SEC Sanctions Private Fund Sponsor for Failing to Disclose Conflicts of Interest

The SEC recently settled an enforcement action[1] with a private fund sponsor (the Sponsor) for alleged violations of the Investment Advisers Act of 1940 (the Advisers Act) arising from the Sponsor’s failure to disclose conflicts of interest. The alleged conflict related to an arrangement between the Sponsor and a group purchasing organization (the GPO), an entity that aggregated spending on certain items in order to provide group-purchasing discounts to portfolio companies of the Sponsor.

During the relevant period, the Sponsor managed two private equity funds (the Funds). The Funds’ organizational documents established an Investment Review Committee (the Committee) comprised of Fund limited partners not affiliated with the Sponsor to “approve in advance any transactions that give rise to potential conflicts of interest” between the Sponsor and the Funds.

Certain Fund portfolio companies used the services of the GPO. An employee of the Sponsor (the Sponsor Employee) provided advice to the portfolio companies regarding purchasing activities as well as certain services for the benefit of the GPO. In addition, an affiliate of the GPO (the GPO Affiliate) had an agreement with one portfolio company (Portfolio Company A) whereby the GPO Affiliate directly provided services to that portfolio company (the Portfolio Company Agreement).

The GPO Affiliate, Portfolio Company A and the Sponsor Employee entered discussions regarding a renewal of the Portfolio Company Agreement. In connection therewith, the Sponsor and the GPO began negotiating an agreement whereby the GPO would pay the Sponsor 25% of the net revenue the GPO received from vendors based on the purchasing activity of Fund portfolio companies done through the GPO (the Sponsor Agreement). The Sponsor Agreement provided that the payments were to be made in consideration for the Sponsor Employee’s services to the GPO. The SEC noted that a GPO Affiliate employee emailed the Sponsor Employee to suggest that the Sponsor Agreement would be approved by the GPO when Portfolio Company A executed the renewal of the Portfolio Company Agreement. Both agreements were signed, and from September 2012 through December 2016, the Sponsor received $623,035 pursuant to the Sponsor Agreement.

The SEC alleged that because of the Sponsor Agreement, the Sponsor had an incentive to recommend the GPO’s services to the Funds’ portfolio companies since the Sponsor would receive a share of revenue generated for the GPO by the portfolio companies’ purchasing activity. In addition, the Sponsor had an incentive to encourage Portfolio Company A to renew the Portfolio Company Agreement because the email mentioned above suggested the GPO would not enter into the Sponsor Agreement until such renewal occurred. As these conflicts had not been disclosed to Fund investors at the time of their investment (which pre-dated these arrangements), the SEC stated that in accordance with its fiduciary obligation to the Funds the Sponsor should have sought approval from the Committee for the conflicts of interest arising from the Sponsor Agreement.

The SEC alleged that the Sponsor violated Sections 206(2)[2] and 206(4) of the Advisers Act and Rule 206(4)-8[3] thereunder. As part of the settlement, the Sponsor (i) agreed to cease and desist from committing or causing any violations and any future violations of Sections 206(2) and 206(4) and Rule 206(4)-8, (ii) was censured and (iii) paid disgorgement of $623,035, prejudgment interest of $65,784.78 and a civil money penalty of $90,000.

Consistent with its fiduciary duty and SEC expectations, a private fund sponsor should disclose all material conflicts of interest prior to the time investors make their investment decision. A key takeaway from this settlement is that when such disclosure is not possible (such as for conflicts that arise during the course of a fund’s life), a sponsor should use its limited partner advisory (or similar) committee as a means to disclose, and if necessary get investor consent regarding, conflicted transactions between the sponsor and a fund/portfolio company.


Endnotes    (↵ returns to text)

  1. The settlement order can be found here.
  2. Section 206(2) prohibits an investment adviser from directly or indirectly engaging in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.
  3. Section 206(4) and Rule 206(4)-8 make it unlawful for any investment adviser to a pooled investment vehicle to make any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle or to otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.