Fiduciary Duties of Venture Capitalists

Venture capitalists are having an increasingly positive impact on the world in improving the lives of countless people around the globe and we are now seeing NextGen VCs take up the mantle to accelerate this change. At VC Lab we provide free resources to champion next-generation venture capitalists and help you successfully launch your venture capital firm. One of the things new fund managers should be aware of when launching a venture firm is their ‘fiduciary duties’ to their limited partners.

A ‘fiduciary’ in this context is an individual or organization that manages assets on behalf of others (the LPs).  Under the Investment Advisers Act of 1940 (the “Advisers Act”) by the SEC, said parties are obligated not only contractually but also by a duty of care and loyalty / fidelity whether or not they are registered with the SEC. Note that venture capital fund managers fall under this definition and as such you are considered an ‘investment adviser’ by the SEC. 

Though the ‘Advisers Act’ lacks detail as to the responsibilities of investment advisers, SEC’s interpretation within the ‘Standard of Conduct for Investment Advisers’ (SCIA) goes on to outline the encompassing fiduciary duties that venture capital fund managers should follow.

1. Duties of Care
2. Duties of Loyalty
3. Common Complications
4. Waivers

Duties of Care

In section II.B. of the SCIA, the SEC breaks down the Duties of Care into 3 core responsibilities:

1. Duty to Provide Advice that is in the Best Interest of the Client

To do so, the advisers should understand the client’s objectives, e.g for retail investors their investment profile, and for institutional investors their investment mandate. Therefore, fund managers should make reasonable inquiries into the client’s financial situation and sophistication. When managing a client’s capital, advisers ought to have reasonable belief that their actions are following said goals of the client. Consequently, venture capital fund managers should ensure their LPs are highly sophisticated individuals with an understanding and tolerance of the risks associated with the asset class.

2. Duty to Seek Best Execution

Advisers should have the goal of maximizing value for the client when executing securities transactions. The SEC states that the determinative factor here is not optimizing for the lowest cost/commission but whether the transaction represents the best qualitative execution. Additionally, it is recommended that fund managers should put systems in place to periodically evaluate the executions it is receiving on behalf of its clients. 

3. Duty to Provide Advice and Monitoring over the Course of the Relationship

Fund managers who receive periodic management fees, as opposed to one-off transaction fees, should monitor the portfolio of investments for the full duration of the relationship with the clients, namely the duration of the fund. 

To summarise, it is advised that fund managers safeguard their client’s assets with due care for the entire duration of the fund, while always seeking the best interests of the clients and conducting the necessary due diligence on both investments and the client’s sophistication to act per the client’s objectives and the agreed-upon investment strategy of the fund.

Duties of Loyalty

Section II.C. of the SCIA outlines the duties of fidelity and necessitates that the fund manager does not subordinate their clients’ interests to their own, meaning that the client’s interest supersedes that of the fund manager’s own interest when there is a conflict between the two. Consequently, fund managers should seek to be provident and make full written disclosure to their LPs at the start of the relationship and specify any conflicts of interest that exist or might arise in the future. 

Fund managers should also consider the conflicts related to the allocation of opportunities among eligible clients (and describe with specific language and in detail within their disclosure, how they will manage such conflicts of interest.

Common Complications

For new venture capital fund managers, multiple complications can arise when setting up their funds and during the funds operating life. Fully disclosing personal angel investments and other notable interests to the LPs is recommended to avoid such complications.

One particular complication arises when picking a selection of a personally held portfolio of companies to transfer into the venture fund. It is advised that when doing so, fund managers act in line with the fund’s thesis as well as disclose relevant information to limited partners. 

It is sometimes not possible to predict every future eventuality and complication. For example, issues can arise when allocating investment opportunities to a co-investment vehicle or another fund. Therefore, it is advisable to create an independent ‘limited partner advisory committee’ (LPAC), which can make decisions on behalf of all the limited partners. This expedites such procedures as it means the fund manager does not have to individually deliberate with every limited partner.

Consequently, due to the conflicts of interest that arise in both managing a fund and making personal investments, fund managers are typically prohibited from making personal investments within venture capital. Other than conflicts in a manager’s duty of loyalty, further issues arise due to clauses addressing such scenarios in most limited partnership agreements. 

A limited partnership agreement (LPA) governs the actions of involved parties and sets forth the economic and control terms of the partnership. LPAs typically exclude such activities on the part of the fund manager. Refer to our lightweight and simplified Cornerstone LPA to see such terms and clauses.

Waivers

Waivers are voluntary relinquishments of a parties legal rights or claims. Typicaly they are used to mitigate the potential liability of a party.

Fund managers should note that the SEC has warned that any effort to avoid such complications as discussed previously via the use of waivers would be inconsistent with the Advisers Act. This includes any documentation “to waive the fund managers federal fiduciary duty such as

(i) a statement that the adviser will not act as a fiduciary,

(ii) a blanket waiver of all conflicts of interest,

(iii) a waiver of any specific obligation under the Advisers Act.”

Consequently, fund managers should not include any such waivers in their fund documents to bypass the aforementioned legislation. Doing so is not advised and may lead to legal complications and liabilities for the fund manager and the venture firm.

Sources and additional resources: 

• Securities and exchange commission – Interpretation Regarding Standard of Conduct for Investment Advisers
• Carrington Coleman Law Firm – George T. Lee
• Akin Gump Law Firm
• Norton Rose Fulbright