New SEC private funds rules will create new burdens and uncertainty for managers, writes George Mazin an independent US based consultant at Paradigm Governance Partners
On August 23, 2023, the US Securities and Exchange Commission (SEC), adopted new rules (the Final Rules) regarding the regulation of private fund advisors. The adoption follows a protracted period of more than 18 months in which the Commission evaluated multiple comments submitted in response to the original rule proposal filed on February 9, 2022.
In its press release, the SEC announced that the Final Rules are designed to protect private fund investors by increasing transparency, competition and efficiency in the private funds market. In its adopting release, the SEC noted that the Final Rules are designed to protect investors who directly or indirectly invest in private funds by increasing visibility into certain practices involving compensation schemes, sales practices, and conflicts of interest through disclosure; establishing requirements to address such practices that have the potential to lead to investor harm; and restricting practices that are contrary to the public interest and the protection of investors.
The adoption of the Final Rules reflects another incremental change in the regulation of private funds and their advisers by bringing the regulation of private funds in the United States closer to the more highly regulated regime in place for the regulation of mutual funds, which are generally marketed to retail investors.
Importantly, the Final Rules incorporate significant changes from the original proposal and reflect the Commission’s response to the significant number of comments received in opposition to the Rules, as well as the impact of intense lobbying by private fund participants. The original Rule Proposal included a number of prescriptive provisions which would have prohibited advisers to private funds from engaging in a variety of practices. For example, the original Proposed Rule would have imposed a flat prohibition on providing preferential redemption terms to an investor or providing greater portfolio transparency.
In the Final Rules, such preferential terms are not prohibited, but the same terms must be offered to all other investors. While the Final Rules continue to attract significant opposition from the industry, the SEC has modified a number of the proposed prescriptive provisions and replaced them with a more traditional approach, which mandates detailed disclosure to investors, and in some cases, the obtaining the consent of investors.
This approach is more consistent with the manner in which private funds in the United States have historically been regulated. Based on the requirement that that private funds can only be marketed to sophisticated investors, who can make their own investment decisions in evaluating the merits and risks of the investment and can afford to bear the loss of their investment, the regime requires detailed and accurate disclosure to prospective and current investors and, in some cases, investor consent.
Notwithstanding these changes, significant opposition persists and on September 1, 2023, a coalition of six trade associations filed a lawsuit with the Federal Court of Appeals in the Fifth Circuit challenging the validity and enforceability of the Final Rules. The Petition asserts that the Final Rules “exceed the Commission’s statutory authority, were adopted without compliance with notice and comment requirements, and are otherwise arbitrary, capricious, an abuse of discretion, and contrary to law”.
At this early stage, it is unclear whether the filing will pause the Rules’ transition periods, or otherwise delay their compliance dates. Any such stay could occur by court order, if requested by any of the parties, or by SEC action. Interestingly, the Petition was filed in the Fifth Circuit, which includes Texas and other southern states, a judicial district that has been more friendly to challenges to federal regulations, compared to the DC Circuit.
Applicability of the Rules
Only a very brief overview of some of the key proposed changes is possible in a brief article. Moreover, the Rules are complex in their application, with applicability and compliance dates varying, in some cases, based on (i) the value of the private fund assets under management by the advisor, (ii) whether the advisor is a US registered adviser or exempt advisor, and whether advisor has US clients, or is located in the United States, (iii) whether the advisor is entitled to rely on certain grandfathering provisions with respect to existing funds, and (iv) whether the fund being managed is a liquid or illiquid fund.
Following below is a brief summary of some of the more significant changes:
More favorable redemption terms and preferential portfolio transparency, if such rights would be expected to have a material negative effect on other investors, must be offered to all investors. In the case of preferential material economic terms, notice of the relevant terms provided to another investor must be provided to all other investors as soon as practicable after the investor receiving the more favorable terms makes its investment, with notice of all preferential economic terms granted to date to investors disclosed on an annual basis.
Fees and Expenses
Fees and expenses incurred by an advisor and associated with a governmental or regulatory investigation may not be paid by an advised fund without the consent of a majority in interest of unaffiliated investors, and if the investigation results in the finding of a violation of applicable law, the fees and expenses may not be passed through to the fund. Deal-related expenses must be allocated pro rata among all participating funds and other accounts, unless a non pro rata allocation is fair and equitable and has been disclosed to investors in advance.
Clawback of Carry.
A general partner’s clawback liability may not be reduced by taxes paid or payable by the general partner on the carry received, unless notice is provided to investors, which specifies the amount or the clawback, both before and after giving effect to the tax offset.
An advisor may not borrow from a private fund client unless a description of the material terms of the borrowing is provided to investors and consent to the borrowing is received from a majority in interest of investors who are not related to the advisor.
Quarterly Statement Rule.
The advisor must provide statements to investors on a quarterly basis which disclose (i) line-item disclosure of all advisor compensation, fees and other amounts received by the advisor for the relevant quarter, (ii) line item disclosure by category of all fund level fees and expenses other than manager compensation, and (iii) all offsets, rebates and waivers. Sufficient detail must be provided on the manner in which each item has been calculated, together with a cross reference to the section of the fund’s governing documents which authorize the fund to incur the expense.
There are separate rules for liquid and illiquid funds with respect to the manner in which fund performance must be disclosed to investors. In the case of liquid funds, annual net returns must be disclosed for each of the prior ten years, or since inception, if less than ten years. In addition, average annual net returns must be provided for one, five and ten year periods. Finally, the cumulative net total returns must be provided for the relevant quarter and year to date.
In addition to the foregoing, there are rules, among others, relating to (i) disclosure and consent requirements for adviser led secondary transactions in which investors are asked to redeem their interest for cash, or to transfer their interest to another related fund, and (ii) fund audit requirements.
Currently, it is impossible to predict whether the challenge to the Rules will be successful, or whether the effective dates of the Rules will be delayed. At the same time, affected advisors will need significant lead time to implement the changes and will be required make a meaningful investment to develop systems necessary to capture the information required to be disclosed to investors, along with processes to prepare reports in a format which complies with the rules and will need to review all existing fund documents to determine the adequacy of current investor disclosure. Of course, advisors would be well advised to continue to closely monitor ongoing developments in the litigation, as well as future pronouncements by the SEC, to be sure they are in position to comply with whatever may come down the road.