On Sept. 22, 2023, the Securities and Exchange Commission (SEC) announced that American Infrastructure Funds LLC (AIM), a California-based registered investment adviser to private funds that specializes in infrastructure and real property-based investments, had agreed to pay more than $1.6 million to settle allegations involving several breaches of fiduciary duty.[1] The SEC alleged that, among other violations, AIM (i) entered into an agreement under which it accelerated a portfolio company monitoring fee without adequate disclosure, (ii) transferred an asset of an existing AIM-advised fund to a newly formed continuation vehicle without adequately disclosing AIM’s conflicts of interest, obtaining investor consent or permitting investors to exit their investment prior to the transfer, and (iii) caused an AIM-advised fund to incur expenses that should have been paid by a fund advised by another AIM affiliate, the practical effect of which was to serve as an indirect loan from one fund to the other.
We have previously written about the SEC’s newly promulgated rules relating to private fund advisers. Each of AIM’s alleged breaches of fiduciary duty implicates points addressed by those rules (indeed, as initially proposed, the rules included outright prohibitions on accelerated monitoring fees and loans from a private fund to its adviser). We note in particular the SEC’s allegation of breach of fiduciary duty in connection with a continuation fund, which is the first of its kind by the SEC and may herald more such actions. Another point to observe is that the SEC alleged not only that AIM had breached its duty of loyalty to its private fund clients but also that AIM had breached its duty of care to those clients. This is the first example of which we are aware of the SEC bringing enforcement action outside the retail context based on a breach of an adviser’s duty of care.
We consider each of the SEC’s allegations, as well as details of the settlement, below.
The SEC alleged that AIM breached its fiduciary duty by entering into an agreement providing for accelerated monitoring fees payable to AIM by a portfolio company of one of AIM’s funds without adequate disclosure to that fund’s investors.
Here, a group of AIM-sponsored funds made an investment in a portfolio company. AIM entered into a monitoring agreement with the portfolio company, providing that, in exchange for AIM’s financial, advisory and consulting services, the portfolio company would pay AIM annual monitoring fees. Under the applicable fund documents, the management fees payable to AIM by the respective funds’ investors would be reduced, dollar for dollar, by the monitoring fees AIM received from the portfolio company. AIM and the portfolio company thereafter agreed to extend the original monitoring agreement for another 10-year term and provided that if either party terminated the agreement prior to the agreement’s expiration date, the portfolio company would pay AIM up to $4.5 million in accelerated monitoring fees. Subsequently, AIM sold its funds’ investment in the portfolio company, terminated the monitoring agreement and received the accelerated monitoring fees. AIM did not disclose to the relevant funds’ investors that AIM had extended the monitoring agreement, including the new accelerated monitoring fee provision, nor did AIM disclose the conflict of interest created thereby.
The SEC also alleged that AIM breached its duty of care by failing to consider whether the acceleration of monitoring fees was in the funds’ best interests. When AIM received the accelerated monitoring fees, the remaining management fee available for offset was less than the (accelerated) monitoring fee. As a result, AIM would effectively receive a windfall.
The AIM settlement is consistent with settlements of past SEC enforcement actions against investment advisers alleging inadequate disclosure practices regarding accelerated monitoring fees. In particular, the SEC, on several occasions, has maintained that an adviser must disclose the accelerated fee provision precommitment and obtain the fund’s consent, not after the provision has been triggered.[2] It is interesting that, as noted above, the SEC’s proposed private fund adviser rules would have expressly precluded advisers from entering into agreements to accelerate portfolio company monitoring fees. At the time, commenters on the proposed rule claimed that an ex ante prohibition was unnecessary since the SEC was, in their view, permitted to enforce implicit prohibitions against such arrangements. The final rules do not preclude acceleration of monitoring fees, although the SEC stated explicitly in the adopting release that the SEC believes, at least absent disclosure and consent, that such fees are inconsistent with an adviser’s fiduciary duties.
The AIM settlement is the SEC’s first enforcement action brought in connection with a continuation fund. Continuation funds are investment vehicles formed to continue a sponsor’s management of portfolio investments made by existing funds, typically (as was the case in the AIM settlement) because the existing fund’s term is nearing its end, but the sponsor believes that investors are best served continuing to hold the investment rather than selling at that time. Continuation vehicles allow managers to retain management of portfolio investments and continue to receive compensation by transferring portfolio investments out of an existing vehicle into a new vehicle managed by the same sponsor, while providing liquidity for investors who want to exit the investment rather than “roll over” into the new vehicle. However, given that the adviser advises both the existing fund and the newly formed vehicle, continuation funds may create conflicts of interest.
Here, AIM caused one of its existing funds, the term of which was to expire in 2017, to transfer that fund’s interest in a portfolio company to a newly formed vehicle AIM managed, the term of which was to expire in 2028. However, AIM disclosed to investors in the existing fund only that AIM intended to raise capital for the portfolio company and invest in additional projects. AIM did not disclose the transfer of the existing fund’s interest in the portfolio company to a new vehicle managed by AIM, nor did AIM give investors in the existing fund an opportunity to object to the transaction or exit their investments in the portfolio company. Instead, investors in the existing fund became investors in the new vehicle and thus subject to its terms (in particular, being locked up for the entire term of the new vehicle).
The SEC alleged that AIM violated its fiduciary duty to the existing fund for failure adequately to disclose the full nature of the transfer of assets to the new fund, including failure to disclose conflicts of interest (in particular relating to the fact that AIM was on both sides of the transaction, as adviser to both the existing fund and the new vehicle, and could earn fees from both). Moreover, the SEC alleged that AIM breached its fiduciary duties to the existing fund by failing to obtain investor consent to the transaction and by failing to provide investors in the existing fund opportunities to liquidate their interests in the existing fund.
Regulation of continuation vehicles has long been on the SEC’s radar. The final private fund rules explicitly acknowledge the conflicts of interest raised by continuation vehicle transactions and add several requirements that advisers must meet to satisfy their fiduciary obligations to existing clients. In particular, advisers sponsoring continuation fund transactions like the transaction in the AIM settlement must provide investors either a fairness opinion or a valuation opinion from an independent opinion provider prior to deciding whether to consent or object to the transaction. The adviser must also prepare a written summary of any material business relationships between the adviser and the opinion provider.
While we will continue to review future SEC enforcement actions, this action is likely just the first of many in the SEC’s focus on continuation funds. Corey Shuster, co-chief of SEC’s Asset Management Unit, noted in the SEC’s press release announcing the AIM settlement that this case demonstrates the SEC’s “continued focus on holding private fund advisers responsible when they fail to act in their clients’ best interest” and added a subtle, but firm, emphasis that this continued focus will encompass continuation funds.
Finally, the SEC alleged breaches of both AIM’s duty of loyalty and its duty of care in connection with AIM’s allocation of deal expenses between two of its funds.
Here, AIM had formed a new fund, managed by an AIM-affiliated adviser, and in January 2019, allocated to an existing fund managed by AIM deal expenses incurred by the new fund. In June 2019, the new fund paid to the existing fund an amount equal to the expenses. The SEC alleged that because the existing fund had borne the new fund’s expenses, the existing fund had “loaned” the amount of the expenses to the new fund for that period. However, AIM had not disclosed the conflicts of interest involved in the allocation to investors in the existing fund, nor had AIM sought investor consent to bear the new fund’s expenses for that period. Moreover, the SEC alleged that AIM had not undertaken to determine whether this allocation of expenses was in the best interest of the existing fund and, in so doing, had violated its duty of care to the existing fund. To make matters worse, although AIM subsequently disclosed the allocation to the existing fund, the SEC alleged that the disclosure did not adequately address the conflicts of interest, nor did it disclose AIM’s failure to determine whether the allocation was in the best interests of the existing fund, and that therefore AIM’s disclosure was misleading.[3]
In connection with AIM’s alleged breaches of its fiduciary duties, the SEC alleged that AIM willfully violated Advisers Act Sections 206(2) and 206(4), as well as Rule 206(4)-8 thereunder. Section 206(2) precludes advisers from engaging “in any transaction, practice, or course of business which operates as a fraud or deceit upon a client or prospective client,” while Section 206(4) and Rule 206(4)-8 preclude an adviser from making “any untrue statement of a material fact or [from] omit[ting] to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading, to an investor or prospective investor,” or from engaging “in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor” in a fund.
Without admitting or denying the SEC’s allegations, AIM agreed to a cease-and-desist order and censure and to pay a $1.2 million penalty as well as $445,460 in disgorgement and prejudgment interest to investors. In addition, the SEC ordered AIM to notify past and current investors of the existing funds of the settlement terms within 30 days of entry of the order and provide written certification of compliance with the undertaking no later than 60 days from the date of completion.
The full text of the SEC press release can be found here.
[1] In re American Infrastructure Funds, LLC, Investment Advisers Act Release No. 6428 (Sept. 22, 2023).
[2] See, e.g., In re TPG Capital Advisors, LLC, Investment Advisers Act Release No. 4830 (Dec. 21 2017) (settlement with investment adviser claiming that the mere disclosure of entering into a monitoring agreement, without disclosing the accelerated monitoring fee provision, is not adequate); In re Apollo Management V, L.P., Investment Advisers Act Release No. 4493 (Aug. 23, 2016) ($52.7 million settlement with investment adviser for alleged failure to adequately disclose receipt of accelerated monitoring fees upon the initial public offering of portfolio companies).
[3] As was the case with accelerated monitoring fees, the proposed private fund adviser rules prohibited advisers from directly or indirectly receiving loans from their private fund clients (even where, as here, the “loan” is not structured as a loan, but rather as an allocation of expenses). Commenters noted that, notwithstanding the conflicts of interests such loans may present, such loans may be beneficial to the private fund making the loan, e.g. in connection with tax distributions. As a result, in lieu of a flat prohibition, the final rules preclude such loans unless the adviser first distributes a written notice or description of the material terms of such borrowings, and obtains consent from at least a majority in interest of the private fund’s investors that are unrelated to the adviser.