Historic Regulatory Shake-up for the Private Funds Industry
In recent months, the U.S. Securities and Exchange Commission (the “SEC”) has introduced a wave of proposals amounting to approximately 1,100 pages of new and amended rules that will significantly impact the private funds industry, likely subjecting it to an unprecedented degree of regulation. Many of these proposed rules would apply to all private fund advisers, regardless of registration status.
Among such proposals, the following are expected to have the most widespread impact for private fund advisers in general:
- proposed new and amended rules under the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”) that would materially increase the degree of supervision and regulation applicable to private fund managers, namely:
- “Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews,” dated February 9, 2022 (the “Private Fund Adviser Proposals”);
- “Cybersecurity Risk Management For Investment Advisers, Registered Investment Advisers, Registered Investment Companies and Business Development Companies,” dated February 9, 2022 (the “Cybersecurity Proposal”); and
- proposed amendments to Form PF1 that will require close to instantaneous reporting for certain private fund managers, including large hedge fund and private equity fund managers.
Although this alert will principally focus on the above proposals, the SEC also proposed amended ownership reporting rules under the U.S. Securities Exchange Act of 1934, as amended (the “Exchange Act”), “Modernization of Beneficial Ownership Reporting,” dated February 10, 2022, and proposed new rules2 under the Exchange Act that would require the reporting of large swap positions and prohibit fraud, manipulation or deception in connection with security-based swaps. This alert will touch on those additional proposed rules at a high level below.
Prior to the release of the onslaught of proposals, the SEC honed in on certain perceived concerns with private fund advisers in a Risk Alert issued January 27, 2022 (the “EXAMS Alert 2022”). The EXAMS Alert 2022 detailed the SEC’s following observations of common private fund adviser deficiencies: “(A) failure to act consistently with disclosures; (B) use of misleading disclosures regarding performance and marketing; (C) due diligence failures relating to investments or service providers; and (D) use of potentially misleading ‘hedge clauses’.” Notably, the SEC’s negative perception of hedge clauses in the aforementioned alert manifested in a proposed rule within the Private Fund Adviser Proposals prohibiting all private fund advisers (regardless of SEC-registration status) from seeking exculpation from liability or indemnification for losses that result from mere negligence (as opposed to “gross” negligence) in providing services to the private fund, which signifies a stark departure from standard industry practices.
Imposing a standard of care on all private fund advisers that disallows liability protection from negligence is just one example of the many changes proposed by the SEC over the past few months, and the combined impact of all this represents a historic regulatory shake-up for the private funds industry. Most strikingly, the SEC declares certain practices as per se illegal, or requires the adoption of certain prescriptive investor-protective measures, regardless of whether the practices may be fully disclosed in fund documentation so that investors can freely decide to invest or not.
In light of this shifting regulatory tide, all private fund advisers, regardless of SEC registration status, would be well-served to start preparing. To aid with that preparation, we have synthesized with some depth the proposed rules comprising the Private Fund Adviser Proposals, the Cybersecurity Proposal and the proposed amendments to Form PF along with related insights and observations. Links to the proposals have also been provided throughout this alert.
The Private Fund Adviser Proposals would prohibit all private fund advisers (regardless of SEC registration status) from engaging in certain activities and practices that are, in the SEC’s words, “contrary to the public interest and the protection of investors” — irrespective of the disclosure or sophistication of the investor base. These practices include:
1. 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 private fund”; under this rule, indemnification for breaching a fiduciary duty, regardless of whether state or other law would permit an adviser to waive its fiduciary duty, would be invalid.
- In the EXAMS Alert 2022, the SEC indicated it observed various fund documentation stating that the private fund adviser and its related persons “will not be subject to any duties or standards (including fiduciary or similar duties or standards) existing under the Advisers Act, Delaware law, or Cayman Islands law or will not be liable to the fund or investors for breaching its duties (including fiduciary duties) or liabilities (that exist at law or in equity).”
- The example of exculpation of liability provision cited by the SEC as being deficient omits the often included “non-waiver disclosure” that clarifies that the client or investors may still have certain legal rights, generally arising under federal and state securities laws. This appears to indicate that the SEC does not consider those so-called “savings” clauses to really be saving anything for private fund advisers. Rather, having such broad exculpation and indemnification provision, whether or not coupled with such savings clauses, would in and of itself be a violation of the Advisers Act.
- Current market practice is for most private funds to have governing documentation setting a standard of at least “gross” negligence for liability and exclusion from indemnification. This proposal would prohibit exculpation from liability or indemnification even in case of “simple” negligence standards going forward, irrespective, it seems, of any accompanying “non-waiver disclosure.”
- This change would result in the private fund adviser’s liability, for example, for many trade errors, even as a result of a so-called “fat-finger” error, and can be expected to increase the premiums for D&O and similar insurances (which are typically at least in part a fund expense). Fund documentation for most private fund products would have to be revised to reflect the newly required standard of care for indemnification and exculpation.
2. Reducing the amount of an adviser clawback (also known as a general partner (“GP”) carry clawback) by actual, hypothetical or potential taxes applicable to the adviser, its related persons, or their respective owners or interest holders.
- Reducing GP carry clawback by taxes is widely practiced in the closed-end private fund industry. The argument is generally that the GP paid the taxes on the income that would have been paid by the investors otherwise, and that the GP should not be out of pocket for taxes on income allocated to it, so any clawback should be net of such taxes. However, the SEC appears unpersuaded by this argument, and believes that “the proposed rule would foster greater alignment of interest between advisers and investors by prohibiting advisers from unfairly causing investors to bear these tax costs associated with the payment, distribution, or allocation of ‘excess’ performance-based compensation.” This despite the fact that some clawbacks provide that the amount clawed back is increased by the tax benefit, if any, to the GP due to the clawing back of such amount in the year of clawback (for example, if the GP has a loss due to the clawback which can offset other income in such year).
- Not allowing the reduction of the carry allocation for taxes effectively encourages the use of fees as opposed to allocations. This is somewhat contrary to the Sections 409A and 457A of the Internal Revenue Code of 1986, as amended, which impose penalties on the deferral of fees. And, more importantly, many investors may be limited in their ability to deduct fees for tax purposes and thus may be hurt if managers are encouraged to structure the carry as fees as opposed to allocations.
- This rule would be particularly significant for private equity funds with a deal-by-deal (so-called “American style”) waterfall provision (rather than all-capital back) given the increased chance for a GP clawback in those waterfall schemes.
3. Charging certain fees and expenses to a private fund or its portfolio investments, such as: fees for unperformed services (e.g., accelerated monitoring fees if a portfolio company investment is disposed earlier than expected);3 fees in connection with an examination or investigation of the adviser; regulatory or compliance expenses or fees of the adviser; fees or expenses related to a portfolio investment on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment.
- In respect of regulatory and compliance expenses or fees, the SEC indicated it “believe[s] advisers should bear the compliance expenses related to their registration with the Commission, including fees and expenses related to preparing and filing all items and corresponding schedules in Form ADV.” Of note, the SEC indicated that it has “seen an increase in private fund advisers charging these expenses to private fund clients” and went on to take the position that “[t]hese types of expenses, which are a cost of being an investment adviser, should not be passed on to private fund investors, whether as a separate expense (in addition to a management fee) or as part of a pass-through expense model.” However, the SEC clarified that the rule would not prohibit charging to a fund “regulatory, compliance, and other similar fees and expenses directly related to the activities of the private fund,” including costs of regulatory filings such as Form D.
- The prohibition of non-pro rata expense sharing will significantly impact the ability for a private fund to make investments in an opportunity that, due to size, strategic relationships or other reasons, would require co-investors. Because co-investors will typically bear (through the co-investment vehicle) their pro rata share of deal expenses only if an investment is consummated, many private fund documents expressly permit that the private fund may bear up to 100% of broken-deal and other expenses relating to unconsummated transactions. In practice, private fund advisers would have to pay, as a manager expense, for the pro rata portion of any broken-deal and other expenses that a co-investment vehicle would have been borne, resulting in a stark disincentive for the adviser to seek a co-investment opportunity in the first place. If enacted, this proposal would necessitate the revision of many fund documents and the inclusion of risk disclosures about the increased difficulties surrounding certain investments.
4. Borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit, from a private fund client.
- The SEC believes that “when an adviser borrows from a private fund client, that adviser has a conflict of interest because it is on both sides of the transaction (i.e., the adviser benefits from the loan and manages the client lender).” Notably, the SEC believes this practice should be prohibited even when disclosed and consented to by a Limited Partner Advisory Committee (“LPAC”) because “only certain investors with specific information or governance rights (such as representation on the LPAC) would potentially be in a position to negotiate or discuss the terms of the borrowing with the adviser, rather than all of the private fund’s investors.”
- The proposed rule would not prevent the adviser from borrowing from a third party on the fund’s behalf (e.g., a subscription facility), or from lending to the fund (e.g., for formation costs) so long as the terms do not include excessive interest rates or other abusive practices.
The SEC believes the above activities “incentivize an adviser to place its interests ahead of the private fund’s interests.” However, some prongs of this proposed rule have garnered significant attention due to the resulting prohibition of certain practices that are currently common within the industry — in particular, exculpation/indemnification prohibition for mere negligence and GP carry clawback with no reduction for the GP’s related taxes.
The Private Fund Adviser Proposals would forbid all private fund advisers (regardless of SEC registration status and regardless of such practice being fully disclosed in fund documents) from granting only to certain investors in a fund or “substantially similar pool of assets” (like a parallel fund) (i) special redemptions rights or (ii) special information rights about portfolio holdings or exposures, in each case, however, only to the extent the adviser “reasonably expects” such preferential terms to have a “material, negative effect” on the other investors in such fund or similar pool. As an example of a potentially “material, negative effect” in the context of redemptions, the SEC cited selling liquid assets to allow a preferred investor to exit the fund early and leaving the fund with less liquid assets that could impinge on executing the strategy or satisfying other redemptions. In respect of preferential transparency, the SEC did not make clear what would be a “material, negative effect.” However, the SEC did note that “selective disclosure of portfolio holdings or exposures can result in profits or avoidance of losses among those who were privy to the information beforehand at the expense of investors who did not benefit from such transparency.”
In addition to these special liquidity and information rights which are per se impermissible, the proposal would also bar all private fund advisers from granting any other preferential treatment (e.g., excuse rights, lower fees or other beneficial rights) unless imparted in advance and in detail to all current and prospective investors in the private fund or a substantially similar pool of assets. The determination of whether certain treatment qualifies as “preferential” would be based on a facts and circumstances analysis. Notice would need to be provided to prospective investors before they invest, and annually to all current investors.4
This proposal would completely transform the process by which most private fund advisers enter into side letters or similar arrangements (e.g., through different classes or shares or parallel vehicles) that offer favorable terms. In particular, it would no longer be permissible (i) to simply disclose in fund documents (with appropriate details) that there “are,” “will” or “may be” preferential terms under side letters or other arrangements nor (ii) to offer preferential terms only to certain investors pursuant to individually negotiated most favorable nation (“MFN”) clauses. Subsequent closings, especially of closed-end funds (which often have detailed and complex side letters with certain investors), would be also delayed because all preferential terms would have to be disclosed to new investors prior to the relevant closing (instead of disclosing them only post-closing and with all details only to certain eligible investors that benefit from an MFN clause).
The proposal would also result in legal uncertainty for the very typical situation of an open-end fund that offers various classes of shares that tie different liquidity terms to different fee levels. This is because there is risk any such preferential liquidity rights may later be challenged by the SEC or certain investors to reasonably be expected to have a “material, negative effect” on the other investors in such fund or similar pool. And while certain preferential terms per class may still be permissible (e.g., because the underlying investments of the fund are generally liquid so that a preferential redemption would not be reasonably expected to have a material, negative effect on the other investors), private fund advisers in a concrete redemption scenario may be forced to exercise their rights to suspend liquidity rights more often. This is due to the fear of otherwise being second guessed because they have offered preferential liquidity terms. It is further unclear how the new rule would apply to the common scenario of a private fund investing side-by-side with a separately managed account (“SMA”) that has a substantially similar or overlapping investment strategy, given that SMA clients typically benefit from full portfolio transparency and more beneficial liquidity terms as compared to the parallel private fund. If an early liquidation of assets in the SMA may adversely affect the parallel private fund and its investors, managing the SMA and private fund side-by-side may become per se prohibited.
The quarterly statement rule of the Private Fund Adviser Proposals would require SEC-registered private fund advisers (i.e., not exempt reporting advisers, nor other unregistered private fund advisers) to provide investors with a quarterly statement about the fund’s fees and expenses. The SEC claimed that investors “often lack transparency regarding the total cost” of private fund fees and expenses. Accordingly, the proposed rule includes format and content requirements intended to enhance clarity and legibility and help investors compare across different funds; however, it does not specify an exact reporting structure.
The quarterly statements, which generally must be delivered within 45 days after each quarter-end, must include: adviser compensation, fund expenses, offsets, rebates and waivers, portfolio investment compensation and private fund ownership of each portfolio investment.
Requirements also include the systematic disclosure of the way in which expenses, payments, allocations, rebates, waivers and offsets are calculated at both the fund and portfolio investment levels (not on an investor-by-investor basis). Expenses would encompass organizational, accounting, legal, administration, audit, tax, due diligence, and travel fees. They would also cover start-up and organizational fees of the fund if they were paid during the reporting period. Furthermore, the reports would have to include clear references to the corresponding sections of the private fund’s organizational and offering documents that explain the calculation methodology.
In the proposal, the SEC stated “we understand that most private fund advisers currently provide current investors with quarterly reporting,” including fee, expense and performance reporting, either pursuant to the fund documentation or contractual agreement (e.g., side letters) with the investors. “However, reports that are provided to investors may report only aggregated expenses, or may not provide detailed information about the calculation and implementation of any negotiated rebates, credits, or offsets.” The SEC went on to state that “[s]ome investors currently do not receive such detailed disclosures, and this reduces their ability to monitor the performance of their existing fund investment or to compare it with other prospective investments.” The SEC then proceeded to outline the wide variation of performance, fee and expense reporting across private fund advisers as one of the central bases for the quarterly reporting rule.
In addition, the quarterly reporting rule would require an adviser to include standardized fund performance information in each quarterly statement, with different requirements for “illiquid funds”5 and “liquid funds,” requiring private fund advisers to determine the category of their fund(s) and to comply with the performance reporting requirements applicable to such category. Closed-end funds, like most private equity, venture capital, real estate and many credit funds, which do not offer periodic redemption rights, fall under illiquid funds. Any private fund that is not an illiquid fund would be a “liquid fund”; therefore, most hedge funds would fall into the liquid fund definition.
Illiquid funds would have to report their performance based on both the internal rate of return (IRR) and a multiple of invested capital (MOIC). Liquid funds would have to report their performance based on net total return on an annual basis since the fund’s inception, over prescribed time periods and on a quarterly basis of the current year.
While these reporting requirements would increase operational costs of a fund, we expect that investors will generally welcome the increased transparency surrounding fees, expenses and performance. In addition, the industry will likely develop software tools that allow the efficient comparison of actual costs and returns of different investment products.
The private fund audit rule proposal would require an annual (and liquidation) financial statement audit of all private funds advised by SEC-registered advisers. The proposal stipulates that the audit must be performed by an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board. The proposal would ultimately require the audited financial statements to be disseminated to investors shortly after the finalization of the audit.
The proposed audit rule is based on Rule 206(4)-2, the so-called “custody rule,” adopted under the Advisers Act, and contains many similar or identical requirements. However, compliance with either rule would not automatically satisfy the requirements of the other.
The most notable difference between the two rules is the lack of choice in obtaining an audit under the proposed audit rule. Under the custody rule, an adviser of a pooled investment vehicle may obtain a surprise examination of the fund instead of an annual financial statement audit. Although most private fund advisers rely on the audit approach, they sometimes opt for a surprise examination, especially for smaller funds, or they may convert to a surprise examination during a lengthy liquidation of a fund. In each case, they typically do so to reduce accounting costs. Another example of a private fund adviser using surprise examinations is when the adviser manages separately managed accounts that are already subject to surprise examinations. In this case, the adviser and its investors are familiar with that practice. Private fund advisers complying with the proposed audit rule would not have a similar choice. They must obtain an audit in all cases and regardless whether investors may have preferred a surprise examination (e.g., for cost reasons).
Another crucial difference between the two rules is the proposed rule’s requirement of a written agreement between the adviser or the private fund and the auditor, pursuant to which the auditor would be required to notify the SEC’s Division of Examinations upon the auditor’s termination or issuance of a “modified” opinion (i.e., a qualified opinion, an adverse opinion, and a disclaimer of opinion). According to the SEC, this would harmonize the private fund audits with the surprise examination approach under the custody rule, which has a similar reporting obligation for the auditor performing the surprise examination.
The SEC acknowledges that some advisers may not have requisite control over a private fund client (e.g., in certain unaffiliated sub-adviser arrangements) to cause its financial statements to undergo an audit in a manner that would satisfy all elements of the proposed rule. Therefore, “so long as the adviser does not control the private fund and is neither controlled by6 nor under common control with the fund,” the SEC is proposing to require that an adviser take “all reasonable steps” to cause its private fund client to undergo an audit that would satisfy the rule. As one would expect, what constitutes “all reasonable steps” would depend on the facts and circumstances. One example the SEC gave that would satisfy this standard is an unaffiliated sub-adviser documenting the sub-adviser’s efforts of including (or seeking to include) the audit requirement in its sub-advisory agreement with the private fund.
The adviser-led secondaries rule proposal would require an SEC-registered private fund adviser to procure a fairness opinion in the instance of an adviser-led secondary transaction.
The SEC proposes to define adviser-led secondaries as “transactions initiated by the investment adviser or any of its related persons that offer the private fund’s investors the choice to: (i) sell all or a portion of their interests in the private fund; or (ii) convert or exchange all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.” Whether the transaction is initiated or led by the adviser would require a facts and circumstances analysis, but generally the adviser’s assistance in a secondary transaction at the unsolicited request of an investor would not constitute an adviser-led secondary transaction according to the SEC.
The independent opinion provider would comment on the fairness of the price being suggested to the investor or the private fund for any interests or assets being sold in connection with the transaction. The SEC-registered private fund adviser would also be required to supply investors with a summary of any material business relationships the adviser or any of its related persons has, or has had, with the independent opinion provider within the past two years.
The SEC believes that this rule would provide a check against “an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors” (e.g., because the adviser may have the opportunity to earn additional management fees or carried interest as a result of an asset being held by a new vehicle after the expiration of a fund’s term). While investors will benefit from a market check through the fairness opinion, the proposal would not give them the right to waive the requirement of such opinion (e.g., for cost reasons). That is notable because a closed-end fund will often have limited cash left at the time of an adviser-led secondary transaction, and it is not clear if the adviser or the investors are required to bear the related costs.
The Private Fund Adviser Proposals include amendments to the compliance rule under the Advisers Act that requires all SEC-registered advisers, including those that do not advise private funds, to maintain written documentation of their annual compliance review. The proposed rule does not enumerate specific elements that advisers must include in the written documentation of their annual review. The requirement is “intended to be flexible to allow advisers to continue to use the review procedures they have developed and found most effective.” The proposal seemingly targets the practice in which advisers receive only oral comments relating to their annual compliance review conducted by outside compliance consultants or legal counsel, thereby preventing the SEC from being able to review a written summary of potential compliance failures in an examination.
With respect to those advisers that do receive written comments from outside compliance consultants or legal counsel, the SEC indicated that any claims of attorney-client privilege or similar protections (based, e.g., on reliance on the engagement of outside compliance consultants through law firms (i.e., the Kovel Privilege)) undermines the SEC staff’s ability to conduct examinations. This signals that such protective claims are either invalid or highly disfavored in the view of the SEC. Accordingly, advisers may be well served to reevaluate whether the added cost of inserting the lawyer between the adviser and the compliance consultant will ultimately produce desired benefits.
Books and Records Rule Amendments
The Private Fund Adviser Proposals include corresponding amendments to the books and records rule under the Advisers Act that would require advisers to keep records in connection with the proposed rules. For example, the proposal would require advisers to keep a copy of any audited financial statements, along with a record of each addressee and the corresponding date(s) sent, address(es), and delivery method(s) for each such addressee.
Notably, the SEC asked for comment on whether the books and records rule should require not only SEC-registered investment advisers but also other advisers (such as exempt reporting advisers) to retain written notices in relation to disclosure of certain types of preferential treatment required under the proposed preferential treatment rules.
The Cybersecurity Proposal would require the implementation of policies and practices that are devised to address cybersecurity risks. Under the proposed rules, an SEC-registered adviser’s or fund’s cybersecurity policies and procedures generally should be tailored based on business operations, including complexity, and attendant cybersecurity risks. Further, the proposed rules would require advisers and funds, at least annually, to review and evaluate the design and effectiveness of their cybersecurity policies and procedures in order to update them “in the face of the constantly evolving cyber threats and technologies.”
The rules would require advisers to prepare a written report of each review that would at least describe the review, assessment, any control tests performed, explain the corresponding results, document any cybersecurity incident, and discuss any material changes to the policies and procedures since the date of the last report. In addition, the rules would require advisers to maintain certain books and records related to the proposed cybersecurity risk management rules and the occurrence of cybersecurity incidents.
There would also be new cybersecurity reporting requirements under the new Cybersecurity Proposal. The proposal would require advisers to further report significant cybersecurity incidents affecting the adviser, or its fund or private fund clients, to the SEC on a confidential basis through the proposed Form ADV-C. The rule would define a significant adviser cybersecurity incident as “a cybersecurity incident, or a group of related incidents, that [(A)] significantly disrupts or degrades the adviser’s ability, or the ability of a private fund client of the adviser, to maintain critical operations7 , or [(B)] leads to the unauthorized access or use of adviser information, where the unauthorized access or use of such information results in: (1) substantial harm to the adviser, or (2) substantial harm to a client, or an investor in a private fund, whose information was accessed.” An adviser would be required to submit the Form ADV-C promptly, but in no event more than 48 hours, after having a reasonable basis to conclude that a significant adviser cybersecurity incident or a significant fund cybersecurity incident had occurred or is occurring.
While Form ADV-C would be confidential and unavailable to the public, the Cybersecurity Proposal would also amend the Form ADV Part 2A to require disclosure of cybersecurity risks and incidents to an adviser’s clients and prospective clients. Such disclosure would include risks that “could materially affect the advisory services” offered by the adviser,8 and how such risks are assessed, prioritized and addressed by the adviser. Advisers would also be required to describe any cybersecurity incidents that occurred within the last two fiscal years that have “significantly disrupted or degraded the adviser’s ability to maintain critical operations, or that have led to the unauthorized access or use of adviser information, resulting in harm to the adviser or its clients.”
The proposals discussed above that were introduced on February 9, 2022, were not the only instance of significant SEC regulatory action in recent months. Major amendments to Form PF were also proposed by the SEC on January 26, 2022. The Form PF proposal would transform the reporting obligations by increasing the breadth of information required to be reported by “large” hedge fund advisers and “large” private equity fund advisers, but also adds certain, near instantaneous reports for any private equity fund adviser. The proposal would also reduce the threshold for reporting as a “large” private equity adviser from $2 billion to $1.5 billion in private equity fund assets under management.
Currently, Form PF requires certain advisers to file Form PF after their quarter- or year-ends, depending on the size and type of private funds they advise. The Form PF proposal would amend the Form PF to require current reporting of certain significant events, generally on a one business day requirement, to the SEC.
Private equity fund advisers (even if they are not “large”) would be required to file current reports within one business day of the occurrence of the following events pertaining to: the execution of adviser-led secondary transactions, the implementation of GP or limited partner clawbacks, the removal of a fund’s GP, the termination of a fund’s investment period, or the termination of a fund.9
Large hedge fund managers would be required to disclose within one business day extraordinary (defined as 20% in ten days) investment losses, significant margin/counterparty default events and other changes in prime broker relationships, changes in unencumbered cash, operations events and certain withdrawal and redemption events.
Large private equity managers would also have to provide detailed information on fund strategies, leverage, portfolio company financings and borrowings, investments in different levels of the capital structure of a portfolio company, and portfolio company restructurings or recapitalizations.
On February 10, 2022, the SEC also proposed to amend Regulation 13D-G and Regulation S-T to address, they said, information asymmetries in financial markets and to modernize the regulations under Section 13 of the Exchange Act to account for technological and financial innovations. The SEC’s proposed amendments would significantly accelerate the filing deadlines for Schedules 13D and 13G, clarify the way certain cash-settled derivatives are treated for beneficial ownership purposes, specify the way the SEC views group formation under Sections 13(d) and 13(g) of the Exchange Act, make technical changes to the electronic format of Schedules 13D and 13G, and extend the filing time to 10:00 p.m. on the deadline date. Please see Kleinberg Kaplan’s recent Client Alert on these proposals here.
While beyond the scope of this alert, proposed rule 10B-1 under the Exchange Act would require any person (including its affiliates and group members) with a security-based swap position (“SBS”) that exceeds the reporting threshold to publicly file a report on EDGAR. This report would need to be filed no later than the end of the first business day following the execution of the SBS transaction that exceeds the relevant reporting threshold amount. Amendments would need to be filed also for any material changes, including any increase of 10% or more in the position or a decrease that results in falling below the reporting threshold. These amendments would need to be filed by the end of the first business day following the material change. Schedule 10B would require disclosure of the identity of the reporting person and position and the underlying securities. The proposed reporting threshold amounts differ depending on the type of SBS acquired or traded. The threshold calculations are complicated and vary depending on the type of SBS. Investors, including private fund advisers, that trade in SBS should carefully review the proposed rule 10B-1.
Further Insights and Observations
These proposed regulations indicate a material increase in the level of scrutiny that private fund advisers face by the SEC. If passed, these rules will have significant implications on the way in which private fund advisers function and interact with investors.
However, it is important to note that some aspects of the proposals are already common among private fund advisers with sophisticated institutional clients. For example, many advisers already provide quarterly statements. Nonetheless, the form and content of these statements will likely have to be adjusted to comply with the proposed requirements. Many advisers also already prepare audited financial statements for their funds, obtain fairness opinions in connection with fund restructurings, continuation funds and other secondary transactions and document the outcome of their annual compliance program reviews. This being said, the proposals would eliminate optionality to deviate from standard market practice when warranted; for example, to structure for cost reasons a GP-led secondary with no fairness opinion or to do a surprise examination instead of an annual fund audit.
Other elements of the proposals signify new hurdles that would be both costly and time consuming for private fund advisers. For example, the proposed preferential treatment disclosure requirements will be cumbersome to implement in comparison to current practices regarding side letters, fund closing and MFN elections (which currently happen post-closing and only for investors that negotiated an MFN clause). Private fund advisers may find it useful to review existing side letters and begin considering how they will disclose preferential treatment to investors, especially for closed-end funds with multiple subsequent closings and many and very complex side letters.
Furthermore, the prohibitions on returning GP clawbacks net of taxes and exculpation/indemnification for simple negligence represent a significant deviation from current market practice. Private fund advisers should analyze their fund documentation to determine what amendments would need to be made if the rules pass as proposed. Advisers may further consider discussing D&O and E&O insurance coverage options with their brokers in advance of final rule adoption.
Exempt reporting advisers should consider the impact of any regulatory recordkeeping requirement as queried by the SEC, and such advisers may want to consider outreach to the SEC on the issue.
The changes to the Form PF would require many advisers to divulge significantly more information and the accelerated (often one business day) turnaround time would necessitate a shift in the way in which subject managers process and report this information — much more similar to the public reporting companies subject to the “current” reporting rules on Form 8-K. Fund advisers should consider the operational and reporting controls necessary to identify the triggering events contemplated by the proposed Form PF amendments.10
Private fund advisers should consider disclosing to investors (sooner rather than later) that certain of their various current practices (e.g., with respect sharing of broken-deal expenses with potential co-investors, charging accelerated monitoring fees or not refunding management fees paid in advance upon mid-period redemptions) may dramatically change and/or become restricted or prohibited altogether. Such changes may have a material adverse effect on the adviser and/or the fund client.11
Finally, asset managers (e.g., family office or certain real estate, credit fund or digital asset managers) that are currently not subject to the Advisers Act, or non-U.S. investment advisers that are still outside the scope of SEC jurisdiction, need to consider carefully what it will mean, in the rather near future, to become an investment adviser under the Advisers Act and be subject to significantly increased regulatory costs and SEC oversight.
As with any proposed rulemaking, it is difficult to predict whether the SEC’s proposals will be enacted, either in their proposed form or modified as a result of public comment; however, private fund advisers can expect that the majority of the proposals will be made effective in some form.
Accordingly, all private fund advisers — whether SEC-registered or not — should promptly and carefully consider the impact of these proposed amendments on their business. Such consideration should include reviewing fund documentation, discussions with investors regarding the impending changes and reviewing personnel and other resources for legal and compliance departments.
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2 “Prohibition Against Fraud, Manipulation, or Deception in Connection with Security-Based Swaps; Prohibition against Undue Influence over Chief Compliance Officers; Position Reporting of Large Security-Based Swap Positions,” dated December 15, 2021.
3 Though not cited in the SEC release, another example of fees for unperformed services (which are prohibited under the proposal) would be a provision that an adviser does not have to return to the fund (for the benefit of redeeming investors or all investors, as applicable) a pro rata portion of any management fee paid in advance for a month, quarter or other period during which a redemption, termination of the fund or termination of an investment management agreement occurs.
4 In discussing this change, the SEC seemed to approvingly note the effect of the EU Alternative Investment Fund Managers Directive (AIFMD)’s preferential treatment disclosure requirements on side letter practice.
5 The SEC proposed to define an illiquid fund as “a private fund that: (i) has a limited life; (ii) does not continuously raise capital; (iii) is not required to redeem interests upon an investor’s request; (iv) has as a predominant operating strategy the return of the proceeds from disposition of investments to investors; (v) has limited opportunities, if any, for investors to withdraw before termination of the fund; and (vi) does not routinely acquire (directly or indirectly) as part of its investment strategy market-traded securities and derivative instruments.” (As a technical observation, prongs (iii) and (v) of this definition appear to overlap and probably should be combined.)
6 We note that the reference of an adviser being “controlled by” the private fund results in legal uncertainty because a private fund typically does not have ownership interests in an adviser, so control would have to result from the contractual arrangement between the adviser and the fund (e.g., arguably if the fund represents a material portion of the adviser’s business).
7 The SEC views critical operations as “including investment, trading, reporting, and risk management of an adviser or fund as well as operating in accordance with the Federal securities laws.”
8 According to the SEC, “[t]he facts and circumstances relevant to determining materiality in this context may include, among other things, the likelihood and extent to which the cybersecurity risk or resulting incident: (1) could disrupt (or has disrupted) the adviser’s ability to provide services, including the duration of such a disruption; (2) could result (or has resulted) in the loss of adviser or client data, including the nature and importance of the data and the circumstances and duration in which it was compromised; and/or (3) could harm (or has harmed) clients (e.g., inability to access investments, illiquidity, or exposure of confidential or sensitive personal or business information).”
9 While this instantaneous one-day reporting refers to certain unusual events (e.g., GP clawback and removal of a GP), others are events that occur in the usual life cycle of any private equity fund (e.g., end of investment period and termination of fund), which seems odd because the SEC justifies the new ad hoc reporting with the need to get “timely information about certain events that may signal distress.”
10 Though not applicable to all private fund managers, in addition, the SEC enumeration of investments at different levels of a capital structure signals an enhanced SEC focus on conflicts arising from such multi-layered investments in the same portfolio company.
11 For example, existing preferential fee and liquidity terms may be challenged by the SEC or other investors and compliance costs (and risks of breach) will increase generally for the adviser and the fund.
12 The authors would like to thank Fiona Danieu for her important contributions to this alert.