§ 5.01 Overview and Fiduciary Obligations

• Jurisdiction: United States
• Publication year: 2022

§ 5.01 Overview and Fiduciary Obligations

[1]—Overview

Hedge funds, and advisers to hedge funds, have long been subject to an array of regulatory requirements. Among other things, these requirements include fiduciary obligations which arise from state fiduciary duty laws, the Investment Advisers Act of 1940 (the "Advisers Act"),¹ the Securities Exchange Act of 1934 (the "Exchange Act"),² the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank").³ Most hedge fund managers are required to be registered with the SEC as investment advisers and to fulfill all of the obligations of being a registered investment adviser. In addition, increasing numbers of hedge funds and advisers to hedge funds are subject to CFTC registration and oversight. This chapter touches upon many of the significant regulatory considerations relevant to hedge funds and their advisers.

[2]—Investment Advisers as Fiduciaries

An investment adviser effectively acts as a fiduciary to its clients, both when it acts as an agent for its client when effecting a securities transaction on the client's behalf,⁴ and when it acts in a non-discretionary capacity. Investment advisers have fiduciary duties of duty of care and loyalty to their clients.⁵

As the U.S. Supreme Court has acknowledged, the Advisers Act "reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship."⁶ The Supreme Court explained in SEC v. Capital Gains Research Bureau, Inc. that a fiduciary has an affirmative duty of "utmost good faith" and to "provide full and fair disclosure of all material facts" as well as an affirmative obligation "to employ reasonable care to avoid misleading his clients."⁷ Capital Gains affirmed the investment advisory duties identified by the SEC in In the Matter of Arleen Hughes, such as the fiduciary duty of loyalty, which includes the duty to disclose all material circumstances, and the duty to obtain or dispose of property at the best price discoverable.⁸

In 2019, the SEC issued a final Commission Interpretation Regarding the Standard of Conduct for Investment Advisers⁹ (the "Fiduciary Duty Interpretation"). The Fiduciary Duty Interpretation reaffirms and, in some cases, clarifies an investment adviser's fiduciary duties to include (a) "duty of care [that] requires an investment adviser to provide investment advice in the best interest of its clients, based on the client's objectives" and (b) a duty of loyalty that requires an investment adviser to "eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which is not disinterested such that a client can provided informed consent to the conflict."¹⁰ While the precedent provided by the Fiduciary Duty Interpretation will be discussed in the following sections, main focus areas relevant to hedge fund managers include:

(1) Differentiation Between Retail and Institutional Clients. The Fiduciary Duty Interpretation states that, with respect to disclosures of conflicts of interest, "institutional clients generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications."¹¹ This is a critically important distinction for hedge fund managers.

(2) Full and Fair Disclosure of Conflicts of Interest. The Fiduciary Duty Interpretation also clarifies that "full and fair disclosure of all material facts relating to the advisory relationship or of conflicts of interest and a client's informed consent prevent the presence of those material facts or conflicts themselves from violating the adviser's fiduciary duty."¹² The SEC's Proposed Interpretation had suggested that there was a category of conflicts that must always be eliminated, regardless of the sophistication of a client, which the final Fiduciary Duty Interpretation corrects.¹³
(3) Use of Contingent Language in Disclosures. The Fiduciary Duty Interpretation provides guidance regarding the use of "may" in disclosures relating to conflicts of interest. The SEC stated that disclosures where an adviser states that it "may" have a conflict are improper when (i) the adviser, in fact, has such conflict, (ii) the conflict exists with respect to some, but not all, of the adviser's clients, or (iii) the word "may" precedes a list of all possible or potential conflicts regardless of likelihood and obfuscates actual conflicts to the point that clients cannot give informed consent.¹⁴ The SEC clarified that the use of "may" in disclosures of potential conflicts is appropriate when a conflict does not currently exist, but might reasonably present itself in the future.

The Fiduciary Duty Interpretation is the SEC's first holistic statement regarding an investment adviser's federal fiduciary duties. While the Fiduciary Duty Interpretation likely does not mandate changes to the fundamental approach to fiduciary obligations under the Advisers Act, it provides important clarifications and precedent.

In June 2020, the SEC's Office of Compliance Inspections and Examinations ("OCIE") published a risk alert identifying common deficiencies in investment advisers' compliance programs relating to conflicts of interest ("Conflicts of Interest Risk Alert").¹⁵ In the Conflicts of Interest Risk Alert, OCIE specifically identified the following topic areas that commonly lacked disclosures: (i) allocation of investment opportunities among client vehicles and accounts (including the allocation of limited opportunities to certain clients or to new clients without adequate disclosure); (ii) conflicts relating to investments by clients in different parts of an issuer's capital structure; (iii) disclosure of economic relationships between a manager and certain clients or investors (including loans and seed investment relationships); (iv) inadequate disclosure of material side letter provisions; (v) failures to adequately identify and detail conflicts associated with principals or fund managers holding interests in investments recommended to clients; (vi) ineffective disclosures with respect to how co-investments operate (including advisers' noncompliance with stated policies or disclosures); (vii) conflicts arising from the use of affiliated service providers or service providers with a special relationship to the adviser or its portfolio companies; (viii) the failure to provide sufficient disclosures concerning conflicts raised by fund restructurings and "stapled secondary transactions"; and (ix) inadequate disclosures of the conflicts inherent in cross transactions (including valuation of the price at sale).¹⁶

[3]—Breach of Fiduciary Duty Under the Advisers Act

Section 206 of the Advisers Act provides the enforcement mechanism with respect to an adviser's fiduciary duties by prohibiting an investment adviser from breaching its fiduciary obligation to its clients.¹⁷ The anti-fraud provisions of Section 206 are applicable to all investment advisers, as such term is defined under the Advisers Act,¹⁸ regardless of whether the adviser is required to register with the SEC.¹⁹ Only the SEC can bring breach of fiduciary duty claims under the Advisers Act—there is no private right of action under Section 206.²⁰

[4]—Investment Advisers' Fiduciary Duties

An investment adviser's fiduciary duty under the Advisers Act comprises a duty of care and a duty of loyalty. The duty of care includes, among other things: (i) the duty to provide advice that is in the best interests of the client, (ii) the duty to seek best execution and (iii) the duty to provide advice and monitoring over the course of the relationship.²¹ The duty of loyalty, under the Fiduciary Duty Interpretation, requires that an adviser (i) eliminate or (ii) make full disclosure of all conflicts of interest which might incline an investment adviser to provide advice that is not disinterested and obtain the client's provide informed consent to those conflicts.²² The SEC views an investment adviser's obligation to act in the best interest of its client as an overarching principle that encompasses both the duty of care and the duty of loyalty.²³

The fiduciary duties an adviser owes to a client can be shaped by contract to match the contours of the adviser-client relationship, provided there is full and fair disclosure and informed consent. However, an adviser cannot make a blanket waiver of all conflicts or a waiver of any specific obligation under the Advisers Act.²⁴

[a]—Duty of Care

[i]—Duty to Provide Advice That Is in the Best Interest of the Client

When hedge fund managers invest on behalf of a fund there is no general obligation with respect to profitability. Any investments, however, must be "suitable" for the fund, based on the fund's stated investment program. In order to provide "suitable" investment advice, the SEC believes an adviser must have a reasonable understanding of a fund's investment guidelines and objectives.²⁵ While for many hedge funds the stated investment program is a broad mandate facilitating a nimble approach to market developments, it is not limitless. Hedge fund managers should understand these limits and monitor for "style creep."

In addition, hedge fund managers must have a reasonable belief that an investment is in the best interest of the fund, based on the fund's stated investment program. The requirement concerning that the investment advice is in the best interest of the fund does not require every investment to be profitable. Instead, hedge fund managers must make suitable investments based on the investment program disclosed in the offering documents. An investment should also have a risk profile that matches the disclosure in the fund's offering documents. The hedge fund manager also must have a reasonable basis for its investments.²⁶ To satisfy its duty of care, an adviser must conduct a reasonable investigation into an investment to ensure it is not basing its advice...