Identifying & Disclosing Conflicts of Interests

Today we are discussing identifying and disclosing conflicts of interest, and here with me today is Attorney, Mark Schaffer, Partner at Tannenbaum Helpern. Mark, thank you for joining me today. Can you explain what a conflict of interest is and where the SEC gets its authority to regulate conflicts and their disclosures?

Mark Schaffer:

Sure. So in reference to investment advisers, according to the SEC, a conflict of interest is any interest that might incline an entity, consciously or unconsciously, to make a recommendation or render advice that is not disinterested. So really, any situation where the investment adviser is wearing two hats or may have divided loyalties. Conflicts of interest arise inevitably in business and some can't be avoided and they're not necessarily bad. But when conflicts do arise, entities must be able to identify those conflicts, manage and properly disclose them to their investors.

And in terms of the statutory authority in relation to investment advisers, Section 206 of the Advisers Act is the Act's anti-fraud provision. And it among other things, requires an adviser to make full and adequate disclosure to clients on matters that affect the adviser's independence or judgment. So basically, conflicts of interest. So the goal is if a conflict can't be mitigated, to bring it to the attention to clients, to permit the clients to make fully informed decisions. Thus, an investment adviser must eliminate or make, this is the important part, full and fair disclosure of all conflicts of interest. And in order for disclosure to be full and fair, it must be sufficiently specific to enable a client to understand the conflict and make an informed decision on whether to provide consent to the transaction.

It's a big area of focus for the SEC and the, "Sufficiently specific," needs to be stressed because blanket disclosure language that there may be conflicts will not suffice. The investor needs to be able to fully understand the conflict.

TaNeka Ray:

Thank you for that explanation. That leads me to my next question. Can you give us an example of a conflict of interest?

Mark Schaffer:

Sure. I'll talk briefly about two different broad situations and then maybe hit a couple of others. So the first is a hot topic now, it's GP-led secondary transactions. And for those not familiar, a GP-led secondary transaction is a transaction which a private equity funds general partner sells one or more of its portfolio companies to a new fund that it manages. These transactions allow the manager and investors a combination of liquidity to the investors in the older fund, as well as giving the GP the ability to prolong the holding period of the asset. This is becoming more common as GPs want to hold assets for longer, perhaps longer than the life of the first fund.

So there's nothing wrong with these transactions, but they obviously present a conflict of interest in that the general partner is acting as the seller for the earlier fund and as the buyer for the latter fund, and it has duties to both. So this is a conflict that can't be avoided. And to address these issues, the new private fund adviser rules put up by the SEC contain an adviser-led secondary rule, which requires advisers who are going to engage in such a transaction to distribute to investors prior to the date of election for such a transaction, either a fairness or valuation opinion from an independent opinion provider and a summary of all relationships between the adviser and the independent opinion provider. As people may be aware, the private fund adviser rules are in question with the Fifth Circuit Court of Appeals having invalidated them. But regardless of the future of those rules, this is probably best practices that people should follow, whether or not they are in a specific rule promulgated by the SEC.

And then the second broad category is the calculation of fees and valuations. Fees usually do follow valuations. So again, an inherently conflicted determination, but disclosure can remedy these. An important settled action by the SEC in June of 2023, referred to as Insight, the Insight private equity fund, really addressed the inherent conflict in valuation decisions. So in brief, Insight's a private equity fund and they charged post-commitment period management fees on the basis of investors' invested capital. The partnership agreements also said that that cost basis could be reduced for investments that had been subject to a permanent impairment with such reduction reducing the management fees.

Among other things in the settled action, the SEC found that Insight had failed to adequately disclose the existence of conflicts of interest in determining whether an investment has been permanently impaired. And they noted, especially given that the criteria were subjective and difficult to satisfy. And that importantly, Insight had not adopted adequate policies and procedures related to permanent impairment criteria, the impact on management fees of that criteria, and any other related conflicts of interest.

TaNeka Ray:

A moment ago, you referenced disclosures can remedy conflicts. Can you explain how disclosure can mitigate a conflict of interest?

Mark Schaffer:

Sure. So again, some conflicts are able to be mitigated, and probably should be mitigated, but there's a lot of circumstances where they really just can't be. And so the purpose of disclosures, it really empowers investors. It puts everything on the table and lets investors decide whether it's a conflict that they're willing to accept or not. But again, to stress that, in order to empower the investors, disclosure needs to be full and fair in that it must be sufficiently specific to enable the LP, the client to understand the conflict and to make an informed decision. So I really do think it's about investor LP empowerment because it can't all be avoided.

TaNeka Ray:

And our last question, what actions can a firm take to avoid potential conflicts, or if unavoidable, to identify and properly disclose the conflict?

Mark Schaffer:

Sure. I think that the key to all of this is to have documented policies, procedures, systems and controls that are reasonably designed to identify, mitigate and disclose. So again, identify, it sounds like a given, but you have to know that a conflict exists in order to either mitigate it or disclose it. And so the policies and procedures, among other things, needs to have a formal process for identifying existing conflicts of interest that may exist. This could be a process, going through the financial relations of the fund, going through the fund documents to identify. This should be done probably by a multidisciplinary committee, management, finance and compliance. So that would be to identify existing conflicts.Then there also needs to be a documented process to continually review for new conflicts of interest because the SEC has emphasized that conflict identification can't be a check-the-box or a one-off exercise because new conflicts can arise at any time. And so it's recommended that there be high-level committee with, again, management, finance and compliance to periodically review for new conflicts of interest. And the minutes of these committee meetings can serve as evidence that the fund is actually taking serious its obligation to identify these conflicts.

And then finally, related to everything with conflicts, I think compliance and management needs to follow the money. Money is at the heart of most conflicts of interest. So the firm should look at its sources of revenue and have its books reviewed, not just by people in finance, but also by compliance and management with an eye towards potential conflicts. So basically, having written policies and procedures that show how the investment adviser identifies, evaluates the severity of whether it can be mitigated, disclose and document. And again, the bottom line is for an investment adviser for any sort of disclosure decision, but especially here, again, do what you say and say what you do.

TaNeka Ray:

Mark, thank you for sharing your insight. That concludes today's discussion of disclosing conflicts of interest. Again, my name is TaNeka Ray with EisnerAmper. I welcome you to connect with me and Mark on LinkedIn. Thank you for watching.

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