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Insight Analytical Note

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SEC Case Reminder that Conflict Identification May Be Challenging

Background:

  • On September 20, 2024, the Securities and Exchange Commission reached a settlement in an administrative proceeding involving an adviser failing to properly manage conflicts of interest related to loans. 1
  • The adviser’s conflicts concerned arranging related party loans without proper controls or disclosure which resulted in violations of Section 206(2) of the Investment Advisers Act and Rule 206(4)-7.

Key Allegations:

  • Loan 1 – The Executive Director and Chief Compliance Officer of the adviser arranged a loan for a prospective fund investment with a lender in which he held a 50% ownership interest (the “Conflicted Lender”). This arrangement was not approved by the fund’s Limited Partner Advisory Committee (LPAC), as required under the fund’s Limited Partnership Agreement.
  • Loan 2 – To finalize the acquisition above, the fund obtained a loan from the same Conflicted Lender at a 24% interest rate, with warrants attached. The loan was repaid within eight months. This transaction was not approved by the fund’s Limited Partner Advisory Committee (LPAC), as required under the fund’s Limited Partnership Agreement.
  • Loan 3 and Loan 4 – An affiliate of the adviser provided short-term, interest-free loans to two client funds, resulting in the adviser becoming a creditor to the funds. This created a conflict of interest, which required either approval from the Limited Partner Advisory Committee (LPAC) or appropriate disclosure, as mandated.
  • This fund manager had not formed LPACs at the time of this conduct.

Takeaways and Analysis:

  • Identification of Conflicts is Paramount – The most challenging part of conflict management is conflict identification. In this instance, the adviser appears to have failed to recognize the conflicts of interest inherent in its lending relationships. This oversight may stem from the adviser’s belief that entering into the loans was the only way to consummate an attractive transaction and therefore in the best interest of the fund. While it may be true that the fund could not have pursued a profitable investment without the conflicted loans, this case illustrates that a transaction can still constitute a conflict of interest, even if it serves the best interests of investors.
  • Complying with Disclosure – Many formation documents set forth the required steps for mitigating conflicts of interest. In this instance, LPAC consent was necessary to address the conflict. The adviser’s failure to seek LPAC consent exacerbated the situation, as it did not properly identify the conflict of interest.

1 In the Matter of Closed Loop Partners, LLC; File Number 3-22138