The Devil in Discretion: What Allocators Should Know About Sponsor Authority and Decision-Making Frameworks in LPAs
>> One of the most bedeviling—yet least scrutinized—risks for Limited Partners stems from how Sponsors are permitted to make decisions that affect the Fund, its portfolio investments, and Limited Partner matters. From transfers and defaults to asset sales and conflicts, many allocators have found themselves blindsided by outcomes that seem self-serving.
Their reaction often comes too late and echoes the same refrain: “How could the Sponsor have done that?” The answer is almost always the same, too: Because the LPA let them. The key lies in little noticed or read provisions usually found buried in the miscellaneous section of the LPA that define and expand the Sponsor's discretion with respect to which interests they are authorized to consider in various situations:
"Whenever in this Agreement a person is permitted or required to make a decision … in its ‘sole discretion,’ ‘sole and absolute discretion" or ‘discretion’ or under a grant of similar authority or latitude, the person shall be entitled to consider any interests and factors as it desires …”1
This doesn't sound so bad, does it? Standard boilerplate, right? It is anything but!
A Federal Fiduciary Duty: The Advisers Act and the Standard of Conduct
It has long been settled law that §206 of the Investment Advisors Act of 1940 establishes a federal fiduciary duty for investment advisers.2 That fiduciary duty is understood to comprise a duty of care and a duty of loyalty that in tandem require the adviser to act in the “best interest” of its client, not subordinate the client’s interests to its own and provide full and fair disclosure of all material facts, including conflicts of interest.3 The duty cannot be waived, but it is applied within the scope of the agreed-upon relationship between adviser and client.
In contrast, fiduciary duties may be waived in partnership agreements under Delaware’s Uniform Limited Partnership Act.4 But Delaware courts have held that the presence of “sole discretion” language alone is not a waiver of fiduciary duties; rather, an explicit disclaimer of fiduciary duties must be set forth clearly in the agreement.5
As a result, when you read “in its sole discretion” in an LPA, it doesn’t mean that the GP can ignore its client’s interests as it might in a different contractual context. But that only makes it that much more important that you understand which interests it can take into account alongside the client’s and precisely where the boundary lines between those interests fall.
In the rest of our writeup, we look at:
The Role of the Compliance Gatekeeper
An Incomplete Fix: “But Not Above the Interests of the Fund”
A Better Approach: Protecting the Fund—and the LP
Conclusion: The Framework Behind Every Decision
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1 Sourced from a typical LPA drawn from the middle-market segment.2 Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979).3 SEC, Commission Interpretation Regarding Standard of Conduct for Investment Advisers (2019), 7-8, 10.4 6 Del. C. § 17-1101(f).5 Paige Capital Management, LLC v. Lerner Master Fund, LLC, C.A. No. 5502-CS (Del. Ch. August 8, 2011).
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