Overview

A Significant Transformation in SEC Regulation

In recent weeks, the U.S. Securities and Exchange Commission (the "SEC") has kicked off a wholesale transformation in the regulation of the private funds industry. These actions include rule proposals, enforcement actions, and SEC Staff guidance that, taken together, represent a shift to direct regulation on a scale never seen before in this segment of the industry.

Use of this Presentation

To aid our clients and friends in preparing for these impending changes, this presentation provides highlights of some key points of the SEC's proposals and other transformative actions. It is intended to provide legal and compliance personnel, as well as investment and operations personnel, with a practical way to understand how the SEC's rapidly evolving regulatory agenda will impact private fund managers.

While it is too early to predict exactly what steps will be required, we do expect most of the proposed changes to be adopted. As a result, it is likely that all private fund managers will need to take at least some of the following steps:

  • Specific assessments of the impact of these proposed changes on their businesses;
  • Careful and extensive reviews of offering documents, fund organizational documents, and management agreements;
  • Discussions with investors and clients on the impending changes; and
  • Reviews of staffing levels in and other resources available to legal and compliance

Unlike many rulemakings, some of these momentous changes apply to investment advisers that are not required to be registered with the SEC (e.g., exempt reporting advisers), so these actions will need to be undertaken by a large number of managers.

 

"Hedge Clauses," Liability Limitations, and Fiduciary Status

Hedge Clauses and Fiduciary Standards

"Hedge clauses" (provisions in an advisory agreement that purport to limit an adviser's liability) are a direct focus of the Risk Alert and also of the Private Funds Proposal's "Prohibited Activities" (the "Prohibited Activities Proposal").

  • The Risk Alert cited advisers that included "potentially misleading hedge clauses" that "purported to waive or limit the Advisers Act fiduciary duty except for certain "
  • The SEC also recently brought an enforcement action against an investment adviser premised on allegations that a "hedge clause" misled retail clients.

This focus is based on the SEC's view that advisers are subject to a "federal fiduciary duty" and language in the 2019 Fiduciary Interpretation, which acknowledged that a manager's "fiduciary duty must be viewed in the context of the agreed-upon scope of the relationship between the adviser and the client" but expressly prohibited, "regardless of the sophistication of the client," contract provisions such as:

  • a statement that an adviser will not act as a fiduciary;
  • a blanket waiver of all of an adviser's conflicts of interest; and
  • a waiver of any specific obligation under the Advisers Act.

Comprehensive Capital

In the recent Comprehensive Capital Management case, the SEC took issue with a limitation of liability utilized in investment management agreements with retail clients.

  • The hedge clause (revised after an earlier version was criticized on examination) stated that the adviser:
    • "will be liable only for ... acts of gross negligence or willful misconduct;"
    • "will not be liable for any act or omission by brokers or other agents selected with "reasonable care;" and
    • "will not be liable for any incidental, indirect, special, punitive or consequential damages,"

subject to a savings clause stating that federal and state securities laws may "impose liability on persons who act in good faith and nothing in this Agreement shall serve to waive or limit any rights Client may have under those laws."

  • The SEC determined that the agreement's hedge clause was "inconsistent with an adviser's fiduciary duty" and with the Fiduciary Interpretation "because it may mislead CCM's retail clients into not exercising their legal "
  • The SEC order also asserted that the agreement's statement that CCM will be liable only for its "own acts of gross negligence or willful misconduct" was "an inaccurate statement of the liability standards under the federal securities laws as they apply to investment advisers" and, accordingly, violated Section 206(2) of the Advisers

While the SEC order emphasized the fact that CCM's client base was primarily retail, the prohibitions in the Prohibited Activities Proposal would not be limited to retail clients.

Prohibited Activities Proposal

The positions taken in Comprehensive Capital were echoed in the January Risk Alert, where the Division of Examinations asserted that:

Whether a clause in an agreement, or a statement in disclosure documents provided to clients and investors, that purports to limit an adviser's liability (a "hedge clause") is misleading and would violate Sections 206(1) and 206(2) of the Advisers Act depends on all of the surrounding facts and circumstances. EXAMS staff observed private fund advisers that included potentially misleading hedge clauses in documents that purported to waive or limit the Advisers Act fiduciary duty except for certain exceptions, such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud. Such clauses could be inconsistent with Sections 206 [an anti-fraud provision] and 215(a) [validity of contracts that purport to effect impermissible waivers] of the Advisers Act.

This focus on narrowing hedge clauses and agreed-upon limitations on liability ultimately culminated in the Prohibited Activities Proposal, which proposes a categorical prohibition on manager 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.

Implications and Next Steps

Implications

  • Expect intense SEC focus on all hedge clauses and liability
  • Prepare for a special focus on hedge clauses in IMAs with retail clients, but note that the Prohibited Activities Proposal would apply to all
  • The Prohibited Activities Proposal could have a large impact on insurance products for managers, in terms of impacting both the cost and the availability of liability insurance
  • The Prohibited Activities Proposal could result in a potential private right of action in contract law.

Next Steps

  • Identify all hedge clauses and limitations of liability in fund PPMs, LPAs and other constituent
  • Review all investment management agreements with retail
  • Consider communicating the adverse impacts on the industry and investors from adoption of the Prohibited Activities Proposal.

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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.