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4. INITIAL OPERATIONS

c. Investor Relations

Contractual Duties

When dealing with investors, fund managers must abide by the articles and operating agreement of their private equity fund.

The fund agreement usually grants economic and governance rights to the investors. The economic rights include the rights to receive allocations of net profits, and distributions of net cash flow. The governance rights may include the rights to vote on major decisions and receive information about the fund.

Besides granting rights to investors, the fund agreement may contain express limitations on the managers. Typical limitations include the following:

• do not use fund capital for any purpose other than the defined purpose
• return any capital not used within the defined period of time
• satisfy the minimum time commitment
• do not participate in competing activities
• obtain investor consent to specific "major decisions"
• do not compensate fund personnel except as authorized

Like every contract, a fund agreement also includes the implied duty of good faith and fair dealing. Every party to the fund agreement has this obligation. "Good faith" is a subjective standard that depends on the actual intent of the managers or investors. "Fair dealing" is an objective standard determined by a court or arbitrator. When contemplating an action that is arguably unfair, fund managers should err on the side of the investors.

Fiduciary Duties

In addition to their contractual duties, fund managers also owe fiduciary duties to the investors. These duties are implied by law. The fiduciary duties are the duties of care and loyalty, and perhaps the duty of candor (in Delaware and other jurisdictions).

The duty of care obligates a fund manager to use reasonable care when managing the fund. In practice, this may mean choosing suitable investments, diversifying the portfolio, protecting the fund capital, exiting investments when appropriate, and otherwise acting in accordance with professional industry standards. A breach of the fiduciary duty of care is considered "gross" negligence, which is more severe than "ordinary" negligence. Applicable law may allow the fund documents to reduce or even eliminate the fiduciary duty of care.

The duty of loyalty obligates the fund manager to act in a manner believed to serve the best interests of the fund and the investors. In general, this means not intentionally causing the fund to provide a disproportional benefit to the manager at the expense of the investors. Common examples include paying excessive salaries, reimbursing personal expenses, making disproportional distributions to the manager, and usurping an investment opportunity. Applicable law may allow the fund documents to authorize certain types of "disloyal" activities, but probably not eliminate the duty entirely.

If applicable, the duty of candor requires the fund manager to make complete and accurate disclosures of material information. This duty is ongoing and not limited to the initial sale of securities. To satisfy the duty of candor, the fund manager should distribute reports to investors on a periodic basis (for example, quarterly or semiannually) and upon the occurrence of significant events. The fund manager should provide additional information upon request. It is unlikely that applicable law would allow the investors to waive the duty of candor.