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SEC Brings Case with Implications for Investment Allocation Practices
Background:
- On September 26, 2024, the Securities and Exchange Commission reached a settlement in an administrative proceeding involving an adviser who failed to adequately disclose conflicts of interests in allocating investment opportunities.1
- This case has broad implications for advisers who allocate to funds-of-one, co-investors, have different fee arrangements for clients with overlapping strategies, or manage separate accounts.
- The adviser was charged with violating IAA Section 206(2) and Rule 206(4)-7. The adviser paid a $75,000 penalty.
Key Allegations:
- Conflicts in Investment Allocation
- Strategy: The adviser pursued an activist strategy by raising capital for each new investment idea through a new fund. To secure additional capital, the adviser also arranged for larger asset managers to co-invest and pay a performance fee to an affiliate of the adviser.
- Disclosure: The adviser stated in various formation and disclosure documents that it “may” or “could” engage in outside activities and other conflicted transactions.
- Ancillary facts: (1) Some co-investment arrangements were not documented in writing; (2) No policies or procedures existed to mitigate conflicts associated with this disclosure.
- Violative conduct: The adviser’s generalized disclosures did not fully and fairly disclose the arrangements and resulting conflicts of interest.
Takeaways and Analysis:
- Major Implications for Advisers with Complex Investment Allocation Practices – This case has significant implications for investment allocation, underscoring the need for clear and specific disclosure whenever a differing fee structure may be seen as creating a conflict of interest. However, many advisers may face challenges as co-investment arrangements and allocation strategies can change significantly over time, making timely and detailed disclosures difficult. Based on our experience, a factor-based allocation approach—where the adviser discloses the factors used in determining allocation criteria, documents allocation decisions, and conducts periodic testing—may offer the best way to mitigate risk.
- Conflicts Cases Do Not Require Investor Harm – In this case, the SEC did not allege that investments were allocated away from the funds or that the investments were capacity constrained, meaning sufficient investment opportunities may have existed for all investors. In fact, the order appeared to acknowledge that the co-investment arrangements benefited fund investors by enabling the adviser to control more stock and exert greater influence in executing its activist strategy. This case demonstrates that the SEC can pursue an enforcement action related to undisclosed conflicts of interest even without evidence of investor harm.
- Use of the Word “May” In Disclosure – The SEC Order reiterates that generalized disclosure is generally insufficient in cases of repeated and frequent conduct. While such disclosure may offer protection in limited, infrequent situations, advisers should carefully assess what material facts must be disclosed as their practices evolve.
1 In the Matter of Macellum Advisors, LP; File Number 3-22209