The SEC’s Laser Focus on Investment Advisers’ Conflicts of Interest and Duty of Care

In the last week and a half of its fiscal year, the SEC announced settled charges against two registered investment advisers for conduct related to the advisers’ failure to provide full and fair disclosure of conflicts of interest to their clients. Significantly, one of the actions charged a private equity fund adviser in one of the SEC’s first cases involving conflicts of interest in connection with a general-partner led secondary transaction. Both cases are the most recent examples of the SEC’s focus on investment adviser conflicts of interest that undergird its new rules for investment advisers adopted on August 23, 2023. 

On September 22, 2023, the SEC announced settled charges against American Infrastructure Funds (“AIM”), a registered investment adviser, for conduct that the SEC found violated the fiduciary duty the adviser owed to the private funds it advised. The charges focused on three specific actions that the SEC claims constituted conflicts of interest. 

First, as was its typical practice, AIM amended a monitoring agreement with one of its portfolio companies to provide for accelerated monitoring fees up to $4.5 million if the monitoring agreement was terminated before its expiration. About a year and a half later, AIM sold the portfolio company, terminated the monitoring agreement, and accelerated monitoring fees of $4.5 million. The SEC concluded that the accelerated fees provision in the monitoring agreement created a conflict of interest, which AIM did not adequately disclose to its funds which invested in the portfolio company or to the funds’ Limited Partnership Advisory Committees (“LPACs”). Notably, the SEC order also found that the conduct violated the adviser’s duty of care by failing to consider whether the accelerated fees were in the funds’ best interest.

Second, AIM transferred assets from certain expiring funds to a new private fund managed by AIM, making the original funds an investor with a limited partner interest in the new fund (a continuation fund). The SEC found that AIM failed to fully disclose the arrangement, including that the investors’ interest would be locked up in the continuation fund for a full term of such fund, and the conflicts of interest inherent to its role as an adviser to both the original funds and the new private fund. By failing to so disclose, the SEC found, AIM breached its fiduciary duty to the funds. The SEC found that AIM also breached its fiduciary duty by not seeking investors’ consent to a transfer and not giving the investors a liquidity option (an opportunity to cash out their interest and not participate in a continuation fund). 

Third, AIM was deemed to have provided an interest-free loan from its funds to another private fund advised by an AIM-affiliated adviser. The genesis of the loan was a group of AIM funds incurring deal expenses evaluating a potential investment that was ultimately not pursued. An AIM-affiliated adviser formed a new private fund and considered the same investment and AIM classified the previously incurred deal expenses as a liability owed by the new private fund to the AIM funds. The new private fund paid the AIM funds for the deal expenses without interest, but then paid interest on the loan “[a]fter the Commission staff raised the issue.” The SEC found a conflict of interest in AIM causing its funds to loan money to the new fund managed by an AIM-affiliated adviser. But AIM did not disclose these conflicts of interest or seek guidance from its funds’ LPACs about the transaction. The SEC also found that the adviser violated its duty of care to the funds because it failed to assess whether the allocation of expenses was in the funds’ best interest.

The SEC found that AIM’s conduct violated the antifraud provisions of the Advisers Act in Section 206(2) and 206(4) and Rule 206(4)-8, and the compliance requirements in Rule 206(4)-7. Without admitting or denying the allegations, AIM settled the charges by accepting a censure, accepting various undertakings related to notifying investors of the SEC Order, and paying approximately $445,000 in disgorgement and prejudgment interest, and a $1.2 million civil penalty.

On September 26, 2023, the SEC announced settled charges against another investment adviser, AssetMark, similarly related to undisclosed conflicts of interest relating to certain fees and payments. According to the SEC’s Order, one such disclosure failure related to AssetMark’s affiliate’s cash sweep program, which transferred AssetMark’s clients’ uninvested cash into interest-earning bank accounts. The SEC found that this program created conflicts of interest for AssetMark because it was involved in setting the fee that the affiliate custodian received under the program, which, in turn, reduced the amount of interest the investor received. But AssetMark failed to disclose its role in setting the fee and the corresponding conflicts of interest.

The SEC also found that AssetMark failed to adequately disclose the conflicts of interest created by payments from third-party custodians related to certain mutual funds it made available on its platform. Although AssetMark disclosed the receipt of the payments, it did not disclose that these payments created an incentive to select strategies for its platform that would increase these payments or that, in some cases, there were alternative, lower-fee share classes available. 

The SEC found that through this conduct, AssetMark willfully violated the antifraud and compliance provisions of the Investment Advisers Act (Sections 206(2) and 206(4) of the Advisers Act and Rules 206(4)-7 and 206(4)-8). AssetMark agreed to a cease and desist order, a censure, certain undertakings related to updating disclosure documents, policies, and procedures, and notifying investors, a civil penalty of $9.5 million, and disgorgement and prejudgment interest of more than $8.5 million. 

The SEC’s focus in these matters on investment adviser conflicts of interest comes on the heels of the SEC’s recent investment adviser rulemaking, which was also focused on mandating disclosure of specific conflicts of interest. Our analysis of the new SEC rules is available here. The SEC appears to continue its focus on making full and fair disclosure of conflicts of interest a priority in its oversight of investment advisers. 

Investment advisers should seek experienced counsel when considering whether their policies and procedures will identify, evaluate, and adequately disclose potential conflicts of interest, including the conflicts of interest implicated by the SEC’s new investment adviser rules and whether their practices are consistent with the general fiduciary duties, including the duty of care, applicable to investment advisers. 

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alicja Biskupska-Haas, an O’Melveny partner licensed to practice law in New York, Jorge deNeve, an O'Melveny partner licensed to practice law in California, Tracie Ingrasin, an O’Melveny partner licensed to practice law in New York, Michele Wein Layne, an O’Melveny of counsel licensed to practice law in California, and Jamie Quinn, an O'Melveny counsel licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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