SEC Announces New Private Fund Advisers Rules

Introduction

On Aug. 23, the Securities and Exchange Commission (SEC) adopted new rules under the Investment Advisers Act of 1940 (the Advisers Act) by a 3-2 vote (Final Rules). The new rules apply to SEC-registered investment advisers and, to a more limited extent, also to unregistered investment advisers. To SEC Chairman Gary Gensler, the rules “enhanc[e] advisers’ transparency and integrity [and] will help promote greater competition and thereby efficiency” in the markets.^[1] To SEC Commissioner Hester Peirce, one of the two dissenters, the rules “uproot[] the historical approach to regulating private funds [and] will irreparably mar the regulatory landscape.”^[2] While time will tell, our initial sense from parsing the 658 pages of rulemaking is that the new rules may burden more than benefit competition but will not leave the private funds landscape entirely bereft of trees.

With some changes, the Final Rules are largely similar to the proposed rules released by the SEC on Feb. 9, 2022 (“Proposed Rules”), available here. We published a client alert on the Proposed Rules here. In this client alert, we analyze the significant changes envisaged by the Final Rules and comment upon the SEC’s revisions to the Proposed Rules. The full release, along with the adopted rules, can be found here.

Negligence Standard

As an initial matter, the Final Rules do not include one of the most significant changes to existing law in the Proposed Rules.^[3] As we noted in our prior alert,^[4] the Proposed Rules imposed liability on advisers on an ordinary, rather than gross, negligence standard, in a departure from prevailing market practice.^[5] One likely outcome if the liability standard had been adopted as proposed would have been to protect advisers from liability through substantial directors and officers and errors and omission insurance for losses arising through negligence that, while no longer indemnifiable, would still presumably have been insurable.

Quarterly Statements

The requirement for registered private fund advisers to make new, standardized quarterly disclosures to their investors remains largely similar to the Proposed Rules.^[6] With respect to the detailed accounting of portfolio investment compensation, the requirement to disclose a private fund’s ownership percentage of each portfolio investment was eliminated by the SEC.^[7]

As far as disclosure of a private fund’s performance information in the quarterly statements is concerned, the SEC made two significant modifications^[8] to the Proposed Rules: (i) for liquid funds, the required reporting period was limited to the prior 10 fiscal years;^[9] and (ii) for illiquid^[10] funds, performance metrics are to be computed both with and without consideration of any fund-level subscription facilities, whereas the Proposed Rules would have required performance to be calculated only without consideration of such facilities.^[11]

Audit Rule

The basic requirement in the Proposed Rules for registered advisers to private funds to obtain an annual audit and liquidation audit of the financial statements of the private funds they advise has been made less cumbersome in the Final Rules. Per the Final Rules, the aud–it requirements will not be necessary if a private fund complies with the “Custody Rule”^[12] under Regulations S-X.^[13]

Codification of Current “Best” Practices

In a departure from the Proposed Rules, many of the previously prohibited activities are now “restricted activities,” and are permitted either with disclosure, or with disclosure and consent.

“Restricted Activities” permitted only with disclosure to all investors^[14] and with their consent^[15]:

• Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority that ended without a sanction being imposed upon the adviser for an Advisers Act violation;^[16]and
• Borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit, from a private fund client.

Timely disclosure,^[17] but not consent, is required for:

• Charging the private fund for any regulatory, examination or compliance fees or expenses of the adviser or its related persons;
• Reducing the amount of any adviser clawback by actual, potential or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders;^[18]and
• Charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis between clients investing in the same portfolio company.^[19]

The SEC did not include in the Adopting Release an express prohibition on charging a portfolio investment for monitoring, servicing, consulting or other fees for services the investment adviser does not ultimately, or does not reasonably expect to, provide to the portfolio investment;^[20] and (ii) the Negligence Standard discussed above. Even absent such an express prohibition, such arrangements have been the subject of robust enforcement action in particular circumstances.

With respect to the question of whether existing contractual arrangements might be grandfathered or given “legacy” status, the SEC in the Adopting Release indicated that it will provide legacy status with respect to (i) the prohibitions aspect of the preferential treatment^[21] rule and (ii) the aspects of the restricted activities rule that require investor consent. It should be noted that the legacy status provisions apply to governing agreements (e.g., the fund’s partnership agreement, subscription agreements, and side letters and documents governing the fund’s borrowing arrangements) that were entered into prior to the compliance date to the extent the private fund had commenced operations (e.g., investment or fundraising activities) as of the compliance date.

Scope

As in the Proposed Rules, the Final Rules relating to the quarterly statement requirement, the audit requirement and adviser-led secondaries apply to all SEC-registered advisers to private funds, while the restricted activities and preferential treatment rules apply to all advisers to private funds. None of the rules apply with respect to the non-U.S. clients, including private funds, of an SEC-registered offshore adviser, continuing the position the SEC has previously taken with respect to such advisers. The restricted activities and preferential treatment rules will also not apply to unregistered offshore advisers with respect to their offshore funds, regardless of the presence of U.S. investors in those funds.^[22]

In addition, the Final Rules do not apply to investment advisers of “securitized asset funds,” defined as funds whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders, solely with respect to securitized asset funds they advise.

Effective Date/Transition

The Final Rules will take effect 60 days after the date of publication of the Adopting Release in the Federal Register.^[23] Thereafter, SEC-registered advisers will have 18 months to comply with the audit and quarterly statement rules. Separately, advisers with $1.5 billion or more in private funds assets under management will have 12 months to comply with the adviser-led secondaries rule, the preferential treatment rule and the restricted activities rule, while advisers with less than that amount in private funds assets under management will have 18 months to comply with those rules to the extent applicable.^[24]

Conclusion

As always, please feel free to contact the members of our Private Funds team with any questions or comments. 

^[1] _{See SEC Approves Private Fund Adviser Reforms, available here.}

^[2] _{See SEC Statement “Uprooted: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews,” available here.} 

^[3] _{See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-6368 (Aug. 23, 2023) at 256 (hereinafter the “Adopting Release”).}

^[4] _{SEC Proposes Changes to Private Fund Rules, Feb. 25, 2022, Kramer Levin, available here.} 

^[5] _{The Proposed Rule explicitly prohibited the sponsors from seeking reimbursement, indemnification, exculpation or limitation of liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, recklessness or negligence in providing services to the private fund. See § 275.211(h)(2)-1(5) of the Proposed Rules.}

^[6] _{The Adopting Release broadens the reference from expenses “paid by” a fund to also include expenses “allocable to” a fund, the latter category still being an item borne by fund investors as an economic matter.}

^[7] _{Adopting Release at 101 – 102.}

^[8] _{The SEC also provided greater time for funds of funds to provide the requisite disclosure, 75 and 120 rather than the otherwise applicable 45 and 90 days.}

^[9] _{Adopting Release at 104, 111, 117 – 118.}

^[10] _{As opposed to the Proposed Rules, which would have established six factors in an assessment of illiquidity of a private fund, the Final Rules limit the determination of whether a fund is “illiquid” to a consideration of two factors: the lack of a requirement to redeem interests upon an investor’s request and presence of limited opportunities, if any, for investor exits before termination of the fund.}

^[11] _{Adopting Release at 124 – 125.}

^[12] _{17 CFR 275.206(4)-2 of the Advisers Act.}

^[13] _{Adopting Release at 23 – 24.}

^[14] _{The disclosure must be made within 45 days after the fiscal quarter end in which the fee or expense was incurred.}

^[15] _{Consent of a majority in interest of investors unrelated to the adviser is required.}

^[16] _{Charging or allocating fees and expenses related to an investigation that resulted in a court or governmental authority imposing such a sanction is flatly prohibited.}

^[17] _{Advance disclosure in a private placement memorandum is insufficient; rather, disclosure on an ongoing basis quantifying the amounts in question must be made.}

^[18] _{Disclosure of both pre- and post-tax clawback amounts is required.}

^[19] _{In addition, the allocation methodology must both (a) actually be fair and equitable and (b) disclose how the allocation methodology is fair and equitable under the particular circumstances.}

^[20] _{See Adopting Release at 14 – 16 for a discussion of the SEC’s enforcement actions against private fund advisers for fraudulent practices related to fee and expense charges or allocations that are influenced by the advisers’ conflicts of interest.}

^[21] _{The preferential treatment rule prohibits private fund advisers (whether registered or unregistered) from providing preferential treatment with respect to redemption rights (except those required by applicable law) and portfolio holdings or exposure information, in each instance, that the adviser reasonably expects would have a material, negative effect on other investors, and requires disclosure of all other types of preferential treatment.}

^[22] _{Adopting Release at 45 – 47.}

^[23] _{Adopting Release at 2.}

^[24] _{Adopting Release at 308.}