SEC Proposes Fundamental Changes to Private Fund Regulation
The U.S. Securities and Exchange Commission (the “SEC”) recently proposed extensive new rules and amendments under the Investment Advisers Act of 1940 (the “Advisers Act”) that mandate new regulations for investment advisers to “private funds,” including some that apply to advisers not registered with the SEC such as exempt private fund advisers and state-registered advisers.1 The SEC’s rationale for the proposed changes is to increase transparency, efficiency and internal governance mechanisms for private fund advisers, who have a large impact on the economy through the funds they manage. A brief overview of the proposed rules and amendments is provided below.
Some of the proposed rules, particularly the rules regarding prohibited activities and preferential treatment discussed below, present a dramatic departure from the position taken historically by the SEC, which refrained from flat prohibitions in favor of meaningful disclosure.2 In addition, it is unclear how the proposed rules would affect existing contracts and arrangements between advisers and investors.
The proposed rules are now open for comment until April 25, 2022. We typically do not provide in-depth summaries on rule proposals (as opposed to final rules) but we believe all industry participants should be aware of the far-reaching nature of this proposal and encourage you to take advantage of the comment period to provide your own perspectives. The SEC has proposed that compliance with the proposed rules would begin on May 25, 2023.
Prohibited Activities. The proposed rules would prohibit an investment adviser to a private fund from engaging, directly or indirectly, in certain activities with respect to the private fund or its investors and portfolio investments. These prohibitions would apply to all private fund advisers, including advisers that are not registered with the SEC, such as exempt reporting advisers and state-registered investment advisers. Some of these prohibitions, such as the prohibiting an adviser from receiving indemnification for negligent activities, would significantly alter the economic relationship between the adviser and the fund.
Indemnification and Limitations on Liability. The proposed rules would prohibit an adviser to a private fund from seeking reimbursement, indemnification, exculpation or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the fund. The SEC noted that the organizational documents of many private funds contain such provisions and, in the SEC’s view, such provisions have become more aggressive. The SEC stated that such provisions are not in the public interest or consistent with the protection of investors.
The proposed rules would significantly expand the potential liability of an adviser to include negligence, rather than limiting the adviser’s liability to gross negligence. The SEC requested comment on whether the prohibition should apply only to gross negligence, rather than mere negligence. It also requested comment regarding whether the proposed rules would increase operating expenses for advisers.
Regulatory Compliance and Examination Expenses. The proposed rules would prohibit an investment adviser from charging a private fund for regulatory or compliance fees or expenses of the investment adviser and its related persons. The proposed rules also would prohibit an investment adviser from charging a private fund for the fees and expenses associated with an examination or investigation of the adviser and its related persons by any governmental or regulatory authority. This prohibition would apply even if the adviser does not charge the private fund management fees, but instead requires the private fund to pay the adviser’s overhead and operating expenses. The SEC requested comment regarding whether an adviser should be permitted to charge these fees and expenses to a private fund if the practice was fully disclosed and consented to by the private fund’s investors or advisory committee.
The rule would not prohibit an adviser from charging a private fund for regulatory, compliance and similar fees and expenses that directly relate to the fund (such as costs incurred in connection with filing a Form D under Regulation D). If it is not clear whether a fee or expense relates to the fund or the adviser, the adviser would be required to allocate such fee or expense in a manner that it believes in good faith is fair and equitable and consistent with its fiduciary duty.
1 See https://www.govinfo.gov/content/pkg/FR-2022-03-24/pdf/2022-03212.pdf
2 See, for example, the 2019 Commission Interpretation Regarding Standard of Conduct for Investment Advisers, available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf.