SEC Settlements Highlight Governing Document Amendment Considerations For Private Funds – Securities

Limited partnership agreements and similar documents that govern
private funds are often amended over the course of a fund’s
life cycle. For example, many funds may be currently going through
the amendment process in connection with the upcoming effective
date of the Private Fund Adviser Rules.¹ We want to
remind fund managers of certain (maybe not so obvious)
considerations to keep in mind when preparing to amend or proposing
amendments to their fund governing documents. To do so, we have
examined two settlements with the U.S. Securities and Exchange
Commission (SEC).

Background

Generally, governing documents have an “amendment”
section that governs how they may be amended (e.g., what threshold
vote of limited partners, if any, is required to amend). While
managers should always comply with the respective governing
document’s amendment requirements, there are other factors to
consider, particularly when it comes to disclosing conflicts of
interest. Below we examine two SEC settlements that make clear that
the amendment section of a governing document provides a floor
rather than a ceiling for a manager’s obligations and duties
and that managers may be required to do more than what is
required under a respective governing document’s amendment
provision.

Fully Informed Consent

In 2023, the SEC settled with a fund manager who, among other
things, failed to disclose material facts and conflicts of interest
when proposing governing document amendments to investors in their
funds.² In this situation, the settlement notes the
manager, who was separately a co-creator of a holding company with
the purpose of operating in California’s marijuana industry,
engaged in fraudulent offerings that resulted in the enrichment of
outside investors who had not made capital contributions to the
fund in question. The manager then transferred hundreds of
thousands of dollars of fund assets to the above-mentioned holding
company for “management expenses.” The manager later
proposed an amendment to the fund’s governing document that
would grant profit interests in the fund to outside investors who
had invested in the marijuana venture but had not made capital
contributions to the fund. The manager, when proposing the
amendment, did not inform fund investors that outside investors
would be sharing in the profits of the fund. Rather:

In seeking the limited partners’
consent to the proposed amendment, [the manager] failed to disclose
anything about the syndicate investors, including the effect of
granting them profit interests. Instead, [the manager] falsely
stated that the requested amendment to the [governing document] was
necessary due to [other reasons]. [The manager] also falsely stated
that the amendment would not “hurt” or
“disadvantage” any limited partner in [the fund], when,
in fact, the limited partners who contributed cash in exchange for
their LP [i]nterests were hurt and disadvantaged since they became
obligated–via the requested amendment–to share [the
fund’s] profits with the converted syndicate investors.

The settlement notes that this series of events violated several
sections of the Securities Exchange Act and the Investment Advisers
Act. While the settlement implies some intentionality on the part
of the manager, it should still serve as an example of why the
reasons for governing document amendments must be fully, fairly,
and accurately disclosed. However, as noted below, this was not a
case of first impression.

Not-So-Unilateral Unilateral Amendments

In a 2014 settlement,³ the SEC describes a scenario
where certain private funds had insufficient cash to pay expenses
but were not permitted under their governing documents to borrow
money or issue promissory notes (which would have been used to
cover expenses). The settlement explains that the manager
unilaterally amended the governing documents to permit borrowing
and then made loans to the funds, without disclosing to the
investors (a) information about the loans, (b) that fund assets
would be pledged as collateral, or (c) the existence of the
amendments themselves. Notwithstanding the fact that the manager
may have ostensibly been permitted to unilaterally amend the
governing documents pursuant to the amendment provision, the SEC
took issue with these actions, noting that “even if the
governing documents had permitted such unilateral amendments, [the
manager], as the holder of the notes and security interest, had a
conflict of interest and could not consent to the loans and pledges
on behalf of the [funds] without adequate disclosure to the
investors.” The SEC also noted these transactions were
“principal transactions” under Rule 206(3) and the
manager did not comply with the requirements
thereunder.⁴

Takeaways

These settlements serve as a cautionary tale and highlight the
importance of full transparency when proposing governing document
amendments. Managers must clearly describe and disclose any
conflicts of interest related to such amendments. Further, managers
must be aware that even if an amendment provision permits
unilateral amendment, the manager still may be unable to do so when
any such conflict is present. Managers often believe that the only
steps they need to take in making an amendment to a governing
document is by following the relevant amendment provision. However,
managers must take into consideration any potential conflicts of
interest outside the scope of their governing documents and ensure
they make full and accurate disclosures when proposing any
amendments.

Next Steps

For further information, guidance, and clarity on how advisers
can approach, tailor, and draft governing document amendments
(including, but not limited to, the disclosure related thereto),
please reach out to the authors of this article or to your regular
Lowenstein Sandler contact directly.

Footnotes

¹ See e.g., https://www.lowenstein.com/news-insights/publications/client-alerts/the-sec-s-private-fund-adviser-rules-explained-part-1-the-restricted-activities-rule-im.

² https://www.sec.gov/files/litigation/admin/2023/33-11160.pdf.

³ https://www.sec.gov/files/litigation/admin/2014/33-9667.pdf.

⁴ See e.g., https://www.lowenstein.com/news-insights/publications/client-alerts/sec-identifies-common-principal-and-agency-cross-trading-compliance-deficiencies-investment-management.

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guide to the subject matter. Specialist advice should be sought
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