provide legal services to both First Reserve and its funds from approximately 2010 to 2014.14 The law firm provided significantly more legal work, and generated significantly more legal fees, in connection with the services it provided to the funds. As part of this arrangement, First Reserve negotiated a legal fee discount from a law firm for itself that was based on the large volume of work the law firm performed for the funds. First Reserve did not negotiate a similar discount for the funds. Beginning in early 2013, First Reserve began disclosing in its Form ADV that it could receive service provider discounts that might be more favourable than those received by the funds, but did not disclose that it was in fact receiving that discount. The SEC concluded that, because First Reserve was a beneficiary of this discount, the discount resulted in a conflict of interest, and First Reserve could not consent on behalf of the funds to First Reserve’s practice of accepting the discount. Following the OCIE examination, First Reserve agreed to pay to the funds its pro rata share of the discount First Reserve received from the law firm, and provided investors with information regarding its planned practices going forward. To settle these allegations, among others, First Reserve agreed to pay a civil money penalty of US$3.5 million.
In another similar example of an undisclosed service provider, the SEC alleged that an adviser negotiated a legal services discount arrangement on behalf of itself and its funds, wherein the adviser received a greater discount on legal services than the funds. The differing discount rates were not disclosed to the funds or the limited partners. The SEC alleged that this practice constituted a conflict of interest.
IV Key takeaways and practice tips
The SEC’s recent statements, examinations and enforcement actions demonstrate the importance of adequate monitoring, evaluation and disclosure of potential conflicts of interest. Both private equity and other types of advisers should evaluate their practices and procedures for any potential conflicts, keeping in mind the following enforcement trends.
i Mitigate, eliminate, or disclose conflicts
Advisers should evaluate any potential conflicts that may exist in their practices, procedures or relationships. If any conflicts exist, advisers should determine whether these conflicts have been adequately disclosed or should be mitigated or eliminated. In particular, advisers should examine their fees and expenses charged to funds and portfolio companies to confirm that the fees and expenses have been adequately described in offering agreements or related disclosure documents, or both. Examples of conflicts in the private equity industry can be found in published enforcement actions, public disclosures and SEC guidance and speeches. An adviser’s counsel is also a good source of this information.
ii Lack of harm or benefit may be irrelevant to liability
The SEC does not consider the fact that limited partners were not harmed – or even received a benefit – to be a complete defence to a potential conflict. Therefore, when an adviser evaluates a practice or relationship to determine whether it constitutes a potential conflict of interest, the relevant metric is not only whether the arrangement is to the limited partners’ benefit, but also whether it could appear that the arrangement could affect the adviser’s judgement. In the SEC’s view, because an adviser is a fiduciary, it must disclose all material conflicts of interest so that the client can evaluate the conflict and make an informed decision for itself. Any benefit or lack of harm to a limited partner does not relieve the adviser of this duty to inform. Notably, however, SEC speeches have suggested that a potential benefit to an investor may be relevant in assessing a potential remedy, even if it is not relevant in assessing the adviser’s liability.
iii Focus on both actual and potential conflicts
The SEC is concerned with both actual and potential conflicts. As seen in the Centre Partners settlement, the SEC has pursued enforcement in situations where there is no actual conflict but the mere potential for a conflict exists. Therefore, an adviser must proactively evaluate its practices, procedures and relationships to determine whether they could possibly tempt the adviser to act in its own best interest over that of its investors.
iv Disclosures in pre-commitment documents
The SEC has emphasised its view that disclosures regarding potential conflicts of interest should be made in pre-commitment, rather than post-commitment, documents. This includes disclosures in a Form ADV, which have been described in SEC speeches as a ‘positive change’, but ‘not a sufficient remedy’. Post-commitment disclosures have been found generally to be insufficient, according to the SEC, because of the unique nature of the private equity industry. Namely, it is the SEC’s view that if limited partners were aware of potential conflicts of interest before committing capital to the fund, they could have bargained for a different arrangement with the adviser. The SEC has generally not been amenable to arguments that it is unfair for advisers to be held accountable for documents drafted long before the SEC began its focus on private equity. As Andrew Ceresney explained in his May 2016 speech, private equity advisers have always been investment advisers subject to the Advisers Act, and were therefore fiduciaries subject to the Advisers Act anti-fraud provisions. Notwithstanding this view, the SEC does appear to take into consideration certain other post-commitment disclosures, including limited partner advisory committee disclosures and consents.
v Detailed disclosures
The SEC expects disclosures to be as detailed as possible. Disclosures involving broad statements in fund documents may be viewed by the SEC as insufficient if a reasonable investor would not have understood the conflict from reading the disclosure. In fact, the SEC has reached out to investors in certain exams and enforcement actions to confirm whether they understood the conflict at issue. In this regard, the SEC has generally rejected arguments that limited partners are sophisticated investors who are aware of industry practices.
In light of the importance of fees paid to affiliates, advisers should consider regularly sending questionnaires to their personnel regarding any outside business contacts or interests. Any responses should be checked against the adviser’s own relationships, as well as those of service providers, portfolio companies, and entities that have relationships with portfolio companies.
The SEC’s pursuit of cases in the private equity context has not only shed light on the type of conduct that the SEC views as most problematic, it has also provided invaluable insight into SEC’s views of fiduciary duty principles under Section 206 of the Advisers Act. Going forward, it is likely that these principles will influence how the SEC approaches and assesses the conduct of all types of private fund advisers. Accordingly, firms are well served by understanding the lessons learned in the private equity context, and using that insight to assess their own practices – asking whether their conduct may be perceived to constitute a conflict or potential conflict and if so, whether those conflicts have been adequately disclosed. Operating with this awareness and taking a proactive approach to remedy any shortcomings will serve firms well in ensuring they are prepared when the SEC eventually comes knocking.
1 Eva Ciko Carman and Jason E Brown are partners and Kirsten Boreen Liedl is an associate at Ropes & Gray.
2 See Technical Committee of the International Organization of Securities Commissions, ‘Private Equity: Final Report’ (May 2008), available at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD274.pdf.
3 See Technical Committee of the International Organization of Securities Commissions, ‘Private Equity Conflicts of Interest: Consultation Report’ (November 2009), available at
4 See Carlo V di Florio, director of OCIE, ‘Private Equity International’s Private Fund Compliance’ (3 May 2011), available at https://www.sec.gov/news/speech/2011/spch050311cvd.htm#P33_11226.
5 See Andrew Bowden, director of Office of Compliance Inspections and Examinations, ‘Spreading Sunshine in Private Equity’ at the Private Equity International Private Fund Compliance Forum (6 May 2014), available at https://www.sec.gov/news/speech/2014--spch05062014ab.html; see also Julie M Riewe, co-chief of Asset Management Division, ‘Conflicts, Conflicts Everywhere’ at the IA Watch 17th Annual IA Compliance Conference (16 February 2015), available at https://www.sec.gov/news/speech/conflicts-everywhere-full-360-view.html; Marc Wyatt, acting director of Office of Compliance Inspections and Examinations at Private Equity International Conference (13 May 2015), available at https://www.sec.gov/news/speech/private-equity-look-back-and-glimpse-ahead.html; Andrew Ceresney, director of Division of Enforcement, Securities Enforcement Forum West 2016 Keynote Address: Private Equity Enforcement (12 May 2016), available at https://www.sec.gov/news/speech/private-equity-enforcement.html.
6 See Julie M Riewe, co-chief of Asset Management Division, ‘Conflicts, Conflicts Everywhere’ at the IA Watch 17th Annual IA Compliance Conference (16 February 2015), available at
7 See Andrew Ceresney, Director of Division of Enforcement, Securities Enforcement Forum West 2016 Keynote Address: Private Equity Enforcement (12 May 2016), available at
8 For example, while no enforcement actions have been brought in the private equity space on allocations of investment and co-investment opportunities, stapled secondary transactions and valuations, these all raise potential conflicts on which the SEC has focused during exams.
9 See In re Cherokee Investment Partners LLC and Cherokee Advisers LLC, Investment Advisers Act of 1940 Release No. 4258, Administrative Proceeding File No. 3-16945 (5 November 2015), available at https://www.sec.gov/litigation/admin/2015/ia-4258.pdf.
10 See In re First Reserve Management, L.P., Investment Advisers Act of 1940 Release No. 4529, Administrative Proceeding File No. 3-17538 (14 September 2016), available at https://www.sec.gov/litigation/admin/2016/ia-4529.pdf.
11 See In re Lincolnshire Management, Inc., Investment Advisers Act of 1940 Release No. 3927,
Administrative Proceeding File No. 3-16139 (22 September 2014), available at
12 See In re JH Partners, LLC, Investment Advisers Act of 1940 Release No. 4276, Administrative
Proceeding File No. 3-16968 (23 November 2015), available at
13 See In re Centre Partners Management, LLC, Investment Advisers Act of 1940 Release No. 4604, Administrative Proceeding File No. 3-17764 (10 January 2017), available at
14 See In re First Reserve Management, L.P., Investment Advisers Act of 1940 Release No. 4529,
Administrative Proceeding File No. 3-17538 (14 September 2016), available at