When it comes to private equity funds, in common fund domiciliation jurisdictions seen in our region, the general partner (GP) has a fiduciary duty towards the fund and the limited partners (LPs). This duty is crucial, legally enshrining the fundamentals of trust and pursuant to which the GP is required to carry out its powers and authorities absent significant oversight from the LPs and in some instances, capital market regulators. However, courts tend to apply the fiduciary standards in a both objective and subjective manner, which means that GPs and legal counsel must give great attention to the limited partnership agreement (LPA) drafting to shape the fiduciary duties by the contractual arrangement and help examining courts in their assessments, and to understanding the details of how such duties may be carried out through the activities of the GP. This article discusses the common tenors of the fiduciary duty placed on GPs in respect of investment funds.
The first tenor of the fiduciary duty is the duty of loyalty, which is a fundamental obligation that GPs owe to LPs in funds they manage. This duty requires GPs to act in the best interests of the fund and its LPs, and to avoid any conflicts of interest that could compromise their ability to do so. One way to manage conflicts of interest is to clearly set out transactions and potential dealings that involve such conflicts in the fund documents. Such disclosure to LPs allows them to make an informed decision about whether to approve such transactions by investing in the fund and accepting its documents. The inclusion of a provision that requires advisory committee (LPAC) approval for all conflicts of interest may not be enough to fully address the concerns of LPs. LPs may still challenge transactions and argue that the GP did not act in their best interests, potentially leading to a breach of fiduciary duty claim, resulting in damages, and possibly grounds for cause GP removal. To mitigate this risk, clauses relating to conflicts of interest can be expanded to provide for a mechanism that counts LPAC approval as equivalent to LPs’ approval. This means that if the LPAC approves a transaction that involves a conflict of interest, the GP will be considered to have fulfilled its duty of loyalty to the LPs regarding the relevant conflict of interest. Such mechanism can help the GP demonstrate that it has taken the necessary steps to manage a conflict of interest through obtaining LP approval.
The second common tenor of the fiduciary duty is the duty to act in good faith. Such duty includes obtaining the LPs’ consent for changes to the fund that could materially impact the LPs interests. Naturally, such consent may prove difficult, hence GPs customarily consider adding a withdrawal provision in the LPA to permit the impacted LPs to withdraw from the fund if the GP proposes specific amendments materially adverse such LPs. This option bridges the gap between the GP’s duty to act in good faith and not harm certain LPs or class of LPs, and act for the benefit for the fund in its entirety.
In summary, GPs and legal counsel must pay close attention to the LPA drafting to ensure that the GP’s fiduciary duties are shaped by the contractual arrangement to help in how courts will interpret them should a dispute arise and to further provide clarity and transparency between the GP on one hand and the LPs on the other hand. Additionally, GPs should clearly set out all conflicts of interest transactions, and consider including a withdrawal option if specific amendments materially adverse certain LPs to ensure that they are acting in good faith and in the best interest of the fund. These measures can help mitigate potential challenges from LPs and ensure that GPs can carry out their powers and authorities effectively.